Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Liquidity and Capital Resources
Our primary sources of liquidity are cash provided by operating activities, short term borrowings under our commercial paper program (which is supported by our Credit Facility) and borrowings under lines of credit. Additionally from time to time, we raise funds from the public debt and equity capital markets through our existing shelf registration statement to fund our liquidity and capital resource needs. We believe these sources will continue to allow us to meet our needs for working capital, construction expenditures, anticipated debt redemptions, interest payments on debt obligations, dividend payments, common share repurchases and other cash needs.
Our issuance of various securities, including long-term and short-term debt, is subject to customary approval or authorization by state and federal regulatory bodies including state public service commissions and the SEC. Furthermore, a substantial portion of our consolidated assets, earnings and cash flow is derived from the operation of our regulated utility subsidiaries, whose legal authority to pay dividends or make other distributions to us is subject to regulation.
We will continue to evaluate our need to increase available liquidity based on our view of working capital requirements, including the impact of changes in natural gas prices, liquidity requirements established by rating agencies and other factors. See Item 1A, "Risk Factors," for additional information on items that could impact our liquidity and capital resource requirements. The following table provides a summary of our operating, investing and financing activities for the last three years.
Cash Flow from Operating Activities We prepare our statement of cash flows using the indirect method. Under this method, we reconcile net income to cash flows from operating activities by adjusting net income for those items that impact net income but may not result in actual cash receipts or payments during the period. These reconciling items include depreciation and amortization, changes in risk management assets and liabilities, undistributed earnings from equity investments, deferred income taxes and changes in the consolidated balance sheet for working capital from the beginning to the end of the period.
Our operations are seasonal in nature, with the business depending to a great extent on the first and fourth quarters of each year. As a result of this seasonality, our natural gas inventories, which usually peak on November 1 and largely are drawn down in the heating season, provide a source of cash as this asset is used to satisfy winter sales demand. The establishment and price fluctuations of our natural gas inventories which meet customer demand during the winter heating season can cause significant variations in our cash flow from operations from period to period and are reflected in changes to our working capital.
Year-over-year changes in our operating cash flows are attributable primarily to working capital changes within our distribution operations, retail energy operations and wholesale services segments resulting from the impact of weather, the price of natural gas, the timing of customer collections, payments for natural gas purchases and deferred gas cost recoveries as our business has grown and prices for natural gas have increased. The increase in natural gas prices directly impacts the cost of gas stored in inventory.
2007 compared to 2006 In 2007, our net cash flow provided from operating activities was $376 million, an increase of $22 million or 6% from 2006. The increase was due to higher realized gains on our energy marketing and risk management assets and liabilities and lower cash requirements for our natural gas inventories due to price and inventory volume fluctuations. This was offset by increased cash payments for income taxes due to realized gains on our energy marketing and risk management activities and higher working capital requirements.
2006 compared to 2005 In 2006, our net cash flow provided from operating activities was $354 million, an increase of $274 million or 343% from 2005. The increase was primarily a result of higher earnings in 2006 of $19 million and the recovery of working capital during 2006 that was deployed in late 2005 due to higher natural gas commodity prices and colder weather in the 2005 heating season. A primary contributor to the recovery of working capital was a $157 million decrease in the amount of natural gas inventory purchases by Sequent and our utilities.
Cash Flow from Investing Activities Our investing activities consisted primarily of property, plant and equipment (PP&E) expenditures. The majority of our PP&E expenditures are within our distribution operations segment, which includes our investments in new construction and infrastructure improvements.
Our estimated PP&E expenditures of approximately $400 million in 2008 and actual PP&E expenditures of $259 million in 2007, $253 million in 2006 and $267 million in 2005 are presented in the following chart. Our estimated expenditures in 2008 include discretionary spending for capital projects principally within the base business and natural gas storage categories. In determining whether to proceed with these projects, we evaluate such discretionary capital projects in relation to a number of factors including our authorized returns on rate base, other returns on invested capital for projects of a similar nature, capital structure and credit ratings, among others. As such, we will make adjustments to these discretionary expenditures as necessary based upon these factors. Our estimated and actual PP&E expenditures are shown within the following categories.
