SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
/X/ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the quarterly period ended SEPTEMBER 30, 2006
or
/ / Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the transition period from ______________ to ______________
Commission File Number 1-3548
ALLETE, INC.
(Exact name of registrant as specified in its charter)
MINNESOTA 41-0418150
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
30 WEST SUPERIOR STREET
DULUTH, MINNESOTA 55802-2093
(Address of principal executive offices)
(Zip Code)
(218) 279-5000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months and (2) has been subject to such filing requirements for
the past 90 days. /X/ Yes / / No
Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of
the Exchange Act).
Large Accelerated Filer /X/ Accelerated Filer / / Non-Accelerated Filer / /
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). / / Yes /X/ No
Common Stock, no par value,
30,381,209 shares outstanding
as of September 30, 2006
INDEX
Page
Definitions 2
Safe Harbor Statement Under the Private Securities Litigation
Reform Act of 1995 3
Part I. Financial Information
Item 1. Financial Statements
Consolidated Balance Sheet -
September 30, 2006 and December 31, 2005 4
Consolidated Statement of Income -
Quarter and Nine Months Ended September 30, 2006
and 2005 5
Consolidated Statement of Cash Flows -
Nine Months Ended September 30, 2006 and 2005 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 24
Item 3. Quantitative and Qualitative Disclosures about
Market Risk 39
Item 4. Controls and Procedures 40
Part II. Other Information
Item 1. Legal Proceedings 41
Item 1A. Risk Factors 41
Item 2. Unregistered Sales of Equity Securities and
Use of Proceeds 41
Item 3. Defaults Upon Senior Securities 41
Item 4. Submission of Matters to a Vote of Security Holders 41
Item 5. Other Information 41
Item 6. Exhibits 43
Signatures 44
1 ALLETE Third Quarter 2006 Form 10-Q
DEFINITIONS
The following abbreviations or acronyms are used in the text. References in this
report to "we," "us" and "our" are to ALLETE, Inc. and its subsidiaries,
collectively.
ABBREVIATION OR ACRONYM TERM
--------------------------------------------------------------------------------
2005 Form 10-K ALLETE's Annual Report on Form 10-K for
the Year Ended December 31, 2005
ADESA ADESA, Inc.
ALLETE ALLETE, Inc.
ALLETE Properties ALLETE Properties, LLC
AREA Arrowhead Regional Emission Abatement Plan
ATC American Transmission Company LLC
BNI Coal BNI Coal, Ltd.
Boswell Boswell Energy Center
Company ALLETE, Inc. and its subsidiaries
Constellation Energy Commodities Constellation Energy Commodities Group, Inc.
DOC Minnesota Department of Commerce
Enventis Telecom Enventis Telecom, Inc.
EITF Emerging Issues Task Force Issue No.
EPA Environmental Protection Agency
ESOP Employee Stock Ownership Plan
FASB Financial Accounting Standards Board
FERC Federal Energy Regulatory Commission
Florida Water Florida Water Services Corporation
FSP Financial Accounting Standards Board Staff
Position
GAAP Accounting Principles Generally Accepted in
the United States of America
Hibbard Hibbard Energy Center
Laskin Laskin Energy Center
Minnesota Power An operating division of ALLETE, Inc.
Minnkota Power Minnkota Power Cooperative, Inc.
MISO Midwest Independent Transmission System
Operator, Inc.
MPCA Minnesota Pollution Control Agency
MPUC Minnesota Public Utilities Commission
MW Megawatt(s)
Note ___ Note ___ to the consolidated financial
statements in this Form 10-Q
NOx Nitrogen Oxide
Palm Coast Park Palm Coast Park development project in
northeast Florida
Palm Coast Park District Palm Coast Park Community Development
District
PSCW Public Service Commission of Wisconsin
Rainy River Energy Rainy River Energy Corporation
Resource Plan Integrated Resource Plan
SEC Securities and Exchange Commission
SFAS Statement of Financial Accounting
Standards No.
SO2 Sulfur Dioxide
Square Butte Square Butte Electric Cooperative
SWL&P Superior Water, Light and Power Company
Taconite Harbor Taconite Harbor Energy Center
Town Center Town Center at Palm Coast development
project in northeast Florida
Town Center District Town Center at Palm Coast Community
Development District
WDNR Wisconsin Department of Natural Resources
ALLETE Third Quarter 2006 Form 10-Q 2
SAFE HARBOR STATEMENT
UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
In connection with the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995, we are hereby filing cautionary statements
identifying important factors that could cause our actual results to differ
materially from those projected in forward-looking statements (as such term is
defined in the Private Securities Litigation Reform Act of 1995) made by or on
behalf of ALLETE in this Quarterly Report on Form 10-Q, in presentations, in
response to questions or otherwise. Any statements that express, or involve
discussions as to, expectations, beliefs, plans, objectives, assumptions or
future events or performance (often, but not always, through the use of words or
phrases such as "anticipates," "believes," "estimates," "expects," "intends,"
"plans," "projects," "will likely result," "will continue," "could," "may,"
"potential," "target," "outlook" or similar expressions) are not statements of
historical facts and may be forward-looking.
Forward-looking statements involve estimates, assumptions, risks and
uncertainties, which are beyond our control and may cause actual results or
outcomes to differ materially from those that may be projected. These statements
are qualified in their entirety by reference to, and are accompanied by, the
following important factors, in addition to any assumptions and other factors
referred to specifically:
- our ability to successfully implement our strategic objectives;
- our ability to manage expansion and integrate acquisitions;
- prevailing governmental policies and regulatory actions, including those
of the United States Congress, state legislatures, the FERC, the MPUC, the
PSCW, and various local and county regulators, and city administrators,
about allowed rates of return, financings, industry and rate structure,
acquisition and disposal of assets and facilities, real estate development,
operation and construction of plant facilities, recovery of purchased power
and capital investments, present or prospective wholesale and retail
competition (including but not limited to transmission costs), and zoning
and permitting of land held for resale;
- effects of restructuring initiatives in the electric industry;
- economic and geographic factors, including political and economic risks;
- changes in and compliance with environmental and safety laws and policies;
- weather conditions;
- natural disasters and pandemic diseases;
- war and acts of terrorism;
- wholesale power market conditions;
- competition for viable real estate for development purposes;
- population growth rates and demographic patterns;
- effects of competition, including competition for retail and wholesale
customers;
- pricing and transportation of commodities;
- changes in tax rates or policies or in rates of inflation;
- unanticipated project delays or changes in project costs;
- unanticipated changes in operating expenses and capital expenditures;
- global and domestic economic conditions;
- our ability to access capital markets;
- changes in interest rates and the performance of the financial markets;
- our ability to replace a mature workforce, and retain qualified, skilled
and experienced personnel; and
- the outcome of legal and administrative proceedings (whether civil or
criminal) and settlements that affect the business and profitability of
ALLETE.
Additional disclosures regarding factors that could cause our results and
performance to differ from results or performance anticipated by this report are
discussed under the heading "Risk Factors" in Part I, Item 1A of our 2005 Form
10-K and Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarter
ended March 31, 2006. Any forward-looking statement speaks only as of the date
on which such statement is made, and we undertake no obligation to update any
forward-looking statement to reflect events or circumstances after the date on
which that statement is made or to reflect the occurrence of unanticipated
events. New factors emerge from time to time, and it is not possible for
management to predict all of these factors, nor can it assess the impact of each
of these factors on the businesses of ALLETE or the extent to which any factor,
or combination of factors, may cause actual results to differ materially from
those contained in any forward-looking statement. Readers are urged to carefully
review and consider the various disclosures made by us in this Form 10-Q and in
our other reports filed with the SEC that attempt to advise interested parties
of the factors that may affect our business.
3 ALLETE Third Quarter 2006 Form 10-Q
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ALLETE
CONSOLIDATED BALANCE SHEET
MILLIONS - UNAUDITED
SEPTEMBER 30, DECEMBER 31,
2006 2005
-------------------------------------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash and Cash Equivalents $ 51.4 $ 89.6
Short-Term Investments 121.6 116.9
Accounts Receivable (Less Allowance of $1.0 for 2006 and 2005) 61.4 79.1
Inventories 43.1 33.1
Prepayments and Other 23.6 23.8
Deferred Income Taxes 7.4 31.0
Discontinued Operations - 0.4
-------------------------------------------------------------------------------------------------------------------
Total Current Assets 308.5 373.9
Property, Plant and Equipment - Net 877.9 860.4
Investments 165.1 117.7
Other Assets 49.4 44.6
Discontinued Operations - 2.2
-------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $1,400.9 $1,398.8
-------------------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Current Liabilities
Accounts Payable $ 27.8 $ 44.7
Accrued Taxes 17.9 19.1
Accrued Interest 4.8 7.4
Long-Term Debt Due Within One Year 1.7 2.7
Deferred Profit on Sales of Real Estate 9.5 8.6
Other 20.9 24.2
Discontinued Operations - 13.0
-------------------------------------------------------------------------------------------------------------------
Total Current Liabilities 82.6 119.7
Long-Term Debt 385.2 387.8
Deferred Income Taxes 134.3 138.4
Other Liabilities 147.0 144.1
Minority Interest 6.0 6.0
-------------------------------------------------------------------------------------------------------------------
Total Liabilities 755.1 796.0
-------------------------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES
-------------------------------------------------------------------------------------------------------------------
SHAREHOLDERS' EQUITY
Common Stock Without Par Value, 43.3 Shares Authorized,
30.4 and 30.1 Shares Outstanding 435.0 421.1
Unearned ESOP Shares (73.5) (77.6)
Accumulated Other Comprehensive Loss (12.2) (12.8)
Retained Earnings 296.5 272.1
-------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 645.8 602.8
-------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $1,400.9 $1,398.8
-------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of these statements.
ALLETE Third Quarter 2006 Form 10-Q 4
ALLETE
CONSOLIDATED STATEMENT OF INCOME
MILLIONS EXCEPT PER SHARE AMOUNTS - UNAUDITED
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2006 2005 2006 2005
-------------------------------------------------------------------------------------------------------------------
OPERATING REVENUE $199.1 $177.4 $569.9 $545.1
-------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Fuel and Purchased Power 79.5 65.4 211.9 201.9
Operating and Maintenance 68.7 67.4 220.0 211.8
Kendall County Charge - - - 77.9
Depreciation 12.2 11.9 36.6 35.7
-------------------------------------------------------------------------------------------------------------------
Total Operating Expenses 160.4 144.7 468.5 527.3
-------------------------------------------------------------------------------------------------------------------
OPERATING INCOME FROM CONTINUING OPERATIONS 38.7 32.7 101.4 17.8
-------------------------------------------------------------------------------------------------------------------
OTHER INCOME (EXPENSE)
Interest Expense (7.3) (6.6) (20.1) (20.1)
Other 3.7 0.4 8.8 (2.3)
-------------------------------------------------------------------------------------------------------------------
Total Other Expense (3.6) (6.2) (11.3) (22.4)
-------------------------------------------------------------------------------------------------------------------
INCOME (LOSS) FROM CONTINUING OPERATIONS
BEFORE MINORITY INTEREST AND INCOME TAXES 35.1 26.5 90.1 (4.6)
MINORITY INTEREST 1.1 1.0 3.2 2.4
-------------------------------------------------------------------------------------------------------------------
INCOME (LOSS) FROM CONTINUING OPERATIONS
BEFORE INCOME TAXES 34.0 25.5 86.9 (7.0)
INCOME TAX EXPENSE (BENEFIT) 12.1 9.7 32.6 (0.4)
-------------------------------------------------------------------------------------------------------------------
INCOME (LOSS) FROM CONTINUING OPERATIONS 21.9 15.8 54.3 (6.6)
LOSS FROM DISCONTINUED OPERATIONS - NET OF TAX (0.1) (0.6) (0.5) (1.1)
-------------------------------------------------------------------------------------------------------------------
NET INCOME (LOSS) $ 21.8 $ 15.2 $ 53.8 $ (7.7)
-------------------------------------------------------------------------------------------------------------------
AVERAGE SHARES OF COMMON STOCK
Basic 27.8 27.4 27.7 27.3
Diluted 27.9 27.5 27.8 27.3
-------------------------------------------------------------------------------------------------------------------
BASIC EARNINGS (LOSS) PER SHARE OF COMMON STOCK
Continuing Operations $0.78 $0.58 $1.96 $(0.24)
Discontinued Operations - (0.02) (0.02) (0.04)
-------------------------------------------------------------------------------------------------------------------
$0.78 $0.56 $1.94 $(0.28)
-------------------------------------------------------------------------------------------------------------------
DILUTED EARNINGS (LOSS) PER SHARE OF COMMON STOCK
Continuing Operations $0.78 $0.58 $1.95 $(0.24)
Discontinued Operations - (0.02) (0.02) (0.04)
-------------------------------------------------------------------------------------------------------------------
$0.78 $0.56 $1.93 $(0.28)
-------------------------------------------------------------------------------------------------------------------
DIVIDENDS PER SHARE OF COMMON STOCK $0.3625 $0.3150 $1.0875 $0.9300
-------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of these statements.
5 ALLETE Third Quarter 2006 Form 10-Q
ALLETE
CONSOLIDATED STATEMENT OF CASH FLOWS
MILLIONS - UNAUDITED
NINE MONTHS ENDED
SEPTEMBER 30,
2006 2005
-------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net Income (Loss) $ 53.8 $ (7.7)
Loss from Discontinued Operations 0.5 1.1
Income from Equity Investments (0.2) -
Loss on Impairment of Investments - 5.1
Depreciation 36.6 35.7
Deferred Income Taxes 19.3 (37.5)
Minority Interest 3.2 2.4
Stock Compensation Expense 1.4 1.1
Bad Debt Expense 0.4 0.8
Changes in Operating Assets and Liabilities
Accounts Receivable 17.3 18.5
Inventories (10.0) (3.8)
Prepayments and Other 0.2 (0.6)
Accounts Payable (13.5) (7.3)
Other Current Liabilities (6.3) 4.3
Other Assets (4.8) 5.9
Other Liabilities 5.7 9.1
Net Operating Activities for Discontinued Operations (13.1) (6.4)
-------------------------------------------------------------------------------------------------------------------
Cash from Operating Activities 90.5 20.7
-------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Proceeds from Sale of Available-For-Sale Securities 483.9 323.5
Payments for Purchase of Available-For-Sale Securities (488.6) (241.0)
Changes to Investments (35.3) (5.0)
Additions to Property, Plant and Equipment (53.3) (37.1)
Other (10.5) (2.2)
Net Investing Activities from (for) Discontinued Operations 2.2 (4.2)
-------------------------------------------------------------------------------------------------------------------
Cash from (for) Investing Activities (101.6) 34.0
-------------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Issuance of Common Stock 12.5 17.0
Issuance of Long-Term Debt 77.8 35.0
Payments of Long-Term Debt (81.4) (36.4)
Dividends on Common Stock and Distributions to Minority Shareholders (32.6) (24.9)
Net Decrease in Book Overdrafts (3.4) -
Net Financing Activities for Discontinued Operations - (0.1)
-------------------------------------------------------------------------------------------------------------------
Cash for Financing Activities (27.1) (9.4)
-------------------------------------------------------------------------------------------------------------------
CHANGE IN CASH AND CASH EQUIVALENTS (38.2) 45.3
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 89.6 46.1
-------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 51.4 $ 91.4
-------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL CASH FLOW INFORMATION
Cash Paid During the Period for
Interest - Net of Amounts Capitalized $32.9 $28.5
Income Taxes $41.2 $23.9
-------------------------------------------------------------------------------------------------------------------
Included $1.2 million of cash from Discontinued Operations at December 31, 2004.
The accompanying notes are an integral part of these statements.
ALLETE Third Quarter 2006 Form 10-Q 6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The accompanying unaudited consolidated financial statements and notes should be
read in conjunction with our 2005 Form 10-K. In our opinion, all adjustments
necessary for a fair statement of the results for the interim periods have been
made. The results of operations for an interim period are not necessarily
indicative of the results to be expected for the full year.
NOTE 1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
Certain reclassifications have been made to prior years' amounts to conform to
current year classifications. We revised our Consolidated Statement of Cash
Flows for the nine months ended September 30, 2005, to reconcile Net Income to
Cash from Operating Activities. Previously, we reconciled Income from Continuing
Operations to Cash from Operating Activities. In addition, we have reclassified
certain amounts in our balance sheet, statement of income, statement of cash
flows and segment information to reflect discontinued operations treatment for
our telecommunications business, which we sold in December 2005. These
reclassifications had no effect on previously reported consolidated net income,
shareholders' equity, comprehensive income or cash flows.
INVENTORIES. Inventories are stated at the lower of cost or market. Cost is
determined by the average cost method.
SEPTEMBER 30, DECEMBER 31,
INVENTORIES 2006 2005
--------------------------------------------------------------------------------
MILLIONS
Fuel $19.2 $11.0
Materials and Supplies 23.9 22.1
--------------------------------------------------------------------------------
Total Inventories $43.1 $33.1
--------------------------------------------------------------------------------
STOCK-BASED COMPENSATION EXPENSE. Effective January 1, 2006, we adopted the fair
value recognition provisions of SFAS 123R, "Share-Based Payment," using the
modified prospective transition method. Under this method, we recognize
compensation expense for all share-based payments granted after January 1, 2006,
and those granted prior to but not yet vested as of January 1, 2006. Under the
fair value recognition provisions of SFAS 123R, we recognize stock-based
compensation net of an estimated forfeiture rate and only recognize compensation
expense for those shares expected to vest over the required service period of
the award. Prior to our adoption of SFAS 123R, we accounted for share-based
payments under Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees" and related interpretations.
