10-Q 1 q10q0602.txt LG&E AND KU JUNE 2002 10Q SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission Registrant, State of Incorporation, IRS Employer File Number Address, and Telephone Number Identification No. 2-26720 Louisville Gas and Electric Company 61-0264150 (A Kentucky Corporation) 220 West Main Street P.O. Box 32010 Louisville, Ky. 40232 (502) 627-2000 1-3464 Kentucky Utilities Company 61-0247570 (A Kentucky and Virginia Corporation) One Quality Street Lexington, Kentucky 40507-1428 (859) 255-2100 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X. No __. Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Louisville Gas and Electric Company 21,294,223 shares, without par value, as of July 31, 2002, all held by LG&E Energy Corp. Kentucky Utilities Company 37,817,878 shares, without par value, as of July 31, 2002, all held by LG&E Energy Corp. This combined Form 10-Q is separately filed by Louisville Gas and Electric Company and Kentucky Utilities Company. Information contained herein related to any individual registrant is filed by such registrant on its own behalf. Each registrant makes no representation as to information relating to the other registrants. TABLE OF CONTENTS PART I Item 1 Consolidated Financial Statements Louisville Gas and Electric Company and Subsidiary Statements of Income 1 Balance Sheets 2 Statements of Cash Flows 4 Statements of Retained Earnings 5 Statements of Other Comprehensive Income 6 Kentucky Utilities Company and Subsidiary Statements of Income 7 Balance Sheets 8 Statements of Cash Flows 10 Statements of Retained Earnings 11 Statements of Other Comprehensive Income 12 Notes to Consolidated Financial Statements 13 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 20 Item 3 Quantitative and Qualitative Disclosures About Market Risk 28 PART II Item 1 Legal Proceedings 30 Item 6 Exhibits and Reports on Form 8-K 30 Signatures 31 Part I. Financial Information - Item 1. Financial Statements Louisville Gas and Electric Company and Subsidiary Consolidated Statements of Income (Unaudited) (Thousands of $) Three Months Six Months Ended Ended June 30, June 30, 2002 2001 2002 2001 OPERATING REVENUES: Electric (Note 7) $191,813 $196,290 $358,059 $351,664 Gas (Note 7) 30,938 32,551 148,056 190,448 Total operating revenues 222,751 228,841 506,115 542,112 OPERATING EXPENSES: Fuel for electric generation 50,550 41,749 94,657 80,233 Power purchased 22,064 32,744 45,645 44,085 Gas supply expenses 18,346 18,822 101,813 144,058 Non-recurring charges (Note 4) - - - 144,385 Other operation expenses 54,807 36,398 103,216 71,681 Maintenance 15,572 13,683 27,573 24,238 Depreciation and amortization 25,889 25,572 51,167 50,840 Federal and state income taxes 8,335 17,828 21,572 (20,183) Property and other taxes 4,778 4,421 9,314 8,883 Total operating expenses 200,341 191,217 454,957 548,220 NET OPERATING INCOME (LOSS) 22,410 37,624 51,158 (6,108) Other income (deduction) - net (67) 363 (66) 1,358 Interest charges (Note 5) 7,087 9,520 14,893 20,898 NET INCOME (LOSS) 15,256 28,467 36,199 (25,648) Preferred stock dividends 1,049 1,220 2,114 2,518 NET INCOME (LOSS) AVAILABLE FOR COMMON STOCK $ 14,207 $ 27,247 $ 34,085 $ (28,166) The accompanying notes are an integral part of these consolidated financial statements. -1- Louisville Gas and Electric Company and Subsidiary Consolidated Balance Sheets (Unaudited) (Thousands of $) ASSETS June 30, Dec. 31, 2002 2001 UTILITY PLANT: At original cost $3,486,441 $3,423,037 Less: reserve for depreciation 1,426,609 1,381,874 Net utility plant 2,059,832 2,041,163 OTHER PROPERTY AND INVESTMENTS - less reserve of $63 as of June 30, 2002 and Dec. 31, 2001 1,277 1,176 CURRENT ASSETS: Cash 20,454 2,112 Accounts receivable - less reserve of $1,575 as of June 30, 2002 and Dec. 31, 2001 (Note 6) 61,856 85,667 Materials and supplies - at average cost: Fuel (predominantly coal) 34,974 22,024 Gas stored underground 16,226 46,395 Other 28,896 29,050 Prepayments and other 4,119 4,688 Total current assets 166,525 189,936 DEFERRED DEBITS AND OTHER ASSETS: Unamortized debt expense 6,042 5,921 Regulatory assets (Note 8) 161,949 197,142 Other 13,996 13,016 Total deferred debits and other assets 181,987 216,079 Total assets $2,409,621 $2,448,354 The accompanying notes are an integral part of these consolidated financial statements. -2- Louisville Gas and Electric Company and Subsidiary Consolidated Balance Sheets (cont.) (Unaudited) (Thousands of $) CAPITALIZATION AND LIABILITIES June 30, Dec. 31, 2002 2001 CAPITALIZATION: Common stock, without par value - Outstanding 21,294,223 shares $ 425,170 $ 425,170 Additional paid-in capital 40,000 40,000 Retained earnings 404,721 393,636 Accumulated other comprehensive income (21,357) (19,900) Other (836) (836) Total common equity 847,698 838,070 Cumulative preferred stock 95,140 95,140 Long-term debt (Notes 10 and 11) 370,704 370,704 Total capitalization 1,313,542 1,303,914 CURRENT LIABILITIES: Current portion of long-term debt 246,200 246,200 Notes payable to parent 91,553 94,197 Accounts payable 100,446 149,070 Accrued taxes 21,105 20,257 Accrued interest 5,421 5,818 Other 13,380 12,840 Total current liabilities 478,105 528,382 DEFERRED CREDITS AND OTHER LIABILITIES: Accumulated deferred income taxes 308,769 298,143 Investment tax credit, in process of amortization 56,581 58,689 Accumulated provision for pensions and related benefits 165,364 167,526 Customer advances for construction 10,072 9,745 Regulatory liabilities (Note 8) 54,720 65,349 Other 22,468 16,606 Total deferred credits and other liabilities 617,974 616,058 Total capital and liabilities $2,409,621 $2,448,354 The accompanying notes are an integral part of these consolidated financial statements. -3- Louisville Gas and Electric Company and Subsidiary Consolidated Statements of Cash Flows (Unaudited) (Thousands of $) Six Months Ended June 30, 2002 2001 CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $ 36,199 $ (25,648) Items not requiring cash currently: Depreciation and amortization 51,167 50,840 Deferred income taxes - net 9,507 (41,833) Investment tax credit - net (2,108) (2,133) Non-recurring charges (Note 4) - 113,645 Other 20,917 7,466 Changes in current assets and liabilities (21,917) 16,670 Changes in accounts receivable securitization-net(Note 6) 16,100 52,900 Other 6,855 (18,568) Net cash flows from operating activities 116,720 153,339 CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of securities (101) - Proceeds from sales of securities - 4,350 Construction expenditures (69,524) (96,050) Net cash flows from investing activities (69,625) (91,700) CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of pollution control bonds 119,067 - Retirement of pollution control bonds (120,000) - Short-term borrowings 278,100 35,763 Repayment of short-term borrowings (280,744) (89,600) Payment of dividends (25,176) (2,665) Net cash flows from financing activities (28,753) (56,502) CHANGE IN CASH 18,342 5,137 CASH AT BEGINNING OF PERIOD 2,112 2,495 CASH AT END OF PERIOD $ 20,454 $ 7,632 SUPPLEMENTAL DISCLOSURES: Cash paid during the period for: Income taxes $ 16,681 $ 15,882 Interest on borrowed money $ 13,019 $ 16,090 For the purposes of these statements, all temporary cash investments purchased with a maturity of three months or less are considered cash equivalents. The accompanying notes are an integral part of these consolidated financial statements. -4- Louisville Gas and Electric Company and Subsidiary Consolidated Statements of Retained Earnings (Unaudited) (Thousands of $) Three Months Six Months Ended June 30, Ended June 30, 2002 2001 2002 2001 Balance at beginning of period $413,514 $259,181 $393,636 $314,594 Net income (loss) 15,256 28,467 36,199 (25,648) Subtotal 428,770 287,648 429,835 288,946 Cash dividends declared on stock: 5% cumulative preferred 269 269 538 538 Auction rate cumulative preferred 413 584 842 1,246 $5.875 cumulative preferred 367 367 734 734 Common 23,000 - 23,000 - Subtotal 24,049 1,220 25,114 2,518 Balance at end of period $404,721 $286,428 $404,721 $286,428 The accompanying notes are an integral part of these consolidated financial statements. -5- Louisville Gas and Electric Company and Subsidiary Consolidated Statements of Other Comprehensive Income (Unaudited) (Thousands of $) Three Months Six Months Ended Ended June 30, June 30, 2002 2001 2002 2001 Net income (loss) $15,256 $28,467 $36,199 $(25,648) Cumulative effect of change in Accounting principle - Accounting For Derivative Instruments and Hedging Activities (Note 5) - - - (5,998) Gains (losses) on derivative instruments and hedging activities (Note 5) (3,939) 977 (2,430) (1,058) Other comprehensive income (loss) before tax 11,317 29,444 33,769 (32,704) Income tax benefit (expense) related to items of other comprehensive income (loss) 1,576 (391) 973 2,822 Other comprehensive income (loss) $12,893 $29,053 $ 34,742$ (29,882) The accompanying notes are an integral part of these consolidated financial statements. -6- Kentucky Utilities Company and Subsidiary Consolidated Statements of Income (Unaudited) (Thousands of $) Three Months Six Months Ended Ended June 30, June 30, 2002 2001 2002 2001 OPERATING REVENUES (Note 7) $203,555 $219,360 $418,723 $431,153 OPERATING EXPENSES: Fuel for electric generation 57,368 55,523 115,639 111,451 Power purchased 39,911 52,023 80,971 84,908 Non-recurring charges (Note 4) - - - 63,788 Other operation expenses 36,201 27,343 70,723 53,961 Maintenance 15,386 15,549 26,945 27,519 Depreciation and amortization 23,515 23,818 46,574 47,646 Federal and state income taxes 7,365 11,821 21,748 5,371 Property and other taxes 3,762 4,277 7,876 8,432 Total operating expenses 183,508 190,354 370,476 403,076 NET OPERATING INCOME 20,047 29,006 48,247 28,077 Other income - net 1,685 2,621 3,324 4,414 Interest charges (Note 5) 8,980 10,425 14,462 18,542 NET INCOME before Cumulative Effect of Accounting Change 12,752 21,202 37,109 13,949 Cumulative Effect of Change in Accounting for Derivative Instruments and Hedging Activities, net of tax - - - 136 NET INCOME 12,752 21,202 37,109 14,085 Preferred stock dividends 564 564 1,128 1,128 NET INCOME AVAILABLE FOR COMMON STOCK $ 12,188 $ 20,638 $ 35,981 $ 12,957 The accompanying notes are an integral part of these consolidated financial statements. -7- Kentucky Utilities Company and Subsidiary Consolidated Balance Sheets (Unaudited) (Thousands of $) ASSETS June 30, Dec. 31, 2002 2001 UTILITY PLANT: At original cost $3,108,339 $3,064,220 Less: reserve for depreciation 1,501,947 1,457,754 Net utility plant 1,606,392 1,606,466 OTHER PROPERTY AND INVESTMENTS - less reserve of $129 as of June 30, 2002 and Dec. 31, 2001 10,089 9,629 CURRENT ASSETS: Cash and temporary cash investments 3,513 3,295 Accounts receivable - less reserve of $520 as of June 30, 2002, and Dec. 31, 2001 (Note 6) 54,047 45,291 Materials and supplies - at average cost: Fuel (predominantly coal) 42,238 43,382 Other 27,060 26,188 Prepayments and other 6,522 4,942 Total current assets 133,380 123,098 DEFERRED DEBITS AND OTHER ASSETS: Unamortized debt expense 3,843 4,316 Regulatory assets (Note 8) 57,768 66,467 Other 17,162 16,926 Total deferred debits and other assets 78,773 87,709 Total assets $1,828,634 $1,826,902 The accompanying notes are an integral part of these consolidated financial statements. -8- Kentucky Utilities Company and Subsidiary Consolidated Balance Sheets (cont.) (Unaudited) (Thousands of $) CAPITALIZATION AND LIABILITIES June 30, Dec. 31, 2002 2001 CAPITALIZATION: Common stock, without par value - Outstanding 37,817,878 shares $ 308,140 $ 308,140 Additional paid-in capital 15,000 15,000 Retained earnings 446,877 410,896 Accumulated other comprehensive income 2,685 1,588 Other (595) (595) Total common equity 772,107 735,029 Cumulative preferred stock 40,000 40,000 Long-term debt (Notes 10 and 11) 336,323 434,506 Total capitalization 1,148,430 1,209,535 CURRENT LIABILITIES: Current portion of long-term debt 153,930 54,000 Notes payable to parent 19,590 47,790 Accounts payable 77,502 85,149 Accrued taxes 16,868 20,520 Accrued interest 4,452 5,668 Other 16,810 16,482 Total current liabilities 289,152 229,609 DEFERRED CREDITS AND OTHER LIABILITIES: Accumulated deferred income taxes 238,680 239,204 Investment tax credit, in process of amortization 9,977 11,455 Accumulated provision for pensions and related benefits 91,827 91,235 Customer advances for construction 1,511 1,526 Regulatory liabilities (Note 8) 33,475 33,889 Other 15,582 10,449 Total deferred credits and other liabilities 391,052 387,758 Total capital and liabilities $1,828,634 $1,826,902 The accompanying notes are an integral part of these consolidated financial statements. -9- Kentucky Utilities Company and Subsidiary Consolidated Statements of Cash Flows (Unaudited) (Thousands of $) Six Months Ended June 30, 2002 2001 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 37,109 $ 14,085 Items not requiring cash currently: Depreciation and amortization 46,574 47,646 Deferred income taxes - net (3,106) (28,061) Investment tax credit - net (1,478) (1,723) Non-recurring charges (Note 4) - 50,078 Other 13,237 5,169 Changes in current assets and liabilities (24,551) (23,032) Changes in accounts receivable securitization-net (Note 6) 2,300 40,000 Other 8,208 (1,545) Net cash flows from operating activities 78,293 102,617 CASH FLOWS FROM INVESTING ACTIVITIES: Construction expenditures (47,844) (80,170) Net cash flows from investing activities (47,844) (80,170) CASH FLOWS FROM FINANCING ACTIVITIES: Short-term borrowings 505,938 229,094 Repayment of short-term borrowings (534,138) (250,543) Issuance of pollution control bonds 37,027 - Retirement of pollution control bonds (37,930) - Payment of dividends (1,128) (1,128) Net cash flows from financing activities (30,231) (22,577) CHANGE IN CASH AND TEMPORARY CASH INVESTMENTS 218 (130) CASH AND TEMPORARY CASH INVESTMENTS AT BEGINNING OF PERIOD 3,295 314 CASH AND TEMPORARY CASH INVESTMENTS AT END OF PERIOD $ 3,513 $ 184 SUPPLEMENTAL DISCLOSURES: Cash paid during the period for: Income taxes $ 27,905 $ 34,994 Interest on borrowed money $ 16,120 $ 16,735 For the purposes of these statements, all temporary cash investments purchased with a maturity of three months or less are considered cash equivalents. The accompanying notes are an integral part of these consolidated financial statements. -10- Kentucky Utilities Company and Subsidiary Consolidated Statements of Retained Earnings (Unaudited) (Thousands of $) Three Months Six Months Ended June 30, Ended June 30, 2002 2001 2002 2001 Balance at beginning of period $434,689 $339,557 $410,896 $347,238 Net income 12,752 21,202 37,109 14,085 Subtotal 447,441 360,759 448,005 361,323 Cash dividends declared on stock: 4.75% preferred 237 237 475 475 6.53% preferred 327 327 653 653 Subtotal 564 564 1,128 1,128 Balance at end of period $446,877 $360,195 $446,877 $360,195 The accompanying notes are an integral part of these consolidated financial statements. -11- Kentucky Utilities Company and Subsidiary Consolidated Statements of Other Comprehensive Income (Unaudited) (Thousands of $) Three Months Six Months Ended Ended June 30, June 30, 2002 2001 2002 2001 Net income $12,752 $21,202 $37,109 $14,085 Cumulative effect of change in accounting principle-Accounting for Derivative Instruments and Hedging activities (Note 5) - - - 2,647 Gains on derivative instruments and hedging activities 1,828 - 1,828 - Other comprehensive income, before tax 14,580 21,202 38,937 16,732 Income tax (expense) related to items of other comprehensive income (731) - (731) (1,059) Other comprehensive income $13,849 $21,202 $38,206 $15,673 The accompanying notes are an integral part of these consolidated financial statements. -12- Louisville Gas and Electric Company and Subsidiary Kentucky Utilities Company and Subsidiary Notes to Consolidated Financial Statements (Unaudited) 1. The unaudited consolidated financial statements include the accounts of Louisville Gas and Electric Company and Subsidiary and Kentucky Utilities Company and Subsidiary ("LG&E" and "KU" or the "Companies"). The common stock of each of LG&E and KU is wholly-owned by LG&E Energy Corp. ("LG&E Energy"). In the opinion of management, the unaudited interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of consolidated financial position, results of operations, comprehensive income and cash flows for the periods indicated. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to Securities and Exchange Commission ("SEC") rules and regulations, although the Companies believe that the disclosures are adequate to make the information presented not misleading. See LG&E's and KU's Annual Reports on Form 10-K for the year ended December 31, 2001 for information relevant to the accompanying financial statements, including information as to the significant accounting policies of the Companies. 