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DGAS > SEC Filings for DGAS > Form 10-K on 27-Aug-2013All Recent SEC Filings

Show all filings for DELTA NATURAL GAS CO INC | Request a Trial to NEW EDGAR Online Pro

Form 10-K for DELTA NATURAL GAS CO INC


27-Aug-2013

Annual Report


Item 7.? Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview of 2013 and Future Outlook

Overview

The following is a discussion of the segments we operate, our corporate strategy for the conduct of our business within these segments and significant events that have occurred during 2013. Our Company has two segments: (i) a regulated natural gas distribution and transmission segment, and (ii) a non-regulated segment which participates in related activities, consisting of natural gas marketing, natural gas production and the sale of liquids extracted from natural gas.

Earnings from the regulated segment are primarily influenced by sales and transportation volumes, the rates we charge our customers and the expenses we incur. In order for us to achieve our strategy of maintaining reasonable long-term earnings, cash flow and stock value, we must successfully manage each of these factors. Regulated sales volumes are temperature-sensitive. Our regulated sales volumes in any period reflect the impact of weather, with colder temperatures generally resulting in increased sales volumes. The impact of winter temperatures on our revenues is partially reduced given our ability to adjust our winter rates for residential and small non-residential customers based on the degree to which actual winter temperatures deviate from normal.

Our non-regulated segment markets natural gas to large-use customers both on and off our regulated system. We endeavor to enter sales agreements matching supply with estimated demand while providing an acceptable gross margin. The non-regulated segment also produces natural gas and sells liquids extracted from natural gas.

Consolidated earnings per common share for 2013 increased $0.20 per common share as compared to 2012. We experienced a winter that was significantly colder than the preceding year resulting in increased volumes of natural gas sold as well as increased volumes transported by our regulated segment. Also, decreased interest expense resulting from the resolution of a tax assessment issued to Delta Resources (as further discussed in Note 13 of the Notes to Consolidated Financial Statements) had a positive impact on earnings. Other factors which influenced our 2013 consolidated earnings per common share are further discussed in the Results of Operations.

Future Outlook

Future profitability of the regulated segment is contingent on the adequate and timely adjustment of the rates we charge our regulated customers. The Kentucky Public Service Commission sets these rates, and we monitor our need to file rate cases with the Kentucky Public Service Commission for a general rate increase for our regulated services. The regulated segment's largest expense is gas supply, which we are permitted to pass through to our customers. We manage remaining expenses through budgeting, approval and review.

Future profitability of the non-regulated segment is dependent on the business plans of some of our industrial and other large use customers and the market prices of natural gas and natural gas liquids, all of which are out of our control. We anticipate our non-regulated segment to continue to contribute to our consolidated net income in fiscal 2014. If natural gas prices increase, we would expect to experience a corresponding increase in our non-regulated segment margins related to our natural gas production and marketing activities. However, if natural gas prices decrease, we would expect a decrease in our non-regulated margins related to our natural gas production and marketing activities. The profitability of selling natural gas liquids is dependent on the amount of liquids extracted and the pricing for any such liquids is determined by a national unregulated market.

Liquidity and Capital Resources

Sources and Uses of Cash

Operating activities provide our primary source of cash. Cash provided by operating activities consists of net income adjusted for non-cash items, including depreciation, amortization, deferred income taxes and changes in working capital. Our sales and cash requirements are seasonal. The largest portion of our sales occurs during the heating months, whereas significant cash requirements for the purchase of natural gas for injection into our storage field and capital expenditures occur during non-heating months. Therefore, when cash provided by operating activities is not sufficient to meet our capital requirements, our ability to maintain liquidity depends on our bank line of credit. The current bank line of credit with Branch Banking and Trust Company


permits borrowings up to $40,000,000. There were no borrowings outstanding on the bank line of credit as of June 30, 2013 or June 30, 2012 and we did not draw on this bank line of credit during 2013.

Cash and cash equivalents were $10,360,000 at June 30, 2013 compared with $9,741,000 at June 30, 2012 and $7,340,000 at June 30, 2011. These changes in cash and cash equivalents are summarized in the following table:

$(000)                                     2013       2012       2011

Provided by operating activities         13,557     13,514     14,467
Used in investing activities             (7,108 )   (7,012 )   (7,520 )
Used in financing activities             (5,829 )   (4,102 )   (4,246 )

   Increase in cash and cash equivalents    620      2,400      2,701

In 2013, there was not a significant change in cash provided by operating activities as compared to 2012.