STOCK INCENTIVE PLAN. Under our Executive Long-Term Incentive Compensation Plan,
share-based awards may be issued to employees via a broad range of methods,
including non-qualified and incentive stock options, performance shares,
performance units, restricted stock, stock appreciation rights and other awards.
There are 3.2 million shares of common stock reserved for issuance under the
plan, with 1.5 million of these shares available for issuance as of September
30, 2006. We currently have the following types of share-based awards
outstanding:
NON-QUALIFIED STOCK OPTIONS. The options allow for the purchase of shares
of common stock at a price equal to the market value of our common stock at
the date of grant. Options become exercisable beginning one year after the
grant date, with one-third vesting each year over three years. Options may
be exercised up to ten years following the date of grant. In the case of
qualified retirement, death or disability, options vest immediately and the
period over which the options can be exercised is shortened. Employees have
up to three months to exercise vested options upon voluntary termination or
involuntary termination without cause. All options are cancelled upon
termination for cause. All options vest immediately upon a change of
control, as defined in the award agreement. We determine the fair value of
options using the Black-Scholes option-pricing model. The estimated fair
value of options, including the effect of estimated forfeitures, is
recognized as expense on the straight-line basis over the options' vesting
periods.
7 ALLETE Third Quarter 2006 Form 10-Q
NOTE 1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (Continued)
The following assumptions were used in determining the fair value of stock
options granted during the first nine months of 2006, under the
Black-Scholes option-pricing model:
2006
----------------------------------------------------------------------------
Risk-Free Interest Rate 4.5%
Expected Life 5 Years
Expected Volatility 20%
Dividend Growth Rate 5%
----------------------------------------------------------------------------
The risk-free interest rate for periods within the contractual life of the
option is based on the U.S. Treasury yield curve in effect at the grant
date. Expected volatility is based on the historic volatility of our stock
and the stock of our peer group companies. We utilize historical option
exercise and employee termination data to estimate the option life.
Dividend growth rate is based upon historic growth rates in our dividends.
PERFORMANCE SHARES. Under these awards, the number of shares earned is
contingent upon attaining specific performance targets over a three-year
performance period. In the case of qualified retirement, death or
disability during a performance period, a pro-rata portion of the award
will be earned at the conclusion of the performance period based on the
performance goals achieved. In the case of termination of employment for
any reason other than qualified retirement, death or disability, no award
will be earned. If there is a change in control, a pro-rata portion of the
award will be paid based on the greater of actual performance up to the
date of the change in control or target performance. The fair value of
these awards is equal to the grant date fair value which is estimated based
upon the assumed share-based payment three years from the date of grant.
Compensation cost is recognized over the three-year performance period
based on our estimate of the number of shares which will be earned by the
award recipients.
EMPLOYEE STOCK PURCHASE PLAN (ESPP). Under our ESPP, eligible employees may
purchase ALLETE common stock at a 5 percent discount from the market price.
Because the discount is not greater than 5 percent, we are not required by SFAS
123R to apply fair value accounting to these awards.
RETIREMENT SAVINGS AND STOCK OWNERSHIP PLAN (RSOP). Shares held in our RSOP are
excluded from SFAS 123R and are accounted for in accordance with the American
Institute of Certified Public Accountants' Statement of Position No. 93-6,
"Employers' Accounting for Employee Stock Ownership Plans."
The following share-based compensation expense amounts were recognized in our
consolidated statement of income for the periods presented since our adoption of
SFAS 123R.
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
SHARE-BASED COMPENSATION EXPENSE 2006 2006
-------------------------------------------------------------------------------------------------------------------
MILLIONS
Stock Options $0.2 $0.6
Performance Shares 0.2 0.8
-------------------------------------------------------------------------------------------------------------------
Total Share-Based Compensation Expense $0.4 $1.4
-------------------------------------------------------------------------------------------------------------------
Income Tax Benefit $0.2 $0.6
-------------------------------------------------------------------------------------------------------------------
There were no significant capitalized stock-based compensation costs at
September 30, 2006.
As of September 30, 2006, the total compensation cost for nonvested awards not
yet recognized in our statements of income was $1.8 million. This amount is
expected to be recognized over a weighted-average period of 1.23 years.
ALLETE Third Quarter 2006 Form 10-Q 8
NOTE 1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The following table presents the pro forma effect of stock-based compensation
had we applied the provisions of SFAS 123 for the quarter and nine months ended
September 30, 2005.
QUARTER ENDED NINE MONTHS ENDED
PRO FORMA EFFECT OF SFAS 123 SEPTEMBER 30, SEPTEMBER 30,
ACCOUNTING FOR STOCK-BASED COMPENSATION 2005 2005
-------------------------------------------------------------------------------------------------------------------
MILLIONS EXCEPT PER SHARE AMOUNTS
Net Income (Loss)
As Reported $15.2 $(7.7)
Plus: Employee Stock Compensation Expense
Included in Net Loss - Net of Tax 0.5 1.1
Less: Employee Stock Compensation Expense
Determined Under SFAS 123 - Net of Tax 0.5 1.2
-------------------------------------------------------------------------------------------------------------------
Pro Forma Net Income (Loss) $15.2 $(7.8)
-------------------------------------------------------------------------------------------------------------------
Basic Earnings (Loss) Per Share
As Reported $0.56 $(0.28)
Pro Forma $0.56 $(0.29)
Diluted Earnings (Loss) Per Share
As Reported $0.56 $(0.28)
Pro Forma $0.56 $(0.29)
-------------------------------------------------------------------------------------------------------------------
In the previous table, the expense determined under SFAS 123 for employee stock
options granted was calculated using the Black-Scholes option-pricing model with
the following assumptions:
2005
-------------------------------------------------------------------------------------------------------------------
Risk-Free Interest Rate 3.7%
Expected Life 5 Years
Expected Volatility 20%
Dividend Growth Rate 5%
-------------------------------------------------------------------------------------------------------------------
The following table presents information regarding our outstanding stock options
for the nine months ended September 30, 2006.
WEIGHTED-AVERAGE
WEIGHTED-AVERAGE AGGREGATE REMAINING
NUMBER OF EXERCISE INTRINSIC CONTRACTUAL
SHARES PRICE VALUE TERM
------------------------------------------------------------------------------------------------------------------
MILLIONS
Outstanding at December 31, 2005 357,827 $34.29 $3.5 7.4 years
Granted 115,653 $44.15
Exercised (26,798) $26.27
Forfeited or Expired (6,233) $38.25
------------------------------------------------------------------------------------------------------------------
Outstanding at September 30, 2006 440,449 $37.31 $2.8 7.4 years
------------------------------------------------------------------------------------------------------------------
Exercisable at September 30, 2006 240,738 $33.15 $2.5 6.4 years
------------------------------------------------------------------------------------------------------------------
The weighted-average grant-date fair value of options was $6.49 for the nine
months ended September 30, 2006. The intrinsic value of a stock award is the
amount by which the fair value of the underlying stock exceeds the exercise
price of the award. The total intrinsic value of options exercised was $0.5
million during the nine months ended September 30, 2006.
9 ALLETE Third Quarter 2006 Form 10-Q
NOTE 1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The following table presents information regarding our nonvested performance
shares for the nine months ended September 30, 2006.
WEIGHTED-AVERAGE
NUMBER OF GRANT DATE
SHARES FAIR VALUE
-------------------------------------------------------------------------------------------------------------------
Nonvested at December 31, 2005 97,884 $38.63
Granted 26,358 $43.93
Awarded (49,076) $37.76
Forfeited (1,819) $39.51
-------------------------------------------------------------------------------------------------------------------
Nonvested at September 30, 2006 73,347 $41.10
-------------------------------------------------------------------------------------------------------------------
NEW ACCOUNTING STANDARDS. FSP INTERPRETATION NO. 46(R)-6. In April 2006, the
FASB issued Staff Position Interpretation No. 46(R)-6, "Determining the
Variability to Be Considered in Applying FASB Interpretation No. 46(R)" (FSP
Interpretation No. 46(R)-6). This FSP addresses how an enterprise should
determine the variability to be considered in applying FASB Interpretation No.
46, "Consolidation of Variable Interest Entities" (Interpretation No. 46(R)).
The variability that is considered in applying Interpretation No. 46(R) affects
the determination of: (a) whether the entity is a variable interest entity
(VIE); (b) which interests are variable interests in the entity; and (c) which
party, if any, is the primary beneficiary of the VIE. This FSP provides a guide
for the qualitative analysis of the design of the entity and clarifying guidance
to assist in determining the variability to consider in applying Interpretation
No. 46(R), determining which interests are variable interests, and ultimately
determining which variable interest holder, if any, is the primary beneficiary.
FSP Interpretation No. 46(R)-6 is applied prospectively to all entities with
which the Company first becomes involved and to all entities previously required
to be analyzed under Interpretation No. 46(R) when a reconsideration event has
occurred, effective as of the first day of the first reporting period after June
15, 2006. We have and will continue to evaluate the impact of this new guidance
on any new contracts or any changes to existing contracts executed after the
effective date to determine the applicability of this FSP. The adoption of this
FSP did not have an impact on our financial position, results of operations or
cash flows.
INTERPRETATION NO. 48. In June 2006, the FASB issued Interpretation No. 48,
"Accounting for Uncertainty in Income Taxes - an Interpretation of FASB
Statement No. 109" (Interpretation No. 48). Interpretation No. 48 clarifies the
accounting for uncertain tax positions in accordance with SFAS 109, "Accounting
for Income Taxes." Pursuant to Interpretation No. 48, the Company will be
required to recognize in its financial statements the largest tax benefit of a
tax position that is "more-likely-than-not" to be sustained on audit based
solely on the technical merits of the position as of the reporting date. Only
tax positions that meet the "more-likely-than-not" threshold at that date may be
recognized. The term "more-likely-than-not" means a likelihood of more than 50
percent. Interpretation No. 48 also provides guidance on new disclosure
requirements, reporting and accrual of interest and penalties, accounting in
interim periods and transition. The cumulative effect of initially applying
Interpretation No. 48 will be recognized as a change in accounting principle as
of the date of adoption. We have begun to evaluate the impact of applying this
interpretation as of January 1, 2007, the effective date of the interpretation
for the Company. We do not expect Interpretation No. 48 to have a material
impact on our financial position, results of operation or cash flows.
SFAS 157. In September 2006, the FASB issued SFAS 157, "Fair Value Measurements"
(SFAS 157), to increase consistency and comparability in fair value measurements
by defining fair value, establishing a framework for measuring fair value in
generally accepted accounting principles, and expanding disclosures about fair
value measurements. The Statement emphasizes that fair value is a market-based
measurement, not an entity-specific measurement. It clarifies the extent to
which fair value is used to measure recognized assets and liabilities, the
inputs used to develop the measurements, and the effect of certain of the
measurements on earnings for the period. SFAS 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and will
be applied on a prospective basis. We are currently evaluating the effect that
the adoption of SFAS 157 will have on our financial position, results of
operations and cash flows.
ALLETE Third Quarter 2006 Form 10-Q 10
NOTE 1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
SFAS 158. In September 2006, the FASB issued SFAS 158, "Employers' Accounting
for Defined Benefit Pension and Other Postretirement Plans" (SFAS 158). SFAS 158
requires that employers recognize on a prospective basis the funded status of
their defined benefit pension and other postretirement plans on their
consolidated balance sheet and recognize as a component of other comprehensive
income, net of tax, the gains or losses and prior service costs or credits that
arise during the period but that are not recognized as components of net
periodic benefit cost. SFAS 158 also requires additional disclosures in the
notes to financial statements. SFAS 158 is effective for fiscal years ending
after December 15, 2006. We are currently assessing the impact of SFAS 158 on
our consolidated financial statements. We do not anticipate that the adoption of
SFAS 158 will affect compliance with our debt covenants.
Based on the funded status of our defined benefit pension and postretirement
medical plans as of December 31, 2005, we would be required to increase our net
liabilities for pension and postretirement medical benefits and reduce
shareholders' equity by approximately $80 million, net of taxes, on our
consolidated balance sheet. This estimate may vary from the actual impact of
implementing SFAS 158. The ultimate amounts recorded are highly dependent on a
number of assumptions, including the discount rates in effect at December 31,
2006, the actual rate of return on our pension assets for 2006 and the tax
effects of the adjustment. Changes in these assumptions since our last
measurement date could increase or decrease the expected impact of implementing
SFAS 158 in our consolidated financial statements at December 31, 2006.
NOTE 2. BUSINESS SEGMENTS
Financial results by segment for the periods presented were impacted by the
integration of our Taconite Harbor facility into the Regulated Utility segment
effective January 1, 2006. The redirection of Taconite Harbor from our
Nonregulated Energy Operations segment to our Regulated Utility segment was in
accordance with the Company's Resource Plan, as approved by the MPUC. Under the
terms of our Resource Plan, we have operated the Taconite Harbor facility as a
rate-based asset within the Minnesota retail jurisdiction effective January 1,
2006. Prior to January 1, 2006, we operated our Taconite Harbor facility as
nonregulated generation (non-rate base generation sold at market-based rates
primarily to the wholesale market). Historical financial results of Taconite
Harbor for periods prior to the redirection are included in our Nonregulated
Energy Operations segment.
Effective the third quarter of 2006, financial results for our equity investment
in ATC have been reported as a separate segment. ATC is a Wisconsin-based public
utility that owns and maintains electric transmission assets in parts of
Wisconsin, Michigan, Minnesota and Illinois. ATC provides transmission service
under rates regulated by the FERC that are set to further the FERC's policy of
establishing the independent operation and ownership of, and investment in,
transmission facilities. (See Note 13.)
11 ALLETE Third Quarter 2006 Form 10-Q
NOTE 2. BUSINESS SEGMENTS (CONTINUED)
ENERGY
--------------------------------------
NONREGULATED
REGULATED ENERGY INVESTMENT REAL
CONSOLIDATED UTILITY OPERATIONS IN ATC ESTATE OTHER
-----------------------------------------------------------------------------------------------------------------------
MILLIONS
FOR THE QUARTER ENDED
SEPTEMBER 30, 2006
Operating Revenue $199.1 $168.1 $15.9 - $15.1 -
Fuel and Purchased Power 79.5 79.5 - - - -
Operating and Maintenance 68.7 49.7 13.6 - 4.9 $ 0.5
Depreciation Expense 12.2 11.1 1.0 - 0.1 -
-----------------------------------------------------------------------------------------------------------------------
Operating Income (Loss) from
Continuing Operations 38.7 27.8 1.3 - 10.1 (0.5)
Interest Expense (7.3) (5.0) (1.0) - - (1.3)
Other Income 3.7 0.1 0.9 $1.0 - 1.7
-----------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations
Before Minority Interest
and Income Taxes 35.1 22.9 1.2 1.0 10.1 (0.1)
Minority Interest 1.1 - - - 1.1 -
-----------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations
Before Income Taxes 34.0 22.9 1.2 1.0 9.0 (0.1)
Income Tax Expense (Benefit) 12.1 9.2 0.1 0.4 3.9 (1.5)
-----------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations 21.9 $ 13.7 $ 1.1 $0.6 $5.1 $ 1.4
--------------------------------------------------------------
Loss from
Discontinued Operations - Net of Tax (0.1)
-----------------------------------------------------
Net Income $ 21.8
-----------------------------------------------------
FOR THE QUARTER ENDED
SEPTEMBER 30, 2005
Operating Revenue $177.4 $137.4 $28.7 - $11.2 $ 0.1
Fuel and Purchased Power 65.4 58.9 6.5 - - -
Operating and Maintenance 67.4 47.0 16.6 - 2.8 1.0
Depreciation Expense 11.9 9.9 1.9 - 0.1 -
-----------------------------------------------------------------------------------------------------------------------
Operating Income (Loss) from
Continuing Operations 32.7 21.6 3.7 - 8.3 (0.9)
Interest Expense (6.6) (4.3) (1.8) - (0.1) (0.4)
Other Income 0.4 - 0.1 - - 0.3
-----------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations
Before Minority Interest
and Income Taxes 26.5 17.3 2.0 - 8.2 (1.0)
Minority Interest 1.0 - - - 1.0 -
-----------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations
Before Income Taxes 25.5 17.3 2.0 - 7.2 (1.0)
Income Tax Expense (Benefit) 9.7 6.7 0.4 - 3.2 (0.6)
-----------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations 15.8 $ 10.6 $ 1.6 - $4.0 $(0.4)
--------------------------------------------------------------
Loss from
Discontinued Operations - Net of Tax (0.6)
-----------------------------------------------------
Net Income $ 15.2
-----------------------------------------------------
ALLETE Third Quarter 2006 Form 10-Q 12
NOTE 2. BUSINESS SEGMENTS (CONTINUED)
ENERGY
--------------------------------------
NONREGULATED
REGULATED ENERGY INVESTMENT REAL
CONSOLIDATED UTILITY OPERATIONS IN ATC ESTATE OTHER
-----------------------------------------------------------------------------------------------------------------------
MILLIONS
FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 2006
Operating Revenue $569.9 $477.0 $48.7 - $44.0 $ 0.2
Fuel and Purchased Power 211.9 211.9 - - - -
Operating and Maintenance 220.0 162.7 41.8 - 13.2 2.3
Depreciation Expense 36.6 33.3 3.1 - 0.1 0.1
-----------------------------------------------------------------------------------------------------------------------
Operating Income (Loss) from
Continuing Operations 101.4 69.1 3.8 - 30.7 (2.2)
Interest Expense (20.1) (15.0) (2.0) - - (3.1)
Other Income 8.8 0.6 1.2 $1.0 - 6.0
-----------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations
Before Minority Interest
and Income Taxes 90.1 54.7 3.0 1.0 30.7 0.7
Minority Interest 3.2 - - - 3.2 -
-----------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations
Before Income Taxes 86.9 54.7 3.0 1.0 27.5 0.7
Income Tax Expense (Benefit) 32.6 21.2 0.1 0.4 11.8 (0.9)
-----------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations 54.3 $ 33.5 $ 2.9 $0.6 $15.7 $ 1.6
--------------------------------------------------------------
Loss from
Discontinued Operations - Net of Tax (0.5)
-----------------------------------------------------
Net Income $ 53.8
-----------------------------------------------------
AT SEPTEMBER 30, 2006
Total Assets $1,400.9 $1,009.9 $78.9 $35.2 $84.9 $192.0
Property, Plant and Equipment - Net $877.9 $822.6 $50.5 - - $4.8
Accumulated Depreciation $816.5 $775.9 $39.0 - - $1.6
Capital Expenditures $53.3 $52.5 $0.8 - - -
FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 2005
Operating Revenue $545.1 $422.8 $ 83.1 - $38.9 $ 0.3
Fuel and Purchased Power 201.9 182.1 19.8 - - -
Operating and Maintenance 211.8 147.5 49.3 - 12.3 2.7
Kendall County Charge 77.9 - 77.9 - - -
Depreciation Expense 35.7 29.5 6.0 - 0.1 0.1
-----------------------------------------------------------------------------------------------------------------------
Operating Income (Loss) from
Continuing Operations 17.8 63.7 (69.9) - 26.5 (2.5)
Interest Expense (20.1) (13.0) (4.7) - (0.3) (2.1)
Other Income (Expense) (2.3) 0.4 0.3 - - (3.0)
-----------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations
Before Minority Interest
and Income Taxes (4.6) 51.1 (74.3) - 26.2 (7.6)
Minority Interest 2.4 - - - 2.4 -
-----------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations
Before Income Taxes (7.0) 51.1 (74.3) - 23.8 (7.6)
Income Tax Expense (Benefit) (0.4) 19.8 (27.0) - 10.1 (3.3)
-----------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations (6.6) $ 31.3 $(47.3) - $13.7 $(4.3)
--------------------------------------------------------------
Loss from
Discontinued Operations - Net of Tax (1.1)
-----------------------------------------------------
Net Loss $ (7.7)
-----------------------------------------------------
AT SEPTEMBER 30, 2005
Total Assets $1,373.6 $899.6 $183.4 - $77.1 $166.4
Property, Plant and Equipment - Net $852.0 $729.5 $117.6 - - $4.9
Accumulated Depreciation $789.2 $742.7 $45.0 - - $1.5
Capital Expenditures $40.4 $31.1 $6.0 - - -
-----------------------------------------------------------------------------------------------------------------------
Discontinued Operations represented $47.1 million of total assets and $3.3 million of capital expenditures
in 2005.
