• 2 0 0 3 A n n u a l R e p o r t t o S h a r e h o l d e r s P N M R E S O U R C E S 33 32 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company records its environmental liabilities when site assessments or remedial actions are probable and a range of reasonably likely cleanup costs can be estimated. The Company reviews its sites and measures the liability quarterly, by assessing a range of reasonably likely costs for each identified site using currently available information, including existing technology, current laws and regulations, experience gained at similar sites, and the probable level of involvement and financial condition of other potentially responsible parties. These estimates include costs for site investigations, remediation, operations and maintenance, monitoring and site closure. Unless there is a probable amount, the Company records the lower end of this reasonably likely range of costs (classified as other long-term liabilities at undiscounted amounts). Subsequent developments could materially alter management’s assessment of a matter’s probable outcome and the estimate of liability. See “Item 7A. Quantitative and Qualitative Disclosure About Market Risk – Interest Rate Risk” for discussion regarding the Company’s accounting policies and sensitivity analysis for the Company’s financial instruments and derivative energy and other derivative contracts. See also “Financing Activities” below for additional discussion regarding the Company’s accounting policies for forward interest swaps. The Company’s long-term contracts to supply power expire from 2006 through 2013. The ability of the Company to renew these contracts at terms comparable to those currently in place is dependent upon prevailing market conditions at the time of negotiations. Currently, the Company has a long-term firm commitment contract of 114 MW set to expire in 2006. The contract is priced significantly above current market prices; however, the Company believes that it will be able to significantly mitigate any revenue loss due to a rising forward market. At December 31, 2003, the Company had cash and short-term investments of $12.7 million compared to $83.3 million in cash and short-term investments at December 31, 2002.  Cash provided by operating activities for the year ended December 31, 2003 was $228.7 million compared to $97.4 million for the year ended December 31, 2002. This increase in cash flows was due to increased profitability in the Company’s wholesale power operations, higher gas sales volumes and lower tax payments. Also contributing to the increase were payments in 2002 which did not recur in 2003. The Company did not make its first quarter 2001 estimated federal income tax payment of $32.0 million until January 2002 because of an extension granted by the IRS to taxpayers in several counties in New Mexico as a result of wildfires in 2000. In addition, the Company made payments in 2002 of $36.0 million for the termination of the surface coal contract and $23.2 million to secure a long-term wholesale contract. This increase in operating cash flows was offset by higher wholesale electric prices and volume and higher gas prices in the current year. The Company’s Gas working capital is negatively affected by the timing difference in gas purchases and collections. The Company pays for gas in the month following purchase. Recovery of gas costs has typically taken up to three months. The negative effect of this mismatch in cash flows was greater in 2003 due to the increase in gas prices. The increase in accounts receivable also reflects higher wholesale electric prices in 2003. In addition, electric retail collections decreased due to the rate reduction. Cash used for investing activities was $101.6 million in 2003 compared to $200.4 million in 2002. Cash used in 2002 for investing activities included construction expenditures for new generating plants of $67.4 million. Payments for combustion turbines were $11.1 million in 2003 compared to $30.0 million in 2002. Cash used for investing activities in 2003 also included the purchase of certain long-term debt underlying leased assets in the open market for $6.7 million (see “Liquidity” below). The cash used for investing activities in 2003 was largely offset by the redemption of short-term investments of $80.3 million in 2003 at the Holding Company level as compared to $45.6 million in 2002 at PNM. These redemptions were primarily used for the Company’s retirement of the EIP long-term debt underlying the lease assets, repayment of short-term debt, debt refinancing and pension funding. Cash used for financing activities was $118.1 million in 2003 compared to cash generated by financing activities of $78.4 million in 2002. Financing activities in 2003 primarily consisted of the retirement of long-term debt of $26.1 million, costs associated with the refunding and refinancing of long-term debt of $55.3 million and short-term debt repayments of $24.1 million. In 2002, the Company had short-term borrowings of $115.0 million for short-term liquidity needs. In May 2003, the board of directors approved the use of Holding Company stock in the funding of the Company’s pension plan as well as its retiree medical trust. Corporate plan sponsors may make contributions of common stock to their defined benefit plans of up to 10% of the value of the portfolio without Department of Labor (“DOL”) approval, provided that the contribution does not otherwise constitute a prohibited transaction under the Employee Retirement Income Security Act (“ERISA”). In June 2003, a contribution of 1,121,495 shares of Holding Company common stock (approximately $28.9 million in market value) was made to the Company’s pension plan. The shares of Holding Company common stock were sold over a period of time and there were no shares of common stock remaining in the defined benefit trust on December 31, 2003. Due to the appreciation in stock value, the net proceeds realized by the pension plan from the sale of Holding Company common stock was $31.0 million. The Company’s ability to access the capital markets, if required, at a reasonable cost and to provide for other capital needs is largely dependent upon its ability to earn a fair return on equity, its results of operations, its credit ratings, obtaining required regulatory approvals and financial and wholesale market conditions. Financing flexibility is enhanced by providing a high percentage of total capital requirements from internal sources and having the ability, if necessary, to issue long-term securities and to obtain short-term credit.  