In 2012, there was not a significant change in cash provided by operating activities as compared to 2011.

Changes in cash used in investing activities result primarily from changes in the level of capital expenditures between years.

In 2013, cash used in financing activities increased $1,727,000 (42%), as compared to 2012, due to a $1,500,000 repayment on our 4.26% Series A Notes.

In 2012, there was not a significant change in cash used in financing activities as compared to 2011.

Cash Requirements

Our capital expenditures result in a continued need for cash. These capital
expenditures are being made for system extensions and for the replacement and
improvement of existing transmission, distribution, gathering, storage and
general facilities. We expect our capital expenditures for fiscal 2014 to be
approximately $7.8 million.

The following is provided to summarize our contractual cash obligations for
indicated periods after June 30, 2013:
                                                  Payments Due by Fiscal Year
$(000)                               2014   2015 - 2016   2017 - 2018   After 2018    Total
Interest payments (a)               2,428         4,554         4,299       22,302   33,583
Long-term debt (b)                  1,500         3,000         3,000       49,000   56,500
Pension contributions (c)             500         1,000         1,000        4,500    7,000
Gas purchases (d)                     328             -             -            -      328
Total contractual obligations (e)   4,756         8,554         8,299       75,802   97,411

(a) Our long-term debt, notes payable, customers' deposits and unrecognized tax positions all require interest payments. Interest payments are projected based on fiscal 2013 interest payments until the underlying obligation is satisfied. As of June 30, 2013, we have also accrued $9,000 of interest related to uncertain tax positions. These amounts have been excluded from the above table of contractual obligations as the timing of such payments is uncertain.

(b) See Note 10 of the Notes to Consolidated Financial Statements for a description of this debt.

(c) This represents currently projected contributions to the defined benefit plan through 2026, as recommended by our actuary.

(d) As of June 30, 2013, we had three contracts which had minimum purchase obligations. These contracts have various terms with the last contract expiring December, 2013. The remainder of our gas purchase contracts are either requirements-based contracts, or contracts with a minimum purchase obligation extending for a time period not exceeding one month.


(e) We have other long-term liabilities which include deferred income taxes ($39,624,000), regulatory liabilities ($1,253,000), asset retirement obligations ($3,547,000) and deferred compensation ($739,000). Based on the nature of these items their expected settlement dates cannot be estimated.

All of our operating leases are year-to-year and cancelable at our option.

See Note 13 of the Notes to Consolidated Financial Statements for other commitments and contingencies.

Sufficiency of Future Cash Flows

Our ability to maintain liquidity, finance capital expenditures and pay dividends is contingent on the adequate and timely adjustment of the regulated rates we charge our customers. The Kentucky Public Service Commission sets these rates and we monitor our need to file for rate increases for our regulated segment. Our regulated base rates were most recently adjusted in our 2010 rate case and became effective in October, 2010. We expect that cash provided by operations will be sufficient to satisfy our operating and normal capital expenditure requirements and to pay dividends for the next twelve months and the foreseeable future.

To the extent that internally generated cash is not sufficient to satisfy seasonal operating and capital expenditure requirements and to pay dividends, we rely on our bank line of credit. Our current available bank line of credit with Branch Banking and Trust Company extends through June 30, 2015 and permits borrowings up to $40,000,000. There were no borrowings outstanding on the bank line of credit during 2013 as we did not draw upon this bank line of credit during 2013.

In December, 2011, we refinanced our 5.75% Insured Quarterly Notes and 7% Debentures from the proceeds of a private debt financing. Under the Note Purchase and Private Shelf Agreement, we issued $58,000,000 of Series A Notes, for which the purchasers paid 100% of the face principal amount. The proceeds from the sale of the Series A Notes were used to fund the redemption of our 5.75% Insured Quarterly Notes Due April 1, 2021, which had an outstanding principal balance of $38,450,000, and our 7% Debentures Due February 1, 2023, which had an outstanding principal balance of $19,410,000.

