NICOR INC. FORM 10-Q 09-30-2006



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

or

[ ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 
SECURITIES EXCHANGE ACT OF 1934


Commission File Number 1-7297

NICOR LOGO
NICOR INC.
(Exact name of registrant as specified in its charter)


Illinois
36-2855175
(State of Incorporation)
(I.R.S. Employer
 
Identification Number)

1844 Ferry Road
 
Naperville, Illinois 60563-9600
(630) 305-9500
(Address of principal executive offices)
(Registrant’s telephone number)


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 and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer [X]
Accelerated filer [ ]
Non-accelerated filer [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. Common stock, par value $2.50, outstanding at October 27, 2006, were 44,709,976 shares.





Table of Contents

 
ii
       
Part I - Financial Information
 
       
 
Item 1.
Financial Statements (Unaudited)
 
       
   
1
   
Three and nine months ended
 
   
September 30, 2006 and 2005
 
       
   
2
   
Nine months ended
 
   
September 30, 2006 and 2005
 
       
   
3
   
September 30, 2006 and 2005, and
 
   
December 31, 2005
 
       
   
4
       
 
Item 2.
22
       
 
Item 3.
36
       
 
Item 4.
36
       
Part II - Other Information
 
       
 
Item 1.
37
       
 
Item 2.
37
       
 
Item 6.
37
       
   
38


 




i


Glossary

Chicago Hub. A venture of Northern Illinois Gas Company, doing business as Nicor Gas Company (“Nicor Gas”) which provides natural gas storage and transmission-related services to marketers and other gas distribution companies.

Degree day. The extent to which the daily average temperature falls below 65 degrees Fahrenheit. Normal weather for Nicor Gas’ service territory, for purposes of this report, is considered to be 5,830 degree days per year.

EN Engineering. EN Engineering, L.L.C., a 50-percent-owned joint venture that provides engineering and corrosion services.

FERC. Federal Energy Regulatory Commission, the agency that regulates the interstate transportation of natural gas, oil and electricity.

Horizon Pipeline. Horizon Pipeline Company, L.L.C., a 50-percent-owned joint venture that operates an interstate regulated natural gas pipeline of approximately 70 miles, stretching from Joliet, Illinois to near the Wisconsin/Illinois border.

ICC. Illinois Commerce Commission, the agency that establishes the rules and regulations governing utility rates and services in Illinois.

Mcf, MMcf, Bcf . Thousand cubic feet, million cubic feet, billion cubic feet.

Nicor Enerchange. Nicor Enerchange, L.L.C., a wholly owned business that engages in wholesale marketing of natural gas supply services primarily in the Midwest, administers the Chicago Hub for Nicor Gas, and manages Nicor’s other energy ventures’ product risks.

Nicor Gas. Northern Illinois Gas Company (doing business as Nicor Gas Company) is a wholly owned public utility business and one of the nation’s largest distributors of natural gas.

Nicor Services. Nicor Energy Services Company, a wholly owned business that provides customer relationship management services to businesses and product warranty contracts, heating, ventilation and air conditioning repair, maintenance and installation services and equipment to retail markets, including residential and small commercial customers.

Nicor Solutions. Nicor Solutions, L.L.C., a wholly owned business that offers residential and small commercial customers energy-related products that provide for natural gas cost stability and management of their utility bill.

PBR. Performance-based rate, a regulatory plan which ended on January 1, 2003, that provided economic incentives based on natural gas cost performance.

TEU. Twenty-foot equivalent unit, a measure of volume in containerized shipping equal to one 20-foot-long container.

Triton. Triton Container Investments L.L.C., a cargo container leasing company in which Nicor Inc. has an investment.

Tropical Shipping. A wholly owned business and a leading carrier of containerized freight in the Bahamas and the Caribbean region.

ii
 


                 
                   
Item 1. Financial Statements
                 
                   
Nicor Inc.
                 
Condensed Consolidated Statements of Operations (Unaudited)
         
(millions, except per share data)
                 
   
Three months ended
 
Nine months ended
 
   
September 30
 
September 30
 
   
2006
 
2005
 
2006
 
2005
 
Operating revenues
                         
Gas distribution (includes revenue taxes of
                         
$12.9, $12.8, $111.5 and $112.4, respectively)
 
$
226.7
 
$
241.5
 
$
1,775.6
 
$
1,692.6
 
Shipping
   
98.3
   
91.9
   
288.1
   
274.7
 
Other energy ventures
   
34.0
   
9.2
   
135.1
   
89.7
 
Corporate and eliminations
   
(7.9
)
 
(6.6
)
 
(77.0
)
 
(56.8
)
Total operating revenues
   
351.1
   
336.0
   
2,121.8
   
2,000.2
 
                           
Operating expenses
                         
Gas distribution
                         
Cost of gas
   
108.0
   
134.9
   
1,258.8
   
1,202.3
 
Operating and maintenance
   
56.6
   
51.0
   
199.9
   
178.4
 
Depreciation
   
40.1
   
38.6
   
120.3
   
115.9
 
Taxes, other than income taxes
   
17.0
   
16.6
   
123.2
   
124.0
 
Mercury-related costs (recoveries), net
   
-
   
.1
   
(3.6
)
 
.3
 
Property sale gains
   
(.6
)
 
(.1
)
 
(3.2
)
 
(.2
)
Shipping
   
87.8
   
82.5
   
258.6
   
242.8
 
Other energy ventures
   
27.1
   
20.9
   
134.4
   
98.3
 
Litigation charges (recoveries), net
   
-
   
-
   
10.0
   
(29.9
)
Other corporate expenses and eliminations
   
(13.4
)
 
(9.1
)
 
(88.1
)
 
(60.1
)
Total operating expenses
   
322.6
   
335.4
   
2,010.3
   
1,871.8
 
                           
Operating income
   
28.5
   
.6
   
111.5
   
128.4
 
Interest expense, net of amounts capitalized
   
11.1
   
10.6
   
35.5
   
32.8
 
Equity investment income, net
   
5.4
   
2.9
   
9.2
   
6.8
 
Interest income
   
2.5
   
1.6
   
7.9
   
4.3
 
Other income (expense), net
   
-
   
(.1
)
 
.4
   
.4
 
                           
Income (loss) before income taxes
   
25.3
   
(5.6
)
 
93.5
   
107.1
 
Income tax expense (benefit)
   
7.7
   
(2.9
)
 
23.5
   
32.7
 
                           
Net income (loss)
 
$
17.6
 
$
(2.7
)
$
70.0
 
$
74.4
 
                           
                           
Average shares of common stock outstanding
                         
Basic
   
44.7
   
44.2
   
44.5
   
44.1
 
Diluted
   
44.8
   
44.5
   
44.6
   
44.4
 
                           
Earnings (loss) per average share of common stock
                         
Basic
 
$
.39
 
$
(.06
)
$
1.57
 
$
1.69
 
Diluted
   
.39
   
(.06
)
 
1.57
   
1.67
 
                           
Dividends declared per share of common stock
 
$
.465
 
$
.465
 
$
1.395
 
$
1.395
 
                           
                           
The accompanying notes are an integral part of these statements.
                 
 
 
1
 


         
Condensed Consolidated Statements of Cash Flows (Unaudited)
         
(millions)
         
   
Nine months ended
 
   
September 30
 
   
2006
 
2005
 
Operating activities
             
Net income
 
$
70.0
 
$
74.4
 
Adjustments to reconcile net income to net cash flow
             
provided from operating activities:
             
Depreciation
   
133.7
   
129.3
 
Deferred income tax benefit
   
(45.2
)
 
(46.9
)
Gain on sale of property, plant and equipment
   
(3.1
)
 
(.1
)
Gain on sale of equity investment
   
(2.4
)
 
-
 
Changes in assets and liabilities:
             
 Receivables, less allowances
   
554.9
   
291.0
 
 Gas in storage
   
58.0
   
(136.6
)
 Deferred/accrued gas costs
   
(114.3
)
 
217.2
 
 Other assets
   
14.1
   
(92.0
)
 Accounts payable
   
(138.8
)
 
130.1
 
 Other liabilities
   
48.7
   
7.3
 
Other items
   
(27.1
)
 
23.7
 
Net cash flow provided from operating activities
   
548.5
   
597.4
 
               
Investing activities
             
Capital expenditures
   
(128.5
)
 
(145.4
)
Additions to restricted short-term investments
   
(10.0
)
 
-
 
Net increase in other short-term investments
   
(8.3
)
 
(34.9
)
Net proceeds from sale of property, plant and equipment
   
3.6
   
.4
 
Net proceeds from sale of equity investment
   
7.0
   
-
 
Other investing activities
   
4.1
   
(1.1
)
Net cash flow used for investing activities
   
(132.1
)
 
(181.0
)
               
Financing activities
             
Repayments of long-term debt
   
(28.0
)
 
-
 
Net repayments of commercial paper with maturities of
             
90 days or less
   
(435.0
)
 
(346.0
)
Dividends paid
   
(62.1
)
 
(61.6
)
Proceeds from exercise of stock options
   
14.1
   
1.4
 
Other financing activities
   
3.7
   
.3
 
Net cash flow used for financing activities
   
(507.3
)
 
(405.9
)
               
Net increase (decrease) in cash and cash equivalents
   
(90.9
)
 
10.5
 
               
Cash and cash equivalents, beginning of period
   
118.9
   
12.9
 
               
Cash and cash equivalents, end of period
 
$
28.0
 
$
23.4
 
               
               
Supplemental schedule of noncash investing activities:
             
               
In 2004, one of Nicor's Directors and Officers insurance carriers paid $29.0 million into an escrow account
to be used to satisfy Nicor's directors' and officers' liabilities and expenses associated with claims
     
asserted against them, with any remaining balance to be paid to Nicor.
             