- Base business new construction and infrastructure improvements at our distribution operations segment
- Natural gas storage salt-dome cavern expansions at Golden Triangle and Jefferson Island
- Hampton Roads Virginia Natural Gas' pipeline project, which will connect its northern and southern systems
- PRP Atlanta Gas Light's program to replace all bare steel and cast iron pipe in its system in Georgia
- SNG a 250-mile pipeline in Georgia acquired from Southern Natural Gas (SNG) in 2005
- Other primarily includes information technology, building and leasehold improvements and AGL Networks' telecommunication expenditures
In 2007, our PP&E expenditures were $6 million or 2% higher than in 2006. This was primarily due to an increase in PRP expenditures of $10 million as we replaced larger-diameter pipe in more densely populated areas and $5 million in expenditures for the Hampton Roads project. This was offset by decreased expenditures of $4 million on our storage projects.
The decrease of $14 million or 5% in PP&E expenditures in 2006 compared to 2005 was primarily due to the SNG pipeline acquisition of $32 million, which occurred in 2005, and $17 million in reduced PRP expenditures, primarily as a result of the June 2005 agreement with the Georgia Commission, which extended the PRP program by five years. This was offset by increased base business expenditures of $19 million, primarily as our utilities expanded their new construction investments. We also incurred higher information technology expenditures of $13 million, which included $5 million at retail energy operations, primarily due to the implementation of a new energy trading and risk management system and enhancements to the retail billing system. Additionally in 2006, we spent $12 million in additional PP&E expenditures at Jefferson Island as it began work on a salt-dome storage expansion project which would add a third and fourth storage cavern. In 2005, our cash flows from investing activities were positively impacted as we sold our 50% interest in Saltville Gas Storage Company (Saltville) and associated subsidiaries for $66 million to a subsidiary of Duke Energy Corporation. We acquired Saltville through our acquisition of NUI in 2004.
Cash Flow from Financing Activities Our financing activities are primarily composed of borrowings and payments of short-term debt, payments of medium-term notes, and notes payable to AGL Capital Trust I and II, borrowings of senior notes, distributions to minority interests, cash dividends on our common stock issuances, purchases and issuances of treasury shares and the use of interest rate swaps for the purpose of hedging interest rate risk. Our capitalization and financing strategy is intended to ensure that we are properly capitalized with the appropriate mix of equity and debt securities. This strategy includes active management of the percentage of total debt relative to total capitalization, appropriate mix of debt with fixed to floating interest rates (our variable debt target is 20% to 45% of total debt), as well as the term and interest rate profile of our debt securities.
As of December 31, 2007, our variable rate debt was $840 million or 37% of our total debt, compared to $733 million or 34% as of December 31, 2006. The increased variable-rate debt was principally due to higher commercial paper borrowings. As of December 31, 2007, our commercial paper borrowings were $58 million or 11% higher than the same time last year, primarily a result of a $42 million increase in common share repurchases in 2007 and slightly higher working capital needs. For more information on our debt, see Note 6.
Credit ratings We also work to maintain or improve our credit ratings on our debt to manage our existing financing costs and enhance our ability to raise additional capital on favorable terms. Factors we consider important in assessing our credit ratings include our balance sheet leverage, capital spending, earnings, cash flow generation, available liquidity and overall business risks. We do not have any trigger events in our debt instruments that are tied to changes in our specified credit ratings or our stock price and have not entered into any agreements that would require us to issue equity based on credit ratings or other trigger events.
Improvements in our operating performance led to our credit outlook being raised from negative to stable by S&P in late 2007. The following table summarizes our credit ratings as of December 31, 2007.
Our credit ratings may be subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating. We cannot ensure that a rating will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a rating agency if, in its judgment, circumstances so warrant. If the rating agencies downgrade our ratings, particularly below investment grade, it may significantly limit our access to the commercial paper market and our borrowing costs would increase. In addition, we would likely be required to pay a higher interest rate in future financings, and our potential pool of investors and funding sources would decrease.
Default Events Our debt instruments and other financial obligations include provisions that, if not complied with, could require early payment, additional collateral support or similar actions. Our most important default events include maintaining covenants with respect to a maximum leverage ratio, insolvency events, nonpayment of scheduled principal or interest payments, and acceleration of other financial obligations and change of control provisions.
Our Credit Facility's financial covenant requires us to maintain a ratio of total debt to total capitalization of no greater than 70%; however, our goal is to maintain this ratio at levels between 50% and 60%. We are currently in compliance with all existing debt provisions and covenants. We believe that accomplishing these capitalization objectives and maintaining sufficient cash flow are necessary to maintain our investment-grade credit ratings and to allow us access to capital at reasonable costs. The components of our capital structure, as of the dates indicated, are summarized in the following table.
