[August 05, 2011] CHESAPEAKE UTILITIES CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) Management's Discussion and Analysis of Financial Condition and Results of Operations is designed to provide a reader of the financial statements with a narrative report on our financial condition, results of operations and liquidity. This discussion and analysis should be read in conjunction with the attached unaudited condensed consolidated financial statements and notes thereto and our Annual Report on Form 10-K for the year ended December 31, 2010, including the audited consolidated financial statements and notes thereto. Safe Harbor for Forward-Looking Statements We make statements in this Quarterly Report on Form 10-Q that do not directly or exclusively relate to historical facts. Such statements are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. One can typically identify forward-looking statements by the use of forward-looking words, such as "project," "believe," "expect," "anticipate," "intend," "plan," "estimate," "continue," "potential," "forecast" or other similar words, or future or conditional verbs such as "may," "will," "should," "would" or "could." These statements represent our intentions, plans, expectations, assumptions and beliefs about future financial performance, business strategy, projected plans and objectives of the Company. These statements are subject to many risks, uncertainties and other important factors that could cause actual results to differ materially from those expressed in the forward-looking statements. Such factors include, but are not limited to: • state and federal legislative and regulatory initiatives that affect cost and investment recovery, have an impact on rate structures, and affect the speed at and degree to which competition enters the electric and natural gas industries (including deregulation); • the outcomes of regulatory, tax, environmental and legal matters, including whether pending matters are resolved within current estimates; • the loss of customers due to government mandated sale of our utility distribution facilities; • industrial, commercial and residential growth or contraction in our service territories; • the weather and other natural phenomena, including the economic, operational and other effects of hurricanes and ice storms; • the timing and extent of changes in commodity prices and interest rates; • general economic conditions, including any potential effects arising from terrorist attacks and any consequential hostilities or other hostilities or other external factors over which we have no control; • changes in environmental and other laws and regulations to which we are subject; • the results of financing efforts, including our ability to obtain financing on favorable terms, which can be affected by various factors, including credit ratings and general economic conditions; • declines in the market prices of equity securities and resultant cash funding requirements for our defined benefit pension plans; • the creditworthiness of counterparties with which we are engaged in transactions; • growth in opportunities for our business units; • the extent of success in connecting natural gas and electric supplies to transmission systems and in expanding natural gas and electric markets; • the effect of accounting pronouncements issued periodically by accounting standard-setting bodies; • conditions of the capital markets and equity markets during the periods covered by the forward-looking statements; - 30 - -------------------------------------------------------------------------------- Table of Contents • the ability to successfully execute, manage and integrate merger, acquisition or divestiture plans, regulatory or other limitations imposed as a result of a merger, acquisition or divestiture, and the success of the business following a merger, acquisition or divestiture; • the ability to manage and maintain key customer relationships; • the ability to maintain key supply sources; • the effect of spot, forward and future market prices on our distribution, wholesale marketing and energy trading businesses; • the effect of competition on our businesses; • the ability to construct facilities at or below estimated costs; • changes in technology affecting our advanced information services business; and • operation and litigation risks that may not be covered by insurance. Introduction We are a diversified utility company engaged, directly or through subsidiaries, in regulated energy businesses, unregulated energy businesses, and other unregulated businesses, including advanced information services. Our strategy is focused on growing earnings from a stable utility foundation and investing in related businesses and services that provide opportunities for returns greater than traditional utility returns. The key elements of this strategy include: • executing a capital investment program in pursuit of organic growth opportunities that generate returns equal to or greater than our cost of capital; • expanding the regulated energy distribution and transmission businesses into new geographic areas and providing new services in our current service territories; • expanding the propane distribution business in existing and new markets through leveraging our community gas system services and our bulk delivery capabilities; • utilizing our expertise across our various businesses to improve overall performance; • enhancing marketing channels to attract new customers; • providing reliable and responsive customer service to retain existing customers; • maintaining a capital structure that enables us to access capital as needed; • maintaining a consistent and competitive dividend for shareholders; and • creating and maintaining a diversified customer base, energy portfolio and utility foundation. Due to the seasonality of our business, results for interim periods are not necessarily indicative of results for the entire fiscal year. Revenue and earnings are typically greater during the first and fourth quarters, when consumption of natural gas and propane is normally highest due to colder temperatures. The following discussions and those later in the document on operating income and segment results include use of the term "gross margin." Gross margin is determined by deducting the cost of sales from operating revenue. Cost of sales includes the purchased cost of natural gas, electricity and propane and the cost of labor spent on direct revenue-producing activities. Gross margin should not be considered an alternative to operating income or net income, which are determined in accordance with GAAP. We believe that gross margin, although a non-GAAP measure, is useful and meaningful to investors as a basis for making investment decisions. It provides investors with information that demonstrates the profitability achieved by the Company under its allowed rates for regulated energy operations and under its competitive pricing structure for unregulated natural gas marketing and propane distribution operations. Our management uses gross margin in measuring our business units' performance and has historically analyzed and reported gross margin information publicly. Other companies may calculate gross margin in a different manner. - 31 --------------------------------------------------------------------------------- Table of Contents Results of Operations for the Quarter Ended June 30, 2011 Overview and Highlights Our net income for the quarter ended June 30, 2011 was $3.5 million, or $0.37 per share (diluted). This represents an increase of $180,000, or $0.02 per share (diluted), compared to a net income of $3.3 million, or $0.35 per share (diluted), as reported in the same period in 2010. Increase For the Three Months Ended June 30, 2011 2010 (decrease) (in thousands except per share) Business Segment: Regulated Energy $ 7,863 $ 8,308 ($445 ) Unregulated Energy 4 (791 ) 795 Other (91 ) 244 (335 ) Operating Income 7,776 7,761 15 Other Income 27 (11 ) 38 Interest Charges 2,114 2,305 (191 ) Income Taxes 2,169 2,105 64 Net Income $ 3,520 $ 3,340 $ 180 Earnings Per Share of Common Stock Basic $ 0.37 $ 0.35 $ 0.02 Diluted $ 0.37 $ 0.35 $ 0.02 Key Factors Affecting Our Businesses The following is a summary of key factors affecting our businesses and their impacts on our results during the second quarter of 2011. More detailed analysis of our results by segment is provided in the following section. Growth. We are continuing to see growth in our natural gas businesses from our efforts over the past several years to expand our services by delivering clean-burning, environmentally friendly natural gas to customers. We are identifying and developing additional opportunities that will generate growth over the next several years. Eastern Shore, our natural gas transmission subsidiary, generated gross margin of $542,000 in the second quarter of 2011 from new transportation services associated with its eight-mile mainline extension to interconnect with TETLP's pipeline system. These services commenced in January 2011 and have a three-year phase-in from 19,324 Mcfs per day to 38,647 Mcfs per day, and an estimated gross margin of $2.4 million in 2011, $3.9 million in 2012 and $4.3 million annually thereafter. 