               
During the second quarter of 2005, the escrow arrangement was terminated and the full amount of the
escrow of $29.0 million plus the earnings thereon of $0.4 million, was distributed to the company and
     
recorded in income. The release of the amount from escrow and the change in the obligation related to
the restricted investment are netted in Investing activities above.
             
               
               
The accompanying notes are an integral part of these statements.
             
 
2
 


             
Condensed Consolidated Balance Sheets (Unaudited)
             
(millions)
             
               
   
September 30
 
December 31
 
September 30
 
   
2006
 
2005
 
2005
 
Assets
                   
                     
Current assets
                   
Cash and cash equivalents
 
$
28.0
 
$
118.9
 
$
23.4
 
Restricted short-term investments
   
10.1
   
-
   
-
 
Short-term investments, at cost which
                 
approximates market
   
16.3
   
8.0
   
87.3
 
Receivables, less allowances of $34.7,
                 
$31.5 and $26.6, respectively
   
334.2
   
889.1
   
292.2
 
Gas in storage
   
203.3
   
261.3
   
357.3
 
Deferred income taxes
   
36.3
   
3.0
   
4.6
 
Other
   
54.4
   
65.4
   
163.7
 
Total current assets
   
682.6
   
1,345.7
   
928.5
 
                     
Property, plant and equipment, at cost
                   
Gas distribution
   
4,118.6
   
4,043.2
   
3,933.2
 
Shipping
   
296.7
   
293.9
   
304.0
 
Other
   
18.8
   
14.2
   
12.4
 
     
4,434.1
   
4,351.3
   
4,249.6
 
Less accumulated depreciation
   
1,743.6
   
1,692.2
   
1,650.4
 
Total property, plant and equipment, net
   
2,690.5
   
2,659.1
   
2,599.2
 
                     
Prepaid pension costs
   
195.0
   
187.6
   
186.1
 
Long-term investments
   
132.1
   
133.2
   
132.1
 
Other assets
   
64.9
   
65.6
   
72.4
 
                     
Total assets
 
$
3,765.1
 
$
4,391.2
 
$
3,918.3
 
                     
                     
Liabilities and Capitalization
                   
                     
Current liabilities
                   
Long-term debt due within one year
 
$
50.0
 
$
50.0
 
$
1.0
 
Short-term debt
   
151.0
   
586.0
   
144.0
 
Accounts payable
   
519.4
   
658.2
   
633.0
 
Accrued gas costs
   
108.9
   
223.2
   
285.5
 
Dividends payable
   
20.8
   
20.5
   
20.5
 
Obligations related to restricted investments
   
10.0
   
-
   
-
 
Deferred income taxes
   
-
   
7.4
   
7.6
 
Other
   
123.3
   
77.6
   
70.0
 
Total current liabilities
   
983.4
   
1,622.9
   
1,161.6
 
                     
Deferred credits and other liabilities
                   
Regulatory retirement cost liability
   
662.8
   
631.7
   
742.8
 
Deferred income taxes
   
415.3
   
421.6
   
484.7
 
Asset retirement obligation
   
170.0
   
164.0
   
-
 
Regulatory income tax liability
   
38.7
   
41.3
   
42.3
 
Unamortized investment tax credits
   
30.2
   
31.7
   
32.2
 
Other
   
176.3
   
180.3
   
177.5
 
Total deferred credits and other liabilities
   
1,493.3
   
1,470.6
   
1,479.5
 
                     
Commitments and contingencies
                   
                     
Capitalization
                   
Long-term obligations
                   
Long-term debt, net of unamortized discount
   
459.4
   
485.8
   
495.7
 
Mandatorily redeemable preferred stock
   
.6
   
.6
   
.6
 
Total long-term obligations
   
460.0
   
486.4
   
496.3
 
                     
Common equity
                   
Common stock
   
111.6
   
110.5
   
110.5
 
Paid-in capital
   
24.5
   
8.0
   
7.9
 
Retained earnings
   
702.2
   
694.5
   
653.0
 
Unearned compensation
   
-
   
(.1
)
 
(.1
)
Accumulated other comprehensive income (loss), net
   
(9.9
)
 
(1.6
)
 
9.6
 
Total common equity
   
828.4
   
811.3
   
780.9
 
                     
Total capitalization
   
1,288.4
   
1,297.7
   
1,277.2
 
                     
Total liabilities and capitalization
 
$
3,765.1
 
$
4,391.2
 
$
3,918.3
 
                     
The accompanying notes are an integral part of these statements.
                   
 
3
 

 
Nicor Inc.
Notes to the Condensed Consolidated Financial Statements (Unaudited)

1. BASIS OF PRESENTATION

The unaudited Condensed Consolidated Financial Statements of Nicor Inc. (“Nicor”) have been prepared by the company pursuant to the rules and regulations of the United States Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to SEC rules and regulations. The unaudited Condensed Consolidated Financial Statements and Notes should be read in conjunction with the financial statements and the notes thereto included in the company’s 2005 Annual Report on Form 10-K.

The information furnished reflects, in the opinion of the company, all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of the results for the interim periods presented. Results for the interim periods presented are not necessarily indicative of the results to be expected for the full fiscal year due to seasonal and other factors.

2. ACCOUNTING POLICIES
 
Gas in storage. Gas distribution segment inventory is carried at cost on a last-in, first-out (“LIFO”) basis. Inventory decrements occurring during interim periods that are expected to be restored prior to year-end are charged to cost of gas at the estimated annual replacement cost, and the difference between this cost and the actual LIFO layer cost is recorded on the balance sheet as a current temporary LIFO liquidation. Interim inventory decrements not expected to be restored prior to year-end are charged to cost of gas at the actual LIFO cost of the layers liquidated.

At September 30, 2006, the company had an inventory decrement of approximately 5 Bcf which it believes will not be restored prior to year-end. The liquidated inventory was charged to cost of gas at a LIFO cost of $7.82 per Mcf. If the company had deemed the decrement to be temporary, it would have charged cost of gas for the estimated annual replacement cost, currently estimated to be about $6.32 per Mcf. Applying LIFO cost in valuing the decrement, as opposed to the estimated annual replacement cost, had the effect of increasing the cost of gas distributed by $7.5 million during 2006. However, since the cost of gas, including inventory costs, is charged to customers without markup, subject to Illinois Commerce Commission (“ICC”) review, this difference had no impact on net income. There was no liquidation of any LIFO layers during 2005.

Regulatory assets and liabilities. Northern Illinois Gas Company (doing business as Nicor Gas Company (“Nicor Gas”)), a wholly owned subsidiary of Nicor, is regulated by the ICC, which establishes the rules and regulations governing utility rates and services in Illinois. The company applies accounting standards that recognize the economic effects of rate regulation and, accordingly, has recorded regulatory assets and liabilities. The company had regulatory assets and liabilities as follows (in millions):
 





4



   
September 30
 
December 31
 
September 30
 
   
2006
 
2005
 
2005
 
Regulatory assets
                   
Deferred environmental costs
 
$
14.2
 
$
15.1
 
$
20.0
 
Unamortized losses on reacquired debt
   
17.9
   
18.7
   
19.0
 
Deferred rate case costs
   
3.1
   
3.5
   
3.6
 
Other
   
3.8
   
.3
   
.4
 
   
$
39.0
 
$
37.6
 
$
43.0
 
                     
Regulatory liabilities
                   
Regulatory retirement cost liability - current
 
$
9.0
 
$
9.0
 
$
12.1
 
Regulatory retirement cost liability - noncurrent
   
662.8
   
631.7
   
742.8
 
Accrued gas costs
   
108.9
   
223.2
   
285.5
 
Regulatory income tax liability
   
38.7
   
41.3
   
42.3
 
Other
   
.1
   
1.8
   
7.7
 
   
$
819.5
 
$
907.0
 
$
1,090.4
 

All regulatory assets noted above are classified in noncurrent other assets. The current portion of the regulatory retirement cost liability is classified in current other liabilities. Regulatory liabilities - Other are classified in noncurrent other liabilities.

Revenue taxes. Nicor Gas classifies revenue taxes billed to customers as operating revenues and related taxes incurred as operating expenses. Revenue taxes included in operating expense for the three and nine months ended September 30, 2006 were $12.6 million and $109.0 million, respectively, and $11.9 million and $109.2 million, respectively, for the same periods ended September 30, 2005.

Reclassifications. Certain reclassifications have been made to conform the prior year’s financial statements to the current year’s presentation.

3.  NEW ACCOUNTING PRONOUNCEMENTS

Uncertain tax positions. In July 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes. This Interpretation sets forth a recognition threshold and valuation method to recognize and measure an income tax position taken, or expected to be taken, in a tax return. The evaluation is based on a two-step approach. The first step requires an entity to evaluate whether the tax position would “more likely than not,” based upon its technical merits, be sustained upon examination by the appropriate taxing authority. The second step requires the tax position be measured at the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement. In addition, previously recognized benefits from tax positions that no longer meet the new criteria would be derecognized. The application of this Interpretation will be considered a change in accounting principle with the cumulative effect of the change recorded to the opening balance of retained earnings in the period of adoption. This Interpretation will be effective for Nicor on January 1, 2007. The company is currently evaluating the Interpretation and the impact it may have on its results of operations and financial condition, but the impact of initial adoption is not expected to be material.






5



Fair value measurements. In September 2006, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The Statement does not require any new fair value measurements, rather it provides guidance on how to perform fair value measurements as required or permitted under other accounting pronouncements. This Statement is effective for Nicor no later than January 1, 2008 and is expected to be adopted prospectively at that time. The company is currently evaluating the Statement and the impact it may have on the company’s results of operations and financial condition.