On August 27, 2003, the Company entered into an unrated private issuance commercial paper program. The Company will periodically issue up to $50.0 million in unrated commercial paper for the shorter of 120 days or the maturity of the Company’s Credit Facility. The commercial paper is unsecured and the proceeds will be used to reduce revolving credit borrowings. The Company’s Credit Facility serves as a backstop for the outstanding commercial paper. On June 12, 2003, the Holding Company and PNM each filed universal shelf registration statements with the SEC for a combination of debt and equity securities for $500.0 million and $285.0 million, respectively. The PNM shelf registration statement when combined with a previously filed shelf registration statement, provides $500.0 million of capacity. The PNM and Holding Company shelf registration statements were declared effective June 28, 2003 and August 28, 2003, respectively. On September 9, 2003, PNM issued and sold $300.0 million of debt under its shelf registration statement (see “Financing Activities” below). As of December 31, 2003, the Holding Company and PNM had remaining unissued securities registered under the shelf registration statements of $500.0 million and $200.0 million, respectively. On April 1, 2003, PNM exercised its early buyout option related to a 60% interest in the EIP transmission line and related facilities held under lease. Through the exercise of the early buyout option, PNM was able to retire all $26.2 million of secured facility bonds, which were issued to originally finance the sale-leaseback transaction. The secured facility bonds had previously been disclosed as off balance sheet lease obligations in the notes to the Company’s financial statements. The Company will continue to exclude approximately $4.0 million of lease obligations relating to the 40% interest the Company does not own from the consolidated balance sheet. On April 8, 2003, the Company entered into the AR Securitization providing for the securitization of PNM’s retail electric service accounts receivable and retail gas services accounts receivable. The total capacity under the AR Securitization is $90.0 million. Under the AR Securitization, PNM will periodically sell its accounts receivable, principally retail receivables, to a bankruptcy remote subsidiary, PNM Receivables Corp, which in turn pledges an undivided interest in the receivables to an unaffiliated conduit commercial paper issuer.  As of March 1, 2004, PNM had $413.0 million of liquidity arrangements. The liquidity arrangements consist of $300.0 million from an unsecured revolving credit facility (“Credit Facility”), $90.0 million from an accounts receivable securitization program (“AR Securitization”) and $23.0 million in local lines of credit. PNM entered into a new revolving credit facility on November 21, 2003, which increased borrowing capacity from $195.0 million to $300.0 million. This facility will mature November 21, 2006. As of March 1, 2004, there were no borrowings against the Credit Facility, PNM was using $60.0 million of the AR Securitization capacity and no borrowings under its local lines of credit. PNM had $50.0 million of commercial paper outstanding as of March 1, 2004. In addition, the Holding Company has $15.0 million in local lines of credit with no usage at December 31, 2003 or March 1, 2004. In the year ended December 31, 2003, the Company utilized cash generated from operations and cash on hand, as well as its liquidity arrangements, to cover its capital requirements and construction expenditures. The Company anticipates that internal cash generation and current debt capacity will be sufficient to meet all of its capital requirements and construction expenditures for the years 2004 through 2008. To cover the difference in the amounts and timing of cash generation and cash requirements, the Company intends to use short-term borrowings under its current and future liquidity arrangements. Total capital requirements include construction expenditures as well as other major capital requirements and cash dividend requirements for both common and preferred stock. The main focus of the Company’s current construction program is upgrading generation systems, upgrading and expanding the electric and gas transmission and distribution systems and purchasing nuclear fuel. To preserve a strong financial position, the Company announced in 2002 its plans to delay capital expenditures for previously planned generation expansion. Projections for total capital requirements for 2004 are $172 million and projections for construction expenditures for 2004 are $154 million. Total capital requirements are projected to be $720 million and construction expenditures are projected to be $624 million for 2004-2008. These estimates are under continuing review and subject to on-going adjustment. This projection excludes any generation fleet expansion capital, including any plans for the utilization of the turbines in storage. The Company continues to look for appropriately priced generation acquisition and expansion opportunities to support retail electric load growth, the continued expansion of its long-term contract business and to supplement its natural transmission position in the Southwest and West. Effects of Certain Events on Future Revenues Liquidity and Capital Resources Pension and Other Post-Retirement Benefits Environmental Issues Capital Requirements Liquidity