14 large commercial and industrial customers added by the Delmarva natural gas operation since July 2010 generated $261,000 in additional gross margin during the second quarter of 2011. These new customers are expected to generate annual margin of $1.1 million in 2011, compared to $196,000 of gross margin generated from these customers in 2010. Also generating additional gross margin of $105,000 for the second quarter of 2011 was a three-percent growth in residential customers for the Delmarva natural gas distribution operation. The Florida natural gas distribution operations generated $376,000 from one-percent growth in residential customers and three-percent growth in commercial customers in the second quarter of 2011, compared to the same quarter in 2010. In addition, 700 new customers, added as a result of our purchase of the operating assets of Indiantown Gas Company in August 2010, generated $142,000 of additional gross margin during the quarter. - 32 --------------------------------------------------------------------------------- Table of Contents We are continuing our efforts to extend natural gas service to Lewes, Delaware and Cecil and Worcester Counties, Maryland. We signed service agreements in March 2011 with Beebe Medical Center and SPI Pharma, both located in Lewes, Delaware, with natural gas service expected to commence to these customers in the third and fourth quarters of 2011, respectively. Gross margin from these customers is expected to equate to gross margin generated by approximately 1,000 residential customers. We have obtained the necessary natural gas franchises from Cecil and Worcester Counties, Maryland and the approval from the Maryland PSC to exercise those franchises, except for the final determination of the service boundary in a small portion of the franchise area in Cecil County. Propane Prices. Higher price volatility and trading volumes in Xeron, our wholesale marketing subsidiary, resulted in a 56-percent increase in its trading volumes during the second quarter of 2011, compared to the same quarter in 2010, and generated $314,000 of additional gross margin. Our propane distribution operations generated additional gross margin of $658,000 from higher margins per gallon in the second quarter of 2011, compared to the same quarter in 2010. Propane retail margins per gallon on the Delmarva Peninsula during the second quarter of 2011 returned to more normal levels, compared to the lower margins per gallon reported during the second quarter of 2010 caused by the higher cost of spot purchases during the peak heating season. Propane retail margins per gallon in Florida also increased in the second quarter of 2011, compared to the same quarter in 2010, as we continued to adjust our retail pricing in response to market conditions. Rates and Regulatory Matters. Eastern Shore's base rate proceeding, which was filed with the FERC on December 30, 2010, is still underway. Eastern Shore expects this proceeding to be completed in 2011. The "Come-Back" filing in Florida, which includes our request for recovery, through rates, of approximately $34.2 million in acquisition adjustment and $2.2 million in merger-related costs, is also still underway. See Note 3, "Rates and Other Regulatory Activities," to the unaudited condensed consolidated financial statements for further discussion. Advanced Information Services. BravePoint, our advanced information services subsidiary, reported $188,000 in operating loss in the second quarter of 2011, compared to operating income of $230,000 reported in the same quarter in 2010. BravePoint's operating results in the second quarter of 2011 reflect approximately $341,000 in additional costs associated with the initial roll-out and implementation of a new product, ProfitZoom™. BravePoint completed the first successful implementation of ProfitZoom™ in July 2011. At present, BravePoint has three customers, which have implemented, or are in the process of implementing, this new product and has several outstanding sales proposals under consideration by other customers. ProfitZoom™ is an integrated system designed specifically for the fire protection and specialty contracting industries, which includes a comprehensive suite of financial, job costing and service management modules, and is a successor product to another software solution that BravePoint previously marketed and supported for companies in the fire suppression industry. Understanding the needs of the industry and utilizing its technology expertise, BravePoint began developing the ProfitZoom™ product in 2009. Other Operating Expenses. Our other operating expenses increased by $2.5 million in the second quarter of 2011, compared to the same quarter in 2010. Included in this increase are $808,000 in non-recurring charges incurred during the second quarter of 2011, which were comprised of $259,000 in additional marketing and development costs of ProfitZoom™, and $549,000 in one-time charges in May 2011 associated with the voluntary workforce reduction of 31 employees in Florida as we continue to integrate our Florida operations. The voluntary workforce reduction in Florida is expected to generate $500,000 in cost savings in 2011 and $800,000 in annual savings thereafter. - 33 --------------------------------------------------------------------------------- Table of Contents The remaining $1.7 million of the increase in other operating expenses, or a six-percent increase compared to other operating expenses during the second quarter of 2010, was attributable to the following factors: • $558,000 in increased payroll and benefits expense, excluding one-time charges associated with the voluntary workforce reduction, due primarily to enhanced benefits offered to FPU and BravePoint employees and higher accruals for performance incentive compensation; • Increased regulatory, legal and other costs related to our regulated energy businesses, including $316,000 of additional costs associated with our electric franchise dispute in Marianna, Florida and $83,000 in costs with respect to our "Come-Back" filing in Florida and the rate case proceeding for Eastern Shore; • $258,000 in higher depreciation expense and asset removal costs in our regulated energy businesses from capital investments made since the second half of 2010; • $153,000 in additional expenses related to pipeline integrity projects for Eastern Shore to comply with pipeline regulatory requirements; and • $79,000 of other operating expenses during the second quarter of 2011 from the purchase of the operating assets of Indiantown Gas Company in August 2010. Both the "Come-Back" filing and the Eastern Shore rate case proceeding are expected to be resolved in 2011. Eastern Shore projects pipeline integrity expenditures to be at about the same level in 2011 and 2012 and projects a decrease in such expenditures in 2013. - 34 --------------------------------------------------------------------------------- Table of Contents Regulated Energy Increase For the Three Months Ended June 30, 2011 2010 (decrease) (in thousands, except degree-day and customer information) Revenue $ 54,327 $ 52,740 $ 1,587 Cost of sales 24,882 24,625 257 Gross margin 29,445 28,115 1,330 Operations & maintenance 15,552 14,074 1,478 Depreciation & amortization 4,020 3,754 266 Other taxes 2,010 1,979 31 Other operating expenses 21,582 19,807 1,775 Operating Income $ 7,863 $ 8,308 $ (445 ) Weather and Customer analysis Delmarva Peninsula Heating degree-days ("HDD"): Actual 382 428 (46 ) 10-year average 487 495 (8 ) Per residential customer added: Estimated gross margin $ 375 $ 375 $ 0 Estimated other operating expenses $ 111 $ 105 $ 6 Florida HDD: Actual 14 9 5 10-year average 30 33 (3 ) Cooling degree-days: Actual 1,027 1,037 (10 ) 10-year average 894 880 14 Residential Customer Information Average number of customers: Delmarva natural gas distribution 48,660 47,431 1,229 Florida natural gas distribution 61,659 60,580 1,079 Florida electric distribution 23,593 23,585 8 Total 133,912 131,596 2,316 Operating income for the regulated energy segment decreased by approximately $445,000, or five percent, in the second quarter of 2011, compared to the same quarter in 2010. An increase in gross margin of $1.3 million, offset by an increase in other operating expense of $1.8 million, resulted in the decrease in operating income. - 35 - -------------------------------------------------------------------------------- Table of Contents Gross Margin Gross margin for our regulated energy segment increased by $1.3 million, or five percent, in the second quarter of 2011 compared to the same quarter in 2010. Our Delmarva natural gas distribution operation generated an increase in gross margin of $426,000 in the second quarter of 2011, compared to the same quarter in 2010. The factors contributing to this increase were as follows: • Customer growth generated a $400,000 increase in gross margin in the second quarter of 2011, compared to the same quarter in 2010. Commercial and industrial customer growth, due primarily to $261,000 in additional gross margin generated from 14 large commercial and industrial customers added since July 2010, generated $295,000 of this increase. These 14 new large commercial and industrial customers are expected to generate annual gross margin of $1.1 million in 2011. The same customers generated $196,000 of gross margin following their addition in the second half of 2010. Three-percent growth in residential customers generated an additional $105,000 in gross margin. • The remaining increase in gross margin of $26,000 was attributable to increased non-weather-related customer consumption, offset partially by a decrease from a change in customer rates and rate classes. Gross margin for our Florida natural gas distribution operation increased by $141,000 in the second quarter of 2011, compared to the same quarter in 2010. The factors contributing to this increase were as follows: • One-percent growth in residential customers and three-percent growth in commercial customers generated additional gross margin of $376,000 in the second quarter of 2011, compared to the same quarter in 2010. • 700 new customers, added as a result of our purchase of the operating assets of Indiantown Gas Company in August 2010, generated $142,000 in gross margin in the second quarter of 2011. • These increases in gross margin in the second quarter were partially offset by decreased gross margin of $377,000, primarily attributable to lower customer consumption during the second quarter, compared to the same quarter in 2010. Our natural gas transmission operations achieved gross margin growth of $761,000 in the second quarter of 2011, compared to the same quarter in 2010. The factors contributing to this increase were as follows: • New transportation services associated with Eastern Shore's eight-mile mainline extension to interconnect with TETLP's pipeline system generated an additional $542,000 of gross margin in the second quarter. These new services commenced in January 2011 and have a three-year phase-in from 19,324 Mcfs per day to 38,647 Mcfs per day, and an estimated annual gross margin of $2.4 million in 2011, $3.9 million in 2012 and $4.3 million annually thereafter. • New transportation services implemented by Eastern Shore in May 2010 and November 2010 as a result of its system expansion projects