Short-term Debt Our short-term debt is composed of borrowings under our commercial paper program, lines of credit at Sequent, SouthStar and Pivotal Utility, the current portion of our medium-term notes (for 2006) and the current portion of our capital leases. Our short-term debt financing generally increases between June and December because our payments for natural gas and pipeline capacity are generally made to suppliers prior to the collection of accounts receivable from our customers. We typically reduce short-term debt balances in the spring because a significant portion of our current assets are converted into cash at the end of the winter heating season.
In June and August 2007 we extended Sequent's $45 million unsecured lines of credit through June ($25 million) and August ($20 million) 2008. Sequent's lines of credit are used solely for the posting of margin deposits for NYMEX transactions. In August 2007, we extended Pivotal Utility's $20 million unsecured line of credit through August 2008. This line of credit supports Elizabethtown Gas' New Jersey Commission mandated hedging program and is used solely for the posting of margin deposits. These lines of credit bear interest at the federal funds effective rate plus 0.4% and are unconditionally guaranteed by us.
Under the terms of our Credit Facility, which expires in August 2011, the aggregate principal amount available is $1 billion and we can request an option to increase the aggregate principal amount available for borrowing to $1.25 billion on not more than three occasions during each calendar year.
As of December 31, 2007 and 2006, we had no outstanding borrowings under the Credit Facility. However, the availability of borrowings and unused credit under our Credit Facility is limited and subject to conditions specified within the Credit Facility, which we currently meet. These conditions include:
- the maintenance of a ratio of total debt to total capitalization of no greater than 70%. As of December 31, 2007, our ratio of total debt of 58% to total capitalization was within our targeted and required ranges, and was consistent with our ratio of 57% at December 31, 2006
- the continued accuracy of representations and warranties contained in the agreement
Long-term Debt Our long-term debt matures more than one year from the balance sheet date and consists of medium-term notes, senior notes, gas facility revenue bonds, and capital leases. The following represents our long-term debt activity in 2007.
- In January 2007, we used proceeds from the sale of commercial paper to redeem $11 million of 7% medium-term notes previously scheduled to mature in January 2015.
- In June 2007 we refinanced $55 million of our gas facility revenue bonds due June 2032. The original bonds had a fixed interest rate of 5.7% per year and were refinanced with $55 million of adjustable-rate gas facility revenue bonds. The maturity date of these bonds remains June 2032 and there is a 35-day auction period where the interest rate adjusts every 35 days. The interest rate at December 31, 2007, was 4.7%.
- In July 2007, we used the proceeds from the sale of commercial paper to pay to AGL Capital Trust I the $75 million principal amount of 8.17% junior subordinated debentures plus a $3 million premium for early redemption of the junior subordinated debentures, and to pay a $2 million note representing our common securities interest in AGL Capital Trust I.
- In December 2007, AGL Capital issued $125 million of 6.375% senior notes. The senior notes are part of a series of notes issued by AGL Capital in June 2006. Both sets of notes are now part of a single series with an aggregate of $300 million in principal outstanding. The proceeds of the note issuance, equal to approximately $123 million, were used to pay down short-term indebtedness incurred under our commercial paper program.
Minority Interest As a result of our consolidation of SouthStar's accounts effective January 1, 2004, we recorded Piedmont's portion of SouthStar's contributed capital as a minority interest in our consolidated balance sheets. A cash distribution of $23 million in 2007, $22 million in 2006 and $19 million in 2005 for SouthStar's dividend distributions to Piedmont were recorded in our consolidated statement of cash flows as a financing activity.
Dividends on Common Stock Our $12 million or 11% increase in common stock dividend payments in 2007 compared to 2006, and $11 million or 11% increase in payments in 2006 compared to 2005, resulted from increases in the amount of our quarterly common stock dividends per share.
In 2007, our dividend payout ratio was 60%. This is an increase of 11% from our payout ratio of 54% in 2006. We expect that our dividend payout ratio will remain consistent with the dividend payout ratios of our peer companies, which is currently in a range of 60% to 65%. Our diluted earnings per share and dividends declared per share along with our payout ratio for the last three years are presented in the following chart.
For information about restrictions on our ability to pay dividends on our common stock, see Note 5 "Common Shareholders' Equity".