2. On December 11, 2000, LG&E Energy was acquired by Powergen plc ("Powergen") for cash of approximately $3.2 billion or $24.85 per share and the assumption of all of LG&E Energy's debt. As a result of the acquisition, among other things, LG&E Energy became a wholly-owned indirect subsidiary of Powergen and, as a result, LG&E and KU became indirect subsidiaries of Powergen. The utility operations (LG&E and KU) of LG&E Energy have continued their separate identities and continue to serve customers in Kentucky and Virginia under their existing names. The preferred stock and debt securities of the utility operations were not affected by this transaction resulting in the utility operations' obligations to continue to file SEC reports. Following the acquisition, Powergen became a registered holding company under the Public Utility Holding Company Act of 1935 ("PUHCA"), and LG&E and KU, as subsidiaries of a registered holding company, became subject to additional regulation under PUHCA. As a result of the Powergen acquisition and in order to comply with PUHCA, LG&E Energy Services Inc. ("LG&E Services") was formed and became operational on January 1, 2001. LG&E Services provides certain services to affiliated entities, including LG&E and KU, at cost, as required under PUHCA. On January 1, 2001, approximately 1,000 employees, primarily from LG&E Energy, LG&E and KU, were moved to LG&E Services. 3. On April 9, 2001, a German company, E.ON AG ("E.ON"), announced a pre- conditional cash offer of 5.1 billion pounds sterling ($7.3 billion) to acquire Powergen. The final regulatory approval needed was received on June 14, 2002 from the SEC. Effective July 1, 2002, the acquisition of Powergen was completed by E.ON. Following this acquisition, E.ON became a registered holding company under PUHCA and subject to regulation thereunder. 4. During the first quarter 2001, LG&E recorded a $144 million charge and KU recorded a $64 million charge for a workforce reduction program. Primary components of the charge were separation benefits, enhanced early retirement benefits, and health care benefits. The result of this workforce reduction was the net elimination of approximately 950 positions, accomplished primarily through a voluntary enhanced severance program. On June 1, 2001, LG&E and KU filed an application ("VDT case") with the Kentucky Public Service Commission (the "Kentucky Commission") to create a regulatory asset relating to these first quarter 2001 charges. The application requested permission to amortize these costs over a four-year period. The Kentucky Commission also opened a case to review a depreciation study and resulting depreciation rates implemented in 2001. -13- LG&E and KU reached a settlement in the VDT case as well as the other cases involving depreciation rates and the Earnings Sharing Mechanism with all intervening parties. The settlement agreement was approved by the Kentucky Commission on December 3, 2001. The Kentucky Commission's December 3, 2001 order allowed LG&E to set up a regulatory asset of $141 million for the workforce reduction costs and begin amortizing these costs over a five year period starting in April 2001. The first quarter charge of $144 million represented all employees who had accepted the voluntary enhanced severance program. Between the time of the original filing and the December 3, 2001 order, some employees rescinded their participation in the voluntary enhanced severance program, thereby decreasing the original charge from $144 million to $141 million. The settlement will also reduce revenues by approximately $26 million through a surcredit on bills to customers over the same five year period. The surcredit represents stipulated net savings LG&E anticipates realizing from implementation of best practices through the value delivery process. The agreement also established LG&E's new depreciation rates in effect retroactive to January 1, 2001. The new depreciation rates decreased depreciation expense by $5.6 million in 2001. The Kentucky Commission's December 3, 2001 order allowed KU to set up a regulatory asset of $54 million for the workforce reduction costs and begin amortizing these costs over a five year period starting in April 2001. The first quarter charge of $64 million represented all employees who had accepted the voluntary enhanced severance program. Some employees rescinded their participation in the voluntary enhanced severance program and, along with the non-recurring charge of $6.9 million for FERC and Virginia jurisdictions, decreased the original charge from $64 million to $54 million. The settlement will also reduce revenues by approximately $11 million through a surcredit on bills to customers over the same five year period. The surcredit represents stipulated net savings KU anticipates realizing from implementation of best practices through the value delivery process. The agreement also established KU's new depreciation rates in effect retroactive to January 1, 2001. The new depreciation rates decreased depreciation expense by $6.0 million in 2001. 5. Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities, establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded on the balance sheet as either an asset or a liability measured at its fair value. SFAS No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that LG&E and KU must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. SFAS No. 133 could increase the volatility in earnings and other comprehensive income. LG&E and KU adopted SFAS No. 133 on January 1, 2001. The effect of adopting this statement in 2001 resulted in a $3.6 million (net of tax of $2.4 million) decrease in other comprehensive income from a cumulative effect of change in accounting principle for LG&E and a $1.6 million (net of tax of $1.1 million) increase in other comprehensive income from a cumulative effect of change in accounting principle for KU. The Companies use interest rate swaps to hedge exposure to market fluctuations in certain of their debt instruments. Pursuant to Company policy, use of these financial instruments is intended to mitigate risk and earnings volatility and is not speculative in nature. Management has designated all of the Companies' interest rate swaps as hedge instruments. Financial instruments designated as cash flow hedges have resulting gains and losses recorded within other comprehensive income and stockholders' equity. To the extent a financial instrument or the underlying item being hedged is prematurely terminated or the hedge becomes ineffective, the resulting gains or losses are reclassified from other comprehensive income to net income. Financial instruments designated as fair value hedges are periodically marked to market with the resulting gains and losses recorded directly into net income to correspond with income or expense recognized from changes in market value of the items being hedged. As of June 30, 2002, LG&E had fixed rate swaps covering $117,335,000 in notional amounts of variable rate debt and with fixed rates ranging from 4.184% to 5.495%. The average variable rate on the debt during -14- the quarter and six months ended June 30, 2002 was 1.53% and 1.47%. The swaps have been designated as cash flow hedges and expire on various dates from September 2003 through November 2020. The hedges were deemed to be fully effective resulting in a pretax loss for the quarter and six months ended June 30, 2002 of $3.9 million and $2.4 million, respectively, recorded in Other Comprehensive Income. Upon expiration of these hedges, the amount recorded in Other Comprehensive Income will be reclassified into earnings. The amount expected to be reclassified from Other Comprehensive Income to earnings in the next twelve months is immaterial. As of June 30, 2002, KU had variable rate swaps covering $153,000,000 in notional amounts of fixed rate debt. The average variable rate on these swaps during both the quarter and six months ended June 30, 2002 was 2.43%. The underlying debt has fixed rates ranging from 5.75% to 7.92%. The swaps have been designated as fair value hedges and expire on various dates from May 2007 through June 2025. During the quarter and six months ended June 30, 2002, the effect of marking these financial instruments and the underlying debt to market resulted in pretax losses of $2.2 million and $0.4 million, respectively, recorded as an increase in interest expense. The Financial Accounting Standards Board created the Derivatives Implementation Group ("DIG") to provide guidance for implementation of SFAS No. 133. DIG Issue C15, Normal Purchases and Normal Sales Exception for Option Type Contracts and Forward Contracts in Electricity was adopted in 2001 and had no impact on results of operations and financial position of the Companies. DIG Issue C16, Applying the Normal Purchase and Normal Sales Exception to Contracts that Combine a Forward Contract and a Purchased Option Contract, was cleared in the third quarter 2001 and stated that option contracts do not meet the normal purchases and normal sales exception and should follow SFAS No. 133. DIG Issue C16 was effective in the second quarter of 2002. The adoption of DIG Issue C16 did not have a material impact on the financial position or results of operations of the Companies pursuant to regulatory treatment prescribed by SFAS No. 71, Accounting for the Effects of Certain Types of Regulation. KU recorded a mark to market asset and corresponding regulatory liability of $1.4 million in the second quarter of 2002. 6. SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, revises the standards for accounting for securitizations and other transfers of financial assets and collateral and requires certain disclosures, and provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. The Companies adopted SFAS No. 140 in the first quarter of 2001, when LG&E and KU entered into accounts receivable securitization programs. On February 6, 2001, LG&E and KU implemented an accounts receivable securitization program. The purpose of this program is to enable the utilities to accelerate the receipt of cash from the collection of retail accounts receivable, thereby reducing dependence upon more costly sources of working capital. The securitization program allows for a percentage of eligible receivables to be sold. Eligible receivables are generally all receivables associated with retail sales that have standard terms and are not past due. LG&E and KU are able to terminate these programs at any time without penalty. If there is a significant deterioration in the payment record of the receivables by retail customers or if the Companies fail to meet certain covenants of the program, the program may terminate at the election of the financial institutions. In this case, payments from retail customers would first be used to repay the financial institutions participating in the program, and would then be available for use by the Companies. As part of the program, LG&E and KU sold retail accounts receivables to wholly owned subsidiaries, LG&E Receivables LLC ("LG&E R") and KU Receivables LLC ("KU R"). Simultaneously, LG&E R and KU R entered into two separate three-year accounts receivable securitization facilities with two financial institutions and their affiliates whereby LG&E R and KU R can sell, on a revolving basis, an undivided interest in certain of their receivables and receive up to $75 million and $50 million, respectively, from an unrelated third party purchaser. The effective cost of the receivables programs is comparable to the Companies' lowest -15- cost source of capital, and is based on prime rated commercial paper. LG&E and KU retain servicing rights of the sold receivables through separate servicing agreements with the third party purchasers. LG&E and KU have obtained opinions from independent legal counsel indicating these transactions qualify as true sales of receivables. As of June 30, 2002 and December 31, 2001, LG&E's outstanding program balances were $58.1 million and $42.0 million, respectively, and KU's balances were $47.4 million and $45.1 million, respectively. Management expects to renew these facilities when they expire. The allowance for doubtful accounts associated with the eligible securitized receivables was $1.6 million for LG&E and $0.5 million for KU for both June 30, 2002 and December 31, 2001, respectively. Charge offs were immaterial for LG&E and KU. The risk of uncollectibility associated with the sold receivables is minimal. 7. External and intersegment revenues (related party transactions between LG&E and KU) and income by business segment for the three and six months ended June 30, 2002, follow (in thousands of $): Three Months Ended June 30, 2002 Net Income/ (Loss) Inter- Avail. External segment For- Revenues Revenues Common Stock LG&E electric $ 181,963 $ 9,850 $ 16,893 LG&E gas 30,938 - (2,686) Total $ 212,901 $ 9,850 $ 14,207 KU electric $ 195,460 $ 8,095 $ 12,188 Six Months Ended June 30, 2002 Net Income/ (Loss) Inter- Avail. External segment For Revenues Revenues Common Stock LG&E electric $ 335,156 $ 22,903 $ 27,071 LG&E gas 148,056 - 7,014 Total $ 483,212 $ 22,903 $ 34,085 KU electric $ 395,847 $ 22,876 $ 35,981 External and intersegment revenues (related party transactions between LG&E and KU) and income by business segment for the three and six months ended June 30, 2001, follow (in thousands of $): Three Months Ended June 30, 2001 Net Income/ (Loss) Inter- Avail. External segment For Revenues Revenues Common Stock LG&E electric $ 187,472 $ 8,818 $ 27,867 LG&E gas 32,551 - (620) Total $ 220,023 $ 8,818 $ 27,247 KU electric $ 209,507 $ 9,853 $ 20,638 -16- Six Months Ended June 30, 2001 Net Income/ (Loss) Inter- Avail. External segment For- Revenues Revenues Common Stock LG&E electric $ 335,833 $ 15,831 $ (16,575) LG&E gas 190,448 - (11,591) Total $ 526,281 $ 15,831 $ (28,166) KU electric $ 415,618 $ 15,535 $ 12,957 8.The following regulatory assets and liabilities were included in the balance sheet of LG&E and KU as of June 30, 2002 and December 31, 2001 (in thousands of $): Louisville Gas and Electric (Unaudited) Jun. 30, Dec. 31, 2002 2001 REGULATORY ASSETS: VDT costs $ 112,529 $ 127,529 Unamortized loss on bonds 17,972 17,902 Gas supply adjustments due from customers 16,342 30,135 LG&E/KU merger costs 3,629 5,444 One utility costs 2,299 3,643 Manufactured gas sites 1,911 2,062 Other 7,267 10,427 Total 161,949 197,142 REGULATORY LIABILITIES: Deferred income taxes - net 47,584 48,703 Gas supply adjustments due to customers 6,207 15,702 Other 929 944 Total $ 54,720 $ 65,349 Kentucky Utilities (Unaudited) Jun. 30, Dec. 31, 2002 2001 REGULATORY ASSETS: VDT costs $ 43,061 $ 48,811 Unamortized loss on bonds 6,916 6,142 LG&E/KU merger costs 4,093 6,139 One utility costs 2,619 4,365 Other 1,079 1,010 Total 57,768 66,467 REGULATORY LIABILITIES: Deferred income taxes - net 31,021 32,872 Mark to market coal supply option contracts 1,419 - Other 1,035 1,017 Total $ 33,475 $ 33,889 -17- 9. SFAS No. 141, Business Combinations and No. 142, Goodwill and Other Intangible Assets were issued in the second quarter of 2001. Therefore, the provisions of these new pronouncements were effective July 1, 2001, for LG&E and KU. SFAS No. 141 requires all business combinations initiated after June 30, 2001, to be accounted for using the purchase method. SFAS No. 142 requires goodwill to be recorded, but not amortized. Furthermore, goodwill will now be subject to a periodic assessment for impairment. LG&E and KU have no recorded goodwill and have no merger or acquisitions in progress. Accordingly, the Companies experienced no impact on the financial position or results of operation as a result of adopting these standards. SFAS No. 143, Accounting for Asset Retirement Obligations and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, were also issued during 2001. SFAS No. 143 establishes accounting and reporting standards for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 144, among other provisions, eliminates the requirement of SFAS No. 121 to allocate goodwill to long-lived assets to be tested for impairment. The effective implementation date for SFAS No. 144 is January 1, 2002 and SFAS No. 143 is January 1, 2003. SFAS No. 144 had no impact on the financial position or results of operations of LG&E or KU. Management is currently conducting an analysis and has not determined what impact SFAS No. 143 will have on the financial position or results of operations of the Companies. SFAS No. 145, Rescission of SFAS Nos. 4, 44 and 64, amendment of SFAS No. 13, and technical corrections was issued in the second quarter 2002. The provisions related to SFAS No. 13 were effective for fiscal years beginning after May 15, 2002. All other provisions of SFAS No. 145 shall be effective for financial statements issued on or after May 15, 2002. The adoption of this standard will not have a material impact on financial position or results of operations of the Companies. SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, was issued in July 2002. SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002. The Companies do not expect the adoption of this standard to have a material impact on financial position or results of operations of the Companies. 