generated an additional $103,000 of gross margin in the second quarter of 2011, compared to the same quarter in 2010. These expansions added 2,666 Mcfs per day and an estimated annual gross margin of $574,000 in 2011. In 2010, these projects generated $216,000 of gross margin, of which $40,000 was recorded in the second quarter of 2010. • Eastern Shore entered into two additional transportation services agreements with an existing industrial customer, one for the period of May 2011 through April 2021 for an additional 3,290 Mcfs per day and the other one for the period of November 2011 through October 2012 for an additional 9,212 Mcfs. These services generated additional gross margin of $61,000 in the second quarter of 2011 and are expected to generate additional gross margin of $356,000 in 2011, $1.2 million in 2012 and $369,000 annually thereafter. • The remaining gross margin increase of $55,000 was attributable primarily to higher volumes delivered to customers on a non-recurring basis during the second quarter. - 36 - -------------------------------------------------------------------------------- Table of Contents Gross margin for our Florida electric distribution operation remained relatively unchanged with a slight increase of $2,000 in the second quarter of 2011, compared to the same quarter in 2010. Other Operating Expenses Other operating expenses for the regulated energy segment increased by $1.8 million, or nine percent, in the second quarter of 2011, compared to the same quarter in 2010, due largely to the following factors: • One-time charges of $481,000 for the regulated energy businesses associated with the voluntary workforce reduction in Florida; • Increased regulatory, legal and other costs, including $316,000 of additional costs associated with our electric franchise dispute in Marianna, Florida and $83,000 in costs associated with the "Come-Back" filing in Florida and the rate case proceeding for Eastern Shore; • $258,000 in higher depreciation expense and asset removal costs from capital investments made since the second half of 2010; • $153,000 in additional expenses related to pipeline integrity projects for Eastern Shore to comply with increased pipeline regulatory requirements; and • $79,000 of other operating expenses associated with the purchase of the operating assets of Indiantown Gas Company in August 2010. Other Development In June 2011, Allen Family Foods, Inc. and related entities (collectively, "Allen") filed for bankruptcy. Our Delmarva natural gas distribution operation serves two of Allen's poultry facilities, one of which is included in our discussion of 14 new large commercial and industrial customers added since July 2010. Gross margin generated from our natural gas service to these two Allen facilities was approximately $94,000 and $24,000 for the three months ended June 30, 2011 and 2010, respectively, and approximately $211,000 and $51,000 for the first six months of 2011 and 2010, respectively. The total gross margin for 2010 from our natural gas service to these two facilities was approximately $156,000. As of June 30, 2011, we had approximately $40,000 in outstanding receivable balances with Allen. Since the bankruptcy filing, these two facilities have been sold to another poultry processor. We cannot predict the future plan for these two facilities by the new purchaser or the level of natural gas consumption, if any, at these two facilities in the future. - 37 --------------------------------------------------------------------------------- Table of Contents Unregulated Energy Increase For the Three Months Ended June 30, 2011 2010 (decrease) (in thousands, except degree-day data) Revenue $ 29,692 $ 24,615 $ 5,077 Cost of sales 22,849 19,068 3,781 Gross margin 6,843 5,547 1,296 Operations & maintenance 5,692 5,331 361 Depreciation & amortization 807 718 89 Other taxes 340 289 51 Other operating expenses 6,839 6,338 501 Operating Income (Loss) $ 4 $ (791 ) $ 795 Weather Analysis - Delmarva Peninsula Actual HDD 382 428 (46 ) 10-year average HDD 487 495 (8 ) Operating income for the unregulated energy segment in the second quarter of 2011 was $4,000, an increase of $795,000, compared to an operating loss of $791,000 in the same quarter in 2010. The increase resulted from an increase in gross margin of $1.3 million, which was offset by an increase in other operating expense of $501,000. Gross Margin Gross margin for our unregulated energy segment increased by $1.3 million, or 23 percent, in the second quarter of 2011, compared to the same quarter in 2010. Our Delmarva propane distribution operation generated an increase in gross margin of $481,000, or 21 percent, in the second quarter of 2011, compared to the same quarter in 2010. The factors contributing to this increase were as follows: • Our Delmarva propane distribution operation generated additional gross margin of $220,000 due to higher margins per gallon in the second quarter of 2011, compared to the same quarter in 2010, as margins per gallon returned to more normal levels during the current quarter. Propane margins per gallon during the second quarter of 2010 were low, compared to historical levels, due to additional spot purchases at increased costs during the peak heating season to meet the weather-related increase in customer consumption. More normal temperatures and fewer spot purchases during 2011 resulted in margins per gallon returning to more normal levels in the second quarter of 2011. • An increase in volumes sold in the second quarter of 2011, compared to the same period in 2010, generated additional gross margin of $109,000. This increase was attributable to the timing of deliveries to bulk customers, offset partially by a decrease in weather-related consumption due to the warmer temperatures on the Delmarva Peninsula. • The remaining gross margin increase of $152,000 is due primarily to increased wholesale margins and higher fees generated from increased service work, continued growth and successful implementation of various customer loyalty programs. - 38 - -------------------------------------------------------------------------------- Table of Contents Our Florida propane distribution operations generated increased gross margin of $302,000 in the second quarter of 2011, compared to the same quarter in 2010. Higher margins per gallon, as we continued to adjust our retail pricing in response to market conditions, generated $438,000 of additional gross margin. Also generating additional gross margin of $77,000 during the current quarter was a new propane rail terminal arrangement with a supplier from November 2010 to May 2011 to provide terminal and storage services. These additional gross margins were offset partially by a decrease in volume sold in the second quarter of 2011, compared to the same period in 2010. Xeron, our propane wholesale marketing subsidiary, generated $314,000 of increase in gross margin during the second quarter of 2011, compared to the same quarter in 2010, due primarily to an increase in Xeron's trading activity by 56 percent in the second quarter of 2011, compared to the same period in 2010. Gross margin generated by PESCO, our natural gas marketing subsidiary, increased by $291,000 in the second quarter of 2011 compared to the same quarter in 2010. This increase was due to favorable imbalance resolutions during the second quarter of 2011 with third-party intrastate pipelines, with which PESCO contracts for supply. Revenues generated from such favorable imbalance resolutions are not predictable and, therefore, are not included in our long-term financial plans or forecasts. Merchandise sales in Florida decreased in the second quarter of 2011, compared to the same period in 2010, resulting in lower gross margin of $92,000. Other Operating Expenses Other operating expenses for the unregulated energy segment increased by $501,000 for the second quarter of 2011, compared to the same period in 2010, due primarily to: (a) increased payroll and benefit costs of $344,000, attributable primarily to higher accruals for performance incentive compensation; (b) increased vehicle expenses of $108,000 resulting from an increase in fuel prices; and (c) one-time charges of $67,000 for the unregulated energy businesses associated with the voluntary workforce reduction in Florida. Other Increase For the Three Months Ended June 30, 2011 2010 (decrease) (in thousands) Revenue $ 2,812 $ 2,706 $ 106 Cost of sales 1,571 1,316 255 Gross margin 1,241 1,390 (149 ) Operations & maintenance 1,049 910 139 Depreciation & amortization 110 73 37 Other taxes 173 163 10 Other operating expenses 1,332 1,146 186 Operating Income - Other (91 ) 244 (335 ) Operating Income - Eliminations - - - Operating Income $ (91 ) $ 244 $ (335 ) Note: Eliminations are entries required to eliminate activities between business segments from the consolidated results. Operating income for the "other" segment decreased by approximately $335,000 in the second quarter of 2011, compared to the same quarter in 2010, which was attributable to a gross margin decrease of $149,000, and an operating expense increase of $186,000. - 39 - -------------------------------------------------------------------------------- Table of Contents Gross margin The gross margin for our "other" segment decreased by $149,000 in the second quarter of 2011, compared to the same quarter in 2010, due primarily to BravePoint, our advanced information services subsidiary. Gross margin for BravePoint decreased by $114,000 as a result of decreased product sales, lower consulting margin and additional costs incurred during initial implementations of ProfitZoom™. Other Operating Expenses Other operating expenses for our "other" segment increased by $186,000 in the second quarter of 2011, compared to the same quarter in 2010. Other operating expenses for BravePoint increased by $304,000, due primarily to $259,000 in additional marketing and development costs, as it began to roll out ProfitZoom™, and $116,000 in increased benefit costs. Benefit costs increased for BravePoint as Chesapeake adopted a safe harbor 401(k) plan design on January 1, 2011, which resulted in an increased 401(k) benefit for BravePoint employees in 2011. The increase in BravePoint's other operating expenses was partially offset by the absence in 2011 