Defined benefit pension and other postretirement plans. In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. This Statement will require an entity to immediately recognize the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet, and to recognize changes in that funded status through comprehensive income to the extent not recognized in net income pursuant to existing accounting rules. As a regulated utility, Nicor Gas expects continued full rate recovery of the costs of its defined benefit postretirement plans. Therefore, the company is evaluating whether changes in the plan’s funded status can be deferred as a regulatory asset or liability until recognized in net income, instead of being recorded in comprehensive income.

Initial and prospective recognition of the funded status of these plans is required for Nicor beginning at December 31, 2006. The company is evaluating this Statement and has not yet determined the impact of adopting its recognition provisions. This Statement, had it been adopted at December 31, 2005, would have reduced the reported pension asset by approximately $50 million and increased the liability for health care and other benefits by approximately $85 million. Depending on the results of the company’s evaluation discussed above, offsetting these amounts would have been a regulatory asset of approximately $135 million or a charge to accumulated other comprehensive income of approximately $80 million ($135 million net of related deferred tax benefits).

This Statement will also require Nicor to change its plan measurement date to December 31. Such provision is effective for Nicor no later than December 31, 2008 and will be adopted prospectively at that time. The company has not yet determined the impact of adopting this provision.

Planned major maintenance activities. In September 2006, FASB Staff Position (“FSP”) No. AUG AIR-1, Accounting for Planned Major Maintenance Activities, was issued. This FSP disallows the accrue-in-advance method of accounting for planned major maintenance activities, which is the method currently utilized by Nicor’s wholly owned subsidiary, Tropical Shipping, for the planned major maintenance of its owned vessels. Tropical Shipping carries an accrual of approximately $3.5 million as of September 30, 2006 for such future maintenance. Tropical Shipping will be required to change its accounting to one of the following methods; direct expensing, built-in overhaul or deferral, which are still permitted under this FSP. This FSP is effective for Nicor on January 1, 2007 and requires retrospective application. The company is currently evaluating the alternative methods permitted by this FSP and the impact the new method will have on its results of operations and financial condition, but the impact of initial adoption is not expected to be material.

Share-based payment. Effective January 1, 2006, the company adopted SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”), using the modified-prospective transition method. Under such method, compensation cost recognized in 2006 includes: (a) compensation cost for all share-based equity awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”) and (b) compensation cost for all share-based equity awards granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the

6


provisions of SFAS 123(R). In addition, liability awards will be adjusted to fair value at each quarter-end. See Note 11 - Stock-Based Compensation for a description of the company’s stock-based compensation plans.

Prior to January 1, 2006, the company accounted for its stock-based compensation plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related Interpretations, as permitted by SFAS 123. Under APB 25, Nicor did not recognize compensation cost for stock options or employee stock purchase plan discounts, and certain liability awards were adjusted to intrinsic value. Results from prior periods have not been restated.

Upon adoption of SFAS 123(R), a $0.1 million after-tax benefit was recognized. As a result of adopting SFAS 123(R), net income, earnings per share and cash flows are not expected to be materially different than if the company had continued to account for share-based compensation under APB 25.

The effect on net income and earnings per share for the three and nine months ended September 30, 2005 had the company applied the fair value recognition provisions of SFAS 123 is illustrated in the following table (in millions, except per share data).
   
Three months ended,
 
Nine months ended,
 
   
September 30, 2005
 
September 30, 2005
 
Net income (loss)
             
As reported
 
$
(2.7
)
$
74.4
 
Less: Total stock-based employee compensation
expense determined under the fair value
method for all awards, net of tax
   
.3
   
.9
 
Pro forma
 
$
(3.0
)
$
73.5
 
               
Earnings (loss) per share
             
Basic - As reported
 
$
(.06
)
$
1.69
 
Basic - Pro forma
   
(.07
)
 
1.66
 
Diluted - As reported
   
(.06
)
 
1.67
 
Diluted - Pro forma
   
(.07
)
 
1.65
 

4. RESTRICTED SHORT-TERM INVESTMENTS

At September 30, 2006, Nicor had $10.1 million of restricted short-term investments, including $0.1 million in interest earned, held in an escrow fund and a corresponding $10.0 million current liability. As reported in the second quarter of 2006, Nicor reached a tentative agreement with the staff of the Enforcement Division of the SEC in settlement of an anticipated civil action against the company for a payment of $10 million. In July 2006, the company deposited $10 million in an escrow account pending review and final approval of the tentative settlement by the SEC commissioners. As of September 30, 2006, the SEC commissioners had not reviewed or approved the tentative settlement. For further information, see Note 17 - Contingencies - SEC and U.S. Attorney Inquiries.

5. ASSET RETIREMENT OBLIGATIONS

Nicor has asset retirement obligations (“AROs”) associated with services, mains and other components of the distribution system and the buildings in its gas distribution segment and with certain equipment in its shipping segment. Nicor Gas has not recognized an ARO associated with gathering lines and storage wells because there is insufficient company or industry retirement history to reasonably estimate the fair value of the obligation.

7



The following table presents a reconciliation of the beginning and ending AROs for the nine months ended September 30, 2006 (in millions): 

Beginning of period
 
$
164.8
 
Liabilities incurred during the period
   
1.7
 
Liabilities settled during the period
   
(2.1
)
Accretion
   
7.1
 
Revision in estimated cash flows
   
.5
 
End of period
 
$
172.0
 

Substantially all of the ARO is classified as a noncurrent liability.

6. SHORT-TERM AND LONG-TERM DEBT

In October 2006, Nicor Gas established a $400 million, 210-day seasonal revolver, which expires in May 2007, to replace the $400 million, 210-day seasonal revolver, which expired in April 2006. In September 2005, Nicor and Nicor Gas established a $600 million, five-year revolver, expiring September 2010. These facilities were established with major domestic and foreign banks and serve as backup for the issuance of commercial paper. The company had $151.0 million, $586.0 million and $144.0 million of commercial paper borrowings outstanding at September 30, 2006, December 31, 2005 and September 30, 2005, respectively.

In October 2006, Nicor Gas entered into an agreement for the issuance of $50 million First Mortgage Bonds at 5.85 percent, due in 2036. The issuance is expected to occur, subject to the satisfaction of the conditions in the underlying agreements, on the maturity date of the $50 million 5.55 percent First Mortgage Bond series due in December 2006.

In December 2005, Tropical Shipping obtained a $40 million two-year senior unsecured term loan used to fund a portion of the repatriation of its cumulative undistributed foreign earnings in connection with the American Jobs Creation Act (the “Jobs Act”). The term loan bears a floating interest rate based on the London Inter-bank Offered Rate (“LIBOR”) plus 0.50 percent per annum. As of September 30, 2006, $12 million of this loan remains outstanding.

The company believes it is in compliance with all debt covenants.

7. INCOME AND OTHER TAXES

In December 2005, the company repatriated $132 million under the Jobs Act. Effective January 2006, the company reorganized certain of its shipping and related operations. The reorganization allows the company to take advantage of certain provisions of the Jobs Act that provide the opportunity for tax savings subsequent to the date of the reorganization. Generally, to the extent foreign shipping earnings are not repatriated to the United States, such earnings are not expected to be subject to current taxation. In addition, to the extent such earnings are expected to be indefinitely reinvested offshore, no deferred income tax expense would be recorded by the company. For the three and nine-month periods ended September 30, 2006, income tax expense has not been provided on approximately $6 million and $17 million, respectively, of foreign company shipping earnings that are expected to be indefinitely reinvested offshore. In connection with these activities, a net income tax benefit of approximately $6 million was recorded in the first quarter of 2006 from the elimination of certain deferred taxes. The company expects to incur approximately $5 million in current tax expense associated with these activities, of which approximately $3 million has been recognized in the first nine months of 2006.


8



The company’s effective income tax rate for the remainder of 2006 is estimated to be approximately 29 percent resulting from the ongoing benefit of untaxed foreign shipping earnings, recognition of certain tax credits and the amortization of excess deferred taxes. During the first nine months of 2006, the effective income tax rate was 25.1 percent. The lower rate for the first nine months reflects the recognition of additional tax benefits related to the first quarter 2006 reorganization of the company’s shipping and related operations and second quarter 2006 favorable adjustments associated with tax audits (which occur in the ordinary course of business) offset, in part, in the second quarter of 2006 by the non-deductible $10 million charge associated with the company’s outstanding SEC inquiry. For the first nine months of 2005, the effective income tax rate was 30.6 percent which reflected the effects of recording 2005 net litigation recoveries and earnings thereon ($29.9 million) at the company’s marginal tax rate of approximately 40 percent as well as miscellaneous third quarter tax benefits ($1.5 million). The effective income tax rate for the quarters ended September 30, 2006 and 2005 was 30.3 percent and 51.3 percent, respectively. For the quarter ended September 30, 2005, in addition to the impact of miscellaneous tax benefits ($1.5 million), the quarter’s effective income tax rate increased due to changes in forecasted annual income. Such change was not significant for the year-to-date period, but did have a disproportionate impact on the third quarter effective income tax rate as the income before income taxes was relatively low.

The company accrues tax and interest related to tax uncertainties. Tax uncertainties arise due to actual or potential disagreements about the tax treatment of specific items between the company and the governmental agency reviewing the company’s tax returns. At September 30, 2006, December 31, 2005 and September 30, 2005, the company had accrued approximately $17.8 million, $17.1 million and $8.1 million, respectively, for such uncertainties.

In 2003, Nicor received an income tax refund of approximately $100 million attributable to a tax loss carryback associated with a change in tax accounting method (which increased its deferred income tax liability), subject to Internal Revenue Service (“IRS”) review and approval as part of normal ongoing audits. Through December 31, 2004, the total current tax benefits previously recorded under this accounting method approximated $135 million (amounts recorded were offset by increases to the deferred tax liability with no net effect on reported net federal income tax expense). In the third quarter of 2005, the IRS revised the regulations pertaining to the aforementioned tax accounting method. The new regulations require repayment in 2005 and 2006 of amounts previously taken as current tax deductions. In the second half of 2005 and during the nine months ended September 30, 2006, Nicor reclassified income tax expense from deferred to current and repaid approximately $67 million and $50 million, respectively. The company expects to repay the remaining amounts during the fourth quarter of 2006. The anticipated repayment is expected to have no direct impact on earnings and no material impact on the company’s financial condition.