10.On May 23, 2002 KU refinanced its pollution control series 1B, 2B, 3B, and 4B bonds, totaling $37.9 million. The new bonds, series 12, 13, 14 and 15 are due in February 2032 and bear interest at a variable rate. The new bonds are secured by first mortgage bonds and have the same principal amount as the prior bonds. The variable rate will be established by the remarketing agent based on conditions in the tax- exempt debt market. On March 22, 2002, LG&E refinanced two $35 million unsecured pollution control bonds due November 1, 2027. The replacement variable rate bonds are secured by first mortgage bonds and will mature November 1, 2027. The variable rate will be established by the remarketing agent taking into account market conditions in the commercial paper market. On March 6, 2002, LG&E refinanced $22.5 million and $27.5 million in unsecured pollution control bonds, both due September 1, 2026. The replacement bonds, due September 1, 2026, are variable rate bonds and are secured by first mortgage bonds. The variable rate will be established by the remarketing agent taking into account market conditions in the commercial paper market. -18- 11.As of June 30, 2002, LG&E Energy owned $104.6 million in varying portions of LG&E's outstanding variable rate pollution control bonds. The bonds were acquired during May 2002 by LG&E Energy as an investment and were sold in their entirety during the first half of July 2002 to unaffiliated third parties. 12.In the normal course of business, lawsuits, claims, environmental actions, and various non-ratemaking governmental proceedings arise against LG&E and KU. To the extent that damages are assessed in any of these lawsuits, LG&E and KU believe that their insurance coverage is adequate. Management, after consultation with legal counsel, and based upon the present status of these items, does not anticipate that liabilities arising out of other currently pending or threatened lawsuits and claims of the type referenced above will have a material adverse effect on LG&E's or KU's consolidated financial position or results of operations, respectively. -19- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. General The following discussion and analysis by management focuses on those factors that had a material effect on LG&E's and KU's financial results of operations and financial condition during the three and six month periods ended June 30, 2002 and should be read in connection with the financial statements and notes thereto. Some of the following discussion may contain forward-looking statements that are subject to certain risks, uncertainties and assumptions. Such forward-looking statements are intended to be identified in this document by the words "anticipate," "expect," "estimate," "objective," "possible," "potential" and similar expressions. Actual results may vary materially. Factors that could cause actual results to differ materially include: general economic conditions; business and competitive conditions in the energy and fuel industry or markets; changes in federal or state legislation; unusual weather; actions by state or federal regulatory agencies; and other factors described from time to time in LG&E's and KU's reports to the Securities and Exchange Commission, including Exhibit No. 99.01 to their Annual Report on Form 10-K for year ended December 31, 2001. Results of Operations The results of operations for LG&E and KU are affected by seasonal fluctuations in temperature and other weather-related factors. Because of these and other factors, the results of one interim period are not necessarily indicative of results or trends to be expected for the full year. Three Months Ended June 30, 2002, Compared to Three Months Ended June 30, 2001 LG&E Results: LG&E's net income decreased $13.2 million for the quarter ended June 30, 2002, as compared to the quarter ended June 30, 2001, primarily due to amortization expenses associated with LG&E's workforce reduction program (See Note 4) and higher employee benefit-related costs caused by lower investment returns. A comparison of LG&E's revenues for the quarter ended June 30, 2002, with the quarter ended June 30, 2001, reflects increases and decreases which have been segregated by the following principal causes (in thousands of $): Electric Gas Cause Revenues Revenues Retail sales: Fuel and gas supply adjustments $ 5,972$ (17,227) Environmental cost recovery surcharge 2,039 - Demand side management cost recovery 151 253 LG&E/KU merger surcredit (830) - Value delivery surcredit (274) (48) Variation in sales volume, etc. 10,547 15,643 Total retail sales 17,605 (1,379) Wholesale sales (23,925) (44) Gas transportation - net - (114) Other 1,843 (76) Total $ (4,477)$ (1,613) Electric revenues decreased primarily because of a decrease in wholesale sales, partially offset by increased retail sales. The decrease in wholesale sales is attributable to lower sales volumes ($12.5 million) and a decrease in wholesale sales prices ($11.4 million). The retail sales -20- increase was due in part to warmer weather experienced this period. Cooling degree days increased 8% for the three months ended June 2002 as compared to three months ended June 2001. Gas revenues decreased primarily as a result of lower gas supply costs billed to customers through the gas supply clause, partially offset by an increase in gas sales volume. Fuel for electric generation and gas supply expenses comprise a large portion of LG&E's total operating expenses. LG&E's electric and gas rates contain a Fuel Adjustment Clause and a Gas Supply Clause, respectively, whereby increases or decreases in the cost of fuel and gas supply may be reflected in retail rates, subject to the approval of the Kentucky Commission. Fuel for electric generation increased $8.8 million (21%) for the quarter because of an increase in the cost of coal burned ($10.4 million), partially offset by a decrease in quantity of coal burned ($1.6 million). Gas supply expenses decreased $0.5 million (3%) due to a decrease in net gas supply cost ($4.4 million), partially offset by an increase in the volume of retail gas delivered to the distribution system ($3.9 million). Power purchased decreased $10.7 million (33%) primarily because of a decrease in volume of purchases to support wholesale sales ($4.0 million) and a decrease in cost of power purchased ($6.7 million). Other operation expenses increased $18.4 million (51%) in 2002, as compared to 2001, primarily due to amortization expenses associated with LG&E's workforce reduction program ($7.5 million), increased costs for pension expenses ($2.2 million), electric transmission expenses ($3.8 million), post-retirement medical expenses ($1.3 million), and steam operation expenses ($1.8 million). Maintenance expenses increased $1.9 million (14%) in 2002 primarily due to increased repairs to steam production ($0.7 million) and maintenance to the electric distribution plant ($0.8 million). A reconciliation of differences between the U.S. statutory federal income tax rate and effective income tax rate for the three months ended June follows: June June Effective Rate 2002 2001 Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 4.3% 5.5% Amortization of investment tax credit & R&D -4.5% -2.3% Other differences -0.4% -0.5% Effective Income Tax Rate 34.4% 37.7% Interest charges decreased $2.4 million (26%) due to lower interest rates on variable rate long-term debt ($1.7 million) and a decrease in interest associated with the accounts receivable securitization program ($0.5 million). The weighted average interest rate on variable-rate tax-exempt debt for the three months ended June 30, 2002 was 1.63%, compared to 3.96% for the comparable period in 2001. KU Results: KU's net income decreased $8.4 million for the quarter ended June 30, 2002, as compared to the quarter ended June 30, 2001. The decrease was primarily due to increased other operation expense and decreased electric revenues partially offset by decreased interest expense. A comparison of KU's revenues for the quarter ended June 30, 2002, with the quarter ended June 30, 2001, reflects increases and decreases which have been segregated by the following principal causes (in thousands of $): -21- Retail sales: Fuel supply adjustments $ 4,226 Environmental cost recovery surcharge 1,033 Demand side management cost recovery 512 LG&E/KU merger surcredit (1,136) Value delivery surcredit (149) Variation in sales volume, etc. 8,595 Total retail sales 13,081 Wholesale sales (30,745) Other 1,859 Total $ (15,805) Electric revenues decreased primarily due to a decrease in volume ($25.3 million) and price ($5.4 million) of wholesale sales, partially offset by increased retail sales. Fuel for electric generation comprises a large portion of KU's total operating expenses. KU's electric rates contain a Fuel Adjustment Clause, whereby increases or decreases in the cost of fuel are reflected in retail rates, subject to the approval of the Kentucky Public Service Commission, the Virginia State Corporation Commission, and the Federal Energy Regulatory Commission. Fuel for electric generation increased $1.8 million (3%) for the quarter due to an increase in the cost of coal burned ($7.1 million) partially offset by a decrease in volume burned ($5.3 million). Power purchased decreased $12.1 million (23%) in 2002 primarily because of a decrease in volumes purchased ($7.6 million) and a decrease in unit cost of