of $92,000 in merger-related costs in the second quarter of 2010. Interest Expense Interest expense for the quarter ended June 30, 2011 decreased by approximately $191,000, or eight percent, compared to the same quarter in 2010, due primarily to lower interest expenses on short-term borrowings and long-term debt. Short-term interest expense decreased by $42,000, which is largely attributable to lower rates on the $29.1 million term loan credit facility used to temporarily refinance the redemption of the 6.85 percent and 4.90 percent series of FPU first mortgage bonds in January 2010. Long-term interest expense decreased by $135,000 due to lower long-term debt as a result of scheduled principal payments. On June 23, 2011, we issued $29 million of 5.68 percent unsecured senior notes to Metropolitan Life Insurance Company and New England Life Insurance Company, pursuant to an agreement executed in June 2010. We used the proceeds to permanently refinance the redemption of the two series of FPU first mortgage bonds mentioned previously, which were temporarily refinanced using a short-term loan credit facility. Compared to interest expense incurred under the short-term loan credit facility during the first half of 2011, issuance of these senior notes will result in an increase in interest expense of $550,000 in the second half of 2011. Income Taxes We recorded an income tax expense of $2.2 million for the quarter ended June 30, 2011, compared to $2.1 million for the quarter ended June 30, 2010. The increase is attributable to increased earnings in the second quarter of 2011 compared to the same period in 2010. - 40 - -------------------------------------------------------------------------------- Table of Contents Results of Operations for the Six Months Ended June 30, 2011 Overview and Highlights Our net income during the six months ended June 30, 2011 was $17.3 million, or $1.79 per share (diluted). This represents a decrease of $0.03 per share (diluted), compared to $1.82 per share (diluted), as reported for the same period in 2010. Increase For the Six Months Ended June 30, 2011 2010 (decrease) (in thousands, except per share) Business Segment: Regulated Energy $ 24,171 $ 25,824 $ (1,653 ) Unregulated Energy 8,518 6,969 1,549 Other (74 ) 366 (440 ) Operating Income 32,615 33,159 (544 ) Other Income 50 103 (53 ) Interest Charges 4,265 4,667 (402 ) Income Taxes 11,133 11,281 (148 ) Net Income $ 17,267 $ 17,314 $ (47 ) Earnings Per Share of Common Stock Basic $ 1.81 $ 1.83 $ (0.02 ) Diluted $ 1.79 $ 1.82 $ (0.03 ) Key Factors Affecting Our Businesses The following is a summary of key factors affecting our businesses and their impacts on our results during the first six months of 2011. More detailed analysis of our results by segment is provided in the following section. Growth. We are continuing to see growth in our natural gas businesses from our efforts over the past several years to expand our services by delivering clean-burning, environmentally friendly natural gas to customers. We are identifying and developing additional opportunities that will generate growth over the next several years. Eastern Shore, our natural gas transmission subsidiary, generated gross margin of $1.1 million in the first six months of 2011 from new transportation services associated with its eight-mile mainline extension to interconnect with TETLP's system. These services commenced in January 2011 and have a three-year phase-in from 19,324 Mcfs per day to 38,647 Mcfs per day, and an estimated gross margin of $2.4 million in 2011, $3.9 million in 2012 and $4.3 million annually thereafter. 14 large commercial and industrial customers added by the Delmarva natural gas operation since July 2010 generated $509,000 in additional gross margin during the first six months of 2011. These new customers are expected to generate annual margin of $1.1 million in 2011, compared to $196,000 of gross margin generated from these customers in the second half of 2010. Also generating additional gross margin of $271,000 for the first six months of 2011 was a two-percent growth in residential customers for the Delmarva natural gas distribution operation. The Florida natural gas distribution operations generated $576,000 from one-percent growth in residential customers and three-percent growth in commercial customers in the six months ended June 30, 2011, compared to the same period in 2010. In addition, 700 new customers, added as a result of our purchase of the operating assets of Indiantown Gas Company in August 2010, generated $325,000 of additional gross margin during the first half of 2011. We are continuing our efforts to extend natural gas service to Lewes, Delaware and Cecil and Worcester Counties, Maryland. We signed service agreements in March 2011 with Beebe Medical Center and SPI Pharma, both located in Lewes, Delaware, with natural gas service expected to commence to these customers in the third and fourth quarters of 2011, respectively. Gross margin from these customers is expected to equate to gross margin generated by approximately 1,000 residential customers. We have obtained the necessary natural gas franchises from Cecil and Worcester Counties, Maryland and the approval from the Maryland PSC to exercise those franchises, except for the final determination of the service boundary in a small portion of the franchise area in Cecil County. - 41 --------------------------------------------------------------------------------- Table of Contents Weather. Warmer temperatures on the Delmarva Peninsula and in Florida during the first half of 2011, compared to the same period in 2010, particularly during the peak heating season, decreased consumer consumption of natural gas and electricity. Lower consumption, attributable primarily to warmer weather, decreased our period-over-period gross margin by approximately $2.4 million. Heating degree-days decreased by five percent, or 144 heating degree-days, on the Delmarva Peninsula and by 43 percent, or 408 heating degree-days, in Florida during the first six months of 2011, compared to the same period in 2010. Propane Prices. Xeron, our wholesale marketing subsidiary, generated a period-over-period gross margin increase of $412,000, resulting from higher price volatility and a 50-percent increase in its trading activity during the first six months of 2011, compared to the same period in 2010. The propane distribution operations generated additional gross margin of $980,000 from higher margins per gallon in the first six months of 2011, compared to the same period in 2010. Propane retail margins per gallon on the Delmarva Peninsula during the first half of 2011 returned to more normal levels, compared to the lower margins per gallon reported during the same period in 2010 caused by colder temperatures and the high cost of spot purchases during the peak heating season. Propane retail margins per gallon in Florida also increased in the first half of 2011, compared to the same period in 2010, as we continued to adjust our retail pricing in response to market conditions. Rates and Regulatory Matters. Eastern Shore's base rate proceeding, which was filed with the FERC on December 30, 2010, is still underway. Eastern Shore expects this proceeding to be completed in 2011. The "Come-Back" filing in Florida, which includes our request for recovery, through rates, of approximately $34.2 million in acquisition adjustment and $2.2 million in merger-related costs, is also still underway. See Note 3, "Rates and Other Regulatory Activities," to the unaudited condensed consolidated financial statements for further discussion. Advanced Information Services. BravePoint, our advanced information services subsidiary, reported $282,000 in operating loss in the six months ended June 30, 2011, compared to operating income of $265,000 reported in the same period in 2010. BravePoint's operating results for the six months ended June 30, 2011 reflected approximately $549,000 in additional costs associated with the initial roll-out and implementation of a new product, ProfitZoom™. BravePoint completed the first successful implementation of ProfitZoom™ in July 2011. At present, BravePoint has three customers, which have implemented, or are currently implementing, this new product and has several outstanding sales proposals under consideration by other potential customers. ProfitZoom™ is an integrated system designed specifically for the fire protection and specialty contracting industries, which includes a comprehensive suite of financial, job costing and service management modules, and is a successor product to another software solution previously marketed and supported for companies in the fire suppression industry. Understanding the needs of the industry and utilizing its technology expertise, BravePoint began developing the ProfitZoom™ product in 2009. Other Operating Expenses. Our other operating expenses increased by $3.4 million in the six months ended June 30, 2011, compared to the same period in 2010. Included in this increase are approximately $1.2 million in non-recurring charges incurred during the first six months of 2011, which were comprised of $439,000 in additional marketing and development costs of ProfitZoom™ and $788,000 in one-time charges associated with the voluntary workforce reduction in Florida and a pension settlement. - 42 --------------------------------------------------------------------------------- Table of Contents The remaining $2.2 million of the increase in other operating expenses, or a four-percent increase compared to other operating expenses during the first six months of 2010, was attributable to the following factors: • $559,000 in higher depreciation expense and asset removal costs in our regulated energy businesses from capital investments made since the second half of 2010; • Increased regulatory, legal and other costs related to our regulated energy businesses, including $316,000 of additional costs associated with our electric franchise dispute in Marianna, Florida and $137,000 in costs with respect to our "Come-Back" filing in Florida and the rate case proceeding for Eastern Shore; • $416,000 in additional expenses related to pipeline integrity projects for Eastern Shore to comply with pipeline regulatory requirements; and • $147,000 of other