13 ALLETE Third Quarter 2006 Form 10-Q
NOTE 3. INVESTMENTS
SHORT-TERM INVESTMENTS. At September 30, 2006 and December 31, 2005, we held
$121.6 million and $116.9 million, respectively, of short-term investments,
consisting of auction rate bonds and variable rate demand notes classified as
available-for-sale securities. Our investments in these securities are recorded
at fair market value because the variable interest rates for these securities
typically reset every 7 to 35 days. Despite the long-term nature of their stated
contractual maturities, we have the ability to quickly liquidate these
securities. As a result, we had no cumulative gross unrealized holding gains
(losses) or gross realized gains (losses) from our short-term investments. All
income generated from these short-term investments was recorded as interest
income.
LONG-TERM INVESTMENTS. At September 30, 2006, Investments included the real
estate assets of ALLETE Properties, our investment in ATC, debt and equity
securities consisting primarily of securities held to fund employee benefits,
and our emerging technology investments.
We account for our investment in ATC under the equity method of accounting,
pursuant to EITF 03-16, "Accounting for Investments in Limited Liability
Companies," which requires the use of the equity method of accounting for
investments in all limited liability companies.
SEPTEMBER 30, DECEMBER 31,
INVESTMENTS 2006 2005
------------------------------------------------------------------------------------------------------------------
MILLIONS
Real Estate Assets $ 84.9 $ 73.7
Debt and Equity Securities 35.9 34.8
Investment in ATC (See Note 13) 35.2 -
Emerging Technology Investments 9.1 9.2
------------------------------------------------------------------------------------------------------------------
Total Investments $165.1 $117.7
------------------------------------------------------------------------------------------------------------------
NINE MONTHS ENDED YEAR ENDED
SEPTEMBER 30, DECEMBER 31,
REAL ESTATE ASSETS 2006 2005
------------------------------------------------------------------------------------------------------------------
MILLIONS
Land Held for Sale Beginning Balance $48.0 $47.2
Additions during period: Capitalized Improvements 11.1 9.4
Purchases 1.4 -
Deductions during period: Cost of Real Estate Sold (7.4) (8.6)
------------------------------------------------------------------------------------------------------------------
Land Held for Sale Ending Balance 53.1 48.0
Long-Term Finance Receivables 16.5 7.4
Other 15.3 18.3
------------------------------------------------------------------------------------------------------------------
Total Real Estate Assets $84.9 $73.7
------------------------------------------------------------------------------------------------------------------
Consisted primarily of a shopping center.
Finance receivables have maturities ranging up to seven years, accrue interest
at market-based rates and are net of an allowance for doubtful accounts of $0.4
million at September 30, 2006 ($0.6 million at December 31, 2005).
NOTE 4. SHORT-TERM AND LONG-TERM DEBT
In January 2006, we renewed, increased and extended a committed, syndicated,
unsecured revolving credit facility (Line) with LaSalle Bank National
Association, as Agent, for $150 million ($100 million at December 31, 2005). The
Line matures on January 11, 2011, and requires an annual commitment fee of
0.125%. At our request and subject to certain conditions, the Line may be
increased to $200 million and extended for two additional 12-month periods. The
Line may be used for general corporate purposes and working capital, and to
provide liquidity in support of our commercial paper program. We may prepay
amounts outstanding under the Line in whole or in part at our discretion without
premium or penalty. Additionally, we may irrevocably terminate or reduce the
size of the Line prior to maturity without premium or penalty. No funds were
drawn under this Line at September 30, 2006.
ALLETE Third Quarter 2006 Form 10-Q 14
NOTE 4. SHORT-TERM AND LONG-TERM DEBT (CONTINUED)
In March 2006, we issued $50 million in principal amount of First Mortgage
Bonds, 5.69% Series due March 1, 2036. Proceeds were used to redeem $50 million
in principal amount of First Mortgage Bonds, 7% Series due March 1, 2008.
In July 2006, the Collier County Industrial Development Authority (Authority or
Issuer) issued $27.8 million of Industrial Development Variable Rate Demand
Refunding Revenue Bonds Series 2006 due 2025 (Refunding Bonds) on behalf of
ALLETE. The interest rate on these bonds was 3.79% at September 30, 2006.
Pursuant to a financing agreement between the Authority and ALLETE dated as of
July 1, 2006, ALLETE is obligated to make payments to the Issuer sufficient to
pay all principal and interest on the Refunding Bonds. ALLETE's obligations
under the financing agreement are supported by a direct pay letter of credit.
Proceeds from the Refunding Bonds and internally generated funds were used to
redeem $29.1 million of outstanding Collier County Industrial Development
Refunding Revenue Bonds 6.5% Series 1996 due 2025 on August 9, 2006. As a result
of an early redemption premium, we recognized a $0.6 million pre-tax charge to
other expense in the third quarter of 2006.
In September 2006, we accepted an offer from certain institutional buyers in the
private placement market to purchase $60 million of ALLETE first mortgage bonds.
When issued, on or about February 1, 2007, the bonds will carry an interest rate
of 5.99% and will have a term of 20 years. We intend to use the proceeds from
the bonds to retire $60 million in principal amount of First Mortgage Bonds, 7%
Series due February 15, 2007.
NOTE 5. COMMON STOCK
SHAREHOLDER RIGHTS PLAN. In 1996, we adopted a rights plan that provides for a
dividend distribution of one preferred share purchase right (Right) to be
attached to each share of common stock. In July 2006, we amended the rights plan
to extend the expiration of the Rights to July 11, 2009. The amendment also
provides that the Company may not consolidate, merge, or sell a majority of its
assets or earning power if doing so would be counter to the intended benefits of
the Rights or would result in the distribution of Rights to the shareholders of
the other parties to the transaction. Finally, the amendment provides for the
creation of a committee of independent directors to annually review the terms
and conditions of the amended rights plan (Rights Plan), as well as to consider
whether termination or modification of the Rights Plan would be in the best
interests of the shareholders and to make a recommendation based on such review
to the Board of Directors.
The Rights, which are currently not exercisable or transferable apart from our
common stock, entitle the holder to purchase one-and-a-half one-hundredths
(three two-hundredths) of a share of ALLETE's Junior Serial Preferred Stock A,
without par value. The purchase price, as defined in the Rights Plan, remains at
$90. These Rights would become exercisable if a person or group acquires
beneficial ownership of 15 percent or more of our common stock or announces a
tender offer which would increase the person's or group's beneficial ownership
interest to 15 percent or more of our common stock, subject to certain
exceptions. If the 15 percent threshold is met, each Right entitles the holder
(other than the acquiring person or group) to receive, upon payment of the
purchase price, the number of shares of common stock (or, in certain
circumstances, cash, property or other securities of ours) having a market value
equal to twice the exercise price of the Right. If we are acquired in a merger
or business combination, or more than 50 percent of our assets or earning power
are sold, each exercisable Right entitles the holder to receive, upon payment of
the purchase price, the number of shares of common stock of the acquiring or
surviving company having a value equal to twice the exercise price of the Right.
Certain stock acquisitions will also trigger a provision permitting the Board of
Directors to exchange each Right for one share of our common stock.
The Rights are nonvoting and may be redeemed by us at a price of $0.005 per
Right at any time they are not exercisable. One million shares of Junior Serial
Preferred Stock A have been authorized and are reserved for issuance under the
Rights Plan.
15 ALLETE Third Quarter 2006 Form 10-Q
NOTE 6. KENDALL COUNTY CHARGE
On April 1, 2005, Rainy River Energy, a wholly-owned subsidiary of ALLETE,
completed the assignment of its power purchase agreement with LSP-Kendall
Energy, LLC, the owner of an energy generation facility located in Kendall
County, Illinois, to Constellation Energy Commodities. Rainy River Energy paid
Constellation Energy Commodities $73 million in cash to assume the power
purchase agreement that remains in effect through mid-September 2017. The
federal tax benefits of the payment were realized through a $24.3 million
capital loss carryback refund in the third quarter of 2006. In addition,
consent, advisory and closing costs of $4.9 million were incurred to complete
the transaction. As a result of this transaction, ALLETE incurred a charge to
operating expenses totaling $77.9 million ($50.4 million after tax, or $1.84 per
diluted share) in the second quarter of 2005.
NOTE 7. OTHER INCOME (EXPENSE)
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2006 2005 2006 2005
-------------------------------------------------------------------------------------------------------------------
MILLIONS
Gain (Loss) on Emerging Technology Investments $0.1 $(0.1) $(1.1) $(5.9)
Income from Investment in ATC (See Notes 3 and 13) 1.0 - 1.0 -
Investment and Other Income 2.6 0.5 8.9 3.6
-------------------------------------------------------------------------------------------------------------------
Total Other Income (Expense) $3.7 $ 0.4 $ 8.8 $(2.3)
-------------------------------------------------------------------------------------------------------------------
NOTE 8. INCOME TAX EXPENSE
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2006 2005 2006 2005
----------------------------------------------------------------------------------------------------------------------
MILLIONS
Current Tax Expense (Benefit)
Federal $(15.2) $10.8 $ 5.2 $30.3
State 3.3 2.3 8.1 6.8
----------------------------------------------------------------------------------------------------------------------
(11.9) 13.1 13.3 37.1
----------------------------------------------------------------------------------------------------------------------
Deferred Tax Expense (Benefit)
Federal 24.3 (2.6) 20.8 (35.2)
State - (0.5) (0.5) (1.3)
----------------------------------------------------------------------------------------------------------------------
24.3 (3.1) 20.3 (36.5)
----------------------------------------------------------------------------------------------------------------------
Deferred Tax Credits (0.3) (0.3) (1.0) (1.0)
----------------------------------------------------------------------------------------------------------------------
Income Tax Expense (Benefit) from Continuing Operations 12.1 9.7 32.6 (0.4)
Income Tax Benefit from Discontinued Operations - (0.2) (0.3) (0.2)
----------------------------------------------------------------------------------------------------------------------
Total Income Tax Expense (Benefit) $ 12.1 $ 9.5 $32.3 $(0.6)
----------------------------------------------------------------------------------------------------------------------
Included a current federal tax benefit of $24.3 million and a deferred federal tax expense of $24.3 million
related to the Kendall County refund. (See Note 6.)
Included a current federal tax benefit of $1.3 million, current state tax benefit of $0.4 million and deferred
federal tax benefit of $25.8 million related to the Kendall County charge. (See Note 6.)
For the nine months ended September 30, 2006, the effective rate for income
taxes was 36.2 percent (8.7 percent benefit for the nine months ended September
30, 2005). The increase in the effective rate compared to last year was
primarily due to the emerging technology impairment and the Kendall County
capital loss recorded in April 2005. The current benefit for these items was
limited to the federal benefit as the state net capital loss carryforwards from
2005 were entirely reserved. The effective rate of 36.2 percent for the nine
months ended September 30, 2006, was less than the statutory rate primarily
because of investment tax credits, deductions for Medicare health subsidies,
depletion and finalization of taxes related to the spin-off of ADESA.
ALLETE Third Quarter 2006 Form 10-Q 16
NOTE 9. DISCONTINUED OPERATIONS
ENVENTIS TELECOM. On December 30, 2005, we sold all the stock of our
telecommunications subsidiary, Enventis Telecom, to Hickory Tech Corporation of
Mankato, Minnesota. In accordance with SFAS 144, "Accounting for the Impairment
or Disposal of Long-Lived Assets," we reported our telecommunications business
in discontinued operations for the quarter and nine months ended September 30,
2005.
WATER SERVICES. In early 2005, we completed the exit from our Water Services
businesses with the sale of our wastewater assets in Georgia, which resulted in
an immaterial gain. In 2005, the Florida Public Service Commission approved the
transfer of 63 water and wastewater systems from Florida Water to Aqua Utilities
Florida, Inc. (Aqua Utilities) and ordered a $1.7 million reduction to plant
investment. The Company reserved for the reduction in 2005. On March 15, 2006,
the Company paid Aqua Utilities the adjustment refund amount of $1.7 million.
For the quarter and nine months ended September 30, 2006, financial results
reflected additional legal and administrative expenses incurred by the Company
to exit the Water Services businesses.
QUARTER ENDED NINE MONTHS ENDED
DISCONTINUED OPERATIONS SEPTEMBER 30, SEPTEMBER 30,
SUMMARY INCOME STATEMENT 2006 2005 2006 2005
-----------------------------------------------------------------------------------------------------------------
MILLIONS
Operating Revenue - Enventis Telecom - $9.5 - $35.6
-----------------------------------------------------------------------------------------------------------------
Pre-Tax Income from Operations
Enventis Telecom - $ 0.3 - $ 1.8
Income Tax Expense
Enventis Telecom - 0.2 - 0.8
-----------------------------------------------------------------------------------------------------------------
Total Income from Operations - 0.1 - 1.0
-----------------------------------------------------------------------------------------------------------------
Loss on Disposal
Water Services $(0.1) (0.9) $(0.8) (2.7)
Enventis Telecom - (0.2) - (0.4)
-----------------------------------------------------------------------------------------------------------------
(0.1) (1.1) (0.8) (3.1)
-----------------------------------------------------------------------------------------------------------------
Income Tax Benefit
Water Services - (0.3) (0.3) (0.8)
Enventis Telecom - (0.1) - (0.2)
-----------------------------------------------------------------------------------------------------------------
- (0.4) (0.3) (1.0)
-----------------------------------------------------------------------------------------------------------------
Net Loss on Disposal (0.1) (0.7) (0.5) (2.1)
-----------------------------------------------------------------------------------------------------------------
Loss from Discontinued Operations $(0.1) $(0.6) $(0.5) $(1.1)
-----------------------------------------------------------------------------------------------------------------
DISCONTINUED OPERATIONS DECEMBER 31,
SUMMARY BALANCE SHEET INFORMATION 2005
---------------------------------------------------------------------------------------------------
MILLIONS
Assets of Discontinued Operations
Other Current Assets $0.4
Property, Plant and Equipment $2.2
Liabilities of Discontinued Operations
Current Liabilities $13.0
---------------------------------------------------------------------------------------------------
17 ALLETE Third Quarter 2006 Form 10-Q
NOTE 10. COMPREHENSIVE INCOME (LOSS)
For the quarter ended September 30, 2006, total comprehensive income (loss), net
of tax, was comprehensive income of $22.1 million ($13.6 million of
comprehensive income, net of tax, for the quarter ended September 30, 2005). For
the nine months ended September 30, 2006, total comprehensive income (loss), net
of tax, was comprehensive income of $54.4 million (a $9.3 million comprehensive
loss, net of tax, for the nine months ended September 30, 2005). Total
comprehensive income (loss) includes net income (loss), unrealized gains and
losses on securities classified as available-for-sale, and additional pension
liability.