purchases ($4.5 million). Other operation expenses increased $8.9 million (32%) compared to 2001, primarily due to amortization expenses associated with KU's workforce reduction program ($2.9 million), higher pension expenses ($0.9 million), outside services ($0.8 million), property insurance ($0.5 million), post- retirement medical expenses ($0.5 million), and increased operation of the electric transmission system ($2.0 million) and distribution system ($0.7 million). A reconciliation of differences between the U.S. statutory federal income tax rate and effective income tax rate for the three months ended June follows: June June Effective Rate 2002 2001 Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 6.8% 5.9% Amortization of investement tax credit & R&D -3.9% -2.5% Other differences -4.5% -3.3% Effective Income Tax Rate 33.4% 35.1% Interest charges decreased $1.4 million (14%) for the second quarter 2002 compared to the second quarter 2001 due to lower rates on variable rate debt ($0.8 million) and a decrease in interest associated with the accounts receivable securitization program ($0.6 million). The weighted average interest rate on variable-rate tax-exempt debt for the three months ended June 30, 2002 was 1.64%, compared to 3.55% for the comparable period in 2001. -22- Six Months Ended June 30, 2002, Compared to Six Months Ended June 30, 2001 LG&E Results: LG&E's net income increased $61.8 million for the six months ended June 30, 2002, as compared to the six months ended June 30, 2001, primarily because of a non-recurring charge of $86.1 million, net of tax, for LG&E's workforce reduction program incurred in 2001. Excluding this one-time charge, LG&E's net income would have decreased $24.3 million primarily due to amortization expenses associated with LG&E's workforce reduction program (See Note 4), lower wholesale margins expenses and higher pension expenses caused by lower investment returns partially offset by lower interest expense. A comparison of LG&E's revenues for the six months ended June 30, 2002, with the six months ended June 30, 2001, reflects increases and decreases which have been segregated by the following principal causes (in thousands of $): Electric Gas Cause Revenues Revenues Retail sales: Fuel and gas supply adjustments $ 3,704 $ (58,158) Environmental cost recovery surcharge 3,685 - Demand side management cost recovery 203 675 LG&E/KU merger surcredit (1,035) - Value delivery surcredit (510) (169) Variation in sales volume, etc. 9,776 5,345 Total retail sales 15,823 (52,307) Wholesale sales (10,825) 9,979 Gas transportation - net - 75 Other 1,397 (139) Total $ 6,395 $ (42,392) Electric revenues increased primarily because of an increase in sales to retail customers, partially offset by decreased wholesale sales. The increase in retail sales was due in part to warmer weather experienced in the period. Cooling degree days increased 8% for the six months ended June 2002 as compared to the six months ended June 2001. Wholesale sales decreased due to lower unit prices ($29.1 million) partially offset by increased volume sold ($18.3 million). Gas revenues decreased primarily as a result of lower gas supply costs billed to customers through the gas supply clause. Fuel for electric generation increased $14.4 million (18%) for the six months because of an increase in the cost of coal burned ($12.9 million) and an increase in quantity of coal burned ($1.5 million). Gas supply expenses decreased $42.2 million (29%) due to a decrease in net gas supply cost ($44.0 million), and a decrease in the volume of retail gas delivered to the distribution system ($6.4 million), partially offset by increased wholesale gas expenses ($8.2 million). The decrease in non-recurring charges of $144.4 million ($86.1 million after tax) is due to the costs associated with LG&E's workforce reduction initiative which were recorded in the first quarter of 2001 (See Note 4). Other operation expenses increased $31.5 million (44%) in 2002, compared to 2001, primarily due to amortization expenses associated with LG&E's workforce reduction program ($15.0 million), increased costs for electric transmission ($5.9 million), pension expenses ($4.9 million), post- retirement medical expenses ($1.8 million), and property insurance ($1.3 million). Maintenance expenses increased $3.3 million (14%) in 2002 primarily due to increased repairs to steam production ($1.6 million) and maintenance to the electric distribution system ($1.1 million). Other income(deduction)-net decreased $1.4 million in 2002 primarily due to an increase in repairs to non-utility property ($0.6 million), a decrease in gains recorded on the sale of non-utility property ($.3 million) and an increase in the tax provision related to other income ($0.6 million). -23- A reconciliation of differences between the U.S. statutory federal income tax rate and effective income tax rate for the six months ended June 30 follows: June June Effective Rate 2002 2001 Statutory federal income tax rate 35.0% -35.0% State income taxes net of federal benefit 5.0% -5.5% Amortization of investment tax credit & R&D -3.7% -4.5% Other differences -0.2% -1.2% Effective Income Tax Rate 36.1% -46.2% The six months ended June 2001 included a net pretax loss because of the workforce reduction charge. Interest charges decreased $6.0 million (29%) due to lower interest rates on variable rate long term debt ($3.7 million), a decrease in interest on debt to parent company ($0.9 million), and a decrease in interest associated with the accounts receivable securitization program ($1.5 million). The weighted average interest rate on variable-rate tax-exempt debt for the six months ended June 30, 2002 was 1.66%, compared to 4.23% for the comparable period in 2001. KU Results: KU's net income increased $23.0 million for the six months ended June 30, 2002, as compared to the six months ended June 30, 2001. The increase was primarily due a non-recurring charge of $38.0 million, net of tax, made in the first quarter of 2001 for costs associated with KU's workforce reduction program. Excluding this one-time charge, net income decreased $15.0 million, due largely to increased operation expenses and lower electric revenues, partially offset by lower interest expense. A comparison of KU's revenues for the six months ended June 30, 2002, with the six months ended June 30, 2001, reflects increases and decreases which have been segregated by the following principal causes (in thousands of $): Retail sales: Fuel supply adjustments $ 9,359 Environmental cost recovery surcharge 2,543 Demand side management cost recovery 1,296 LG&E/KU merger surcredit (2,161) Value delivery surcredit (338) Variation in sales volume, etc. 4,782 Total retail sales 15,481 Wholesale sales (31,050) Other 3,139 Total $ (12,430) Electric revenues decreased primarily due to a decrease in wholesale sales, partially offset by increased sales to retail customers. The decrease in wholesale sales is primarily due to a decrease in the price of wholesale sales ($21.4 million) and a decrease in volume sold ($9.7 million). Fuel for electric generation increased $4.2 million (4%) for the six months due to a $12.6 million increase in the cost of coal burned partially offset by a decrease of $8.4 million in volume burned. -24- Power purchased decreased $3.9 million (5%) in 2002 primarily because of a decrease in unit cost ($10.2 million), partially offset by an increase in KWH purchased ($6.3 million). Non-recurring charges decreased $63.8 million ($38.0 million after tax). These costs were due to KU's workforce reduction program which were recorded in the first quarter of 2001 (See Note 4). Other operation expenses increased $16.8 million (31%) compared to 2001, primarily due to amortization expenses associated with KU's workforce reduction program ($5.8 million), higher pension expenses ($2.1 million), property insurance ($1.3 million) and outside services ($1.9), higher costs for electric transmission ($3.4 million) and increases in uncollectible accounts and customer assistance programs ($1.3 million). Other income-net decreased $1.1 million (25%) in 2002 primarily due to a gain on disposition of property in 2001 of $1.3 million. A reconciliation of differences between the U.S. statutory federal income tax rate and effective income tax rate for the six months ended June follows: June June Effective Rate 2002 2001 Statutory federal income tax rate 35.0% 35.0% State income taxes net of federal benefit 6.3% 7.7% Amortization of investment tax credit & R&D -3.5% -9.7% Other differences -3.0% -11.4% Effective Income Tax Rate 34.8% 21.6% The amortization of investment tax credit and other differences were approximately the same