8. ACCRUED UNBILLED REVENUES

Receivables include accrued unbilled revenues of $52.9 million, $300.9 million and $52.9 million at September 30, 2006, December 31, 2005 and September 30, 2005, respectively, related primarily to gas distribution operations. Nicor Gas accrues revenues for estimated deliveries to customers from the date of their last bill until the balance sheet date.







9

 
9. FAIR VALUE OF FINANCIAL INSTRUMENTS

The recorded amount of short-term investments and short-term borrowings approximates fair value because of the short maturity of the instruments. Long-term debt outstanding, including current maturities, is recorded at the principal balance outstanding, net of unamortized discount. The principal balance of Nicor Gas’ First Mortgage Bonds outstanding at September 30, 2006, December 31, 2005 and September 30, 2005 was $500 million. Based on quoted market interest rates, the fair value of the company’s First Mortgage Bonds outstanding, including current maturities, was approximately $515 million, $525 million and $531 million at September 30, 2006, December 31, 2005 and September 30, 2005, respectively. The recorded amount of the Tropical Shipping two-year senior unsecured term loan for the periods presented approximated fair value because of its variable interest rate.

Derivative financial instruments are recorded at fair value as determined primarily from actively quoted prices. The fair value of derivative financial instruments relates largely to Nicor Gas. The majority of derivative financial instruments held by Nicor Gas are for the purpose of hedging natural gas purchases, and their settlement is passed directly through to customers without markup, subject to ICC review. The gross asset and liability fair values of these instruments are reflected on the Condensed Consolidated Balance Sheets as follows (in millions):

   
September 30
 
December 31
 
September 30
 
   
2006
 
2005
 
2005
 
                     
Current other assets
 
$
13.0
 
$
29.2
 
$
100.2
 
Noncurrent other assets
   
1.1
   
2.3
   
4.1
 
   
$
14.1
 
$
31.5
 
$
104.3
 
                     
Current other liabilities
 
$
50.3
 
$
6.1
 
$
11.1
 
Noncurrent other liabilities
   
4.9
   
1.4
   
2.4
 
   
$
55.2
 
$
7.5
 
$
13.5
 

Nicor maintains margin accounts related to financial derivative transactions. At September 30, 2006, December 31, 2005 and September 30, 2005, the balance of these accounts was $35.7 million, $37.0 million and $3.2 million, respectively, and was reflected in the Condensed Consolidated Balance Sheets as Receivables.

10. POSTRETIREMENT BENEFITS

Nicor Gas maintains a noncontributory defined benefit pension plan covering substantially all employees hired prior to 1998. Pension benefits are based on years of service and highest average salary for management employees and job level for unionized employees. The benefit obligation related to collectively bargained benefits considers the company’s past practice of regular benefit increases to reflect current wages. Nicor Gas also provides health care and life insurance benefits to eligible retired employees under a plan that includes limits on the company’s share of cost for employees hired after 1982. The company’s postretirement benefit costs have historically been considered in rate proceedings in the period they are accrued.






10



About one-fourth of the net periodic benefit cost or credit related to these plans has been capitalized as a cost of constructing gas distribution facilities and the remainder is included in gas distribution operating and maintenance expense. Net periodic benefit cost (credit) included the following components (in millions):
   
Pension benefits
 
Health care and
other benefits
 
   
2006
 
2005
 
2006
 
2005
 
                           
Three months ended September 30
                         
Service cost
 
$
2.3
 
$
2.3
 
$
.6
 
$
.7
 
Interest cost
   
3.8
   
3.9
   
2.5
   
2.6
 
Expected return on plan assets
   
(8.8
)
 
(8.3
)
 
(.1
)
 
(.2
)
Recognized net actuarial loss
   
.1
   
.4
   
1.4
   
1.1
 
Amortization of prior service cost
   
.1
   
.2
   
(.1
)
 
-
 
Net periodic benefit cost (credit)
 
$
(2.5
)
$
(1.5
)
$
4.3
 
$
4.2
 
                           
Nine months ended September 30
                         
Service cost
 
$
7.0
 
$
7.0
 
$
1.8
 
$
2.0
 
Interest cost
   
11.2
   
11.7
   
7.7
   
7.7
 
Expected return on plan assets
   
(26.2
)
 
(24.9
)
 
(.2
)
 
(.7
)
Recognized net actuarial loss
   
.2
   
1.1
   
3.8
   
3.8
 
Amortization of prior service cost
   
.4
   
.5
   
(.1
)
 
(.1
)
Net periodic benefit cost (credit)
 
$
(7.4
)
$
(4.6
)
$
13.0
 
$
12.7
 

The company reflected its best estimate of the potential subsidy it may receive under the Medicare Prescription Drug, Improvement and Modernization Act of 2003 in its October 1, 2005 and 2004 measurement of the postretirement health care obligation and of net periodic postretirement health care costs. The estimated subsidy reduced such costs by $1.3 million and $4.0 million for the three and nine months ended September 30, 2006, respectively, and $0.6 million and $1.8 million, respectively, for the corresponding prior-year periods.

11. STOCK-BASED COMPENSATION

Nicor has a long-term incentive compensation plan that permits the granting of restricted stock, performance units and stock options to key executives and managerial employees. The company may grant up to 1.5 million common shares under a plan approved in the second quarter of 2006. In addition, Nicor has a stock deferral plan, employee stock purchase plan and directors’ stock-based compensation plans.

In 2006, the company primarily granted restricted stock and performance units under these plans, whereas in prior years, grants consisted primarily of stock options and performance units.

As of September 30, 2006, there was $1.1 million of total unrecognized compensation cost related to all nonvested share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 3.3 years. The company recognized compensation cost and related tax effects for all share-based compensation arrangements as follows (in millions):







11



   
Three months ended
 
Nine months ended
 
   
September 30
 
September 30
 
   
2006
 
2005
 
2006
 
2005
 
                           
Operating and maintenance expense
 
$
.9
 
$
.6
 
$
2.8
 
$
2.3
 
Income tax benefits
   
.4
   
.2
   
1.1
   
.9
 

Cash flows related to stock-based options were as follows (in millions):

   
Three months ended
 
Nine months ended
 
   
September 30
 
September 30
 
   
2006
 
2005
 
2006
 
2005
 
                           
Proceeds from the exercise of stock options
 
$
7.6
 
$
.5
 
$
14.1
 
$
1.4
 
Associated income tax benefits realized
   
.9
   
.2
   
1.8
   
.4
 

The difference between the proceeds from the exercise of stock options and the par value of the stock is recorded within Paid-in capital on the balance sheet.

Restricted stock. Restricted stock represents shares of common stock that are nontransferable during a vesting period of generally four years. Compensation cost was measured at the grant date share price for all periods.

A summary of the status of the company’s restricted stock and changes during the nine months ended September 30, 2006 is as follows:
       
Weighted-
 
   
Number of
 
average grant-
 
   
shares
 
date fair value
 
               
Nonvested at January 1, 2006
   
5,999
 
$
41.11
 
Granted
   
35,870
   
41.62
 
Vested
   
(3,000
)
 
41.11
 
Forfeited
   
(1,670
)
 
41.62
 
Nonvested at September 30, 2006
   
37,199
   
41.58
 

The weighted-average fair value of shares granted during the nine months ended September 30, 2006 was $41.62. There was no restricted stock granted during the three-month period ended September 30, 2006 or during the three and nine months ended September 30, 2005. The total fair value of shares vested for each of the year-to-date periods ended September 30, 2006 and 2005 was $0.1 million. There were no restricted stock awards that vested during the third quarters of 2006 or 2005.

Performance units. These awards are paid out in cash based on a measure of relative total shareholder return over a three-year performance period as compared to the performance of the companies in a utility industry peer group (Standard & Poor’s utility group). Units vest over approximately three years, or upon retirement one year or more after the grant date. The liability for the units is adjusted to fair value each
quarter-end, and compensation cost is ultimately measured as the settlement date fair value (or cash payment). Interim fair values are estimated by discounting probability-weighted expected cash flows. The company paid $0.8 million and $0.2 million during the year-to-date periods ended September 30, 2006 and 2005, respectively, to settle performance unit obligations. There were no such payments made during the third quarters of 2006 or 2005.
 

 
12
 
 
Other. As noted in the company’s 2005 Annual Report on Form 10-K, the company has other stock-based compensation plans, but the impact on net income, earnings per share and cash flows for the three and nine months ended September 30, 2006 is immaterial.
 
12. EQUITY INVESTMENT INCOME, NET

Net equity investment income includes investment income from Triton Container Investments L.L.C. (“Triton”), a cargo container leasing company, of $2.0 million and $4.5 million, respectively, for the three and nine-month periods ended September 30, 2006 and $1.7 million and $5.3 million, for the same periods ended September 30, 2005, respectively. Also included in net equity investment income for the three and nine months ended September 30, 2006 is a $2.4 million gain on a sale of an equity investment. Nicor received cash distributions from equity investees for the three and nine-month periods ended September 30, 2006 of $1.5 million and $4.8 million, respectively, and $1.0 million and $3.5 million, respectively, for the same periods ended September 30, 2005.
 