operating expenses during the first six months of 2011 from the purchase of the operating assets of Indiantown Gas Company in August 2010. Both the "Come-Back" filing and the Eastern Shore rate case proceeding are expected to be resolved in 2011. Eastern Shore projects pipeline integrity expenditures to be at about the same level in 2011 and 2012 and projects a decrease in such expenditures in 2013. - 43 --------------------------------------------------------------------------------- Table of Contents Regulated Energy Increase For the Six Months Ended June 30, 2011 2010 (decrease) (in thousands, except degree-day and customer information) Revenue $ 139,329 $ 144,367 $ (5,038 ) Cost of sales 72,872 78,889 (6,017 ) Gross margin 66,457 65,478 979 Operations & maintenance 29,862 27,889 1,973 Depreciation & amortization 8,187 7,478 709 Other taxes 4,237 4,287 (50 ) Other operating expenses 42,286 39,654 2,632 Operating Income $ 24,171 $ 25,824 $ (1,653 ) Weather and Customer analysis Delmarva Peninsula Heating degree-days ("HDD"): Actual 2,827 2,971 (144 ) 10-year average 2,863 2,831 32 Per residential customer added: Estimated gross margin $ 375 $ 375 $ 0 Estimated other operating expenses $ 111 $ 105 $ 6 Florida HDD: Actual 534 942 (408 ) 10-year average 594 547 47 Cooling degree-days: Actual 1,107 1,040 67 10-year average 961 952 9 Residential Customer Information Average number of customers: Delmarva natural gas distribution 48,986 47,808 1,178 Florida natural gas distribution 61,603 60,530 1,073 Florida electric distribution 23,591 23,558 33 Total 134,180 131,896 2,284 - 44 - -------------------------------------------------------------------------------- Table of Contents Operating income for the regulated energy segment decreased by approximately $1.7 million, or six percent, during the first six months of 2011, compared to the same period in 2010. An increase in gross margin of $979,000, offset by an increase in other operating expenses of $2.6 million, resulted in the decrease in operating income. Gross Margin Gross margin for our regulated energy segment increased by $979,000, or two percent, during the first six months of 2011, compared to the same period in 2010. Our Delmarva natural gas distribution operation generated an increase in gross margin of $866,000 in the first six months of 2011, compared to the same period in 2010. The factors contributing to this increase were as follows: • Customer growth generated an $855,000 increase in gross margin in the first six months of 2011, compared to the same period in 2010. Commercial and industrial customer growth, due primarily to $509,000 in addition gross margin generated from 14 large commercial and industrial customers added since the second half of 2010, generated $584,000 of this increase. These 14 new large commercial and industrial customers are expected to generate annual gross margin of $1.1 million in 2011. The same customers generated $196,000 of gross margin following their addition in the second half of 2010. Two-percent growth in residential customers generated an additional $271,000 in gross margin for the Delmarva natural gas distribution operation. • The remaining increase in gross margin of $11,000 was attributable to higher customer consumption, offset partially by a decrease from a change in customer rates and rate classes. Gross margin for our Florida natural gas distribution operation decreased by $977,000 during the first six months of 2011 compared to the same quarter in 2010. The factors contributing to this decrease were as follows: • Lower customer consumption during the first six months of 2011, compared to the same period in 2010, due primarily to significantly warmer weather during the heating season, decreased gross margin by $1.9 million. Heating degree-days in Florida decreased by 43 percent, or 408 heating degree-days, during the first six months of 2011, compared to the same period in 2010. • One-percent customer growth in residential customers and three-percent growth in commercial customers for the Florida natural gas distribution operation generated additional gross margin of $576,000 in the first half of 2011, compared to the same period in 2010. • 700 new customers, added as a result of our purchase of the operating assets of Indiantown Gas Company in August 2010, generated $325,000 in new gross margin in the first six months of 2011. Our natural gas transmission operations achieved gross margin growth of $1.4 million during the first six months of 2011 compared to the same period in 2010. The factors contributing to this increase were as follows: • New transportation services associated with Eastern Shore's eight-mile mainline extension to interconnect with TETLP's pipeline system generated an additional $1.1 million of gross margin in the six months ended June 30, 2011. These new services commenced in January 2011 and have a three-year phase-in from 19,324 Mcfs per day to 38,647 Mcfs per day, and an estimated annual gross margin of $2.4 million in 2011, $3.9 million in 2012 and $4.3 million annually thereafter. • New transportation services implemented by Eastern Shore in May 2010 and November 2010 as a result of its system expansion projects generated an additional $247,000 of gross margin during the first half of 2011, compared to 2010. These expansions added 2,666 Mcfs of capacity per day and an estimated annual gross margin of $574,000 in 2011. These projects generated $216,000 of gross margin in 2010, $40,000 of which was recorded in the first half of 2010. - 45 - -------------------------------------------------------------------------------- Table of Contents • Eastern Shore entered into two additional transportation services agreements with an existing industrial customer, one for the period of May 2011 through April 2021 for an additional 3,290 Mcfs per day and the other one for the period of November 2011 through October 2012 for an additional 9,192 Mcfs per day. These services generated additional gross margin of $61,000 in the first half of 2011 and are expected to generate additional gross margin of $356,000 in 2011, $1.2 million in 2012 and $369,000 annually thereafter. • The foregoing increases to gross margin were offset by the expiration of two small firm transportation service contracts in April 2010, decreasing gross margin by $40,000 in the second half of 2011. Gross margin for our Florida electric distribution operation decreased by $319,000 in the first six months of 2011, compared to the same period in 2010, due primarily to lower customer consumption during the heating season. Heating degree-days in Florida decreased by 43 percent, or 408 heating degree-days during the first six months of 2011, compared to the same period in 2010. Other Operating Expenses Other operating expenses for the regulated energy segment increased by $2.6 million in the six months ended June 30, 2011, due largely to the following factors: • One-time charges totaling $651,000 associated with the voluntary workforce reduction in Florida and a pension settlement; • Increased regulatory, legal and other costs, including $316,000 of additional costs associated with the electric franchise dispute in Marianna, Florida and $137,000 in costs with respect to the "Come-Back" filing in Florida and the rate case proceeding for Eastern Shore; • $559,000 in higher depreciation expense and asset removal costs from capital investments made since the second half of 2010; • $416,000 in additional expenses related to pipeline integrity projects for Eastern Shore to comply with increased pipeline regulatory requirements; and • $147,000 of other operating expenses during the first half of 2011 associated with the purchase of the operating assets of Indiantown Gas Company in August 2010. Other Development In June 2011, Allen Family Foods, Inc. and related entities (collectively, "Allen") filed for bankruptcy. Our Delmarva natural gas distribution operation serves two of Allen's poultry facilities, one of which is included in our discussion of 14 new large commercial and industrial customers added since July 2010. Gross margin generated from our natural gas service to these two Allen facilities was approximately $94,000 and $24,000 for the three months ended June 30, 2011 and 2010, respectively, and approximately $211,000 and $51,000 for the first six months of 2011 and 2010, respectively. The total gross margin for 2010 from our natural gas service to these two facilities was approximately $156,000. As of June 30, 2011, we had approximately $40,000 in outstanding receivable balances with Allen. Since the bankruptcy filing, these two facilities have been sold to another poultry processor. We cannot predict the future plan for these two facilities by the new purchaser or the level of natural gas consumption, if any, at these two facilities in the future. - 46 --------------------------------------------------------------------------------- Table of Contents Unregulated Energy Increase For the Six Months Ended June 30, 2011 2010 (decrease) (in thousands, except degree-day data) Revenue $ 88,442 $ 83,885 $ 4,557 Cost of sales 65,604 63,027 2,577 Gross margin 22,838 20,858 1,980 Operations & maintenance 11,924 11,356 568 Depreciation & amortization 1,562 1,765 (203 ) Other taxes 834 768 66 Other operating expenses 14,320 13,889 431 Operating Income $ 8,518 $ 6,969 $ 1,549 Weather Analysis - Delmarva Peninsula Actual HDD 2,827 2,971 (144 ) 10-year average HDD 2,863 2,831 32 Operating income for the unregulated energy segment increased by approximately $1.5 million, or 22 percent, during the first six months of 2011, compared to the same period in 2010, primarily due to a gross margin increase of $2.0 million, partially offset by an operating expense increase of $431,000. Gross Margin Gross margin for our unregulated energy segment increased by $2.0 million, or nine percent, for the first six months of 2011, compared to the same period in 2010. Our Delmarva propane distribution operation experienced an increase in gross margin of $1.4 million for the first six months of 2011, compared to the same period in 2010. The factors contributing to this increase were as follows: • Our Delmarva propane distribution operation generated additional gross margin of $980,000 due to higher margins per gallon during