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 35 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS PNM’s credit outlook is considered stable by Moody’s Investor Services, Inc. (“Moody’s”) and Standard and Poor’s Ratings Services (“S&P”). The Company is committed to maintaining or improving its investment grade ratings. On June 13, 2003, S&P improved PNM’s business position to a five from its previous position of six. On February 27, 2004, S&P upgraded PNM’s ratings on its senior unsecured notes (“SUNs”) to “BBB” with a stable outlook and its preferred stock to “BB+”. On March 9, 2004, Moody’s upgraded PNM’s SUNs, senior unsecured pollution control revenue bonds and $300 million 3 year credit facility to “Baa2” and its preferred stock “Ba1”. Fitch rated PNM’s SUNs and senior unsecured pollution control revenue bonds “BBB-” and its preferred stock “BB-” at December 31, 2003. Beginning in 2004, Fitch will no longer be rating PNM debt. Investors are cautioned that a security rating is not a recommendation to buy, sell or hold securities, that it is subject to revision or withdrawal at any time by the assigning rating organization, and that each rating should be evaluated independently of any other rating. Off Balance Sheet Arrangements The Company’s off balance sheet arrangements consist primarily of operating lease obligations for PVNGS Units 1 and 2, EIP and the Delta operating lease. The total capitalization in relation to these obligations was $179.4 million as of December 31, 2003 and $195.8 million as of December 31, 2002 (see “Commitments and Contractual Obligations” below). Commitments and Contractual Obligations The following tables show the Company’s long-term obligations and commitments as of December 31, 2003 (In thousands). 34 PAYMENTS DUE  LESS THAN AFTER CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR 2-3 YEARS 4-5 YEARS 5 YEARS Short-Term Debt (a) $ 125,918)% $ 125,918)% $ –)% $ –)% $ –)% Long-Term Debt 987,210)% 407)% 814)% 300,170)% 685,819)% Operating Leases 425,540)% 29,068)% 62,266)% 65,796)% 268,410)% Purchased Power Agreements 203,282)% 27,733)% 50,870)% 35,233)% 89,446)% Coal Contract (b) 1,395,926)% 109,309)% 192,456)% 182,359)% 911,802)% Total Contractual Cash Obligations $ 3,137,876)% $ 292,435)% $ 306,406)% $ 583,558)% $1,955,477)% (a) Represents the actual outstanding balance of the various credit facilities as of December 31, 2003. (b) Assumes normal deliveries under the coal contract. If no deliveries are made, certain minimum payments may be required under the coal contract. AMOUNT OF COMMITMENT EXPIRATION PER PERIOD TOTAL AMOUNTS AFTER OTHER COMMERCIAL COMMITMENTS COMMITTED 1 YEAR 2-3 YEARS 4-5 YEARS 5 YEARS Short-Term Debt (c) $ 335,500)% $ –)% $ 335,500)% $ –)% $ –)% Local Lines of Credit 38,500)% 38,500)% –)% –)% –)% Letters of Credit 4,500)% 4,500)% –)% –)% –)% Total Commercial Commitments $ 378,500)% $ 43,000)% $ 335,500)% $ –)% $ –)% (c) Represents the unused borrowing capacity of the various credit facilities less outstanding letters of credit of $4.5 million as of December 31, 2003. PNM leases interests in Units 1 and 2 of PVNGS, certain transmission facilities, office buildings and other equipment under operating leases. The lease expense for PVNGS is $66.3 million per year over base lease terms expiring in 2015 and 2016. In 1998, PNM established PVNGS Capital Trust (“Capital Trust”) for the purpose of acquiring all the debt underlying the PVNGS leases. PNM consolidates Capital Trust in its consolidated financial statements. The purchase was funded with the proceeds from the issuance of $435 million of SUNs, which were loaned to Capital Trust. Capital Trust then acquired and now holds the debt component of the PVNGS leases. For legal and regulatory reasons, the PVNGS lease payment continues to be recorded and paid gross with the debt component of the payment returned to PNM through Capital Trust. As a result, the net cash outflows for the PVNGS lease payment were $14.2 million for the year ended December 31, 2003. The table above reflects the net lease payment. PNM’s other significant operating lease obligations include the EIP, a leased interest in transmission line with annual lease payments of $2.9 million (see “Financing Activities” below), and an operating lease for the entire output of Delta, a gas fired generating plant in Albuquerque, New Mexico, with imputed annual lease payments of $6.0 million.  The Company’s off-balance sheet obligations are limited to PNM’s operating leases and certain financial instruments related to the purchase and sale of energy (see below). The present value of PNM’s operating lease obligations for PVNGS Units 1 and 2, EIP and the Delta operating lease was $179.4 million as of December 31, 2003. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS PNM has entered into various long-term power purchase agreements (“PPAs”) obligating it to buy electricity for aggregate fixed payments of $203.3 million plus the cost of production and a return. These contracts expire December 2005 through December 2020. In addition, PNM is obligated to sell electricity for $191.5 million in fixed payments plus the cost of production and a return. These contracts expire through May 2013. PNM’s marketing portfolio as of December 31, 2003 included open forward contract positions to buy $30.6 million of electricity and to sell $28.6 million of electricity. In addition, PNM had open forward contract positions classified as normal sales of electricity under the derivative accounting rules of $153.3 million and normal purchases of electricity of $64.1 million.  