13.COMPREHENSIVE INCOME

Total comprehensive income, as defined by SFAS No. 130, Reporting Comprehensive Income, is equal to net income plus other comprehensive income and is as follows (in millions):

   
Three months ended
 
Nine months ended
 
   
September 30
 
September 30
 
   
2006
 
2005
 
2006
 
2005
 
                           
Net income (loss)
 
$
17.6
 
$
(2.7
)
$
70.0
 
$
74.4
 
Other comprehensive income (loss), after tax
   
(4.6
)
 
13.8
   
(8.3
)
 
16.4
 
Total comprehensive income
 
$
13.0
 
$
11.1
 
$
61.7
 
$
90.8
 

Net other comprehensive income (loss) generally consists of net unrealized gains and losses from derivative financial instruments accounted for as cash flow hedges, including Nicor’s share of such amounts from joint ventures and other equity-method investees.



 






13



14. BUSINESS SEGMENT INFORMATION

Financial data by major business segment is presented below (in millions):
   
 
Gas distribution
 
 
 
Shipping
 
Other energy ventures
 
Corporate and
eliminations
 
 
 
Consolidated
 
                                 
Three months ended September 30, 2006
                       
Operating revenues
                               
External customers
 
$
219.7
 
$
98.3
 
$
33.1
 
$
-
 
$
351.1
 
Intersegment
   
7.0
   
-
   
.9
   
(7.9
)
 
-
 
   
$
226.7
 
$
98.3
 
$
34.0
 
$
(7.9
)
$
351.1
 
                                 
Operating income
 
$
5.6
 
$
10.5
 
$
6.9
 
$
5.5
 
$
28.5
 
                                 
Three months ended September 30, 2005
                       
Operating revenues
                               
External customers
 
$
235.7
 
$
91.9
 
$
8.4
 
$
-
 
$
336.0
 
Intersegment
   
5.8
   
-
   
.8
   
(6.6
)
 
-
 
   
$
241.5
 
$
91.9
 
$
9.2
 
$
(6.6
)
$
336.0
 
                                 
Operating income (loss)
 
$
.4
 
$
9.4
 
$
(11.7
)
$
2.5
 
$
.6
 
                                 
Nine months ended September 30, 2006
                       
Operating revenues
                               
External customers
 
$
1,714.4
 
$
288.1
 
$
119.3
 
$
-
 
$
2,121.8
 
Intersegment
   
61.2
   
-
   
15.8
   
(77.0
)
 
-
 
   
$
1,775.6
 
$
288.1
 
$
135.1
 
$
(77.0
)
$
2,121.8
 
                                 
Operating income
 
$
80.2
 
$
29.5
 
$
.7
 
$
1.1
 
$
111.5
 
                                 
Nine months ended September 30, 2005
                       
Operating revenues
                               
External customers
 
$
1,641.5
 
$
274.7
 
$
84.0
 
$
-
 
$
2,000.2
 
Intersegment
   
51.1
   
-
   
5.7
   
(56.8
)
 
-
 
   
$
1,692.6
 
$
274.7
 
$
89.7
 
$
(56.8
)
$
2,000.2
 
                                 
Operating income (loss)
 
$
71.9
 
$
31.9
 
$
(8.6
)
$
33.2
 
$
128.4
 

The majority of intersegment revenues represent gas distribution revenues related to customers entering into certain utility-bill management contracts with Nicor’s other energy ventures. Under these utility-bill management contracts, Nicor’s other energy ventures bill a fixed amount to a customer, regardless of changes in natural gas prices or weather, and in exchange pays the customer’s utility bills from Nicor Gas. Intersegment revenues are eliminated in the Condensed Consolidated Financial Statements.









14



Operating income in the “Corporate and eliminations” column includes the following items:

·  
In the third quarter of 2006 and 2005, the company recognized $5.2 million and $2.6 million, respectively, of insurance recoveries related to previously incurred legal expenses associated with the securities class action and shareholder derivative lawsuit settlements. For more information, see Note 17 - Contingencies - Other.
·  
In the year-to-date 2006 period, the company recorded a $10 million charge (non-deductible for tax purposes) associated with the outstanding SEC inquiry. In the year-to-date 2005 period, the company recorded $29.9 million of net insurance recoveries and earnings thereon of securities class action and derivative lawsuit settlements. For more information on both items, see Note 17 - Contingencies.
·  
Benefits (costs) associated with Nicor’s other energy ventures’ utility-bill management contracts attributable to warmer (colder) than normal weather for the three and nine months ended September 30, 2006 were $(0.1) million and $6.3 million, respectively, and $0.5 million and $1.7 million, respectively, for the same periods ending September 30, 2005. The weather impact of these contracts generally serves to offset the gas distribution segment’s weather risk. This benefit (cost) is recorded at the corporate level as a result of an agreement between the parent company and certain of its subsidiaries.


15. RATE PROCEEDING

Nicor Gas filed a request with the ICC for an overall increase in base rates on November 4, 2004. In late 2005, Nicor Gas received approval from the ICC for a $54.2 million base rate increase which reflected an allowed rate of return on original-cost rate base of 8.85 percent, including a 10.51 percent cost of common equity. The order also included the authorization to pass all Chicago Hub revenues directly through to customers as a credit to Nicor Gas’ Purchased Gas Adjustment (“PGA”) rider and the shifting of certain storage-related costs from the PGA rider to base rates. In addition, rates were established using a 10-year average for weather as opposed to the previous use of a 30-year average. These rates were implemented in the fourth quarter of 2005.

In October 2005, Nicor Gas and six other parties filed applications for rehearing of the final order of the rate case. The ICC granted rehearing on seven issues, only two of which relate to the amount of the approved annual net revenue increase, and denied rehearing on all other issues raised in the applications. In March 2006, the ICC issued its decision on rehearing in which it adjusted the amount of the annual net rate increase to $49.7 million from the $54.2 million that had been approved in the earlier order. Rate changes resulting from the rehearing order are prospective and went into effect on April 11, 2006. Parties, including Nicor Gas, that appealed the ICC’s rate case decision to the state appellate courts have since withdrawn their appeals. As a result, the ICC rate order is no longer subject to judicial review.

As a result of the rate order which became effective in the fourth quarter of 2005, certain storage-related costs are now recorded in operating and maintenance expense. For the three and nine months ended September 30, 2006, storage-related gas costs in operating and maintenance expense totaled $1.0 million and $15.4 million, respectively. Such costs totaled zero and $11.1 million, respectively, for the corresponding prior-year periods and since they were incurred prior to the effective date of the rate order were recorded as cost of gas.





15



16. GUARANTEES AND INDEMNITIES

Nicor and certain subsidiaries enter into various financial and performance guarantees and indemnities providing assurance to third parties.

Financial guarantees. The company has issued guarantees of affiliate obligations to vendors and other third parties, requiring Nicor to repay the obligations should its affiliates default. The obligations of the company’s wholly owned subsidiaries are reflected in Nicor’s Condensed Consolidated Balance Sheets, while the obligations of its unconsolidated equity investments are not. As of September 30, 2006, Nicor had guaranteed the payment of $0.2 million of lease obligations extending through February 2007 in support of one of its unconsolidated equity investee’s operations. No liability has been recorded for this guarantee as Nicor believes the likelihood of payment under this guarantee is remote.

Tropic Equipment Leasing Inc. (“TEL”), an indirectly wholly owned subsidiary of Nicor, holds the company’s interests in Triton. TEL has a contingent liability to restore to zero any deficit in its equity account for income tax purposes in the unlikely event that Triton is liquidated and a deficit balance remains. This contingent liability continues for the life of the Triton partnerships and any payment is effectively limited to the assets of TEL, which were approximately $9 million at September 30, 2006. Nicor believes the likelihood of any such payment by TEL is remote, and no liability has been recorded for this contingency.

Performance guarantees. Nicor Services markets separately priced product warranty contracts that provide for the repair of heating, ventilation and air conditioning equipment, natural gas lines, and other appliances within homes. Revenues from these product warranty contracts are recognized ratably over the coverage period, and related repair costs are charged to expense as incurred. Repair expenses of $1.5 million and $4.3 million were incurred in the three and nine months ended September 30, 2006, respectively, and $1.2 million and $3.3 million, respectively, for the same periods last year.

Indemnities. In certain instances, Nicor has undertaken to indemnify current property owners and others against costs associated with the effects and/or remediation of contaminated sites for which the company may be responsible under applicable federal or state environmental laws, generally with no limitation as to the amount. Aside from liabilities recorded in connection with coal tar cleanup, as discussed in Note 17 - Contingencies - Manufactured Gas Plant Sites, Nicor believes that the likelihood of payment under these indemnifications is either remote, or the fair value of the indemnification is immaterial, and no liability has been recorded for these indemnifications.

Nicor has also indemnified, to the fullest extent permitted under the laws of the State of Illinois and any other applicable laws, its present and former directors, officers and employees against expenses they may incur in connection with litigation they are a party to by reason of their association with the company. There is generally no limitation as to the amount. Expenses associated with these indemnifications were insignificant in the three and nine-month periods ended September 30, 2006 and 2005. As of September 30, 2006, the company had a remaining estimated liability of $0.2 million in connection with these indemnifications. While the company does not expect to incur significant additional costs under these indemnifications, it is not possible to estimate the maximum potential payments.

 




16
 
 
17.CONTINGENCIES

The following contingencies of Nicor are in various stages of investigation or disposition. Although in some cases the company is unable to estimate the amount of loss reasonably possible in addition to any amounts already recognized, it is possible that the resolution of these contingencies, either individually or in aggregate, will require the company to take charges against, or will result in reductions in, future earnings. It is the opinion of management that the resolution of these contingencies, either individually or in aggregate, could be material to earnings in a particular period but is not expected to have a material adverse impact on Nicor’s liquidity or financial condition.