in both periods, but lower pretax income for the six months ended June 30, 2001 (resulting from the workforce reduction charge) caused the percentage changes to be greater in the 2001 period. Interest charges decreased $4.1 million (22%) for the first six months of 2002 as compared to the six months of 2001 primarily due to lower rates on variable rate debt ($2.7 million) and a decrease in interest associated with the accounts receivable securitization program ($1.0 million). The weighted average interest rate on variable-rate tax-exempt debt for the six months ended June 30, 2002 was 1.66%, compared to 3.76% for the comparable period in 2001. Liquidity and Capital Resources LG&E's and KU's need for capital funds are largely related to the construction of plant and equipment necessary to meet the needs of electric and gas utility customers. Internal and external lines of credit, the accounts receivable securitization programs, and commercial paper programs are maintained to fund short-term capital requirements. Construction expenditures for the six months ended June 30, 2002 for LG&E and KU amounted to $69.5 million and $47.8 million, respectively. Such expenditures related primarily to construction to meet nitrogen oxide (NOx) emission standards, and were financed with internally generated funds and accounts receivable securitization program funds. Also, a common stock dividend of $23 million was paid by LG&E. See Note 6 of Notes to Financial Statements concerning accounts receivable securitization. LG&E's and KU's cash and temporary cash investment balance increased $18.3 million and $0.2 million, respectively during the six months ended June 30, 2002. The increases reflect cash flows from operations, partially offset by construction expenditures and LG&E's common dividend payment. KU also reduced notes payable by $28.2 million. Variations in accounts receivable, accounts payable and materials and supplies are generally not significant indicators of LG&E's and KU's liquidity. Such variations are primarily attributable to fluctuations in weather, which have a direct effect on sales of electricity and natural -25- gas. The increases in accounts receivable for KU resulted primarily from seasonal fluctuations. The decrease in accounts receivable at LG&E resulted primarily from the increased sale of accounts receivable through the accounts receivable securitization program. (See Note 6 of Notes to Financial Statements). The increase in fuel inventory at LG&E and the decrease in LG&E's gas stored underground resulted from seasonal fluctuations. LG&E and KU participate in a money pool whereby LG&E Energy can make funds available to LG&E and KU at market-based rates up to $200 million each. LG&E Energy maintains a facility of $200 million with a Powergen subsidiary to ensure funding availability for the money pool. There is no balance outstanding under the Powergen line of credit as of June 30, 2002 and no outstanding commercial paper program balance. LG&E Energy has provided loans to LG&E and KU through the money pool that total $91.6 million and $19.6 million, respectively, as of June 30, 2002. These borrowings carried a commercial paper grade interest rate of 1.82% at June 30, 2002. On March 6, 2002, LG&E refinanced its $22.5 million and $27.5 million unsecured pollution control bonds, both due September 1, 2026. The replacement bonds, due September 1, 2026, are variable rate bonds and are secured by first mortgage bonds. On March 22, 2002, LG&E refinanced its two $35 million unsecured pollution control bonds due November 1, 2027. The replacement variable rate bonds are secured by first mortgage bonds and will mature November 1, 2027. On May 23, 2002 KU refinanced its pollution control series 1B, 2B, 3B, and 4B bonds, totaling $37.9 million. The new bonds, series 12, 13, 14 and 15 are due in February 2032 and bear interest at a variable rate. The new bonds are secured by first mortgage bonds and have the same principal amount as the prior bonds. The variable rate will be established by the remarketing agent based on conditions in the tax-exempt debt market. As of June 30, 2002, LG&E Energy owned $104.6 million in varying portions of LG&E's outstanding variable rate pollution control bonds. The bonds were acquired during May 2002 by LG&E Energy as an investment and were sold in their entirety during the first half of July 2002 to unaffiliated third parties. LG&E's security ratings as of June 30, 2002, were: Moody's S&P Fitch First mortgage bonds A1 A- A+ Preferred stock a2 BBB- A- Commercial paper P-1 A-2 F-1 KU's security ratings as of June 30, 2002, were: Moody's S&P Fitch First mortgage bonds A1 A- A+ Preferred stock a2 BBB- A- Commercial paper P-1 A-2 F-1 The S&P ratings of LG&E's and KU's debt securities are on Credit Watch for upgrade as the result of the E.ON acquisition. Fitch has placed LG&E and KU on credit watch evolving as a result of the acquisition by E.ON. These ratings reflect the views of Moody's, S&P and Fitch. A security rating is not a recommendation to buy, sell or hold securities and is subject to revision or withdrawal at any time by the rating agency. -26- LG&E's capitalization ratios at June 30, 2002, and December 31, 2001, follow: Jun. 30, Dec. 31, 2002 2001 Long-term debt (including current portion) 37.4% 37.5% Notes payable 5.5 5.7 Preferred stock 5.8 5.8 Common equity 51.3 51.0 Total 100.0% 100.0% KU's capitalization ratios at June 30, 2002, and December 31, 2001, follow: Jun. 30, Dec. 31, 2002 2001 Long-term debt (including current portion) 37.1% 37.2% Notes payable 1.5 3.6 Preferred stock 3.0 3.1 Common equity 58.4 56.1 Total 100.0% 100.0% New Accounting Pronouncements SFAS No. 141, Business Combinations and No. 142, Goodwill and Other Intangible Assets were issued in the second quarter of 2001. Therefore, the provisions of these new pronouncements were effective July 1, 2001, for LG&E and KU. SFAS No. 141 requires all business combinations initiated after June 30, 2001, to be accounted for using the purchase method. SFAS No. 142 requires goodwill to be recorded, but not amortized. Furthermore, goodwill will now be subject to a periodic assessment for impairment. LG&E and KU have no recorded goodwill and have no merger or acquisitions in progress. Accordingly, the Companies experienced no impact on the financial position or results of operation as a result of adopting these standards. SFAS No. 143, Accounting for Asset Retirement Obligations and SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, were issued during 2001. SFAS No. 143 establishes accounting and reporting standards for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 144, among other provisions, eliminates the requirement of SFAS No. 121 to allocate goodwill to long-lived assets to be tested for impairment. The effective implementation date for SFAS No. 144 is January 1, 2002 and SFAS No. 143 is January 1, 2003. SFAS No. 144 had no impact on the financial position or results of operations of LG&E or KU. Management is currently conducting an analysis and has not determined what impact SFAS No. 143 will have on the financial position or results of operations of the Companies. The Financial Accounting Standards Board created the Derivatives Implementation Group ("DIG") to provide guidance for implementation of SFAS No. 133. DIG Issue C15, Normal Purchases and Normal Sales Exception for Option Type Contracts and Forward Contracts in Electricity was adopted in 2001 and had no impact on results of operations and financial position of the Companies. DIG Issue C16, Applying the Normal Purchase and Normal Sales Exception to Contracts that Combine a Forward Contract and a Purchased Option Contract, was cleared in the third quarter 2001 and stated that option contracts do not meet the normal purchases and normal sales exception and should follow SFAS No. 133. DIG Issue C16 was effective in the second quarter of 2002. The adoption of DIG Issue C16 did not have a material impact on the financial position or results of operations of the Companies pursuant to regulatory treatment prescribed by SFAS No. 71, Accounting for the Effects of Certain Types of Regulation. KU recorded a mark to market asset and corresponding regulatory liability of $1.4 million in the second quarter of 2002. -27- SFAS No. 145, Rescission of SFAS Nos. 4, 44 and 64, amendment of SFAS No. 13, and technical corrections was issued in the second quarter 2002. The provisions related to SFAS No. 13 were effective for fiscal years beginning after May 15, 2002. All other provisions of SFAS No. 145 shall be effective for financial statements issued on or after May 15, 2002. The adoption of this standard will not have a material impact on financial