the first six months of 2011, compared to the same quarter in 2010, as margins per gallon returned to more normal levels during the current period. Propane margins per gallon during the first half of 2010 were low, compared to historical levels, due to additional spot purchases at increased costs during the peak heating season to meet the weather-related increase in customer consumption. More normal temperatures and fewer spot purchases during 2011 resulted in margins per gallon in the first six months of 2011 returning to more normal levels. • A one-time gain of $575,000 was recorded in the first six months of 2011, as a result of our share of proceeds received from an antitrust litigation settlement with a major propane supplier. • An increase in other fees generated additional gross margin of $152,000, due primarily to the continued growth and successful implementation of various customer pricing programs. • A decline in volumes sold in the first half of 2011, compared to the same period in 2010, decreased gross margin by $279,000. This decrease was attributable to timing of deliveries to bulk customers and a decrease in weather-related consumption due to the warmer temperatures on the Delmarva Peninsula. Our Florida propane distribution operations experienced an increase in gross margin of $75,000 during the first half of 2011 compared to the same period in 2010. Higher margins per gallon, as we continued to adjust our retail pricing in response to market conditions, were offset by a decrease in volume sold during the period. - 47 - -------------------------------------------------------------------------------- Table of Contents Xeron, the Company's propane wholesale marketing subsidiary, generated $412,000 of increase in gross margin during the first six months of 2011, compared to the same period in 2010, due primarily to an increase in Xeron's trading activity by 50 percent in the first six months of 2011, compared to the same period in 2010. Gross margin generated by PESCO, our natural gas marketing subsidiary, increased by $301,000 during the first six months of 2011, compared to the same period in 2010. This increase was due to favorable imbalance resolutions during the first half of 2011 with third-party intrastate pipelines, with which PESCO contracts for supply. Revenues generated from favorable imbalance resolutions with intrastate pipelines are not predictable and, therefore, are not included in our long-term financial plans or forecasts. Merchandise sales in Florida decreased in the first six months of 2011, compared to the same period in 2010, resulting in lower gross margin of $174,000. Other Operating Expenses Other operating expenses for the unregulated energy segment increased by $430,000 for the first half of 2011, compared to the same period in 2010, due primarily to the following factors: (a) increased payroll and benefit costs of $347,000, attributable primarily to higher accruals for performance incentive compensation; (b) increased vehicle expenses of $202,000 resulting from an increase in fuel prices; and (c) one-time charges of $67,000 for the unregulated energy businesses associated with the voluntary workforce reduction in Florida. - 48 - -------------------------------------------------------------------------------- Table of Contents Other Increase For the Six Months Ended June 30, 2011 2010 (decrease) (in thousands) Revenue $ 5,658 $ 5,069 $ 589 Cost of sales 3,107 2,448 659 Gross margin 2,551 2,621 (70 ) Operations & maintenance 2,046 1,768 278 Depreciation & amortization 209 145 64 Other taxes 370 342 28 Other operating expenses 2,625 2,255 370 Operating Income - Other (74 ) 366 (440 ) Operating Income - Eliminations - - - Operating Income ($74 ) $ 366 ($440 ) Note: Eliminations are entries required to eliminate activities between business segments from the consolidated results. Operating income for the "other" segment decreased by approximately $440,000 during the first six months of 2011, compared to the same period in 2010, which was attributable to a gross margin decrease of $70,000 and an operating expense increase of $370,000. Gross margin The gross margin decrease of $70,000 for our "other" segment was primarily a result of lower consulting margin and additional costs associated with initial implementation of ProfitZoom™, which were slightly offset by an increase of product sales for BravePoint, our advanced information services subsidiary. Other Operating Expenses Other operating expenses increased by $370,000 in the first six months of 2011, compared to the same period in 2010. Other operating expenses for BravePoint increased by $498,000, due primarily to $439,000 in additional marketing and development costs, as it began to roll out ProfitZoom™, and $249,000 in increased benefit costs. Benefit costs increased for BravePoint as Chesapeake adopted a safe harbor 401(k) plan design on January 1, 2011, which resulted in an increased 401(k) benefit for BravePoint employees in 2011. The increase in BravePoint's other operating expenses was offset partially by the absence in 2011 of $111,000 in merger-related costs in the first half of 2010. Interest Expense Interest expense for the six months ended June 30, 2011 decreased by approximately $403,000, or nine percent, compared to the same period in 2010, due primarily to a decrease of $424,000 in other long-term interest expense as the outstanding principal balance decreased as a result of scheduled repayments. On June 23, 2011, we issued $29 million of 5.68 percent unsecured senior notes to Metropolitan Life Insurance Company and New England Life Insurance Company, pursuant to an agreement executed in June 2010. We used the proceeds to permanently refinance the redemption of the two series of FPU first mortgage bonds mentioned previously, which were temporarily refinanced using a short-term loan credit facility. Compared to interest expense incurred under the short-term loan credit facility during the first half of 2011, issuance of these senior notes will result in an increase in interest expense of $550,000 in the second half of 2011. - 49 - -------------------------------------------------------------------------------- Table of Contents Income Taxes We recorded an income tax expense of $11.1 million for the first half of 2011, compared to $11.3 million for the same period in 2010. The period-over-period decrease in income tax expense is primarily a function of lower earnings for the period. Financial Position, Liquidity and Capital Resources Our capital requirements reflect the capital-intensive and seasonal nature of our business and are principally attributable to investment in new plant and equipment, retirement of outstanding debt and seasonal variability in working capital. We rely on cash generated from operations, short-term borrowings, and other sources to meet normal working capital requirements and to finance capital expenditures. Our energy businesses are weather sensitive and seasonal. We normally generate a large portion of our annual net income and subsequent increases in our accounts receivable in the first and fourth quarters of each year due to significant volumes of natural gas and propane delivered by our natural gas and propane distribution operations to customers during the peak heating season. In addition, our natural gas and propane inventories, which usually peak in the fall months, are largely drawn down in the heating season and provide a source of cash as the inventory is used to satisfy winter sales demand. Capital expenditures are one of our largest capital requirements. We originally budgeted $51.7 million for capital expenditures during 2011. As a result of continued growth, expansion opportunities and timing of capital projects, we increased our capital spending projection for 2011 to $62.6 million. This amount includes $54.3 million for the regulated energy segment, $2.9 million for the unregulated energy segment and $5.4 million for the "other" segment. The amount for the regulated energy segment includes estimated capital expenditures for expansion and improvement of facilities for the following: (a) natural gas distribution operation ($21.8 million); (b) natural gas transmission operation ($27.3 million); and (c) electric distribution operation ($5.2 million). The amount for the unregulated energy segment includes estimated capital expenditures for the propane distribution operations for customer growth and replacement of equipment. The amount for the "other" segment includes an estimated capital expenditure of $377,000 for the advanced information services operation, with the remaining balance for other general plant, computer software and hardware. We expect to fund the 2011 capital expenditures program from short-term borrowing, cash provided by operating activities, and other sources. The capital expenditures program is subject to continuous review and modification. Actual capital requirements may vary from the above estimates due to a number of factors, including changing economic conditions, customer growth in existing areas, regulation, new growth or acquisition opportunities and availability of capital. - 50 - -------------------------------------------------------------------------------- Table of Contents Capital Structure We are committed to maintaining a sound capital structure and strong credit ratings to provide the financial flexibility needed to access capital markets when required. This commitment, along with adequate and timely rate relief for our regulated operations, is intended to ensure our ability to attract capital from outside sources at a reasonable cost. We believe that the achievement of these objectives will provide benefits to our customers, creditors and investors. The following presents our capitalization, excluding and including short-term borrowings, as of June 30, 2011 and December 31, 2010: June 30, December 31, (in thousands) 2011 2010 Long-term debt, net of current maturities $ 117,123 33 % $ 89,642 28 % Stockholders' equity 238,000 67 % 226,239 72 % Total capitalization, excluding short-term debt $ 355,123 100 % $ 315,881 100 % June 30, December 31, (in thousands) 2011 2010 Short-term debt $ 4,248 1 % $ 63,958 16 % Long-term debt, including current maturities 126,319 34 % 98,858 25 % Stockholders' equity 