Performance-Based Rate (“PBR”) Plan. Nicor Gas’ PBR plan for natural gas costs went into effect in 2000 and was terminated by the company effective January 1, 2003. Under the PBR plan, Nicor Gas’ total gas supply costs were compared to a market-sensitive benchmark. Savings and losses relative to the benchmark were determined annually and shared equally with sales customers. The PBR plan is currently under ICC review. There are allegations that the company acted improperly in connection with the PBR plan, and the ICC and others are reviewing these allegations. On June 27, 2002, the Citizens Utility Board (“CUB”) filed a motion to reopen the record in the ICC’s proceedings to review the PBR plan (the “ICC Proceedings”). As a result of the motion to reopen, Nicor Gas, the Cook County State’s Attorney Office (“CCSAO”), the staff of the ICC and CUB entered into a stipulation providing for additional discovery. The Illinois Attorney General’s Office (“IAGO”) has also intervened in this matter. In addition, the IAGO issued Civil Investigation Demands (“CIDs”) to CUB and the ICC staff. The CIDs ordered that CUB and the ICC staff produce all documents relating to any claims that Nicor Gas may have presented, or caused to be presented, false information related to its PBR plan. Parties who were plaintiffs in a dismissed class action proceeding against the company could potentially intervene in these proceedings. The company has committed to cooperate fully in the reviews of the PBR plan.

In response to these allegations, on July 18, 2002, the Nicor Board of Directors appointed a special committee of independent, non-management directors to conduct an inquiry into issues surrounding natural gas purchases, sales, transportation, storage and such other matters as may come to the attention of the special committee in the course of its investigation. The special committee presented the report of its counsel (“Report”) to Nicor’s Board of Directors on October 28, 2002.

In response, the Nicor Board of Directors directed the company’s management to, among other things, make appropriate adjustments to account for, and fully address, the adverse consequences to ratepayers of the items noted in the Report, and conduct a detailed study of the adequacy of internal accounting and regulatory controls. The adjustments were made in prior years’ financial statements resulting in a $24.8 million liability. Included in such $24.8 million liability is a $4.1 million loss contingency. A $1.8 million adjustment to the previously recorded liability, which is discussed below, was made in 2004 increasing the recorded liability to $26.6 million. In addition, Nicor Gas estimates that there is $26.9 million due to the company from the 2002 PBR plan year, which has not been recognized in the financial statements due to uncertainties surrounding the PBR plan. The net of these items and interest income on certain components results in a $1.0 million reimbursement the company is seeking as of September 30, 2006, pending resolution of the proceedings discussed below. By the end of 2003, the company completed steps to correct the weaknesses and deficiencies identified in the detailed study of the adequacy of internal controls.

Pursuant to the agreement of all parties, including the company, the ICC re-opened the 1999 and 2000 purchased gas adjustment filings for review of certain transactions related to the PBR plan and consolidated the reviews of the 1999-2002 purchased gas adjustment filings with the PBR plan review.




17
 
 
On February 5, 2003, the CCSAO and CUB filed a motion for $27 million in sanctions against the company in the ICC Proceedings. In that motion, CCSAO and CUB alleged that Nicor Gas’ responses to certain CUB data requests were false. Also on February 5, 2003, CUB stated in a press release that, in addition to $27 million in sanctions, it would seek additional refunds to consumers. On March 5, 2003, the ICC staff filed a response brief in support of CUB’s motion for sanctions. On May 1, 2003, the Administrative Law Judges issued a ruling denying CUB and CCSAO’s motion for sanctions. CUB has filed an appeal of the motion for sanctions with the ICC, and the ICC has indicated that it will not rule on the appeal until the final disposition of the ICC Proceedings. It is not possible to determine how the ICC will resolve the claims of CCSAO, CUB or other parties to the ICC Proceedings.

In November 2003, the ICC staff, CUB, CCSAO and the IAGO filed their respective direct testimony in the ICC Proceedings. The ICC staff is seeking refunds to customers of approximately $108 million and CUB and CCSAO were jointly seeking refunds to customers of approximately $143 million. The IAGO direct testimony alleges adjustments in a range from $145 million to $190 million. The IAGO testimony as filed is presently unclear as to the amount which IAGO seeks to have refunded to customers. On February 27, 2004, the above referenced intervenors filed their rebuttal testimony in the ICC Proceedings. In such rebuttal testimony, CUB and CCSAO amended the alleged amount to be refunded to customers from approximately $143 million to $190 million. Nicor Gas filed rebuttal testimony in January 2004, which is consistent with the findings of the special committee Report. Nicor Gas seeks a reimbursement of approximately $1 million as referenced above. The parties to the ICC Proceedings have agreed to a stay of the evidentiary hearings on this matter in order to undertake additional third party discovery from Entergy-Koch Trading, LP (“EKT”), a natural gas, storage and transportation trader and consultant with whom Nicor did business under the PBR plan.

During the course of the United States Securities and Exchange Commission (“SEC”) investigation discussed below, the company became aware of additional information relating to the activities of individuals affecting the PBR plan for the period from 1999 through 2002, including information consisting of third party documents and recordings of telephone conversations from EKT. Review of additional information completed in 2004 resulted in the $1.8 million adjustment to the previously recorded liability referenced above.

Although the Report of the special committee’s counsel did not find that there was criminal activity or fraud, a review of this additional information (which was not available to the independent counsel who prepared the Report) and re-interviews of certain Nicor Gas personnel in 2004 indicated that certain former Nicor Gas personnel may have engaged in potentially fraudulent conduct regarding the PBR plan in violation of company policy, and in possible violation of SEC rules and applicable law. Further, certain former Nicor Gas personnel also may have attempted to conceal their conduct in connection with an ICC review of the PBR plan. The company continues to cooperate with the SEC, the U.S. Attorney’s office and the ICC on this matter. The company has reviewed all third party information it has obtained and will continue to review any additional third party information the company may obtain. The company terminated four employees in connection with this matter in 2004.

Nicor is unable to predict the outcome of the ICC’s review or the company’s potential exposure thereunder. Because the PBR plan and historical gas costs are still under ICC review, the final outcome could be materially different than the amounts reflected in the company’s financial statements as of September 30, 2006.
 




18
 
 
SEC and U.S. Attorney Inquiries. In 2002, the staff of the SEC Division of Enforcement (“SEC Staff”) informed Nicor that the SEC is conducting a formal inquiry regarding the PBR plan. A representative of the Office of the United States Attorney for the Northern District of Illinois (the “U.S Attorney”) has notified Nicor that that office is conducting an inquiry on the same matters that the SEC is investigating, and a grand jury is also reviewing these matters. In April 2004, Nicor was advised by the SEC Staff that it intended to recommend to the SEC that it bring a civil injunctive action against Nicor, alleging that Nicor violated Sections 17(a) of the Securities Act of 1933 and Sections 10(b) and 13(a) of the Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder. On July 7, 2006, the company announced that it reached a tentative agreement with the SEC Staff in settlement of an anticipated civil action to which the company and the SEC will be parties. Under the terms of the tentative settlement, the company will be subject to disgorgement of one dollar, a monetary fine of $10 million and an injunction. The company will neither admit nor deny any wrongdoing. In July 2006, the company deposited the $10 million in escrow pending final approval of the tentative settlement by the SEC commissioners and entry of a final judgment by a federal court. The SEC Staff will submit the tentative settlement to the SEC commissioners for approval. The SEC commissioners have the authority to approve, modify or reject the tentative settlement. Nicor recorded a $10 million charge to its second quarter earnings in connection with this matter. The $10 million fine is not deductible for federal or state income tax purposes. Nicor is unable to predict the outcome of the separate inquiry by the U.S. Attorney or Nicor’s potential exposure related thereto and has not recorded a liability associated with the outcome of that matter.
 
Fixed Bill Service. On April 29, 2003, a second amended purported class action complaint was filed in the Circuit Court of Cook County, Illinois against Nicor Energy Services Company (“Nicor Services”) alleging violation of the Illinois Consumer Fraud Act (“ICFA”) by Nicor Services relating to the fixed bill service offered by Nicor Services. Nicor Services offered a fixed bill product under which it paid the annual gas service portion of a customer’s Nicor Gas utility bill in exchange for twelve equal monthly payments by the customer to Nicor Services, regardless of changes in the price of natural gas or weather. The plaintiff sought compensatory damages, prejudgment and postjudgment interest, punitive damages, attorneys’ fees and injunctive relief on behalf of a proposed class consisting of all purchasers of the fixed bill service from February 1, 2002 through December 31, 2002. On October 7, 2005, the Circuit Court denied plaintiffs’ motion to certify the proposed class. As a result, if the case proceeds in the Circuit Court, it will be as an individual action on behalf of the named plaintiff alone. The class certification decision remains subject to appeal. Nicor is unable to predict the outcome of this litigation or to reasonably estimate its potential exposure related thereto and has not recorded a liability associated with this contingency.

Mercury. Nicor Gas has incurred, and expects to continue to incur, costs related to its historical use of mercury in various kinds of company equipment.

Nicor Gas is a defendant in several private lawsuits, all in the Circuit Court of Cook County, Illinois, seeking a variety of unquantified damages (including bodily injury, property and punitive damages) allegedly caused by mercury spillage resulting from the removal of mercury-containing regulators. Under the terms of a class action settlement agreement, Nicor Gas will continue, until 2007, to provide medical screening to persons exposed to mercury from its equipment, and was to use reasonable efforts to remove any remaining inside residential mercury regulators by March of 2006. Nicor Gas believes it is in compliance with its obligations under the settlement agreement. The class action settlement permitted class members to “opt out” of the settlement and pursue their claims individually. Nicor Gas is currently defending claims brought by 26 households.




19
 
As of September 30, 2006, Nicor Gas had remaining an estimated liability of $15.3 million, representing management’s best estimate of future costs, including potential liabilities relating to remaining lawsuits, based on an evaluation of currently available information. Actual costs may vary from this estimate. The company will continue to reassess its estimated obligation and will record any necessary adjustment, which could be material to operating results in the period recorded.