Our Series A Notes are unsecured, bear interest at a rate of 4.26% per annum, which is payable quarterly, and mature on December 20, 2031. We are required to make an annual $1,500,000 principal payment on the Series A Notes each December. Any refinance of the Series A Notes, or any additional prepayments of principal, may be subject to a prepayment penalty.

The Agreement for the Series A Notes contains a private shelf facility that extends through December, 2013. We may, with mutual agreement between us and the purchasers or their affiliates, issue them additional long-term unsecured promissory notes of the Company in an aggregate principal amount up to $17,000,000.

With our bank line of credit agreement and Series A Notes, we have agreed to certain financial covenants. Noncompliance with these covenants can make the obligation immediately due and payable. We have agreed to the following financial covenants:

The Company must at all times maintain a tangible net worth of at least $25,800,000.

         The Company must at the end of each fiscal quarter maintain a total
          debt to capitalization ratio of no more than 70%. The total debt to
          capitalization ratio is calculated as the ratio of (i) the Company's
          total debt to (ii) the sum of the Company's shareholders' equity plus
          total debt.



         The Company must maintain a fixed charge coverage ratio for the twelve
          months ending each quarter of not less than 1.20x. The fixed charge
          coverage ratio is calculated as the ratio of (i) the Company's earnings
          adjusted for certain unusual or non-recurring items, before interest,
          taxes, depreciation and amortization plus rental expense to (ii) the
          Company's interest and rental expense.



         The Company may not pay aggregate dividends on its capital stock (plus
          amounts paid in redemption of its capital stock) in excess of the sum
          of $15,000,000 plus the Company's cumulative earnings after September
          30, 2011 adjusted for certain unusual or non-recurring items.


The following table shows the required and actual financial covenants under our Series A Notes as of June 30, 2013:

                     Requirement                            Actual

Tangible net worth           no less than $25,800,000   $ 68,674,245
Debt to capitalization ratio no more than 70%                     45 %
Fixed charge coverage ratio  no less than 1.20x                 7.75   x

Dividends paid no more than $28,318,000 $ 8,526,000

Our 4.26% Series A Notes restrict us from:

with limited exceptions, granting or permitting liens on or security interests in our properties,

selling a subsidiary, except in limited circumstances,

         incurring secured debt, or permitting a subsidiary to incur debt or
          issue preferred stock to any third party, in an aggregate amount that
          exceeds 10% of our tangible net worth,

changing the general nature of our business,

         merging with another company, unless (i) we are the survivor of the
          merger or the survivor of the merger is another domestic company that
          assumes the 4.26% Series A Notes, (ii) there is no event of default
          under the 4.26% Series A Notes and (iii) the continuing company has a
          tangible net worth at least as high as our tangible net worth
          immediately prior to such merger, or



         selling or transferring assets, other than (i) the sale of inventory in
          the ordinary course of business, (ii) the transfer of obsolete
          equipment and (iii) the transfer of other assets in any 12 month period
          where such assets constitute no more than 5% of the value of our
          tangible assets and, over any period of time, the cumulative value of
          all assets transferred may not exceed 15% of our tangible assets.

Without the consent of the bank that has extended to us our bank line of credit or terminating our bank line of credit, we may not:

merge with another entity;

sell a material portion of our assets other than in the ordinary course of business,

issue stock which in the aggregate exceeds thirty-five percent (35%) of our outstanding shares of common stock, or

permit any person or group of related persons to hold more than twenty percent (20%) of the Company's outstanding shares of stock.

Furthermore, the agreement governing our 4.26% Series A Notes contains a cross-default provision which provides that we will be in default under the 4.26% Series A Notes if we are in default on any other outstanding indebtedness that exceeds $2,500,000. Similarly, the loan agreement governing the bank line of credit contains a cross-default provision which provides that we will be in default under the bank line of credit if we are in default under our 4.26% Series A Notes and fail to cure the default within ten days of notice from the bank. We were in compliance with the covenants under our bank line of credit and 4.26% Series A Notes for all periods presented in the Consolidated Financial Statements.