ACCUMULATED OTHER COMPREHENSIVE SEPTEMBER 30,
INCOME (LOSS) - NET OF TAX 2006 2005
----------------------------------------------------------------------------------------------------------------
MILLIONS
Unrealized Gain on Securities $ 2.7 $ 1.9
Additional Pension Liability (14.9) (12.9)
----------------------------------------------------------------------------------------------------------------
$(12.2) $(11.0)
----------------------------------------------------------------------------------------------------------------
NOTE 11. EARNINGS PER SHARE
The difference between basic and diluted earnings per share arises from
outstanding stock options and performance share awards granted under our
Executive and Director Long-Term Incentive Compensation Plans. In accordance
with SFAS 128, "Earnings Per Share," for the quarter and nine months ended
September 30, 2006, no options to purchase shares of common stock were excluded
in the computation of diluted earnings per share because the average market
prices were greater than the option exercise prices. For the nine months ended
September 30, 2005, 0.1 million dilutive securities were excluded in the
computation of diluted earnings per share because their effect would have been
anti-dilutive due to our loss from continuing operations (no options were
excluded for the quarter ended September 30, 2005).
2006 2005
-------------------------------------------------------------------
RECONCILIATION OF BASIC AND DILUTED DILUTIVE DILUTIVE
EARNINGS PER SHARE BASIC SECURITIES DILUTED BASIC SECURITIES DILUTED
-------------------------------------------------------------------------------------------------------------------
MILLIONS EXCEPT PER SHARE AMOUNTS
FOR THE QUARTER ENDED SEPTEMBER 30,
Income from Continuing Operations $21.9 - $21.9 $15.8 - $15.8
Common Shares 27.8 0.1 27.9 27.4 0.1 27.5
Per Share from Continuing Operations $0.78 - $0.78 $0.58 - $0.58
-------------------------------------------------------------------------------------------------------------------
FOR THE NINE MONTHS ENDED SEPTEMBER 30,
Income (Loss) from Continuing Operations $54.3 - $54.3 $(6.6) - $(6.6)
Common Shares 27.7 0.1 27.8 27.3 - 27.3
Per Share from Continuing Operations $1.96 - $1.95 $(0.24) - $(0.24)
-------------------------------------------------------------------------------------------------------------------
ALLETE Third Quarter 2006 Form 10-Q 18
NOTE 12. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS
POSTRETIREMENT
PENSION HEALTH AND LIFE
-----------------------------------------------------------
COMPONENTS OF NET PERIODIC BENEFIT EXPENSE 2006 2005 2006 2005
-------------------------------------------------------------------------------------------------------------------
MILLIONS
FOR THE QUARTER ENDED SEPTEMBER 30,
Service Cost $2.3 $2.1 $1.1 $1.1
Interest Cost 5.5 5.4 1.9 1.6
Expected Return on Plan Assets (7.1) (7.0) (1.4) (1.2)
Amortization of Prior Service Costs 0.1 0.2 - -
Amortization of Net Loss 1.2 0.7 0.4 0.2
Amortization of Transition Obligation - - 0.6 0.6
-------------------------------------------------------------------------------------------------------------------
Net Periodic Benefit Expense $2.0 $1.4 $2.6 $2.3
-------------------------------------------------------------------------------------------------------------------
FOR THE NINE MONTHS ENDED SEPTEMBER 30,
Service Cost $ 6.9 $ 6.5 $3.3 $3.1
Interest Cost 16.6 16.0 5.6 4.9
Expected Return on Plan Assets (21.4) (21.2) (4.2) (3.6)
Amortization of Prior Service Costs 0.5 0.6 - -
Amortization of Net Loss 3.6 2.3 1.3 0.6
Amortization of Transition Obligation (0.1) 0.1 1.8 1.9
-------------------------------------------------------------------------------------------------------------------
Net Periodic Benefit Expense $ 6.1 $ 4.3 $7.8 $6.9
-------------------------------------------------------------------------------------------------------------------
In 2005, we determined that our postretirement health care plans met the
requirements of the Centers for Medicare and Medicaid Services' (CMS)
regulations and enrolled with the CMS to begin recovering the subsidy. We expect
to receive the first subsidy check in early 2007 for 2006 credits.
In July 2006, we made an $8.3 million contribution to the Company's defined
benefit plan.
On August 9, 2006, ALLETE's Board of Directors approved amendments to the
Minnesota Power and Affiliated Companies Retirement Plan A (Retirement Plan A)
and the Minnesota Power and Affiliated Companies Retirement Savings and Stock
Ownership Plan (RSOP).
Retirement Plan A was amended to suspend further crediting service pursuant to
the plan, effective as of September 30, 2006, and to close Retirement Plan A to
new participants. Participants will continue to accrue benefits under the plan
for future pay increases. In conjunction with this change, the Board of
Directors took action to increase benefits employees will receive under the
RSOP.
The modification of Retirement Plan A required us to re-measure our pension
expense as of August 9, 2006. As a result of the re-measurement, Retirement Plan
A pension expense for 2006 will be reduced by $0.2 million.
19 ALLETE Third Quarter 2006 Form 10-Q
NOTE 13. COMMITMENTS, GUARANTEES AND CONTINGENCIES
OFF-BALANCE SHEET ARRANGEMENTS. SQUARE BUTTE POWER PURCHASE AGREEMENT. Minnesota
Power has a power purchase agreement with Square Butte that extends through 2026
(Agreement). It provides a long-term supply of low-cost energy to customers in
our electric service territory and enables Minnesota Power to meet power pool
reserve requirements. Square Butte, a North Dakota cooperative corporation, owns
a 455-MW coal-fired generating unit (Unit) near Center, North Dakota. The Unit
is adjacent to a generating unit owned by Minnkota Power, a North Dakota
cooperative corporation whose Class A members are also members of Square Butte.
Minnkota Power serves as the operator of the Unit and also purchases power from
Square Butte.
Minnesota Power was entitled to approximately 71 percent of the Unit's output
under the Agreement prior to 2006. Beginning in 2006, Minnkota Power exercised
its option to reduce Minnesota Power's entitlement by approximately 5 percent
annually, to 66 percent. We received notices from Minnkota Power that they will
further reduce our output entitlement by approximately 5 percent on January 1,
2007 and 2008, to 60 percent and 55 percent, respectively. Minnkota Power has
the option to reduce Minnesota Power's entitlement to 50 percent. Minnesota
Power is obligated to pay its pro rata share of Square Butte's costs based on
Minnesota Power's entitlement to Unit output. Minnesota Power's payment
obligation will be suspended if Square Butte fails to deliver any power, whether
produced or purchased, for a period of one year. Square Butte's fixed costs
consist primarily of debt service. At September 30, 2006, Square Butte had total
debt outstanding of $304.0 million. Total annual debt service for Square Butte
is expected to be approximately $26 million in each of the years 2006 through
2010. Variable operating costs include the price of coal purchased from BNI
Coal, our subsidiary, under a long-term contract. Minnesota Power's payments to
Square Butte are approved as a purchased power expense for ratemaking purposes
by both the MPUC and the FERC.
LEASING AGREEMENTS. BNI Coal is obligated to make lease payments for a dragline
totaling $2.8 million annually for the lease term which expires in 2027. BNI
Coal has the option at the end of the lease term to renew the lease at a fair
market rental, to purchase the dragline at fair market value, or to surrender
the dragline and pay a $3.0 million termination fee. We lease other properties
and equipment under operating lease agreements with terms expiring through 2013.
The aggregate amount of minimum lease payments for all operating leases is $6.4
million in 2006, $5.9 million in 2007, $5.2 million in 2008, $4.7 million in
2009, $4.2 million in 2010 and $46.9 million thereafter.
COAL, RAIL AND SHIPPING CONTRACTS. We have three coal supply agreements with
various expiration dates ranging from December 2006 to December 2009. We also
have rail and shipping agreements for the transportation of all of our coal,
with various expiration dates ranging from December 2006 to December 2011. Our
minimum annual payment obligations under these coal, rail and shipping
agreements are currently $45.2 million in 2006, $9.5 million in 2007, $9.7
million in 2008, $5.8 million in 2009 and no specific commitments beyond 2009.
Our minimum annual payment obligations will increase when annual nominations are
made for coal deliveries in future years.
FUEL CLAUSE RECOVERY OF MISO DAY 2 COSTS. Minnesota Power filed a petition with
the MPUC in February 2005 to amend its fuel clause to accommodate costs and
revenue related to the MISO Day 2 energy market, the market through which
Minnesota Power engages in wholesale energy transactions in MISO's day-ahead and
real-time markets (MISO Day 2). On April 7, 2005, the MPUC approved interim
accounting treatment of MISO Day 2 costs to be accounted for on a net basis and
recovered through the fuel clause, subject to refund with interest. This interim
treatment has continued while the MPUC has addressed the cost recovery petitions
from Xcel Energy Inc., Otter Tail Power Company, Alliant Energy Corporation and
Minnesota Power.
On December 21, 2005, the MPUC issued an order which denied recovery through the
fuel clause of uplift charges, congestion revenue and expenses, and
administrative costs related to Minnesota Power's MISO Day 2 market activities.
Minnesota Power requested rehearing of the order in a filing made with the MPUC
on January 10, 2006. The other three utilities affected by the order also filed
for rehearing, as did the DOC and MISO. In a hearing on February 9, 2006, the
MPUC granted rehearing of the MISO Day 2 docket and suspended the refund
obligation for charges recovered through the fuel clause denied in the December
21, 2005 order. The MPUC requested that the affected utilities and interested
parties provide a joint recommendation regarding the MISO Day 2 costs to
determine which costs should be recovered on a current basis through the fuel
clause and which costs are more appropriately deferred for potential
ALLETE Third Quarter 2006 Form 10-Q 20
NOTE 13. COMMITMENTS, GUARANTEES AND CONTINGENCIES (CONTINUED)
recovery through base rates. The requested joint report and recommendations were
filed with the MPUC on June 23, 2006. Comments on the joint report were received
from the DOC and the Office of the Minnesota Attorney General on July 24, 2006.
Reply comments were filed by the four utilities on August 7, 2006. A technical
conference is scheduled for October 31, 2006, with a hearing currently scheduled
for November 9, 2006. The Company is unable to predict the outcome of this
matter.
EMERGING TECHNOLOGY PORTFOLIO. We have investments in emerging technologies
through minority investments in venture capital funds structured as limited
liability companies, and direct investments in privately-held, start-up
companies. The carrying value of our direct investments in privately-held,
start-up companies was zero at September 30, 2006, and December 31, 2005. We
have committed to make additional investments in certain emerging technology
venture capital funds. The total future commitment was $2.5 million at September
30, 2006 ($3.1 million at December 31, 2005), and may be invested at various
times through 2007. We do not have plans to make any additional investments
beyond this commitment.
INVESTMENT IN ATC. In December 2005, we entered into an agreement with Wisconsin
Public Service Corporation and WPS Investments, LLC that provides for our
Wisconsin subsidiary, Rainy River Energy Corporation - Wisconsin, to invest $60
million in ATC. Our investment is expected to represent an estimated 9 percent
ownership interest in ATC. On May 4, 2006, the PSCW reviewed and approved the
request that allows us to invest in ATC. As of September 30, 2006, our equity
investment in ATC was $35.2 million including reinvested earnings less
dividends, which equated to approximately a 5 percent ownership interest. By the
end of 2006, we anticipate having approximately $60 million invested in ATC.
ENVIRONMENTAL MATTERS. Our businesses are subject to regulation of environmental
matters by various federal, state and local authorities. Due to future stricter
environmental requirements through legislation and/or rulemaking, we anticipate
that potential expenditures for environmental matters will be material and will
require significant capital investments. We review environmental matters on a
quarterly basis. Accruals for environmental matters are recorded when it is
probable that a liability has been incurred and the amount of the liability can
be reasonably estimated, based on current law and existing technologies. These
accruals are adjusted periodically as assessment and remediation efforts
progress or as additional technical or legal information becomes available.
Accruals for environmental liabilities are included in the balance sheet at
undiscounted amounts and exclude claims for recoveries from insurance or other
third parties. Costs related to environmental contamination treatment and
cleanup are charged to expense unless recoverable in rates from customers.
SWL&P MANUFACTURED GAS PLANT. In May 2001, SWL&P received notice from the WDNR
that the City of Superior had found soil contamination on property adjoining a
former Manufactured Gas Plant (MGP) site owned and operated by SWL&P from 1889
to 1904. The WDNR requested SWL&P to initiate an environmental investigation.
The WDNR also issued SWL&P a Responsible Party letter in February 2002. In
February 2003, SWL&P submitted a Phase II environmental site investigation
report to the WDNR. This report identified some MGP-like chemicals that were
found in the soil near the former plant site. During March and April 2003,
sediment samples were taken from nearby Superior Bay. The report on the results
of this sampling was completed and sent to the WDNR during the first quarter of
2004. The next phase of the investigation was to determine any impact to soil or
ground water between the former MGP site and Superior Bay. Site work for this
phase of the investigation was performed during October 2004, and a report was
sent to the WDNR in March 2005. Additional site investigation was performed
during September and October 2005. The investigation will continue through the
fall of 2006. It is anticipated that the final report for this portion of the
investigation will be completed during the first quarter of 2007. Although it is
not possible to quantify the potential clean-up cost until the investigation is
completed, a $0.5 million liability was recorded in December 2003 to address the
known areas of contamination. The Company has recorded a corresponding dollar
amount as a regulatory asset to offset this liability. The PSCW has approved
SWL&P's deferral of these MGP environmental investigation and potential clean-up
costs for future recovery in rates, subject to a regulatory prudency review. In
May 2005, the PSCW approved the collection through rates of $150,000 of site
investigation costs that had been incurred at the time SWL&P filed their 2005
rate request. In May 2006, SWL&P filed an application with the PSCW for
authority to increase retail utility rates by an average of 5.2 percent. This
filing includes a request to recover an additional $186,000 of site
investigation costs that had been incurred through 2005. ALLETE maintains
pollution liability insurance coverage that includes coverage for SWL&P. A claim
has been filed with respect to this matter. The insurance carrier has issued a
reservation of rights letter and the Company continues to work with the insurer
to determine the availability of insurance coverage.
21 ALLETE Third Quarter 2006 Form 10-Q
NOTE 13. COMMITMENTS, GUARANTEES AND CONTINGENCIES (CONTINUED)
SQUARE BUTTE GENERATING FACILITY. On April 24, 2006, Minnkota Power announced a
settlement agreement with the EPA and the State of North Dakota regarding
emissions at the M.R. Young Station, which includes the Square Butte generating
unit. In June 2002, Minnkota Power, the operator of Square Butte, received a
Notice of Violation from the EPA regarding alleged New Source Review violations
at the M.R. Young Station. The EPA claimed certain capital projects completed by
Minnkota Power should have been reviewed pursuant to the New Source Review
regulations, potentially resulting in new air permit operating conditions and
possible significant capital expenditures to comply. As a result of the
settlement agreement, the current Square Butte flue gas desulfurization system
(FGD) will be upgraded in 2010 to increase its removal efficiency from 70
percent to 90 percent, and an over-fire air system will also be installed in
2007 to reduce NOx emissions. Capital expenditures for the emission control
additions and modifications on Square Butte are estimated at $35 million. These
estimated capital expenditures may be significantly offset by the sale of
surplus SO2 allowance credits created by the early upgrade of the FGD system,
which is being upgraded two years earlier than required by Federal rules. These
additional surplus allowances could also be banked for future use. We expect
Square Butte will utilize debt to finance such capital expenditures. Our future
cost of purchased power from the Square Butte generating unit would include our
pro rata share of this additional debt service. On April 24, 2006, a Complaint
and a Consent Decree with respect to this settlement agreement were filed in
U.S. District Court for the District of North Dakota, and the settlement was
finalized on July 28, 2006. As finalized, the Consent Decree settlement requires
Square Butte to pay approximately $0.6 million in administrative costs and
penalties in 2006, $0.4 million of which was paid by Minnesota Power in
conjunction with monthly purchased power billings. The Consent Decree settlement
also requires Square Butte to pay $3.3 million toward additional environmental
projects including wind power installations or power purchase agreements.
Minnesota Power is obligated to pay its pro rata share of Square Butte's costs
based on Minnesota Power's entitlement to the output from the Square Butte
generating unit.
EPA CLEAN AIR INTERSTATE RULE AND CLEAN AIR MERCURY RULE. In March 2005, the EPA
announced the final Clean Air Interstate Rule (CAIR) that reduces and
permanently caps emissions of SO2 and NOx in many states in the eastern United
States. The CAIR includes Minnesota as one of the 28 states it considers an
"eastern" state. The EPA also announced the final Clean Air Mercury Rule (CAMR)
that reduces and permanently caps electric utility mercury emissions in the
continental United States. The CAIR and the CAMR regulations have been
challenged in the federal court system, which may delay implementation or modify
provisions. Minnesota Power is participating in a legal challenge to the CAIR,
but is not participating in the challenge of the CAMR. However, if the CAMR and
the CAIR do go into effect, Minnesota Power expects to be required to: (1) make
emissions reductions; (2) purchase mercury, SO2 and NOx allowances through the
EPA's cap-and-trade system; or (3) use a combination of both.