Nicor Gas continues to pursue recovery from insurers and independent contractors that had performed work for the company. When received, these recoveries are recorded as a reduction to gas distribution operating expense. Nicor Gas received approximately $3.8 million, net of legal fees, from an independent contractor in the first quarter of 2006. Amounts recovered during 2004 and 2005 were immaterial. On October 25, 2004, the Circuit Court of Cook County, Illinois entered judgment in favor of Nicor and Nicor Gas and against various insurers in the amount of $10.2 million with respect to one of Nicor’s and Nicor Gas’ mercury-related insurance claims. The insurers filed an appeal of the judgment. On November 29, 2005, the First District Appellate Court reversed the Circuit Court’s judgment in favor of Nicor and Nicor Gas and remanded the case to the Circuit Court for proceedings consistent with the Appellate Court’s decision. The Illinois Supreme Court has granted Nicor and Nicor Gas leave to appeal the decision of the Appellate Court.

The final disposition of these mercury-related matters is not expected to have a material adverse impact on the company’s financial condition.

Manufactured Gas Plant Sites. Manufactured gas plants were used in the 1800’s and early to mid 1900’s to produce manufactured gas from coal, creating a coal tar byproduct. Current environmental laws may require the cleanup of coal tar at certain former manufactured gas plant sites.

To date, Nicor Gas has identified about 40 properties for which it may have some responsibility. Most of these properties are not presently owned by the company. Nicor Gas and Commonwealth Edison Company (“ComEd”) are parties to an interim agreement to cooperate in cleaning up residue at many of these properties. Under the interim agreement, mutually agreed costs are to be evenly split between Nicor Gas and ComEd until such time as they are finally allocated either through negotiation or arbitration. On April 17, 2006, Nicor Gas initiated arbitration to determine the final allocations of these costs between Nicor Gas and ComEd. The ultimate outcome of the arbitration is not presently determinable. Information regarding preliminary site reviews has been presented to the Illinois Environmental Protection Agency for
certain properties. More detailed investigations and remedial activities are complete, in progress or planned at many of these sites. The results of the detailed site-by-site investigations determine the extent additional remediation is necessary and provide a basis for estimating additional future costs. As of September 30, 2006, the company had recorded a liability in connection with these matters of $14.1 million. In accordance with ICC authorization, the company has been recovering, and expects to continue to recover, these costs from its customers, subject to annual prudence reviews.

In December 2001, a purported class action lawsuit was filed against Exelon Corporation, ComEd and Nicor Gas in the Circuit Court of Cook County alleging, among other things, that the cleanup of a former manufactured gas plant site in Oak Park, Illinois was inadequate. Since then, additional lawsuits have been filed related to this same former manufactured gas plant site. These lawsuits seek, in part, unspecified damages for property damage, nuisance, and various personal injuries that allegedly resulted from exposure to contaminants allegedly emanating from the site, and punitive damages. An agreement in principle to settle the purported class action lawsuit has been reached and, as of September 30, 2006, the company has recorded a $2.25 million liability in connection with this matter. In accordance with ICC authorization, the company expects to recover costs of such settlement from its customers, subject to an annual prudence review. Management cannot predict the outcome of certain other pending lawsuits relating to the Oak Park site or the company’s potential exposure thereto and has not recorded a liability associated with those other pending matters.

20
 
In April 2002, Nicor Gas was named as a defendant, together with ComEd, in a lawsuit brought by the Metropolitan Water Reclamation District of Greater Chicago (the “MWRDGC”) under the Federal Comprehensive Environmental Response, Compensation and Liability Act seeking recovery of past and future remediation costs and a declaration of the level of appropriate cleanup for a former manufactured gas plant site in Skokie, Illinois now owned by the MWRDGC. In January 2003, the suit was amended to include a claim under the Federal Resource Conservation and Recovery Act. The suit was filed in the United States District Court for the Northern District of Illinois. Management cannot predict the outcome of this litigation or the company’s potential exposure thereto and has not recorded a liability associated with this contingency.

Since costs and recoveries relating to the cleanup of manufactured gas plant sites are passed directly through to customers in accordance with ICC regulations, subject to an annual ICC prudence review, the final disposition of manufactured gas plant matters is not expected to have a material impact on the company’s financial condition or results of operations.

Other. On April 27, 2004, one of Nicor’s Directors and Officers insurance carriers agreed to pay $29.0 million to a third party escrow agent on behalf of Nicor and its insured directors and officers to be used to satisfy Nicor directors’ and officers’ liabilities and expenses associated with claims asserted against them in securities class actions that were settled in 2004, the related shareholder derivative lawsuits that were settled in 2005 and related matters, with any remaining balance to be paid to Nicor. The escrow was terminated and the $29.0 million, plus earnings of approximately $0.4 million, held by the escrow agent was paid to Nicor in the second quarter of 2005. In the second half of 2005, Nicor received $2.8 million of additional insurance proceeds related to legal defense costs. In connection with the settlement of the derivative lawsuits referred to above, in the first quarter of 2005, Nicor’s excess insurance carrier paid Nicor $4 million to settle certain claims that Nicor had asserted and Nicor paid $3.5 million of that amount to plaintiffs’ attorneys to reimburse them for the fees and costs expended in pursuing the derivative actions. In the third quarter of 2006, Nicor received a payment of $5.2 million from its excess insurance carrier as reimbursement of legal defense costs in connection with these matters. This payment has been recorded in “Other corporate eliminations and expenses” in the Condensed Consolidated Statement of Operations for the quarter ended September 30, 2006.

In addition to the matters set forth above, the company is involved in legal or administrative proceedings before various courts and agencies with respect to general claims, rates, taxes, environmental, gas cost prudence reviews and other matters. Although unable to determine the ultimate outcome of these other contingencies, management believes that these amounts are appropriately reflected in the financial statements, including the recording of appropriate liabilities when reasonably estimable.





 

21


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Management’s Discussion and Analysis section of the Nicor Inc. (“Nicor”) 2005 Annual Report on Form 10-K. Results for the interim periods presented are not necessarily indicative of the results to be expected for the full fiscal year due to seasonal and other factors.

SUMMARY

Nicor is a holding company with two principal business segments - gas distribution and shipping. Northern Illinois Gas Company (doing business as Nicor Gas Company (“Nicor Gas”)) is one of the nation’s largest natural gas distribution companies, and it is Nicor’s primary business. Tropical Shipping is a containerized shipping business serving the Bahamas and the Caribbean region. Nicor also owns or has equity interests in several energy-related businesses.

Net income and diluted earnings per common share are presented below for the three and nine-month periods ended September 30, 2006 and 2005 (in millions, except per share data):

   
Three months ended
 
Nine months ended
 
   
September 30
 
September 30
 
   
2006
 
 2005
 
2006
 
 2005
 
                           
Net income (loss)
 
$
17.6
 
$
(2.7
)
$
70.0
 
$
74.4
 
                           
Diluted earnings (loss) per common share
 
$
.39
 
$
(.06
)
$
1.57
 
$
1.67
 

Included in year-to-date 2006 results is a second quarter $10 million charge ($.22 per share and non-deductible for tax purposes) associated with the company’s outstanding United States Securities and Exchange Commission (“SEC”) inquiry and a first quarter pretax recovery of $3.8 million ($.05 per share) associated with Nicor Gas’ mercury inspection and repair program. Included in year-to-date 2005 results is a pretax benefit of $29.9 million ($.41 per share) related to net insurance recoveries.

Quarter over quarter comparisons reflect improved operating results across all business segments. Year-to-date comparisons (before consideration of the items noted above) reflect higher gas distribution, other energy ventures and corporate operating results, and the recognition of certain income tax benefits including those resulting from the reorganization of certain shipping and related operations, offset, in part, by lower operating results in the shipping segment.

Operating income by segment. Operating income (loss) by major business segment is presented below (in millions):

   
Three months ended
 
Nine months ended
 
   
September 30
 
September 30
 
   
2006
 
2005
 
2006
 
2005
 
                           
Gas distribution
 
$
5.6
 
$
.4
 
$
80.2
 
$
71.9
 
Shipping
   
10.5
   
9.4
   
29.5
   
31.9
 
Other energy ventures
   
6.9
   
(11.7
)
 
.7
   
(8.6
)
Corporate and eliminations
   
5.5
   
2.5
   
1.1
   
33.2
 
   
$
28.5
 
$
.6
 
$
111.5
 
$
128.4
 



22



The following summarizes operating income (loss) comparisons by major business segment:

·  
Gas distribution operating income increased $5.2 million and $8.3 million for the three and nine months ended September 30, 2006, respectively, compared with the year-earlier periods due primarily to the positive effects of higher gas distribution margin ($11.4 million and $26.7 million increases, respectively), partially offset by higher operating and maintenance expenses ($5.6 million and $21.5 million increases, respectively). The year-to-date 2006 results were also favorably impacted by a first quarter mercury-related recovery of $3.8 million.

·  
Shipping operating income increased $1.1 million to $10.5 million in the third quarter of 2006, compared to $9.4 million for the year-earlier period as higher operating revenues ($6.4 million increase) were partially offset by higher operating costs ($5.3 million increase). Higher operating revenues were attributable to higher average rates ($10.0 million increase), partially offset by lower volumes shipped ($3.0 million decrease). Higher operating costs were due to higher fuel ($1.9 million increase), employee-related costs ($1.2 million increase), repairs and maintenance ($1.1 million increase) and leased freight equipment ($1.0 million increase).

For the nine-month period ended September 30, 2006, shipping operating income decreased $2.4 million compared to the year-earlier period as higher operating revenues ($13.4 million increase) were more than offset by higher operating costs ($15.8 million increase). Higher operating revenues were attributable to higher average rates ($35.0 million increase), partially offset by lower volumes shipped ($21.0 million decrease). Higher operating costs were due to higher fuel ($6.3 million increase), employee-related costs ($4.1 million increase), repairs and maintenance ($2.4 million increase) and leased freight equipment ($2.0 million increase).