PNM contracts for the purchase of gas to serve its retail customers. These contracts are short-term in nature, supplying the gas needs for the current heating season and the following off-season months. The price of gas is a pass-through, whereby PNM recovers 100% of its cost of gas. Contingent Provisions of Certain Obligations The Holding Company and PNM have a number of debt obligations and other contractual commitments that contain contingent provisions. Some of these, if triggered, could affect the liquidity of the Company. The Holding Company or PNM could be required to provide security, immediately pay outstanding obligations or be prevented from drawing on unused capacity under certain credit agreements if the contingent requirements were to be triggered. The most significant consequences resulting from these contingent requirements are detailed in the discussion below. PNM's master purchase agreement for the procurement of gas for its retail customers contains a contingent requirement that could require PNM to provide security for its gas purchase obligations if the seller were to reasonably believe that PNM was unable to fulfill its payment obligations under the agreement. The master agreement for the sale of electricity in the Western Systems Power Pool (“WSPP”) contains a contingent requirement that could require PNM to provide security if its debt were to fall below investment grade rating. The WSPP agreement also contains a contingent requirement, commonly called a material adverse change (“MAC”) provision, which could require PNM to provide security if a material adverse change in its financial condition or operations were to occur. PNM’s committed Credit Facility contains a “ratings trigger,” for pricing purposes only. If PNM is downgraded or upgraded by the ratings agencies, the result would be an increase or decrease in interest cost, respectively. PNM's committed Credit Facility contains a MAC provision which, if triggered, could prevent PNM from drawing on its unused capacity under the Credit Facility. In addition, the Credit Facility contains a contingent requirement that requires PNM to maintain a debt-to-capital ratio, inclusive of off-balance sheet debt, of less than 65% as well as maintenance of an earnings before interest, taxes, depreciation and amortization (“EBITDA”)/interest coverage ratio of three times. If PNM’s debt-to-capital ratio, inclusive of off-balance sheet debt, were to exceed 65% or its interest coverage ratio falls below 3.0, PNM could be required to repay all borrowings under the Credit Facility, be prevented from drawing on the unused capacity under the Credit Facility, and be required to provide security for all outstanding letters of credit issued under the Credit Facility.  If a contingent requirement were to be triggered under the Credit Facility resulting in an acceleration of the outstanding loans under the Credit Facility, a cross-default provision in the PVNGS leases could occur if the accelerated amount is not paid. If a cross-default provision is triggered, the lessors have the ability to accelerate their rights under the leases, including acceleration of all future lease payments. Financing Activities Pursuant to PRC approval, on September 9, 2003, PNM issued and sold $300.0 million aggregate principal amount of its senior unsecured notes with a 4.40% interest rate that mature September 15, 2008. The transaction closed on September 17, 2003 and the proceeds were used to retire $268.4 million of long-term debt that would otherwise have matured in August 2005, pay the transaction costs, and improve working capital. All other long-term debt of PNM matures in 2016 or later. The premium paid to refinance the long-term debt was $23.9 million of which $16.6 million was charged against earnings based on prior regulatory agreements. The remaining balance was capitalized as loss on reacquired debt and will be amortized over the life of the new debt. On May 13, 2003, the Company priced $182.0 million of tax exempt pollution control bonds. The bonds were priced at an initial interest rate of 2.75%. The bond sale closed on May 23, 2003. By April 1, 2004, $146.0 million of bonds will need to be remarketed and $36.0 million of bonds will need to be remarketed by July 1, 2004. A portion of the proceeds were used to redeem the $46.0 million of pollution control bonds, which became callable on December 15, 2002. The remaining $136.0 million was used to redeem $136.0 million of pollution control bonds in August 2003. The Company had previously entered into various forward swaps in 2001 and 2002, to hedge the interest rate on the refinancing (see Note 6 – “Fair Value of Financial Instruments - Forward Starting Interest Rate Swaps” in the Notes to Consolidated Financial Statements).  The Company could enter into other long-term financings or hedging transactions for the purpose of strengthening its balance sheet, funding growth and reducing its cost of capital. The Company continues to evaluate its investment and debt retirement options to optimize its financing strategy and earnings potential. No additional first mortgage bonds may be issued under PNM’s mortgage. The amount of SUNs that may be issued is not limited by the SUNs indenture. However, debt-to-capital requirements in certain of PNM’s financial instruments and regulatory agreements would ultimately limit the amount of additional debt PNM would issue.