We believe that the CAIR contains flaws in its methodology and application,
which will cause Minnesota Power to incur higher compliance costs. Consequently,
on July 11, 2005, Minnesota Power filed a Petition for Review with the U.S.
Court of Appeals for the District of Columbia Circuit (Court of Appeals). On
November 22, 2005, the EPA agreed to reconsider certain aspects of the CAIR,
including the Minnesota Power petition addressing modeling used to determine
Minnesota's inclusion in the CAIR region and our claims about inequities in the
SO2 allowance methodology. On March 15, 2006, the EPA announced that it would
not make any changes to the CAIR as a result of the petitions for
reconsideration. Petitions for Review (including Minnesota Power's) remain
pending at the Court of Appeals. If the Petitions for Review filed with the
Court of Appeals are successful, we expect to incur lower compliance costs,
consistent with the rules applicable to those states considered as "western"
states under the CAIR. Resolution of the CAIR Petition for Review with the Court
of Appeals is anticipated by early 2008.
ALLETE Third Quarter 2006 Form 10-Q 22
NOTE 13. COMMITMENTS, GUARANTEES AND CONTINGENCIES (CONTINUED)
COMMUNITY DEVELOPMENT DISTRICT OBLIGATIONS. TOWN CENTER. In March 2005, the Town
Center District issued $26.4 million of tax-exempt, 6% Capital Improvement
Revenue Bonds, Series 2005, due May 1, 2036. The bonds were issued to fund a
portion of the Town Center development project. Approximately $21 million of the
bond proceeds will be used for construction of infrastructure improvements at
Town Center, with the remaining funds to be used for capitalized interest, a
debt service reserve fund and costs of issuance. The bonds are payable from and
secured by the revenue derived from assessments imposed, levied and collected by
the Town Center District. The assessments represent an allocation of the costs
of the improvements, including bond financing costs, to the lands within the
Town Center District benefiting from the improvements. The assessments will be
included in the annual property tax bills of landowners beginning in November
2006. To the extent that we still own land at the time of the assessment, in
accordance with EITF 91-10, we will recognize the cost of our portion of these
assessments, based upon our ownership of benefited property. At September 30,
2006, we owned approximately 78 percent of the assessable land in the Town
Center District.
PALM COAST PARK. In May 2006, the Palm Coast Park District issued $31.8 million
of tax-exempt, 5.7% Special Assessment Bonds, Series 2006, due May 1, 2037. The
bonds were issued to fund a portion of the Palm Coast Park development project.
Bond proceeds of $26.3 million will be used for environmental and traffic
mitigation, and the construction of infrastructure improvements, including
utility extensions, roadways, parks, drainage, recreational facilities,
landscaping and a multi-purpose trail system. The remaining funds will be used
for capitalized interest, a debt service reserve fund and the costs of issuance.
The bonds are payable from and secured by the revenue derived from assessments
imposed, levied and collected by the Palm Coast Park District. The assessments
represent an allocation of the costs of the improvements, including bond
financing costs, to the lands within the Palm Coast Park District benefiting
from the improvements. The assessments will be included in the annual property
tax bills of landowners beginning in November 2007. To the extent that we still
own land at the time of the assessment, in accordance with EITF 91-10, we will
recognize the cost of our portion of these assessments, based upon our ownership
of benefited property. At September 30, 2006, we owned 97 percent of the
assessable land in the Palm Coast Park District.
OTHER. We are involved in litigation arising in the normal course of business.
Also in the normal course of business, we are involved in tax, regulatory and
other governmental audits, inspections, investigations and other proceedings
that involve state and federal taxes, safety, compliance with regulations, rate
base and cost of service issues, among other things. While the resolution of
such matters could have a material effect on earnings and cash flows in the year
of resolution, none of these matters are expected to materially change our
present liquidity position, or have a material adverse effect on our financial
condition.
23 ALLETE Third Quarter 2006 Form 10-Q
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our consolidated
financial statements and notes to those statements and the other financial
information appearing elsewhere in this report. In addition to historical
information, the following discussion and other parts of this report contain
forward-looking information that involves risks and uncertainties. Readers are
cautioned that forward-looking statements should be read in conjunction with our
disclosures in this Form 10-Q under the headings: "Safe Harbor Statement Under
the Private Securities Litigation Reform Act of 1995" located on page 3 and
"Risk Factors" located in Part I, Item 1A of our 2005 Form 10-K and Part II,
Item 1A of our Quarterly Report on Form 10-Q for the quarter ended March 31,
2006. The risks and uncertainties described in this Form 10-Q and our 2005 Form
10-K are not the only risks facing our Company. Additional risks and
uncertainties that we are not presently aware of, or that we currently consider
immaterial, may also affect our business operations. Our business, financial
condition or results of operations could suffer if the concerns set forth are
realized.
EXECUTIVE SUMMARY
ALLETE's operations focus on two core businesses--ENERGY and REAL ESTATE. In
addition, we have other operations that provide earnings to the Company.
ENERGY is comprised of Regulated Utility, Nonregulated Energy Operations and our
Investment in ATC.
- REGULATED UTILITY includes retail and wholesale rate regulated electric,
water and gas services in northeastern Minnesota and northwestern
Wisconsin under the jurisdiction of state and federal regulatory
authorities.
- NONREGULATED ENERGY OPERATIONS includes our coal mining activities in
North Dakota, approximately 50 MW of nonregulated generation and
Minnesota land sales.
In 2005, Nonregulated Energy Operations also included nonregulated
generation (non-rate base generation sold at market-based rates primarily
to the wholesale market) from our Taconite Harbor facility in northern
Minnesota, and generation secured through the Kendall County power
purchase agreement. Effective January 1, 2006, Taconite Harbor was
integrated into our Regulated Utility business to help meet forecasted
base load energy requirements. In April 2005, the Kendall County power
purchase agreement was assigned to Constellation Energy Commodities.
- INVESTMENT IN ATC includes our equity ownership interest in ATC.
REAL ESTATE includes our Florida real estate operations.
OTHER includes our investments in emerging technologies, and earnings on cash,
cash equivalents and short-term investments.
Financial results by segment for the periods presented and discussed in this
Form 10-Q were impacted by the integration of our Taconite Harbor facility into
the Regulated Utility segment effective January 1, 2006. The redirection of
Taconite Harbor from our Nonregulated Energy Operations segment to our Regulated
Utility segment was in accordance with the Company's Resource Plan, as approved
by the MPUC. Under the terms of our Resource Plan, we have operated the Taconite
Harbor facility as a rate-based asset within the Minnesota retail jurisdiction
effective January 1, 2006. Prior to January 1, 2006, we operated our Taconite
Harbor facility as nonregulated generation. Historical financial results of
Taconite Harbor for periods prior to the redirection are included in our
Nonregulated Energy Operations segment.
Financial results for the periods presented and discussed in this Form 10-Q were
also impacted by the assignment of our Kendall County power purchase agreement
to Constellation Energy Commodities, which was a key strategic accomplishment
for the Company. As a result of this assignment, we incurred a charge to our
operating expenses totaling $77.9 million ($50.4 million after tax, or $1.84 per
diluted share) in the second quarter of 2005 (Kendall County Charge).
ALLETE Third Quarter 2006 Form 10-Q 24
EXECUTIVE SUMMARY (CONTINUED)
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2006 2005 2006 2005
---------------------------------------------------------------------------------------------------------------------
MILLIONS EXCEPT PER SHARE AMOUNTS
Operating Revenue
Regulated Utility $168.1 $137.4 $477.0 $422.8
Nonregulated Energy Operations 15.9 28.7 48.7 83.1
Real Estate 15.1 11.2 44.0 38.9
Other - 0.1 0.2 0.3
---------------------------------------------------------------------------------------------------------------------
$199.1 $177.4 $569.9 $545.1
--------------------------------------------------------------------------------------------------------------------
Operating Expenses
Regulated Utility $140.3 $115.8 $407.9 $359.1
Nonregulated Energy Operations 14.6 25.0 44.9 153.0
Real Estate 5.0 2.9 13.3 12.4
Other 0.5 1.0 2.4 2.8
---------------------------------------------------------------------------------------------------------------------
$160.4 $144.7 $468.5 $527.3
---------------------------------------------------------------------------------------------------------------------
Interest Expense
Regulated Utility $5.0 $4.3 $15.0 $13.0
Nonregulated Energy Operations 1.0 1.8 2.0 4.7
Real Estate - 0.1 - 0.3
Other 1.3 0.4 3.1 2.1
---------------------------------------------------------------------------------------------------------------------
$7.3 $6.6 $20.1 $20.1
---------------------------------------------------------------------------------------------------------------------
Other Income (Expense)
Regulated Utility $0.1 - $0.6 $ 0.4
Nonregulated Energy Operations 0.9 $0.1 1.2 0.3
Investment in ATC 1.0 - 1.0 -
Other 1.7 0.3 6.0 (3.0)
---------------------------------------------------------------------------------------------------------------------
$3.7 $0.4 $8.8 $(2.3)
---------------------------------------------------------------------------------------------------------------------
Income (Loss)
Regulated Utility $13.7 $ 10.6 $33.5 $ 31.3
Nonregulated Energy Operations 1.1 1.6 2.9 (47.3)
Investment in ATC 0.6 - 0.6 -
Real Estate 5.1 4.0 15.7 13.7
Other 1.4 (0.4) 1.6 (4.3)
---------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations 21.9 15.8 54.3 (6.6)
Loss from Discontinued Operations (0.1) (0.6) (0.5) (1.1)
---------------------------------------------------------------------------------------------------------------------
Net Income (Loss) $21.8 $ 15.2 $53.8 $ (7.7)
---------------------------------------------------------------------------------------------------------------------
Diluted Average Shares of Common Stock 27.9 27.5 27.8 27.3
---------------------------------------------------------------------------------------------------------------------
Diluted Earnings (Loss)
Per Share of Common Stock
Continuing Operations $0.78 $0.58 $1.95 $(0.24)
Discontinued Operations - (0.02) (0.02) (0.04)
---------------------------------------------------------------------------------------------------------------------
$0.78 $0.56 $1.93 $(0.28)
---------------------------------------------------------------------------------------------------------------------
Included operating expenses totaling $77.9 million ($50.4 million after tax, or $1.84 per diluted share)
related to the assignment of the Kendall County power purchase agreement. (See Note 6.)
25 ALLETE Third Quarter 2006 Form 10-Q
EXECUTIVE SUMMARY (CONTINUED)
Net income for the quarter ended September 30, 2006, was $21.8 million, or $0.78
per diluted share ($15.2 million, or $0.56 per diluted share, for the quarter
ended September 30, 2005). Net income was higher in 2006 due to a $3.1 million
increase in income from Regulated Utility, a $1.1 million increase in income
from Real Estate, a $0.4 million increase in earnings on cash and short-term
investments, and $0.6 million of income from Investment in ATC.
Net income for the nine months ended September 30, 2006, was $53.8 million, or
$1.93 per diluted share (a $7.7 million, or $0.28 per diluted share, net loss
for the nine months ended September 30, 2005). Net income was higher in 2006 due
to the absence of: (1) the $50.4 million, or $1.84 per share, Kendall County
Charge incurred in the second quarter of 2005; (2) Kendall County operating
losses ($1.9 million in 2005); and (3) emerging technology impairments ($3.3
million in 2005). Net income in 2006 also reflected a $2.2 million increase in
income from Regulated Utility, a $2.0 million increase in income from Real
Estate, a $2.0 million increase in earnings on cash and short-term investments,
and $0.6 million of income from Investment in ATC.
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
KILOWATTHOURS SOLD 2006 2005 2006 2005
--------------------------------------------------------------------------------------------------------------------
MILLIONS
Regulated Utility
Retail and Municipals
Residential 263.0 254.5 800.1 804.2
Commercial 361.7 346.6 1,005.9 986.9
Industrial 1,836.9 1,782.8 5,429.1 5,306.8
Municipals 248.6 236.0 684.0 657.3
Other 20.8 20.7 59.4 59.2
--------------------------------------------------------------------------------------------------------------------
Total Retail and Municipals 2,731.0 2,640.6 7,978.5 7,814.4
Other Power Suppliers 584.3 261.3 1,604.9 864.9
--------------------------------------------------------------------------------------------------------------------
Total Regulated Utility 3,315.3 2,901.9 9,583.4 8,679.3
Nonregulated Energy Operations 60.4 405.8 181.3 1,159.6
--------------------------------------------------------------------------------------------------------------------
3,375.7 3,307.7 9,764.7 9,838.9
--------------------------------------------------------------------------------------------------------------------
QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2006 2005 2006 2005
-------------------------------------------------------------------------------
REAL ESTATE
REVENUE AND SALES ACTIVITY QTY AMOUNT QTY AMOUNT QTY AMOUNT QTY AMOUNT
-------------------------------------------------------------------------------------------------------------------
DOLLARS IN MILLIONS
Town Center Sales
Commercial Sq. Ft. 114,300 $ 3.6 246,000 $ 5.0 364,995 $ 9.8 643,000 $15.1
Residential Units 356 3.8 - - 542 9.4 - -
Palm Coast Park
Residential Units 200 3.0 - - 200 3.0 - -
Other Land Sales
Acres 242 4.9 521 7.6 708 20.4 1,058 32.2
Lots - - - - - - 7 0.4
-------------------------------------------------------------------------------------------------------------------
Contract Sales Price - 15.3 - 12.6 - 42.6 - 47.7
Revenue Recognized from
Previously Deferred Sales - 1.0 - - - 5.3 - -
Deferred Revenue - (2.9) - (2.5) - (6.8) - (11.0)
Adjustments - 0.6 - (0.7) - (0.9) - (1.6)
-------------------------------------------------------------------------------------------------------------------
Revenue from Land Sales 14.0 9.4 40.2 35.1
Other Revenue 1.1 1.8 3.8 3.8
-------------------------------------------------------------------------------------------------------------------
$15.1 $11.2 $44.0 $38.9
-------------------------------------------------------------------------------------------------------------------
Reflected total contract sales price on closed land transactions.
Contributed development dollars, which are credited to cost of real estate sold.
ALLETE Third Quarter 2006 Form 10-Q 26
NET INCOME
The following income discussion summarizes a comparison of the nine months ended
September 30, 2006, to the nine months ended September 30, 2005, by segment.
REGULATED UTILITY contributed income of $33.5 million in 2006 ($31.3 million in
2005). Higher earnings in 2006 reflected a 10 percent increase in kilowatthour
sales partially offset by higher operating expenses. Electric sales increased
904.1 million kilowatthours, primarily due to the inclusion of Taconite Harbor
and its pre-existing wholesale energy sales obligations. Operating expenses were
higher in 2006 due to the inclusion of Taconite Harbor, effective January 1,
2006, and increased planned maintenance, employee compensation and pension
expenses.
NONREGULATED ENERGY OPERATIONS reported income of $2.9 million in 2006 ($47.3
million loss in 2005). In April 2005, we completed the assignment of our Kendall
County power purchase agreement to Constellation Energy Commodities. As a result
of this transaction, we incurred a charge to operating expenses totaling $50.4
million after tax in the second quarter of 2005. In 2006, financial results
reflected the absence of income from Taconite Harbor ($3.7 million in 2005)
which is now reported as part of Regulated Utility and operating losses from
Kendall County ($1.9 million in 2005). Income from our coal operations was up
$0.4 million from 2005 primarily due to an 11 percent increase in the delivery
price per ton due to higher coal production expenses.
INVESTMENT IN ATC contributed income of $0.6 million in 2006. We began investing
in ATC in May 2006. As of September 30, 2006, our equity investment in ATC was
$35.2 million including reinvested earnings less dividends, which equated to
approximately a 5 percent ownership interest. By the end of 2006, we anticipate
having approximately $60 million invested in ATC.
REAL ESTATE contributed income of $15.7 million in 2006 ($13.7 million in 2005).
Income was higher in 2006 due to the timing and mix of land sale transaction
closings, and earnings from prior land sales at our Town Center development
project which are accounted for under the percentage-of-completion method. The
timing of the closing of real estate sales varies from period to period and
impacts comparisons between years.
In June 2005, we began selling property from our Town Center development
project. In August 2006, we began selling property from our Palm Coast Park
development project. Since land is being sold before completion of the project
infrastructure, revenue, cost of real estate sold and selling expenses are
recorded using the percentage-of-completion method as development obligations
are completed. As of September 30, 2006, we had $9.5 million ($13.0 million
revenue; $3.1 million cost of real estate sold; $0.4 million selling expense) of
deferred profit on sales of real estate, before taxes and minority interest, on
our balance sheet. Most of the deferred profit relates to Town Center.
REAL ESTATE
PENDING CONTRACTS CONTRACT
AT SEPTEMBER 30, 2006 QUANTITY SALES PRICE
--------------------------------------------------------------------------------
DOLLARS IN MILLIONS
Town Center
Commercial Sq. Ft. 789,977 $ 24.0
Residential Units 1,241 19.8
Palm Coast Park
Commercial Sq. Ft. 50,000 2.5
Residential Units 2,269 60.3
Other Land
Acres 231 7.9
--------------------------------------------------------------------------------
$ 114.5
--------------------------------------------------------------------------------
Acreage amounts are approximate and shown on a gross basis, including
wetlands and minority interest. Acreage amounts may vary due to platting or
surveying activity. Wetland amounts vary by property and are often not
formally determined prior to sale. Commercial square feet and residential
units are estimated and include minority interest. The actual property
allocation at full build-out may be different than these estimates.