Critical Accounting Policies and Estimates

Preparation of financial statements and related disclosures in compliance with generally accepted accounting principles requires the use of assumptions and estimates regarding future events, including the likelihood of success of particular investments or initiatives, estimates of future prices or rates, legal and regulatory challenges and anticipated recovery of costs. Therefore, the


possibility exists for materially different reported amounts under different conditions or assumptions. We consider an accounting estimate to be critical if
(i) the accounting estimate requires us to make assumptions about matters that were reasonably uncertain at the time the accounting estimate was made and (ii) changes in the estimate are reasonably likely to occur from period to period.

These critical accounting estimates should be read in conjunction with the Notes to Consolidated Financial Statements. We have other accounting policies that we consider to be significant; however, these policies do not meet the definition of critical accounting estimates, because they generally do not require us to make estimates or judgments that are particularly difficult or subjective.

Regulatory Accounting

Our accounting policies reflect the effects of the rate-making process in accordance with regulatory accounting standards. Our regulated segment continues to be cost-of-service rate regulated, and we believe the application of regulatory accounting standards to that segment is appropriate. If, as a result of a change in circumstances, it is determined that the regulated segment no longer meets the criteria of regulatory accounting, that segment will have to discontinue regulatory accounting and write-off the respective regulatory assets and liabilities. Such a write-off could have a material impact on our consolidated financial statements.

The application of regulatory accounting standards results in recording regulatory assets and liabilities. Regulatory assets represent the deferral of incurred costs that are probable of future recovery in customer rates. In some cases, we record regulatory assets before approval for recovery has been received from the Kentucky Public Service Commission. We must use judgment to conclude that costs deferred as regulatory assets are probable of future recovery. We base this conclusion on certain factors, including changes in the regulatory environment, recent rate orders issued by the Kentucky Public Service Commission and the status of any potential new legislation. Regulatory liabilities represent revenues received from customers to fund expected costs that have not yet been incurred, or they represent probable future refunds to customers.

We use our best judgment when recording regulatory assets and liabilities; however, regulatory commissions can reach different conclusions about the recovery of costs, and those conclusions could have a material impact on our consolidated financial statements. We believe it is probable that we will recover the regulatory assets that have been recorded.

Pension

We have a trusteed, non-contributory, defined benefit pension plan covering all eligible employees hired prior to May 9, 2008. The net periodic benefit costs ("pension costs") for our defined benefit plan as described in Note 6 of the Notes to Consolidated Financial Statements are dependent upon numerous factors resulting from actual plan experience and assumptions concerning future experience. These costs, for example, are impacted by employee demographics (including age, compensation levels and employment periods), the level of contributions we make to the plan and earnings on plan assets. Additionally, changes made to the provisions of the plan may impact current and future pension costs. Pension costs may also be significantly affected by changes in key actuarial assumptions, including anticipated rates of return on plan assets and the discount rates used in determining the projected benefit obligation and pension costs. For the years ended June 30, 2013, 2012 and 2011, we recorded pension costs for our defined benefit pension plan of $980,000, $481,000 and $1,129,000, respectively.

Changes in pension obligations associated with the above factors may not be immediately recognized as pension costs in the Consolidated Statements of Income, but may be deferred and amortized in the future over the average remaining service period of active plan participants. As of June 30, 2013, $6,369,000 of net losses have been deferred for amortization as pension costs into future periods.

Our pension plan assets are principally comprised of equity and fixed income investments. Differences between actual portfolio returns and expected returns will result in increased or decreased pension costs in future periods. Likewise, changes in assumptions regarding current discount rates and expected rates of return on plan assets could also increase or decrease pension costs in future periods.

In selecting our discount rate assumption we considered rates of return on high-quality fixed-income investments that are expected to be available through the maturity dates of the pension benefits. Our expected long-term rate of return on pension plan assets was 7% for 2013 and was based on our targeted asset allocation assumption for 2013 of approximately 70% equity investments and approximately 30% fixed income investments. Our target investment allocation for equity investments includes allocations to domestic, global and real estate markets. Our asset allocation is designed to achieve a moderate level of overall portfolio risk in keeping with our desired risk objective. We regularly review our asset allocation and periodically rebalance our investments to our targeted allocation as appropriate.


The funded status of our plan reflects investment gains or losses in the year in which they occur based on the market value of assets at the measurement date.