238,000 65 % 226,239 59 % Total capitalization, including short-term debt $ 368,567 100 % $ 389,055 100 % Short-term Borrowings Our outstanding short-term borrowings at June 30, 2011 and December 31, 2010 were $4.2 million and $64.0 million, respectively, at weighted average interest rates of 1.54 percent and 1.77 percent, respectively. We utilize bank lines of credit to provide funds for our short-term cash needs to meet seasonal working capital requirements and to fund temporarily portions of the capital expenditure program. As of June 30, 2011, we had four unsecured bank lines of credit with two financial institutions for a total of $100.0 million. Two of these unsecured bank lines, totaling $60.0 million, are available under committed lines of credit. None of these unsecured bank lines of credit requires compensating balances. Advances offered under the uncommitted lines of credit are subject to the discretion of the banks. We are currently authorized by our Board of Directors to borrow up to $85.0 million of short-term debt, as required, from these unsecured bank lines of credit. Our outstanding borrowings under these unsecured bank lines of credit at June 30, 2011 and December 31, 2010 were $3.4 million and $30.8 million, respectively, at weighted average interest rates of 1.50 percent and 1.65 percent, respectively. In addition to the four unsecured bank lines of credit, we entered into a new short-term credit facility for $29.1 million with an existing lender in March 2010 to temporarily finance the early redemption of the 6.85 percent and 4.90 percent series of FPU's secured first mortgage bonds. On June 23, 2011, we issued $29.0 million of 5.68 percent Chesapeake's unsecured senior notes to repay the new short-term credit facility and permanently finance the FPU first mortgage bonds. Cash Flows Provided By Operating Activities Cash flows provided by operating activities were as follows: For the Six Months Ended June 30, 2011 2010 (in thousands) Net Income $ 17,267 $ 17,314 Non-cash adjustments to net income 25,869 15,152 Changes in assets and liabilities 16,953 24,549 Net cash provided by operating activities $ 60,089 $ 57,015 - 51 - -------------------------------------------------------------------------------- Table of Contents During the six months ended June 30, 2011 and 2010, net cash flow provided by operating activities was $60.1 million and $57.0 million, respectively, a period-over-period increase of $3.1 million. Significant operating activities reflected in the change in cash flows provided by operating activities were as follows: • Net cash flows related to income taxes, which include deferred income taxes in non-cash adjustments to net income and the change in income taxes receivable, increased by $3.9 million in the first half of 2011, compared to the same period in 2010, due primarily to the 100 percent bonus depreciation deduction allowed in 2011, which is reducing our income tax payments in the current period. • Net cash flows from trading receivables and payables increased by $3.0 million, due primarily to the timing of collections and payments of trading contracts entered into by our propane wholesale marketing operation, offset partially by a decrease in net cash flows from receivables and payables in the natural gas and propane distributions operations. • Net cash flows from customer deposits decreased by $2.2 million, due primarily to a large deposit received from a new industrial customer during the first half of 2010, which increased the cash flow for that period. • Net cash flows from accrued compensation decreased by $2.3 million, as a result of a smaller decrease in the change in accrued payroll due to timing of payroll periods and higher incentive compensation payments in the first half of 2011, compared to the same period in 2010. Cash Flows Used in Investing Activities Net cash flows used in investing activities totaled $21.4 million and $14.3 million during the six months ended June 30, 2011 and 2010, respectively. Cash utilized for capital expenditures was $21.2 million and $13.6 million for the first six months of 2011 and 2010, respectively. Cash Flows Used by Financing Activities Cash flows used in financing activities totaled $38.5 million and $36.3 million for the first six months of 2011 and 2010, respectively. Significant financing activities reflected in the change in cash flows used by financing activities were as follows: • During the first six months of 2011 we had a net repayment of $27.4 million under our line of credit agreements related to working capital, compared to $29.2 million in the same period in 2010, resulting in a period-over-period net cash increase of $1.8 million. Changes in cash overdrafts increased by $2.4 million, resulting in a period-over-period net cash decrease. • Net repayments of other short-term debt and long-term debt during the first six months of 2011 were $1.6 million, compared to net repayments of $1.2 million in the same period in 2010. During the first six months of 2010, we redeemed the 6.85 and 4.90 series of FPU's secured first mortgage bonds prior to their respective maturities by using the proceeds from a new short-term credit facility. During the first six months of 2011, we issued Chesapeake's unsecured senior notes, using the proceeds to repay the new short-term credit facility and permanently finance the FPU bonds. • We paid $5.7 million and $5.4 million in cash dividends for the six months ended June 30, 2011 and 2010, respectively. Off-Balance Sheet Arrangements We have issued corporate guarantees to certain vendors of our subsidiaries, primarily the propane wholesale marketing subsidiary and the natural gas marketing subsidiary. These corporate guarantees provide for the payment of propane and natural gas purchases in the event of the respective subsidiary's default. None of these subsidiaries has ever defaulted on its obligations to pay its suppliers. The liabilities for these purchases are recorded in our financial statements when incurred. The aggregate amount guaranteed at June 30, 2011 was $25.6 million, with the guarantees expiring on various dates through 2012. - 52 --------------------------------------------------------------------------------- Table of Contents In addition to the corporate guarantees, we have issued a letter of credit to our primary insurance company for $441,000, which expires on December 2, 2011. The letter of credit is provided as security to satisfy the deductibles under our various insurance policies. Although we recently changed our primary insurance company, we still have an outstanding letter of credit for $725,000 to our former primary insurance company, which will expire on June 1, 2012. There have been no draws on these letters of credit as of June 30, 2011. We do not anticipate that the letters of credit will be drawn upon by the counterparties, and we expect that the letters of credit will be renewed to the extent necessary in the future. We provided a letter of credit for $2.5 million under the Precedent Agreement with TETLP, which is the maximum amount required under the agreement. Contractual Obligations There has not been any material change in the contractual obligations presented in our 2010 Annual Report on Form 10-K, except for commodity purchase obligations and forward contracts entered into in the ordinary course of our business. The following table summarizes the commodity and forward contract obligations at June 30, 2011. Payments Due by Period Purchase Obligations Less than 1 year 1 - 3 years 3 - 5 years More than 5 years Total (in thousands) Commodities (1) $ 13,892 $ - $ - $ - $ 13,892 Propane (2) 24,406 - - - 24,406 Total Purchase Obligations $ 38,298 $ - $ - $ - $ 38,298 (1) In addition to the obligations noted above, the natural gas distribution, the electric distribution and propane distribution operations have agreements with commodity suppliers that have provisions with no minimum purchase requirements. There are no monetary penalties for reducing the amounts purchased; however, the propane contracts allow the suppliers to reduce the amounts available in the winter season if we do not purchase specified amounts during the summer season. Under these contracts, the commodity prices will fluctuate as market prices fluctuate. (2) We have also entered into forward sale contracts in the aggregate amount of $13.9 million. See Part I, Item 3, "Quantitative and Qualitative Disclosures about Market Risk," below, for further information. Environmental Matters As more fully described in Note 4, "Environmental Commitments and Contingencies," to the unaudited condensed consolidated financial statements in this Quarterly Report on Form 10-Q, we continue to work with federal and state environmental agencies to assess the environmental impact and explore corrective action at seven environmental sites. We believe that future costs associated with these sites will be recoverable in rates or through sharing arrangements with, or contributions by, other responsible parties. Other Matters Rates and Regulatory Matters Our natural gas distribution operations in Delaware, Maryland and Florida and electric distribution operation in Florida are subject to regulation by their respective PSC; Eastern Shore is subject to regulation by the FERC; and Peninsula Pipeline is subject to regulation by the Florida PSC. At June 30, 2011, we were involved in rate filings and/or regulatory matters in each of the jurisdictions in which we operate. Each of these rate filings and/or regulatory matters is fully described in Note 3, "Rates and Other Regulatory Activities," to the unaudited condensed consolidated financial statements in this Quarterly Report on Form 10-Q. - 53 - -------------------------------------------------------------------------------- Table of Contents Competition Our natural gas and electric distribution operations and our natural gas transmission operation compete with other forms of energy, including natural gas, electricity, oil and propane. The principal competitive factors are price and, to a lesser extent, accessibility. Our natural gas distribution operations have several large-volume industrial customers that are able to use fuel oil as an alternative to natural gas. When oil prices decline, these interruptible customers