27 ALLETE Third Quarter 2006 Form 10-Q
NET INCOME (CONTINUED)
At September 30, 2006, total pending land sales under contract were $114.5
million and are anticipated to close at various times through 2012. Pricing on
these contracts range from $20 to $50 per commercial square foot, $8,600 to
$34,000 per residential unit and $11,000 to $1,091,000 per acre for all other
properties. The majority of the other properties under contract are zoned
commercial or mixed use. Prices per acre are stated on a gross acreage basis and
are dependent on the type and location of the properties sold. In addition,
certain contracts will allow us to receive participation revenue when gross
revenue from sales by our purchaser exceeds contractually defined price levels.
If a purchaser defaults under terms of a contract, our remedies generally
include retention of the purchaser's deposit and the ability to remarket the
property to other prospective buyers. In many cases the purchaser has also
incurred significant costs in planning, designing and marketing of the property
under contract before the contract closes.
OTHER reflected net income of $1.6 million in 2006 (a $4.3 million loss in
2005). In 2006, a $2.0 million increase in earnings on cash and short-term
investments more than offset a $0.3 million increase in equity losses related to
emerging technology investments and a $0.3 million call premium we incurred
related to the early redemption of industrial development refunding revenue
bonds. In 2005, we recorded $3.3 million of impairments related to two
privately-held emerging technology investments and also recognized a $0.6
million charge due to the probable payment under our guarantee of Northwest
Airlines debt.
DISCONTINUED OPERATIONS included our Water Services businesses that we sold over
the three-year period from 2003 to 2005, and Enventis Telecom, our
telecommunications business that we sold in December 2005. In 2006, discontinued
operations reflected a $0.5 million loss resulting from additional legal and
administrative expenses related to exiting the Water Services businesses. In
2005, $0.8 million of income from Enventis Telecom was offset by $1.9 million of
administrative and other expenses incurred to support Florida Water transfer
proceedings. (See Note 9.)
COMPARISON OF THE QUARTERS ENDED SEPTEMBER 30, 2006 AND 2005
REGULATED UTILITY
OPERATING REVENUE was up $30.7 million, or 22 percent, from 2005,
reflecting increased kilowatthour sales and increased fuel clause
recoveries. Electric sales increased 413.4 million kilowatthours, or 14
percent, due mostly to the addition of Taconite Harbor wholesale power
obligations to the Regulated Utility segment effective January 1, 2006. In
2006, the majority of Taconite Harbor sales are reflected in sales to other
power suppliers. Sales to other power suppliers were 584.3 million
kilowatthours and $27.2 million in 2006 (261.3 million kilowatthours and
$12.5 million in 2005). Absent the inclusion of pre-existing Taconite
Harbor wholesale obligations, sales to other power suppliers were down
reflecting less excess energy available for sale due to planned outages at
Company generating facilities in 2006. Electric sales to retail and
municipal customers increased 90.4 million kilowatthours, or 3 percent, and
$16.3 million, as a result of strong demand from residential, commercial,
and municipal customers due to record warm temperatures in 2006 and
increased usage by industrial customers, primarily in the paper and
pipeline industries. Fuel clause recoveries were higher in 2006 as a result
of increased fuel and purchased power expenses in 2006.
Revenue from electric sales to taconite customers accounted for 24 percent
of consolidated operating revenue in both 2006 and 2005. Revenue from
electric sales to paper and pulp mills accounted for 9 percent of
consolidated operating revenue in both 2006 and 2005.
OPERATING EXPENSES were up $24.5 million, or 21 percent, from 2005.
FUEL AND PURCHASED POWER EXPENSE. Fuel and purchased power expense was up
$20.6 million from 2005 reflecting the inclusion of Taconite Harbor
beginning in 2006 ($5.8 million) and higher purchased power expense due to
increased kilowatthour sales, less Company hydro generation available as a
result of below normal precipitation levels, and planned maintenance
outages at Company generating facilities in 2006.
ALLETE Third Quarter 2006 Form 10-Q 28
COMPARISON OF THE QUARTERS ENDED SEPTEMBER 30, 2006 AND 2005
REGULATED UTILITY (CONTINUED)
OTHER OPERATING EXPENSES. In total, other operating expenses were up $3.9
million from 2005. Employee compensation was up $1.7 million primarily due
to the inclusion of Taconite Harbor, annual wage increases and the
inclusion of union employees in our results sharing compensation awards
program. Depreciation expense increased $1.2 million primarily due to the
inclusion of Taconite Harbor. In total, plant maintenance expense increased
$0.9 million from 2005 reflecting the inclusion of Taconite Harbor
maintenance in 2006 ($0.8 million), a planned outage at our Boswell Unit 3
generating facility ($0.7 million) and increased equipment fuel expense
($0.4 million), partially offset by a $1.0 million reduction in expenses at
our other generating facilities primarily due to the timing of outages.
Pension expense increased $0.6 million due to a reduction in the discount
rate. MISO expenses were down $0.5 million, primarily due to decreased
transactions with other power suppliers.
INTEREST EXPENSE was up $0.7 million, or 16 percent, from 2005 due to the
inclusion of Taconite Harbor in 2006, partially offset by lower effective
interest rates (5.91 percent in 2006; 6.02 percent in 2005).
NONREGULATED ENERGY OPERATIONS
OPERATING REVENUE was down $12.8 million, or 45 percent, from 2005 due to
the absence of revenue from Taconite Harbor ($15.0 million in 2005).
Effective January 1, 2006, Taconite Harbor is reported as part of the
Regulated Utility segment. Coal revenue, realized under a cost-plus
contract, was up $1.1 million from 2005 reflecting a 16 percent increase in
the delivery price per ton due to higher coal production expenses (see
operating expenses below), partially offset by a 3 percent decrease in tons
of coal sold in 2006. Tons of coal sold were lower in 2006 primarily due to
an outage at the Square Butte generating facility.
OPERATING EXPENSES were down $10.4 million, or 42 percent, from 2005
reflecting the absence of expenses related to Taconite Harbor ($12.2
million in 2005). Expenses related to coal operations were up $1.4 million,
mainly due to increased equipment lease costs and increased fuel expenses
in 2006.
INTEREST EXPENSE was down $0.8 million, or 44 percent, from 2005 primarily
due to the absence of Taconite Harbor in 2006.
INVESTMENT IN ATC
OTHER INCOME (EXPENSE) reflected $1.0 million of income in 2006 from our
equity investment in ATC, resulting from our share of ATC's earnings.
REAL ESTATE
OPERATING REVENUE was up $3.9 million, or 35 percent, from 2005, due to the
timing and mix of land sale transaction closings, and revenue from prior
land sales at our Town Center development project which are accounted for
under the percentage-of-completion method. Revenue from land sales was
$14.0 million in 2006 which included $1.0 million of previously deferred
revenue. In 2005, revenue from land sales was $9.4 million. In 2006, 242
acres of other land were sold (521 acres in 2005). Sales at Town Center
represented 356 residential units and the rights to build up to 114,300
square feet of commercial space in 2006 (246,000 commercial square feet in
2005). Sales at Palm Coast Park represented 200 residential units in 2006.
In 2006, revenue of $2.9 million ($2.5 million in 2005) was deferred and
will be recognized on a percentage-of-completion basis as development
obligations are completed.
OPERATING EXPENSES were up $2.1 million, or 72 percent, from 2005
reflecting a $1.4 million increase in the cost of real estate sold ($2.8
million in 2006; $1.4 million in 2005) due to the mix of land sold and
increased expense recognition at our Town Center development project, which
are accounted for under the percentage-of-completion method, and a $0.4
million increase in selling expenses due to higher brokerage fees.
29 ALLETE Third Quarter 2006 Form 10-Q
COMPARISON OF THE QUARTERS ENDED SEPTEMBER 30, 2006 AND 2005 (CONTINUED)
OTHER
OPERATING EXPENSES were down $0.5 million, or 50 percent, from 2005,
reflecting lower general and administrative expenses in 2006.
INTEREST EXPENSE was up $0.9 million from 2005, primarily due to interest
on additional taxes owed on the gain on the sale of our Florida Water
assets.
OTHER INCOME was up $1.4 million from 2005 reflecting a $1.1 million
increase in earnings on cash and short-term investments, and the absence of
a $1.0 million charge recognized in 2005 for the probable payment under our
guarantee of Northwest Airlines debt partially offset by a $0.6 million
call premium related to the early redemption of industrial development
refunding revenue bonds in 2006.
INCOME TAXES
For the quarter ended September 30, 2006, the effective rate for income taxes
was 34.5 percent (36.6 percent for the quarter ended September 30, 2005). The
decrease in the effective rate compared to last year was primarily due to
finalization of taxes related to the spin-off of ADESA. The effective rate of
34.5 percent for the quarter ended September 30, 2006, was less than the
statutory rate, primarily because of investment tax credits, deductions for
Medicare health subsidies, depletion and finalization of taxes related to the
spin-off of ADESA.
COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
REGULATED UTILITY
OPERATING REVENUE was up $54.2 million, or 13 percent, from 2005,
reflecting increased kilowatthour sales and increased fuel clause
recoveries. Electric sales increased 904.1 million kilowatthours, or 10
percent, due mostly to the addition of Taconite Harbor wholesale power
obligations to the Regulated Utility segment effective January 1, 2006. In
2006, the majority of Taconite Harbor sales are reflected in sales to other
power suppliers. Sales to other power suppliers were 1,604.9 million
kilowatthours and $71.0 million (864.9 million kilowatthours and $38.6
million in 2005). Absent the inclusion of pre-existing Taconite Harbor
wholesale obligations, sales to other power suppliers were down reflecting
less excess energy available for sale due to planned outages at Company
generating facilities in 2006. Electric sales to retail and municipal
customers increased 164.1 million kilowatthours, or 2 percent, and $20.5
million, mainly due to strong demand from industrial customers. Fuel clause
recoveries were higher in 2006 as a result of increased fuel and purchased
power expenses in 2006.
Revenue from electric sales to taconite customers accounted for 24 percent
of consolidated operating revenue in 2006 (23 percent in 2005). Revenue
from electric sales to paper and pulp mills accounted for 9 percent of
consolidated operating revenue in both 2006 and 2005.
OPERATING EXPENSES were up $48.8 million, or 14 percent, from 2005.
FUEL AND PURCHASED POWER EXPENSE. Fuel and purchased power expense was up
$29.8 million from 2005, reflecting the inclusion of Taconite Harbor
operations beginning in 2006 ($16.6 million) and increased purchased power
expense due to higher prices paid for purchased power, less Company hydro
generation available as a result of below normal precipitation levels, and
planned maintenance at Company generating facilities in 2006.
OTHER OPERATING EXPENSES. In total, other operating expenses were up $19.0
million from 2005. Employee compensation was up $6.8 million primarily due
to the inclusion of Taconite Harbor, annual wage increases and the
inclusion of union employees in our results sharing compensation awards
program. In total, plant maintenance expense increased $4.0 million from
2005 reflecting the inclusion of Taconite Harbor maintenance in 2006 ($3.0
million), increased planned maintenance expense at Boswell Unit 4 ($1.9
million) and increased equipment fuel expenses ($0.8 million) partially
offset by a decrease in maintenance expense at Boswell Unit 3 ($1.6
million). In 2005, planned maintenance was performed at Boswell Unit 3
while the unit was down due to a cooling tower failure. Depreciation
expense increased $3.8 million primarily due to the inclusion of Taconite
Harbor. Pension expense increased $1.8 million due to a reduction in the
discount rate.
ALLETE Third Quarter 2006 Form 10-Q 30
COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005 (CONTINUED)
REGULATED UTILITY (CONTINUED)
INTEREST EXPENSE was up $2.0 million, or 15 percent, from 2005, due to the
inclusion of Taconite Harbor in 2006 partially offset by lower effective
interest rates (5.93 percent in 2006; 6.10 percent in 2005).
NONREGULATED ENERGY OPERATIONS
OPERATING REVENUE was down $34.4 million, or 41 percent, from 2005 due to
the absence of revenue from Taconite Harbor ($39.6 million in 2005) and
Kendall County ($3.1 million in 2005). Effective January 1, 2006, Taconite
Harbor is reported as part of Regulated Utility. Kendall County operations
ceased to be included with our operations effective April 1, 2005, when the
Company assigned the power purchase agreement to Constellation Energy
Commodities. Coal revenue, realized under a cost-plus contract, was up $3.3
million from 2005 reflecting an 11 percent increase in the delivery price
per ton due to higher coal production expenses (see operating expenses
below). In 2006, tons of coal sold were similar to 2005.
OPERATING EXPENSES were down $108.1 million, or 71 percent, from 2005
reflecting the absence of a $77.9 million charge related to the assignment
of the Kendall County power purchase agreement to Constellation Energy
Commodities on April 1, 2005, expenses related to Taconite Harbor ($31.2
million in 2005) and other expenses related to Kendall County ($6.3 million
in 2005) that were incurred prior to April 1, 2005. Expenses related to
coal operations were up $3.0 million mainly due to increased equipment
lease costs and increased fuel expenses in 2006.
INTEREST EXPENSE was down $2.7 million, or 57 percent, primarily due to the
absence of Taconite Harbor in 2006.
INVESTMENT IN ATC
OTHER INCOME (EXPENSE) reflected $1.0 million of income in 2006 from our
equity investment in ATC, resulting from our share of ATC's earnings.
REAL ESTATE
OPERATING REVENUE was up $5.1 million, or 13 percent, from 2005, due to the
timing and mix of land sale transaction closings, and revenue from prior
land sales at our Town Center development project which are accounted for
under the percentage-of-completion method. Revenue from land sales was
$40.2 million in 2006 which included $5.3 million of previously deferred
revenue. In 2005, revenue from land sales was $35.1 million. In 2006, 708
acres of other land were sold (1,058 acres and 7 lots in 2005). Sales at
Town Center represented 542 residential units and the rights to build up to
364,995 square feet of commercial space in 2006 (643,000 commercial square
feet in 2005). Sales at Palm Coast Park represented 200 residential units
in 2006. The first land sales for Town Center were recorded in June 2005
and the first land sales at Palm Coast Park were recorded in August 2006.
In 2006, revenue of $6.8 million ($11.0 million in 2005) was deferred and
will be recognized on a percentage-of-completion basis as development
obligations are completed.
OPERATING EXPENSES were up $0.9 million, or 7 percent, from 2005 reflecting
a $0.2 million increase in the cost of real estate sold ($7.4 million in
2006; $7.2 million in 2005), and a $0.2 million increase in selling
expenses.
31 ALLETE Third Quarter 2006 Form 10-Q
COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005 (CONTINUED)
OTHER
OPERATING EXPENSES were down $0.4 million, or 14 percent, from 2005,
reflecting lower general and administrative expenses in 2006.
INTEREST EXPENSE was up $1.0 million, or 48 percent, from 2005, primarily
due to interest on additional taxes owed on the gain on the sale of our
Florida Water assets.
OTHER INCOME (EXPENSE) reflected $9.0 million more income in 2006 due to a
$3.6 million increase in earnings on cash and short-term investments, the
absence of $5.1 million of impairments related to two privately-held
emerging technology impairments recorded in 2005 and the absence of a $1.0
million charge recognized in 2005 for the probable payment under our
guarantee of Northwest Airlines debt. In 2006, other income (expense) also
reflected a $0.6 million call premium related to the early redemption of
industrial development refunding revenue bonds and a $0.4 million increase
in equity losses related to emerging technology investments.
INCOME TAXES
For the nine months ended September 30, 2006, the effective rate for income
taxes was 36.2 percent (8.7 percent benefit for the nine months ended September
30, 2005). The increase in the effective rate compared to last year was
primarily due to the emerging technology impairment and the Kendall County
capital loss recorded in April 2005. The current benefit for these items was
limited to the federal benefit as the state net capital loss carryforwards from
2005 were entirely reserved. The effective rate of 36.2 percent for the nine
months ended September 30, 2006, was less than the statutory rate primarily
because of investment tax credits, deductions for Medicare health subsidies,
depletion and finalization of taxes related to the spin-off of ADESA.
NON-GAAP FINANCIAL MEASURES
We prepare financial statements in accordance with GAAP. Along with this
information, we disclose and discuss certain non-GAAP financial information in
our quarterly earnings releases, on investor conference calls and during
investor conferences and related events. Management believes that non-GAAP
financial data supplements our GAAP financial statements by providing investors
with additional information which enhances the investors' overall understanding
of our financial performance and the comparability of our operating results from
period to period. The presentation of this additional information is not meant
to be considered in isolation or as a substitute for our results of operations
prepared and presented in accordance with GAAP.
As earlier mentioned, our financial results for 2005 were significantly impacted
by a $50.4 million after tax, or $1.84 per share, charge due to the assignment
of the Kendall County power purchase agreement to Constellation Energy
Commodities. (See Note 6.)
Since the Kendall County transaction significantly impacted the financial
results from continuing operations for the nine months ended September 30, 2005,
we believe that, for comparative purposes and a more accurate reflection of our
ongoing operations, it is useful to present diluted earnings per share from
continuing operations for each applicable period excluding the impact of this
transaction. The table below reconciles actual reported diluted earnings per
share from continuing operations to the adjusted results that exclude the
Kendall County transaction in the respective period.