Based on an assumed long-term rate of return of 6%, discount rate of 4.5%, and various other assumptions, we estimate that our pension costs associated with our defined benefit pension plan will decrease from $980,000 in 2013 to $750,000 in 2014. Modifying the expected long-term rate of return on our pension plan assets by .25% would change pension costs for 2014 by approximately $65,000. Increasing the discount rate assumption by .25% would decrease pension costs by approximately $82,000. Decreasing the discount rate assumption by .25% would increase pension costs by approximately $86,000.

Provisions for Doubtful Accounts

We encounter risks associated with the collection of our accounts receivable. As such, we record a monthly provision for accounts receivable that are considered to be uncollectible. In our regulated segment, the risk of non-collection on accounts receivable is partially mitigated by our ability to recover the portion of bad debt expense that relates to the customers' gas cost through our gas cost recovery mechanism.

In order to calculate the appropriate monthly provision, we primarily utilize our historical experience related to accounts written-off. Quarterly, at a minimum, we review the reserve for reasonableness based on the level of revenue and the aging of the receivable balance. Additionally, we specifically review significant account balances for collectibility. The underlying assumptions used for the allowance can change from period to period and the allowance could potentially cause a material impact to the Consolidated Statements of Income. The actual weather, commodity prices and other internal and external economic conditions, such as the mix of the customer base between residential, commercial and industrial, may vary significantly from our assumptions and may impact operating income.

Unbilled Revenues and Gas Costs

At each month-end, we estimate the gas service that has been rendered from the date the customer's meter was last read to month-end. This estimate of unbilled usage is based on projected base load usage for each day unbilled plus projected weather-sensitive usage for each degree day during the unbilled period. Unbilled revenues and gas costs are calculated from the estimate of unbilled usage multiplied by the rates in effect at month-end. Actual usage patterns may vary from these assumptions and may impact operating income.

Asset Retirement Obligations

We have accrued asset retirement obligations for gas well plugging and abandonment costs. Additionally, we have recorded asset retirement obligations required pursuant to regulations related to the retirement of our service lines and mains, although the timing of such retirements is uncertain. The fair value of our retirement obligations is recorded at the time the obligations are incurred. We do not recognize asset retirement obligations relating to assets with indeterminate useful lives. Upon initial recognition of an asset retirement obligation, we increase the carrying amount of the long-lived asset by the same amount as the liability. Over time the liabilities accrete for the change in their present value, and the initial capitalized costs depreciate over the useful lives of the related assets. For asset retirement obligations attributable to assets of our regulated operations, the accretion and depreciation are deferred as a regulatory asset. We must use judgment to identify all appropriate asset retirement obligations. The underlying assumptions used for the value of the retirement obligations and related capitalized costs can change from period to period. These assumptions include the estimated future retirement costs, the estimated retirement date and the assumed credit-adjusted risk-free interest rate. Our asset retirement obligations are further discussed in Note 4 of the Notes to Consolidated Financial Statements.

New Accounting Pronouncements

Significant management judgment is generally required during the process of adopting new accounting pronouncements. See Note 2 of the Notes to Consolidated Financial Statements for a discussion of these pronouncements.


Forward-Looking Statements

Management's Discussion and Analysis of Financial Condition and Results of Operations and the other sections of this report contain forward-looking statements that relate to future events or our future performance. We have attempted to identify these statements by using words such as "estimates", "attempts", "expects", "monitors", "plans", "anticipates", "intends", "continues", "could", "strives" ,"seeks", "will rely", "believes" and similar expressions.

These forward-looking statements include, but are not limited to, statements about:
operational plans,
the cost and availability of our natural gas supplies,
capital expenditures,
sources and availability of funding for our operations and expansion, anticipated growth and growth opportunities through system expansion and
acquisition,
competitive conditions that we face, production, storage, gathering, transportation, marketing and natural gas
liquids activities,
acquisition of service franchises from local governments,
pension plan costs and management,
contractual obligations and cash requirements, management of our gas supply and risks due to potential fluctuation in the
price of natural gas,
revenues, income, margins and profitability,
efforts to purchase and transport locally produced natural gas,
recovery of regulatory assets,
litigation and other contingencies,
regulatory and legislative matters, and
dividends.

. . .

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