Share Repurchases In March 2001 our Board of Directors approved the purchase of up to 600,000 shares of our common stock to be used for issuances under the Officer Incentive Plan. During 2007, we purchased 10,667 shares. As of December 31, 2007, we had purchased a total 297,234 shares, leaving 302,766 shares available for purchase.
In February 2006, our Board of Directors authorized a plan to purchase up to 8 million shares of our outstanding common stock over a five-year period. These purchases are intended principally to offset share issuances under our employee and non-employee director incentive compensation plans and our dividend reinvestment and stock purchase plans. Stock purchases under this program may be made in the open market or in private transactions at times and in amounts that we deem appropriate. There is no guarantee as to the exact number of shares that we will purchase, and we can terminate or limit the program at any time.
For the year ended December 31, 2007, we purchased approximately 2 million shares of our common stock at an average cost of $39.56 per share and an aggregate cost of $80 million. During the same period in 2006, we purchased approximately 1 million shares of our common stock at a weighted average cost of $36.67 per share and an aggregate cost of $38 million. This represented an increase of $42 million or 111% from last year. We hold the purchased shares as treasury shares. For more information on our share repurchases see Item 5 "Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities."
Shelf Registration In August 2007, we filed a new shelf registration with the SEC. The debt securities and related guarantees will be issued by AGL Capital under an indenture dated as of February 20, 2001, as supplemented and modified, as necessary, among AGL Capital, AGL Resources and The Bank of New York Trust Company, N.A., as trustee. The indenture provides for the issuance from time to time of debt securities in an unlimited dollar amount and an unlimited number of series subject to our Credit Facility's financial covenants related to total debt to total capitalization. The debt securities will be guaranteed by AGL Resources. This replaces the previous shelf registration, filed in October 2004, which had $782 million available to be issued.
Contractual Obligations and Commitments We have incurred various contractual obligations and financial commitments in the normal course of our operating and financing activities that are reasonably likely to have a material effect on liquidity or the availability of requirements for capital resources. Contractual obligations include future cash payments required under existing contractual arrangements, such as debt and lease agreements. These obligations may result from both general financing activities and from commercial arrangements that are directly supported by related revenue-producing activities. The following table illustrates our expected future contractual obligation payments such as debt and lease agreements, and commitments and contingencies as of December 31, 2007.
Pipeline Charges, Storage Capacity and Gas Supply Contracts. A subsidiary of NUI entered into two 20-year agreements for the firm transportation and storage of natural gas during 2003 with annual aggregate demand charges of approximately $5 million. As a result of our acquisition of NUI and accordance with SFAS 141, we valued the contracts at fair value and established a long-term liability for the excess liability that will be amortized over the remaining lives of the contracts. The gas supply amount includes SouthStar gas commodity purchase commitments of 1.3 Bcf at floating gas prices calculated using forward natural gas prices as of December 31, 2007, and is valued at $98 million.
Operating leases. We have certain operating leases with provisions for step rent or escalation payments and certain lease concessions. We account for these leases by recognizing the future minimum lease payments on a straight-line basis over the respective minimum lease terms, in accordance with SFAS 13. However, this accounting treatment does not affect the future annual operating lease cash obligations as shown herein. We expect to fund these obligations with cash flow from operating and financing activities.
Standby letters of credit and surety bonds. We also have incurred various financial commitments in the normal course of business. Contingent financial commitments represent obligations that become payable only if certain predefined events occur, such as financial guarantees, and include the nature of the guarantee and the maximum potential amount of future payments that could be required of us as the guarantor. We would expect to fund these contingent financial commitments with operating and financing cash flows.
Pension and Postretirement Obligations We calculate any required pension contributions using the projected unit credit cost method. Under this method, we were not required to and did not make any pension contribution during 2007. During 2006, we voluntarily contributed $5 million to the AGL Resources Inc. Retirement Plan.
The state regulatory commissions have phase-ins that defer a portion of the postretirement benefit expense for future recovery. We recorded a regulatory asset for these future recoveries of $12 million as of December 31, 2007 and $13 million as of December 31, 2006. In addition, we recorded a regulatory liability of $4 million as of December 31, 2007 and $4 million as of December 31, 2006 for our expected expenses under the AGL Postretirement Plan. See Note 3 "Employee Benefit Plans," for additional information about our pension and postretirement plans.