NINE MONTHS ENDED
SEPTEMBER 30,
2006 2005
------------------------------------------------------------------------------------------------
DILUTED EARNINGS (LOSS) PER SHARE OF COMMON STOCK
Continuing Operations - As Reported $1.95 $(0.24)
Add: Kendall County Charge - 1.84
------------------------------------------------------------------------------------------------
Continuing Operations - As Adjusted $1.95 $ 1.60
------------------------------------------------------------------------------------------------
ALLETE Third Quarter 2006 Form 10-Q 32
CRITICAL ACCOUNTING POLICIES
Certain accounting measurements under applicable GAAP involve management's
judgment about subjective factors and estimates, the effects of which are
inherently uncertain. Accounting measurements that we believe are most critical
to our reported results of operations and financial condition include:
impairment of long-lived assets, pension and postretirement health and life
actuarial assumptions, valuation of investments and provisions for environmental
remediation. These policies are reviewed with the Audit Committee of our Board
of Directors on a regular basis and summarized in our 2005 Form 10-K.
OUTLOOK
EARNINGS GUIDANCE. In February 2006, we projected ALLETE's earnings per share
from continuing operations to grow by 15 percent to 20 percent in 2006 as
outlined in our 2005 Form 10-K. We now expect ALLETE's 2006 earnings to be near
the upper end of our earnings guidance range. The growth is expected to come
from continued strong electric sales, increased earnings from real estate and
our investment in ATC. It also reflects the absence of operating losses from
Kendall County and impairments related to our emerging technology investments
which impacted the Company's financial results in 2005.
ENERGY. Over the next several years, we believe electric utilities will be
facing the unfolding impacts of three major developments that occurred in
2005--changes in regional transmission operation, the development of rulemaking
on the enactment of stricter environmental regulations and federal legislation
impacting the structure and organization of the electric utility industry. We
believe our energy businesses are well positioned to successfully deal with
these issues and to compete successfully. Our access to and ownership of
low-cost power are our greatest strengths. We anticipate that we will have ready
access to sufficient capital for general business purposes.
RESOURCE PLAN. In 2006, the MPUC approved our Resource Plan, which detailed our
retail energy demand projections and our energy sourcing options to meet
projected demand. We project a load growth of approximately 150 MW by 2010, with
another 200 MW of growth anticipated by 2015. One of the key components of the
Resource Plan was the redirection of our Taconite Harbor generating facility
from nonregulated energy operations to regulated utility operations effective
January 1, 2006. The Taconite Harbor generation will be supplemented with a
50-MW long-term power purchase agreement with Manitoba Hydro which extends from
2009 to 2015. This agreement was executed in June 2006 and will be filed for
approval with the MPUC. Expansion of our renewable generating assets to meet
Minnesota's Renewable Energy Objective was also approved by the MPUC. The
Renewable Energy Objective seeks a 10 percent supply of qualified renewable
energy resources for each Minnesota utility by 2015. In April 2006, construction
began on a 50-MW wind facility in North Dakota and is expected to be completed
by the end of 2006. We will purchase the output from this wind facility under a
25-year power purchase agreement with an affiliate of FPL Energy, LLC. We
anticipate that retail demand by customers in our service territory will
increase at an average annual rate of 1.5 percent to 2019.
AREA AND BOSWELL 3 EMISSION REDUCTION PLANS. In May 2006, the MPUC approved our
filing for cost recovery of planned expenditures to reduce emissions to meet
pending federal requirements at Taconite Harbor and Laskin under the AREA plan.
The AREA plan approval allows Minnesota Power to recover Minnesota
jurisdictional costs for SO2, NOx and mercury emission reductions made at these
facilities without a rate proceeding. Minnesota cost recovery will include
return on investment, depreciation, and incremental operations and maintenance
expenses. Minnesota Power plans to complete installation of new equipment at the
first of two Laskin units by the end of November 2006, with the first of three
Taconite Harbor unit installations anticipated to be completed by mid-2007. Work
on all units is anticipated to be completed by the end of 2008. Cost recovery
filings are required to be made 90 days prior to the anticipated in-service date
for the equipment at each unit, with rate recovery beginning the month following
the in-service date.
In May 2006, we announced plans to make emission reduction investments at our
Boswell Unit 3 generating unit. Plans include reductions of particulate, SO2,
NOx and mercury emissions to meet pending federal and state requirements. The
estimated cost for these reductions is $200 million, which the Company expects
to spend from 2007 through 2009. On October 27, 2006, we submitted a filing to
the MPCA for approval of the Boswell Unit 3 emission reduction plan. A filing
with the MPUC for approval
33 ALLETE Third Quarter 2006 Form 10-Q
OUTLOOK (CONTINUED)
of Minnesota jurisdictional related expenditures on Boswell Unit 3 will follow
in approximately 60 days. MPUC approval would allow cost recovery on these
investments without a rate proceeding. Filing approval would authorize a cash
return on construction work in progress during the construction phase and allow
recovery for a return on investment, depreciation and incremental operations and
maintenance expenses once placed into service in late 2009.
LARGE POWER CONTRACTS. Electric power is a key component in the production of
taconite and paper, and these industries represent more than half of Minnesota
Power's regulated utility electric sales. In March and April 2006, the MPUC
approved new all-requirements agreements with Stora Enso Oyj's Duluth mills
through August 31, 2013, and UPM-Kymmene Corporation's Blandin Paper mill in
Grand Rapids through April 30, 2010. Three other long-term agreements were
approved by the MPUC in 2005, extending contracts for an additional four to
eight years. The extension of our electric supply contracts is an important
achievement for our large power customers and Minnesota Power because it
provides planning certainty for both our customers and us.
MISO AND FUEL CLAUSE. In February 2006, the MPUC issued an order that granted
rehearing of the MISO Day 2 docket and suspended the refund obligation. The
Company worked with other Minnesota utilities, the DOC and other stakeholders to
prepare a joint recommendation required by the MPUC in its February 2006 order,
of which costs should be recovered on a current basis through the fuel clause
and which costs are more appropriately deferred for potential recovery through
base rates. The joint report and recommendations were filed with the MPUC in
June 2006. A technical conference on the report is scheduled at the MPUC for
October 31, 2006, with a hearing currently scheduled for November 9, 2006. (See
Note 13.)
EXCELSIOR ENERGY INC. (Excelsior) has proposed to construct two 600 MW (net)
coal-gasification generation units in northern Minnesota. The project is in the
early development stages but may be an option for our long-term forecasted
energy and capacity needs. Excelsior says the facility could be operational in
2011, but it needs to obtain the necessary permits and financing. In 2003, the
Minnesota legislature enacted several provisions that provide Excelsior with
special considerations, including requiring utilities within the state to
"consider" Excelsior before pursuing new fossil-fuel-fired resource additions
within Minnesota. In December 2005, Excelsior filed a petition with the MPUC
seeking approval of an unexecuted power purchase agreement with Xcel Energy Inc.
In January 2006, Minnesota Power filed comments with the MPUC in Excelsior's
proposed power purchase agreement proceeding, focusing on the importance to the
state of maintaining a range of base load energy options, including multiple
fuel types and generating technologies. In April 2006, the MPUC referred
Excelsior's petition to an administrative law proceeding to further develop the
record in the case for subsequent MPUC deliberations. Minnesota Power continues
to be a participant in these proceedings, focusing its comments on energy policy
and infrastructure impacts.
INVESTMENT IN ATC. In May 2006, the PSCW reviewed and approved the request that
allows us to invest $60 million in ATC. As of September 30, 2006, our equity
investment in ATC was $35.2 million including reinvested earnings less
dividends, which equated to approximately a 5 percent ownership interest. By the
end of 2006, we anticipate having approximately $60 million invested in ATC.
SWL&P RATE CASE. In May 2006, SWL&P filed an application with the PSCW for
authority to increase retail utility rates an average of 5.2 percent and
requested an 11.7 percent return on common equity. Cost of service studies and
rate designs for all retail customer classes were filed in June 2006. The PSCW
has scheduled a public hearing for November 2006. The Company anticipates an
order before year end and that new rates will become effective in January 2007.
ALLETE Third Quarter 2006 Form 10-Q 34
OUTLOOK (CONTINUED)
REAL ESTATE. Our real estate business, ALLETE Properties, is well positioned to
continue year over year earnings growth. We have a diversified mix of property
under contract and available for sale--residential, commercial and industrial.
Rapid residential growth over the past few years in our markets has created a
steady demand for our commercial properties. As of September 30, 2006, we had
$114.5 million of pending contracts scheduled to close over the next several
years. Once our Ormond Crossings development project approval process is
complete, the amount of entitled property available for sale will increase. We
believe the long-term growth indicators for Florida real estate remain strong.
Progress continues on our three major planned development projects in
Florida--Town Center, which will be a new downtown for Palm Coast; Palm Coast
Park, which is located in northwest Palm Coast; and Ormond Crossings, which is
located in Ormond Beach along Interstate 95.
TOWN CENTER. We began selling property from our Town Center development project
in northeast Florida in 2005. Developers who have purchased land from us have
started construction activities. Since land is being sold before completion of
the project infrastructure, revenue and cost of real estate sold are recorded
using a percentage-of-completion method. Pending land sales under contract for
properties at Town Center totaled $43.8 million at September 30, 2006.
PALM COAST PARK. In May 2006, Palm Coast Park District issued $31.8 million of
tax-exempt, special assessment bonds, the majority of which will be used to fund
environmental and traffic mitigation, and the construction of infrastructure
improvements at Palm Coast Park. We began selling property at Palm Coast Park in
August 2006. At September 30, 2006, pending land sales under contract for
properties at Palm Coast Park totaled $62.8 million. We have the opportunity to
receive participation revenue as part of these sales contracts.
ORMOND CROSSINGS. We anticipate that the Development of Regional Impact approval
process will be concluded in late 2006, at which time we would receive a
Development Order from the City of Ormond Beach. Engineering, design and
permitting will continue through 2007. It is not anticipated that any sales will
be made at Ormond Crossings until 2008.
As of September 30, 2006, we had $9.5 million of deferred profit on sales of
real estate, before taxes and minority interest, on our balance sheet. Most of
the deferred profit relates to Town Center.
ALLETE Properties provides seller financing, and outstanding finance receivables
were $16.5 million at September 30, 2006, with maturities ranging up to seven
years. Outstanding finance receivables accrue interest at market-based rates.
These finance receivables are collateralized by the financed properties.
SUMMARY OF DEVELOPMENT PROJECTS INVENTORY RESIDENTIAL COMMERCIAL
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006 OWNERSHIP UNITS SQ. FT.
-----------------------------------------------------------------------------------------------------------------------
Town Center at Palm Coast 80%
At December 31, 2005 2,833 2,927,700
Property Sold (542) (364,995)
Change in Estimate 247 (23,130)
-----------------------------------------------------------------------------------------------------------------------
2,538 2,539,575
-----------------------------------------------------------------------------------------------------------------------
Palm Coast Park 100%
At December 31, 2005 3,600 3,200,000
Property Sold (200) -
Change in Estimate - -
-----------------------------------------------------------------------------------------------------------------------
3,400 3,200,000
Ormond Crossings 100%
-----------------------------------------------------------------------------------------------------------------------
5,938 5,739,575
-----------------------------------------------------------------------------------------------------------------------
Estimated and includes minority interest. The actual property allocation at full build-out may be different than
these estimates.
Includes industrial, office and retail square footage.
The Development of Regional Impact Application for Development Approval submitted in August 2005 proposed
4,400 residential units and 5 million square feet of commercial space, and is subject to approval by regulating
governmental entities.
35 ALLETE Third Quarter 2006 Form 10-Q
OUTLOOK (CONTINUED)
SUMMARY OF OTHER LAND INVENTORIES
FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 2006 OWNERSHIP TOTAL MIXED USE RESIDENTIAL COMMERCIAL AGRICULTURAL
-----------------------------------------------------------------------------------------------------------------------
ACRES
Palm Coast Holdings 80%
At December 31, 2005 2,566 1,692 346 281 247
Property Sold (308) (289) - (18) (1)
Contributed Land (4) - - (4) -
Change in Estimate (97) - - - (97)
-----------------------------------------------------------------------------------------------------------------------
2,157 1,403 346 259 149
-----------------------------------------------------------------------------------------------------------------------
Lehigh 80%
At December 31, 2005 613 390 140 74 9
Property Sold (390) (390) - - -
-----------------------------------------------------------------------------------------------------------------------
223 - 140 74 9
-----------------------------------------------------------------------------------------------------------------------
Cape Coral 100%
At December 31, 2005 41 - 1 40 -
Property Sold (10) - - (10) -
-----------------------------------------------------------------------------------------------------------------------
31 - 1 30 -
-----------------------------------------------------------------------------------------------------------------------
Other 100% 944 - - - 944
-----------------------------------------------------------------------------------------------------------------------
3,355 1,403 487 363 1,102
-----------------------------------------------------------------------------------------------------------------------
Acreage amounts are approximate and shown on a gross basis, including wetlands and minority interest. Acreage
amounts may vary due to platting or surveying activity. Wetland amounts vary by property and are often not
formally determined prior to sale. The actual property allocation at full build-out may be different than these
estimates.
Includes land located in Ormond Beach, Florida, and other land located in Palm Coast, Florida not included in
development projects.
LIQUIDITY AND CAPITAL RESOURCES
CASH FLOW ACTIVITIES
A primary goal of our strategic plan is to improve cash flow from operations.
Our strategy includes growing our businesses both internally by expanding
facilities, services and operations (see Capital Requirements), and externally
through acquisitions.
We believe our financial condition is strong, as evidenced by cash and cash
equivalents and short-term investments of $173.0 million, and a debt to total
capital ratio of 37 percent at September 30, 2006.
OPERATING ACTIVITIES. Cash flow from operating activities was $90.5 million for
the nine months ended September 30, 2006 ($20.7 million for the nine months
ended September 30, 2005). Cash from operating activities was higher in 2006,
primarily due to the $77.9 million Kendall County Charge in 2005 and related
$24.3 million deferred federal tax refund received in 2006. Cash used for
inventories was $6.2 million higher in 2006 reflecting more coal purchases in
anticipation of maintenance on some coal handling equipment which was completed
at the end of September. Cash used for discontinued operations was higher in
2006 due to payment of approximately $13 million of 2005 accrued liabilities.
INVESTING ACTIVITIES. Cash flow for investing activities was $101.6 million for
the nine months ended September 30, 2006 (cash flow from investing activities
was $34.0 million for the nine months ended September 30, 2005). Cash used for
investing activities was higher in 2006 than 2005, primarily due to activities
within our short-term investments. In 2006, net purchases of $4.7 million were
used for short-term investments, while 2005 included $82.5 million of net
proceeds that were received from the sale of short-term investments. Gross
proceeds from the sale of available-for-sale securities were $483.9 million in
2006 ($323.5 million in 2005) and purchases were $488.6 million ($241.0 million
in 2005). Cash used for investing activities in 2006 reflected $34.3 million
invested in ATC and a $16.2 million increase in additions to property, plant and
equipment which vary from year to year.
ALLETE Third Quarter 2006 Form 10-Q 36
LIQUIDITY AND CAPITAL RESOURCES (CONTINUED)
FINANCING ACTIVITIES. Cash flow for financing activities was $27.1 million for
the nine months ended September 30, 2006 ($9.4 million for the nine months ended
September 30, 2005). Cash used for financing activities increased in 2006 due to
an additional $7.7 million of dividends paid because of more shares outstanding
and an increase in the dividend rate. Cash from financing activities was $4.3
million lower in 2006, primarily due to fewer shares issued under our long-term
incentive compensation plan. In 2006, we refinanced $77.8 million of long-term
debt at lower rates.
WORKING CAPITAL. Additional working capital, if and when needed, generally is
provided by the sale of commercial paper. We have 0.6 million original issue
shares of our common stock available for issuance through INVEST DIRECT, our
direct stock purchase and dividend reinvestment plan. We have bank lines of
credit aggregating $170.0 million, the majority of which expire in January 2011.
In January 2006, we renewed, increased and extended a committed, syndicated,
unsecured revolving credit facility with LaSalle Bank National Association, as
Agent, for $150 million (Line). The Line matures on January 11, 2011. At our
request and subject to certain conditions, the Line may be increased to $200
million and extended for two additional 12-month periods. We may prepay amounts
outstanding under the Line in whole or in part at our discretion without premium
or penalty. Additionally, we may irrevocably terminate or reduce the size of the
Line prior to maturity without premium or penalty. The Line may be used for
general corporate purposes and working capital, and to provide liquidity in
support of our commercial paper program. The amount and timing of future sales
of our securities will depend upon market conditions and our specific needs. We
may sell securities to meet capital requirements, to provide for the retirement
or early redemption of issues of long-term debt, to reduce short-term debt and
for other corporate purposes.
In May 2006, Palm Coast Park District issued $31.8 million of tax-exempt, 5.7%
Special Assessment Bonds, Series 2006, due May 1, 2037. The bonds were issued to
fund a portion of the Palm Coast Park development project in Florida. Bond
proceeds of $26.3 million will be used for environmental and traffic mitigation,
and the construction of infrastructure improvements, including utility
extensions, roadways, parks, drainage, recreational facilities, landscaping and
a multi-purpose trail system. The remaining funds will be used for capitalized
interest, a debt service reserve fund and the costs of issuance. The bonds are
payable from and secured by the revenue derived from assessments imposed, levied
and collected by the Palm Coast Park District. The assessments represent an
allocation of the costs of the improvements, including bond financing costs, to
the lands within the Palm Coast Park District benefiting from the improvements.
