MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Operating revenues decreased $3.1 million or 5.7% over the prior year period primarily due to lower demand for wheeling of $7.4 million to California from Arizona as a result of lower demand in the California market, partially offset by increased demand for wheeling in New Mexico of $1.7 million and $2.3 million in new 2003 contract revenue. This contract was not renewed for 2004. Cost of energy represents purchased transmission to support transmission offerings. This cost and the resulting gross margin do not fully represent cost of services as these purchases are incidental to the services provided. Total non-fuel O&M expenses decreased $2.4 million or 13.9% over the prior year period. Transmission O&M decreased $2.2 million or 15.0% due to a decrease in lease costs of $3.3 million for the EIP transmission line, a portion of which was repurchased in April 2003, offset by increased maintenance costs incurred for reliability purposes. Depreciation and amortization increased $1.4 million or 15.6% primarily due to the purchase of additional transmission lines. WHOLESALE The table below sets forth the operating results for Wholesale (In thousands). YEAR ENDED DECEMBER 31, 2003 2002 VARIANCE OPERATING REVENUES: External sales $ 548,847)% $ $^{343,780}$)% $ $^{205,067}$)% Intersegment sales 1,535)%) $^{–}$)% $^{1,535}$)% TOTAL REVENUES 550,382)% 343,780)% 206,602)% Less: Cost of energy 414,550)% $^{262,517}$)% $^{152,033}$)% Intersegment energy transfer 32,474)% $^{29,155}$)% $^{3,319}$)% GROSS MARGIN 103,358)% 52,108)% 51,250)% Energy production costs 29,919)% $^{32,507}$)% $^{(2,588)}$% Transmission and distribution O&M 59)% $^{45}$)% $^{14}$)% Customer related expense 711)% $^{754}$)% $^{(43)}$% Administrative and general 8,390)% $^{3,199}$)% $^{5,191}$)% TOTAL NON-FUEL O&M 39,079)% 36,505)% 2,574)% Corporate allocation 5,673)% $^{4,023}$)% $^{1,650}$)% Depreciation and amortization 14,230)% $^{8,808}$)% $^{5,422}$)% Taxes other than income taxes 3,263)% $^{2,619}$)% $^{644}$)% Income taxes 10,116)% $^{(3,245)}$% $^{13,361}$)% TOTAL NON-FUEL OPERATING EXPENSES 72,361)% 48,710)% 23,651)% OPERATING INCOME $ 30,997)% $ 3,398)% $ 27,599)% The following table shows revenues by customer class (In thousands): WHOLESALE REVENUES YEAR ENDED DECEMBER 31, 2003 2002 VARIANCE Long-term contracts $ 147,447)% $ $^{58,546}$)% $ $^{88,901}$)% Forward sales * 166,557)% $^{77,560}$)% $^{88,997}$)% Short-term sales 234,843)% $^{207,674}$)% $^{27,169}$)% Intersegment sales 1,535)% $^{–}$)% $^{1,535}$)% $ 550,382)% $ $^{343,780}$)% $ $^{206,602}$)% $^{*}$Includes mark-to-market gains/(losses). 22 The following table shows sales by customer class (Megawatt hours): WHOLESALE SALES YEAR ENDED DECEMBER 31, 2003 2002 VARIANCE Long-term contracts 2,719,432)% $^{844,169}$)% $^{1,875,263}$)% Forward sales 3,597,325)% $^{1,336,745}$)% $^{2,260,580}$)% Short-term sales 5,531,019)% $^{7,269,240}$)% $^{(1,738,221)}$% 11,847,776)% 9,450,154)% 2,397,622)% Operating revenues increased $206.6 million or 60.1% over the prior year period to $550.4 million. This increase in wholesale electric sales primarily reflects additional long-term contract sales and more stable wholesale market conditions. The Company sold wholesale (bulk) power of 11.8 million MWh of electricity for the year ended December 31, 2003, compared to 9.5 million MWh for 2002. The gross margin, or operating revenues minus cost of energy sold and intersegment energy transfer, increased $51.3 million or 98.4% over the prior year period. A higher gross margin was achieved primarily by additional long-term sales under new and existing contracts, a return to more stable market prices and improved market liquidity. The addition of 273 MW of long-term contracts added $37.4 million or 72.9% of the total gross margin increase for the year. In December 2003 and January 2004, the Company added an additional 57 MW of long-term contracts. In addition, long-term contract margin increased due to the transfer of a significant customer from retail to wholesale. Forward sales margin increased $14.3 million or 27.9% of the total gross margin increase reflecting higher prices. The average price realized by the Company on its forward sales was $46 per MWh in 2003, compared to $37 per MWh in 2002. Liquidity returning to the market helped drive improvement of forward sales, as the Company had velocity of 1.9 vs. 1.6 a year ago. Short-term sales margin decreased $0.4 million or 0.8% of total gross margin due to lower volume from retail growth, increased long-term sales contracts and fewer available resources caused by a significant outage schedule in 2003, mostly offset by higher prices. The average price realized by the Company on its short-term sales was $42 per MWh in 2003, compared to $29 per MWh in 2002. Overall open market sales (forward and short-term sales) averaged $44 per MWh in 2003 versus $33 per MWh in 2002. This increase was partially offset by increased purchased power costs resulting from the 2003 outage schedule, which reduced availability of generation for wholesale sales. In addition, the Company had to buy power in the open market at higher prices to cover its contractual obligations, which resulted in increased purchased power costs of $20.5 million. The Company had a favorable change in the unrealized mark-to-market position of the forward sales portfolio of $1.0 million period-over-period ($3.5 million gain in 2003 versus $2.5 million gain in 2002). Total non-fuel O&M expenses increased $2.6 million or 7.1% over the prior year period. Energy production costs decreased $2.6 million or 8.0% primarily due to decreased decommissioning costs of $3.1 million and prior period, non-recurring engineering costs of $4.0 million related to the start-up of the Afton plant. These cost decreases were offset by increases of $2.3 million for the operation of the new Afton and Lordsburg gas fired facilities and $1.8 million due to increased Palo Verde Unit 3 outages. Administrative and general costs increased $5.2 million or 162.3% primarily due to transportation and storage costs of $1.2 million for turbines that will be utilized in future construction for merchant plant growth and increased pension and benefits costs of $4.0 million at SJGS and PVNGS. Depreciation and amortization increased $5.4 million or 61.6% primarily due to the addition of Lordsburg and Afton, which added $3.6 million of depreciation expense and an increase of $1.6 million for the change in accounting for asset retirement obligations as required by SFAS 143. Taxes other than income taxes increased $0.6 million or 24.6% primarily due to increased property taxes from the addition of Afton and Lordsburg. Corporate administrative and general expenses, which represent costs that are driven primarily by corporate-level activities, is allocated to the business segments and is presented in the corporate allocation line item in the segment statements. These costs increased $19.7 million or 22.4% over the prior year period to $107.9 million. This increase was due to increased pension and benefits expense of $17.9 million, resulting from lower prior-year returns on pension investments and increasing healthcare costs. Consulting expenses increased $1.5 million primarily for Sarbanes-Oxley Act compliance and other strategic corporate initiatives.  Taxes other than income decreased $2.5 million, or 79.6% over the prior year period due to the favorable resolution of certain outstanding tax issues and a decrease in social security taxes from lower payroll costs. CORPORATE AND OTHER P N M R E S O U R C E S • 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 23