may convert to oil to satisfy their fuel requirements, and our interruptible sales volumes may decline. Oil prices, as well as the prices of other fuels, fluctuate for a variety of reasons; therefore, future competitive conditions are not predictable. To address this uncertainty, we use flexible pricing arrangements on both the supply and sales sides of this business to compete with alternative fuel price fluctuations. As a result of the transmission operation's conversion to open access and Chesapeake's Florida natural gas distribution division's restructuring of its services, these businesses have shifted from providing bundled transportation and sales service to providing only transmission and contract storage services. Our electric distribution operation currently does not face substantial competition because the electric utility industry in Florida has not been deregulated. In addition, natural gas is the only viable alternative fuel to electricity in our electric service territories and is available only in a small area. Our natural gas distribution operations in Delaware, Maryland and Florida offer unbundled transportation services to certain commercial and industrial customers. In 2002, Chesapeake's Florida natural gas distribution division, Central Florida Gas, extended such service to residential customers. With such transportation service available on our distribution systems, we are competing with third-party suppliers to sell gas to industrial customers. With respect to unbundled transportation services, our competitors include interstate transmission companies, if the distribution customers are located close enough to a transmission company's pipeline to make connections economically feasible. The customers at risk are usually large volume commercial and industrial customers with the financial resources and capability to bypass our existing distribution operations in this manner. In certain situations, our distribution operations may adjust services and rates for these customers to retain their business. We expect to continue to expand the availability of unbundled transportation service to additional classes of distribution customers in the future. We have also established a natural gas marketing operation in Florida, Delaware and Maryland to provide such service to customers eligible for unbundled transportation services. Our propane distribution operations compete with several other propane distributors in their respective geographic markets, primarily on the basis of service and price, emphasizing responsive and reliable service. Our competitors generally include local outlets of national distributors and local independent distributors, whose proximity to customers entails lower costs to provide service. Propane competes with electricity as an energy source, because it is typically less expensive than electricity, based on equivalent BTU value. Propane also competes with home heating oil as an energy source. Since natural gas has historically been less expensive than propane, propane is generally not distributed in geographic areas served by natural gas pipeline or distribution systems. The propane wholesale marketing operation competes against various regional and national marketers, many of which have significantly greater resources and are able to obtain price or volumetric advantages. Our advanced information services subsidiary faces significant competition from a number of larger competitors having substantially greater resources available to them than does our subsidiary. In addition, changes in the advanced information services business are occurring rapidly and could adversely affect the markets for the products and services offered by these businesses. This segment competes on the basis of technological expertise, reputation and price. Inflation Inflation affects the cost of supply, labor, products and services required for operations, maintenance and capital improvements. While the impact of inflation has remained low in recent years, natural gas and propane prices are subject to rapid fluctuations. In the regulated natural gas and electric distribution operations, fluctuations in natural gas and electricity prices are passed on to customers through the fuel cost recovery mechanism in our tariffs. To help cope with the effects of inflation on our capital investments and returns, we seek rate increases from regulatory commissions for our regulated operations and closely monitor the returns of our unregulated business operations. To compensate for fluctuations in propane gas prices, we adjust propane selling prices to the extent allowed by the market. - 54 --------------------------------------------------------------------------------- Table of Contents Recent Authoritative Pronouncements on Financial Reporting and Accounting Recent accounting developments applicable to us and their impact on our financial position, results of operations and cash flows are described in Note 1, "Summary of Accounting Policies," to the unaudited condensed consolidated financial statements in this Quarterly Report on Form 10-Q. Item 3. Quantitative and Qualitative Disclosures about Market Risk Market risk represents the potential loss arising from adverse changes in market rates and prices. Long-term debt is subject to potential losses based on changes in interest rates. Our long-term debt consists of fixed-rate senior notes, secured debt and convertible debentures. All of our long-term debt is fixed-rate debt and was not entered into for trading purposes. The carrying value of long-term debt, including current maturities, was $126.3 million at June 30, 2011, as compared to a fair value of $145.0 million, based on a discounted cash flow methodology that incorporates a market interest rate that is based on published corporate borrowing rates for debt instruments with similar terms and average maturities with adjustments for duration, optionality, credit risk, and risk profile. We evaluate whether to refinance existing debt or permanently refinance existing short-term borrowing, based in part on the fluctuation in interest rates. Our propane distribution business is exposed to market risk as a result of propane storage activities and entering into fixed price contracts for supply. We can store up to approximately six million gallons of propane (including leased storage and rail cars) during the winter season to meet our customers' peak requirements and to serve metered customers. Decreases in the wholesale price of propane may cause the value of stored propane to decline. To mitigate the impact of price fluctuations, we have adopted a Risk Management Policy that allows the propane distribution operation to enter into fair value hedges or other economic hedges of our inventory. Our propane wholesale marketing operation is a party to natural gas liquids forward contracts, primarily propane contracts, with various third parties. These contracts require that the propane wholesale marketing operation purchase or sell natural gas liquids at a fixed price at fixed future dates. At expiration, the contracts are settled by the delivery of natural gas liquids to us or the counter-party or "booking out" the transaction. Booking out is a procedure for financially settling a contract in lieu of the physical delivery of energy. The propane wholesale marketing operation also enters into futures contracts that are traded on the New York Mercantile Exchange. In certain cases, the futures contracts are settled by the payment or receipt of a net amount equal to the difference between the current market price of the futures contract and the original contract price; however, they may also be settled by physical receipt or delivery of propane. - 55 --------------------------------------------------------------------------------- Table of Contents The forward and futures contracts are entered into for trading and wholesale marketing purposes. The propane wholesale marketing business is subject to commodity price risk on its open positions to the extent that market prices for natural gas liquids deviate from fixed contract settlement prices. Market risk associated with the trading of futures and forward contracts is monitored daily for compliance with our Risk Management Policy, which includes volumetric limits for open positions. To manage exposures to changing market prices, open positions are marked up or down to market prices and reviewed daily by our oversight officials. In addition, the Risk Management Committee reviews periodic reports on markets and the credit risk of counter-parties, approves any exceptions to the Risk Management Policy (within limits established by the Board of Directors) and authorizes the use of any new types of contracts. Quantitative information on forward and futures contracts at June 30, 2011 is presented in the following tables. Quantity in Estimated Market Weighted Average At June 30, 2011 Gallons Prices Contract Prices Forward Contracts Sale 9,240,000 $ 1.3900 - $1.5700 $ 1.5005 Purchase 8,106,000 $ 1.3344 - $1.5850 $ 1.4878 Estimated market prices and weighted average contract prices are in dollars per gallon. All contracts expire during or prior to the first quarter of 2012. At June 30, 2011 and December 31, 2010, we marked these forward contracts to market, using market transactions in either the listed or OTC markets, which resulted in the following assets and liabilities: June 30, December 31, (in thousands) 2011 2010 Mark-to-market energy assets $ 335 $ 1,642 Mark-to-market energy liabilities $ 216 $ 1,492 Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures The Chief Executive Officer and Chief Financial Officer of the Company, with the participation of other Company officials, have evaluated our "disclosure controls and procedures" (as such term is defined under Rules 13a-15(e) and 15d-15(e), promulgated under the Securities Exchange Act of 1934, as amended) as of June 30, 2011. Based upon their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2011. Changes in Internal Control over Financial Reporting During the quarter ended June 30, 2011, there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. - 56 --------------------------------------------------------------------------------- Table of Contents [ Back To TMCnet.com's Homepage ]