The assessments will be included in the annual property tax bills of landowners
beginning in November 2007. To the extent that we still own land at the time of
the assessment, in accordance with EITF 91-10, we will recognize the cost of our
portion of these assessments, based upon our ownership of benefited property. At
September 30, 2006, we owned 97 percent of the assessable land in the Palm Coast
Park District.
SECURITIES
In March 2001, ALLETE, ALLETE Capital II and ALLETE Capital III, jointly filed a
registration statement with the SEC, pursuant to Rule 415 under the Securities
Act of 1933. The registration statement, which has been declared effective by
the SEC, relates to the possible issuance of a remaining aggregate amount of
$387 million of securities, which may include ALLETE common stock, first
mortgage bonds and other debt securities, and ALLETE Capital II and ALLETE
Capital III preferred trust securities. ALLETE also previously filed a
registration statement, which has been declared effective by the SEC, relating
to the possible issuance of $25 million of first mortgage bonds and other debt
securities. We may sell all or a portion of the remaining registered securities
if warranted by market conditions and our capital requirements. Any offer and
sale of the above-mentioned securities will be made only by means of a
prospectus meeting the requirements of the Securities Act of 1933 and the rules
and regulations thereunder.
In March 2006, we issued $50 million in principal amount of First Mortgage
Bonds, 5.69% Series due March 1, 2036. Proceeds were used to redeem $50 million
in principal amount of First Mortgage Bonds, 7% Series due March 1, 2008.
37 ALLETE Third Quarter 2006 Form 10-Q
LIQUIDITY AND CAPITAL RESOURCES (CONTINUED)
On July 5, 2006, the Collier County Industrial Development Authority (Authority
or Issuer) issued $27.8 million of Industrial Development Variable Rate Demand
Refunding Revenue Bonds Series 2006 due 2025 (Refunding Bonds) on behalf of
ALLETE. The interest rate on these bonds was 3.7% at September 30, 2006.
Pursuant to a financing agreement between the Authority and ALLETE dated as of
July 1, 2006, ALLETE is obligated to make payments to the Issuer sufficient to
pay all principal and interest on the Refunding Bonds. ALLETE's obligations
under the financing agreement are supported by a direct pay letter of credit.
Proceeds from the Refunding Bonds and internally generated funds were used to
redeem $29.1 million of outstanding Collier County Industrial Development
Refunding Revenue Bonds 6.5% Series 1996 due 2025 on August 9, 2006. As a result
of an early redemption premium, we recognized a $0.6 million pre-tax charge to
other expense in the third quarter of 2006.
In September 2006, we accepted an offer from certain institutional buyers in the
private placement market to purchase $60 million of ALLETE first mortgage bonds.
When issued, on or about February 1, 2007, the bonds will carry an interest rate
of 5.99% and will have a term of 20 years. We intend to use the proceeds from
the bonds to retire $60 million in principal amount of First Mortgage Bonds, 7%
Series due February 15, 2007.
OFF-BALANCE SHEET ARRANGEMENTS
Off-balance sheet arrangements are summarized in our 2005 Form 10-K, with
additional disclosure discussed in Note 13 of this Form 10-Q.
CAPITAL REQUIREMENTS
For the nine months ended September 30, 2006, capital expenditures for
continuing operations totaled $53.3 million ($37.1 million in 2005).
Expenditures for the nine months ended September 30, 2006, included $52.5
million for Regulated Utility and $0.8 million for Nonregulated Energy
Operations. Internally-generated funds were the source of funding for these
expenditures.
Real estate development expenditures are and will be funded with a revolving
development loan and tax-exempt bonds issued by community development districts.
The Town Center District issued $26.4 million of tax-exempt bonds in 2005.
Approximately $21 million of the bond proceeds will be used for construction of
infrastructure improvements at Town Center, with the remaining funds to be used
for capitalized interest, a debt service reserve fund and costs of issuance. The
Palm Coast Park District issued $31.8 million of tax-exempt bonds in May 2006.
Bond proceeds of $26.3 million will be used for environmental and traffic
mitigation, and the construction of infrastructure improvements at Palm Coast
Park, with the remaining funds to be used for capitalized interest, a debt
service reserve fund and costs of issuance. Company expenditures related to our
real estate developments in Florida increase the carrying value of our land
assets, which are classified as Investments on our consolidated balance sheet.
ENVIRONMENTAL MATTERS AND OTHER
As previously discussed in our Critical Accounting Policies section, our
businesses are subject to regulation of environmental matters by various
federal, state and local authorities. Due to future stricter environmental
requirements through legislation and/or rulemaking, we anticipate that potential
expenditures for environmental matters will be material and will require
significant capital investments. We are unable to predict the outcome of the
issues discussed in Note 13.
NEW ACCOUNTING STANDARDS
New accounting standards are discussed in Note 1.
ALLETE Third Quarter 2006 Form 10-Q 38
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
SECURITIES INVESTMENTS
AVAILABLE-FOR-SALE SECURITIES. Our available-for-sale securities portfolio
consists of securities in a grantor trust established to fund certain employee
benefits included in Investments, and various auction rate bonds and variable
rate demand notes included in Short-Term Investments. Available-for-sale
securities are recorded at fair value with unrealized gains and losses included
in accumulated other comprehensive income (loss), net of tax. Unrealized losses
that are other than temporary are recognized in earnings. Our short-term
investments classified as available-for-sale securities are recorded at fair
market value which equates to cost because the variable interest rates for these
securities typically reset every 7 to 35 days. Despite the long-term nature of
their stated contractual maturities, we have the ability to quickly liquidate
these securities. As a result, we had no cumulative gross unrealized holding
gains (losses) or gross realized gains (losses) from our short-term investments.
All income generated from these short-term investments was recorded as interest
income. Our available-for-sale securities portfolio had a fair value of $145.5
million at September 30, 2006 ($139.5 million at December 31, 2005) and a total
unrealized after-tax gain of $2.7 million at September 30, 2006 ($2.1 million at
December 31, 2005).
We use the specific identification method as the basis for determining the cost
of securities sold. Our policy is to review on a quarterly basis
available-for-sale securities for other than temporary impairment by assessing
such factors as the share price trends and the impact of overall market
conditions. As a result of our periodic assessments, we did not record any
impairment of available-for-sale securities for the nine months ended September
30, 2006.
EMERGING TECHNOLOGY PORTFOLIO. As part of our emerging technology portfolio, we
have several minority investments in venture capital funds and direct
investments in privately-held, start-up companies. We account for our
investments in venture capital funds under the equity method and account for our
direct investments in privately-held companies under the cost method based
primarily on our ownership percentages. The total carrying value of our emerging
technology portfolio was $9.1 million at September 30, 2006 ($9.2 million at
December 31, 2005). Our policy is to review these investments quarterly for
impairment by assessing such factors as continued commercial viability of
products, cash flow and earnings. Any impairment would reduce the carrying value
of the investment. Our basis in direct investments in privately-held companies
included in the emerging technology portfolio was zero at September 30, 2006,
and December 31, 2005.
COMMODITY PRICE RISK
Our regulated utility operations in Minnesota and Wisconsin incur costs for fuel
(primarily coal), power and natural gas purchased for resale in our regulated
service territories, and related transportation. Our regulated utilities'
exposure to price risk for these commodities is significantly mitigated by the
current ratemaking process and regulatory environment, which generally allows a
fuel clause surcharge if costs are in excess of those in our last rate filing.
Conversely, costs below those in our last rate filing result in a rate credit.
We seek to prudently manage our customers' exposure to price risk by entering
into contracts of various durations and terms for the purchase of coal and power
(in Minnesota), power and natural gas (in Wisconsin), and related transportation
costs.
39 ALLETE Third Quarter 2006 Form 10-Q
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (CONTINUED)
POWER MARKETING
Our power marketing activities consist of: (1) purchasing energy in the
wholesale market for resale in our regulated service territories when retail
energy requirements exceed generation output; and (2) selling excess available
generation and purchased power.
From time to time, our utility operations may have excess generation that is
temporarily not required by retail and municipal customers in our regulated
service territory. We actively sell this generation to the wholesale market to
optimize the value of our generating facilities. This generation is generally
sold in the MISO market at market prices.
Approximately 200 MW of generation from our Taconite Harbor facility in northern
Minnesota has been sold through various long-term capacity and energy contracts.
Long-term, we have entered into two capacity and energy sales contracts totaling
175 MW (201 MW including a 15 percent reserve), which were effective May 1,
2005, and expire on April 30, 2010. Both contracts contain fixed monthly
capacity charges and fixed minimum energy charges. One contract provides for an
annual escalator to the energy charge based on increases in our cost of coal,
subject to a small minimum annual escalation. The other contract provides that
the energy charge will be the greater of a fixed minimum charge or an amount
based on the variable production cost of a combined-cycle, natural gas unit. Our
exposure in the event of a full or partial outage at our Taconite Harbor
facility is significantly limited under both contracts. When the buyer is
notified at least two months prior to an outage, there is no exposure. Outages
with less than two months' notice are subject to an annual duration limitation
typical of this type of contract. We also have a 50-MW capacity and energy sales
contract that extends through April 2008, with formula pricing based on variable
production cost of a combustion-turbine, natural gas unit.
ITEM 4. CONTROLS AND PROCEDURES
We maintain a system of controls and procedures designed to provide reasonable
assurance as to the reliability of the financial statements and other
disclosures included in this report, as well as to safeguard assets from
unauthorized use or disposition. We evaluated the effectiveness of the design
and operation of our disclosure controls and procedures under the supervision
and with the participation of management, including our chief executive officer
and chief financial officer, as of the end of the period covered by this Form
10-Q. Based upon that evaluation, our chief executive officer and chief
financial officer concluded that our disclosure controls and procedures are
effective. While we continue to enhance our internal control over financial
reporting, there has been no change in our internal control over financial
reporting that occurred during our most recent fiscal quarter that has
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
ALLETE Third Quarter 2006 Form 10-Q 40
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Material legal and regulatory proceedings are included in the discussion of
Other Information in Part II, Item 5 and/or Note 13, and are incorporated by
reference herein.
ITEM 1A. RISK FACTORS
There have been no material changes from the risk factors disclosed under the
heading "Risk Factors" in Part I, Item 1A of our 2005 Form 10-K and Part II,
Item 1A of our Form 10-Q for the Quarter Ended March 31, 2006.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
Reference is made to our 2005 Form 10-K for background information on the
following updates. Unless otherwise indicated, cited references are to our 2005
Form 10-K.
Ref. Page 7 - Minimum Revenue and Demand Under Contract Table
Ref. Form 10-Q for the Quarter Ended March 31, 2006, Page 32 - Eighth Paragraph
MINIMUM REVENUE AND DEMAND UNDER CONTRACT MINIMUM MONTHLY
AS OF OCTOBER 1, 2006 ANNUAL REVENUE MEGAWATTS
-------------------------------------------------------------------------------------------------------------------
2006 $109.3 million 711
2007 $60.1 million 356
2008 $27.7 million 158
2009 $25.9 million 151
2010 $23.6 million 134
-------------------------------------------------------------------------------------------------------------------
Based on past experience, we believe revenue from our large power customers will be substantially in excess
of the minimum contract amounts.
Although several contracts have a feature that allows demand to go to zero after a two-year advance notice of
a permanent closure, this minimum revenue summary does not reflect this occurrence happening in the
forecasted period because we believe it is unlikely.
41 ALLETE Third Quarter 2006 Form 10-Q
ITEM 5. OTHER INFORMATION (CONTINUED)
Ref. Page 20 - Sixth Full Paragraph
Ref. Form 10-Q for the Quarter Ended June 30, 2006, Page 41 - Third Paragraph
On June 16, 2006, Minnesota Power filed an application with the MPCA for a
variance from a wastewater discharge standard for mercury included in its
National Pollutant Discharge Elimination System (NPDES) permit for Laskin. The
variance requested an extension for Laskin to meet mercury discharge
requirements which become effective March 23, 2007, as set forth in Laskin's
NPDES permit issued by the MPCA in May 2005. In view of the EPA's proposed
changes relating to the implementation of mercury water policy and recent
developments in mercury treatment technologies, the MPCA believes it is more
appropriate at this time to forego the processing of mercury variances. Instead
a permit modification will be used which will contain a compliance schedule that
specifies interim actions and limits that lead to compliance with the final
limits by March 31, 2010. This approach will allow Minnesota Power to further
investigate treatment alternatives. It is expected that a permit modification
will be issued in late 2006 or early 2007. In October 2006, Minnesota Power
submitted a letter withdrawing its variance request. The Company is unable to
predict the outcome of this matter.
Ref. Page 20 - Insert before First Full Paragraph
Ref. Page 49 - Fifth Paragraph
Ref. Form 10-Q for the Quarter Ended March 31, 2006, Page 34 - Last Paragraph
On October 27, 2006, we submitted a filing to the MPCA for approval of the
Boswell Unit 3 emission reduction plan. A filing with the MPUC for approval of
Minnesota jurisdictional related expenditures on Boswell Unit 3 will follow in
approximately 60 days. MPUC approval would allow cost recovery on these
investments without a rate proceeding. Filing approval would authorize a cash
return on construction work in progress during the construction phase and allow
recovery for a return on investment, depreciation and incremental operations and
maintenance expenses once placed into service in late 2009.
Ref. Page 21 - First Full Paragraph
CLEAN WATER ACT - AQUATIC ORGANISMS. In June 2006, biological studies required
by Section 316(b) Phase II Rule of the Clean Water Act at our Boswell, Laskin,
Hibbard and Taconite Harbor generating facilities as well as the Square Butte
generating facility were completed. Engineering analyses to determine best
technology available for cooling water intake operations will take place during
2007. The estimated total cost of these biological studies and engineering
analyses for our facilities is expected to be in the range of $0.5 million to
$1.2 million. At this time, we cannot estimate the capital and/or aquatic
restoration expenditures that may be required to comply with the Section 316(b)
Phase II Rule.
ALLETE Third Quarter 2006 Form 10-Q 42
ITEM 6. EXHIBITS
EXHIBIT
NUMBER
+10(a) August 2006 Amendments to the ALLETE and Affiliated Companies
Supplemental Executive Retirement Plan.
+10(b) August 2006 Amendment to the Minnesota Power and Affiliated Companies
Executive Investment Plan I.
+10(c) August 2006 Amendment to the Minnesota Power and Affiliated Companies
Executive Investment Plan II.
+10(d) August 2006 Amendment to the ALLETE Director Compensation Deferral
Plan.
31(a) Rule 13a-14(a)/15d-14(a) Certification by the Chief Executive
Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31(b) Rule 13a-14(a)/15d-14(a) Certification by the Chief Financial Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32 Section 1350 Certification of Periodic Report by the Chief Executive
Officer and Chief Financial Officer Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
99 ALLETE News Release dated October 30, 2006, announcing 2006 third
quarter earnings. (THIS EXHIBIT HAS BEEN FURNISHED AND SHALL NOT BE
DEEMED "FILED" FOR PURPOSES OF SECTION 18 OF THE SECURITIES EXCHANGE
ACT OF 1934, NOR SHALL IT BE DEEMED INCORPORATED BY REFERENCE IN ANY
FILING UNDER THE SECURITIES ACT OF 1933, EXCEPT AS SHALL BE EXPRESSLY
SET FORTH BY SPECIFIC REFERENCE IN SUCH FILING.)
--------------------------------
+ MANAGEMENT CONTRACT OR COMPENSATORY PLAN OR ARRANGEMENT.
43 ALLETE Third Quarter 2006 Form 10-Q
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.
ALLETE, INC.
October 30, 2006 Mark A. Schober
-------------------------------------------------
Mark A. Schober
Senior Vice President and Chief Financial Officer
ALLETE Third Quarter 2006 Form 10-Q 44
EXHIBIT INDEX
EXHIBIT
NUMBER
--------------------------------------------------------------------------------
10(a) August 2006 Amendments to the ALLETE and Affiliated Companies
Supplemental Executive Retirement Plan.
10(b) August 2006 Amendment to the Minnesota Power and Affiliated Companies
Executive Investment Plan I.
10(c) August 2006 Amendment to the Minnesota Power and Affiliated Companies
Executive Investment Plan II.
10(d) August 2006 Amendment to the ALLETE Director Compensation Deferral Plan.
31(a) Rule 13a-14(a)/15d-14(a) Certification by the Chief Executive Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31(b) Rule 13a-14(a)/15d-14(a) Certification by the Chief Financial Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32 Section 1350 Certification of Periodic Report by the Chief Executive
Officer and Chief Financial Officer Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
99 ALLETE News Release dated October 30, 2006, announcing 2006 third
quarter earnings. (THIS EXHIBIT HAS BEEN FURNISHED AND SHALL NOT BE
DEEMED "FILED" FOR PURPOSES OF SECTION 18 OF THE SECURITIES EXCHANGE ACT
OF 1934, NOR SHALL IT BE DEEMED INCORPORATED BY REFERENCE IN ANY FILING
UNDER THE SECURITIES ACT OF 1933, EXCEPT AS SHALL BE EXPRESSLY SET FORTH
BY SPECIFIC REFERENCE IN SUCH FILING.)
ALLETE Third Quarter 2006 Form 10-Q