position or results of operations of the Companies. SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, was issued in July 2002. SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002. The Companies do not expect the adoption of this standard to have a material impact on financial position or results of operations of the Companies. Contingencies For a description of significant contingencies that may affect LG&E and KU, reference is made to Part I, Item 3, Legal Proceedings, and Notes 12 (LG&E) and 11 (KU) to the financial statements contained in LG&E's and KU's Annual Reports on Form 10-K for the year ended December 31, 2001 and to Part II - Item 1, Legal Proceedings herein. Item 3. Quantitative and Qualitative Disclosures About Market Risk. LG&E and KU are exposed to market risks. Both operations are exposed to market risks from changes in interest rates and commodity prices. To mitigate changes in cash flows attributable to these exposures, the Companies have entered into various derivative instruments. Derivative positions are monitored using techniques that include market value and sensitivity analysis. The Companies use interest rate swaps to hedge exposure to market fluctuations in certain of their debt instruments. Pursuant to Company policy, use of these financial instruments is intended to mitigate risk and earnings volatility and is not speculative in nature. Management has designated all of the Companies' interest rate swaps as hedge instruments. Financial instruments designated as cash flow hedges have resulting gains and losses recorded within other comprehensive income and stockholders' equity. To the extent a financial instrument or the underlying item being hedged is prematurely terminated or the hedge becomes ineffective, the resulting gains or losses are reclassified from other comprehensive income to net income. Financial instruments designated as fair value hedges are periodically marked to market with the resulting gains and losses recorded directly into net income to correspond with income or expense recognized from changes in market value of the items being hedged. The potential change in interest expense resulting from changes in base interest rates of the Companies' unswapped debt did not change materially during the first six months of 2002. The potential changes in the fair values of the Company's interest-rate swaps resulting from changes in interest rates and the yield curve also did not change materially during the first six months of 2002. The Companies' exposure to market risks from changes in commodity prices remained immaterial during the first six months of 2002. The Companies have entered into fuel purchase contracts that contain options which allow the Companies to purchase additional tons of coal, as needed, or purchase less coal that contractually required, as needed. The potential change resulting from variations in coal commodity prices of the Companies' coal supply contracts containing option features are not material during the first six months of 2002. The Companies' exposure to market risks from changes in commodity prices are immaterial during the first six months of 2002. -28- Energy Trading & Risk Management Activities LG&E and KU conduct energy trading and risk management activities to maximize the value of power sales from physical assets it owns, in addition to the wholesale sale of excess asset capacity. Certain energy trading activities are accounted for on a mark-to-market basis in accordance with EITF 98-10 Accounting for Contracts Involved in Energy Trading and Risk Management Activities, SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities, and SFAS No. 138 Accounting for Certain Derivative Instruments and Certain Hedging Activities. Wholesale sales of excess asset capacity and wholesale purchases are treated as normal sales and purchases under SFAS No. 133 and SFAS No. 138 and are not marked to market. The table below summarizes both LG&E and KU's energy trading and risk management activities during January through June of 2002 (in thousands of $), as trading volumes are evenly divided between the two regulated utilities. Fair value of contracts at 12/31/01, net liability $ (186) Fair value of contracts when entered into during Jan- Jun 2002 (57) Contracts realized or otherwise settled during Jan- Jun 2002 335 Changes in fair values due to changes in assumptions (66) Fair value of contracts at 6/30/02, net asset $ 26 No changes to valuation techniques for energy trading and risk management activities occurred during January through June of 2002. All contracts outstanding at June 30, 2002 have a maturity of less than one year and are valued using prices actively quoted for proposed or executed transactions or quoted by brokers. LG&E and KU maintain policies intended to minimize credit risk and revalues credit exposures daily to monitor compliance with those policies. As June 30, 2002, 100% of the trading and risk management commitments were with counterparties rated BBB- equivalent or better. -29- Part II. Other Information Item 1. Legal Proceedings. For a description of the significant legal proceedings involving LG&E and KU, reference is made to the information under the following items and captions of LG&E's and KU's (A) respective combined Annual Report on Form 10-K for the year ended December 31, 2001: Item 1, Business; Item 3, Legal Proceedings; Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations; Notes 3, 12 and 16 of LG&E's Notes to Financial Statements under Item 8 and Notes 3, 11 and 14 of KU's Notes to Financial Statements under Item 8 and (B) respective combined Quarterly Report on Form 10-Q for the quarter ended March 31, 2002: Item I of Part II, Legal Proceedings. Except as described herein, to date, the proceedings reported in LG&E's and KU's respective combined Annual Report on Form 10-K have not changed materially. E.ON-Powergen Transaction Effective July 1, 2002, E.ON, a Germany company, completed its acquisition of Powergen, following receipt of the final necessary regulatory approval on June 14, 2002 from the Securities and Exchange Commission. E.ON had announced its pre-conditional cash offer of 5.1 billion pounds sterling ($7.3 billion) for Powergen on April 9, 2001. LG&E Employment Discrimination Claim In June 2002, alternative amended complaints were filed against LG&E and certain related and unrelated parties whereby approximately 30 employees or former employees claimed past and current instances of employment discrimination. The complaints demand various forms of declarative, injunctive and class action relief, as well as a claim of $150 million in monetary damages. LG&E has removed the case to the U.S. District Court for the Western District of Kentucky and filed an answer denying all plaintiffs' claims. Certain plaintiffs' claims have completed a process of preliminary administrative review before the U.S. Equal Employment Opportunity Commission, which has, to date, declined to proceed on any of the claims reviewed. LG&E intends to vigorously defend itself in the action and management does not anticipate that the outcome will have a material impact on LG&E's operations or financial condition. Fuel Adjustment Clause Proceedings In May 2002 the Kentucky Commission granted final approval to the December 21, 2001 comprehensive settlement regarding pending fuel adjustment clause proceedings involving LG&E and KU and in July 2002 the Kentucky Court of Appeals dismissed the associated appeal. Pursuant to such settlement, LG&E and KU credited customers approximately $720,000 and $954,000, respectively, during June and July 2002. See Legal Proceedings under Item 3 of LG&E's and KU's Annual Report on Form 10-K for the year ended December 31, 2001. Other On April 16, 2002, the LG&E 5% Cumulative Preferred class of stock was delisted from the NASDAQ Small Capitalization Market. On June 3, 2002, the KU 4.75% Cumulative Preferred class of stock was delisted from the Philadelphia Stock Exchange. Delisting will enable the Companies to realize certain administrative and corporate governance efficiencies. Item 6(a). Exhibits. None. Item 6(b). Reports on Form 8-K. None. -30- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Louisville Gas and Electric Company Registrant Date: August 14, 2002 /s/ S. Bradford Rives S. Bradford Rives Senior Vice President - Finance and Controller (On behalf of the registrant in his capacity as Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Kentucky Utilities Company Registrant Date: August 14, 2002 /s/ S. Bradford Rives S. Bradford Rives Senior Vice President - Finance and Controller (On behalf of the registrant in his capacity as Principal Accounting Officer) -31-