·  
Operating income from Nicor’s other energy ventures increased $18.6 million in the third quarter of 2006 compared to the prior-year period due to reductions in the reported operating loss at Nicor’s wholesale natural gas marketing business, Nicor Enerchange ($12.5 million reduction), and improved operating results at Nicor’s energy-related products and services businesses ($6.2 million increase). Nicor Enerchange’s favorable third quarter operating results as compared with the prior year are due primarily to a significant reduction in 2006 versus 2005 in net unfavorable adjustments related to derivative instruments and inventory carrying values. Nicor Enerchange uses derivative instruments to economically hedge future purchases and sales of natural gas inventory. Nicor Enerchange purchases and holds natural gas in storage to earn a profit margin from its ultimate sale. Nicor Enerchange uses derivatives to mitigate commodity price risk in order to substantially lock-in the profit margin that will ultimately be realized. However, gas stored in inventory is required to be accounted for at the lower of weighted-average cost or market, whereas the derivatives used to reduce the risk associated with a change in the value of the inventory are accounted for at fair value, with changes in fair value recorded in operating results in the period of change. As a result, earnings are subject to volatility as the market price of derivatives change, even when the underlying hedged value of the inventory is unchanged. The volatility resulting from this accounting can be significant from period to period. Improved operating results at Nicor’s energy-related products and services businesses were due primarily to the recognition of a significant portion of previously deferred revenues associated with its utility-bill management contracts. Revenue is recognized on such contracts as the lesser of cumulative earned or cumulative billed amounts, while expenses are recorded as incurred.




23



For the nine months ended September 30, 2006, operating income increased $9.3 million due primarily to reductions in the reported operating loss at Nicor Enerchange ($12.5 million reduction), offset by lower operating results at Nicor’s energy-related products and services businesses ($3.1 million decrease). Improved operating results at Nicor Enerchange were due primarily to the net adjustments to derivative instruments and inventory carrying values discussed previously in the quarter over quarter comparison. Lower operating results at Nicor’s energy-related products and services businesses were due to higher operating costs ($34.7 million increase) offset, in part, by higher revenues ($31.6 million increase).

·  
“Corporate and Eliminations” operating income for the quarter ended September 30 for both years reflects the positive impact of insurance recoveries related to previously incurred legal expenses associated with the securities class action and shareholder derivative lawsuits. The recoveries totaled $5.2 million and $2.6 million for the three months ended September 30, 2006 and 2005, respectively.

“Corporate and eliminations” operating income for both year-to-date periods were impacted by noteworthy items. In July 2006, the company reached a tentative agreement with the staff of the SEC Enforcement Division in settlement of an anticipated civil action for a payment of $10 million. For more information, see Item 1 - Notes to the Condensed Consolidated Financial Statements - Note 17 - Contingencies - SEC and U.S. Attorney Inquiries. In the second quarter of 2006, Nicor recorded a $10 million charge (non-deductible for tax purposes) associated with the outstanding SEC inquiry. In 2005, the company recorded a $29.4 million pretax recovery from an insurance carrier related to costs previously incurred by Nicor in connection with a securities class action and a related shareholder derivative action which were previously settled and a $0.5 million pretax net recovery which was comprised of a shareholder derivative action settlement ($3.5 million) and a related Directors and Officers insurance recovery ($4.0 million). For more information, see Item 1 - Notes to the Condensed Consolidated Financial Statements - Note 17 - Contingencies - Other.
 
Financial results within “Corporate and eliminations” for the year-to-date periods ended September 30, 2006 and 2005 also include approximately $6.3 million and $1.7 million, respectively, of benefits associated with Nicor’s other energy ventures’ utility-bill management contracts attributable to warmer than normal weather. Benefits or costs resulting from variances from normal weather are recorded at the corporate level as a result of an agreement between the parent company and certain of its subsidiaries. The weather impact of these contracts generally serves to partially offset the gas distribution segment’s weather risk. The amount of the offset attributable to the utility-bill management contracts marketed by Nicor’s other energy ventures will vary depending upon a number of factors including the time of year, weather patterns, the number of customers for these products and the market price for natural gas.

Rate proceeding. Nicor Gas filed a request with the Illinois Commerce Commission (“ICC”) for an overall increase in base rates on November 4, 2004. In late 2005, Nicor Gas received approval from the ICC for a $54.2 million base rate increase which reflected an allowed rate of return on original-cost rate base of 8.85 percent, including a 10.51 percent cost of common equity. The order also included the authorization to pass all Chicago Hub revenues directly through to customers as a credit to Nicor Gas’ Purchased Gas Adjustment (“PGA”) rider and the shifting of certain storage-related costs from the PGA rider to base rates. In addition, rates were established using a 10-year average for weather as opposed to the previous use of a 30-year average. These rates were implemented in the fourth quarter of 2005. Because the order shifts certain items between base rates and Nicor Gas’ PGA rider, the company estimated that, under normal weather conditions and demand as reflected in the rate case, the annual net revenue increase resulting from implementing the rate order would have been about $34.7 million under the tariffs that were placed into effect.
24
 
In October 2005, Nicor Gas and six other parties filed applications for rehearing of the final order of the rate case.  The ICC granted rehearing on seven issues, only two of which relate to the amount of the approved annual net revenue increase, and denied rehearing on all other issues raised in the applications. In March 2006, the ICC issued its decision on rehearing in which it adjusted the amount of the annual net rate increase to $49.7 million from the $54.2 million that had been approved in the earlier order. The company estimates that because the revised order similarly shifts certain items between base rates and Nicor Gas’ PGA rider, under normal weather conditions and demand as reflected in the rate case, the annual net revenue increase will decrease to $30.2 million from the estimated $34.7 million under the previous order. Rate changes resulting from the rehearing order are prospective and went into effect on April 11, 2006. Parties, including Nicor Gas, that appealed the ICC’s rate case decision to the state appellate courts have since withdrawn their appeals. As a result, the ICC rate order is no longer subject to judicial review.

As a result of the rate order which became effective in the fourth quarter of 2005, certain storage-related costs are now recorded in operating and maintenance expense. For the three and nine months ended September 30, 2006, storage-related gas costs in operating and maintenance expense totaled $1.0 million and $15.4 million, respectively. Such costs totaled zero and $11.1 million, respectively, for the corresponding prior-year periods and since they were incurred prior to the effective date of the rate order were recorded as cost of gas.

RESULTS OF OPERATIONS

Details of various financial and operating information by segment can be found in the tables throughout this review. The following discussion summarizes the major items impacting Nicor’s operating income.

Operating revenues. Operating revenues by major business segment are presented below (in millions):

   
Three months ended
 
Nine months ended
 
   
September 30
 
September 30
 
   
2006
 
2005
 
2006
 
2005
 
                           
Gas distribution
 
$
226.7
 
$
241.5
 
$
1,775.6
 
$
1,692.6
 
Shipping
   
98.3
   
91.9
   
288.1
   
274.7
 
Other energy ventures
   
34.0
   
9.2
   
135.1
   
89.7
 
Corporate and eliminations
   
(7.9
)
 
(6.6
)
 
(77.0
)
 
(56.8
)
   
$
351.1
 
$
336.0
 
$
2,121.8
 
$
2,000.2
 

Gas distribution revenues are impacted by changes in natural gas costs, which are passed directly through to customers without markup, subject to ICC review. For the third quarter of 2006 compared with a year ago, gas distribution revenues decreased $14.8 million due to lower natural gas costs (approximately $50 million decrease), partially offset by the impact of colder weather than in 2005 (approximately $13 million increase) and the base rate increase (approximately $11 million). For the 2006 year-to-date period compared with a year ago, gas distribution revenues increased $83.0 million due to higher natural gas costs (approximately $175 million increase) and the impact of the base rate increase (approximately $36 million), partially offset by the negative impact of warmer weather than the corresponding period in 2005 (approximately $126 million decrease) and lower demand unrelated to weather (approximately $21 million decrease).

Third quarter and year-to-date 2006 shipping segment operating revenues increased $6.4 million and $13.4 million, respectively, compared with the prior-year periods due to higher average rates ($10.0 million and $35.0 million increases, respectively), partially offset by lower volumes shipped ($3.0 million and $21.0 million decreases, respectively). Rates were higher due to general rate increases across all markets and higher cost-recovery surcharges for fuel and security.

25
 
Third quarter 2006 revenues for Nicor’s other energy ventures increased $24.8 million due to higher revenues at Nicor Enerchange ($12.7 million increase) and at Nicor’s energy-related products and services businesses ($12.2 million increase). Nicor Enerchange revenues increased due primarily to the net adjustments to derivative instruments and inventory carrying values discussed previously under the “Operating income by segment” section. Higher revenues at Nicor’s energy-related products and services businesses are attributable to the recognition of previously deferred revenues associated with its utility-bill management contracts ($7.2 million increase) and an increase in contract volumes ($3.0 million increase). Year-to-date 2006 revenues increased $45.4 million due primarily to higher revenues at Nicor’s energy-related products and services businesses ($31.6 million increase) and higher revenues at Nicor Enerchange ($13.9 million increase). Higher revenues at Nicor’s energy-related products and services businesses were attributable to higher average gas costs ($15.3 million increase) and an increase in customer contracts ($10.7 million increase). Higher revenues at Nicor Enerchange ($13.9 million increase) reflect the net adjustments discussed in the quarter over quarter comparison.

Corporate and eliminations reflects primarily the elimination of gas distribution revenues against Nicor’s other energy ventures’ expenses for customers purchasing the utility-bill management products.

Gas distribution margin. Nicor utilizes a measure it refers to as “gas distribution margin” to evaluate the operating income impact of gas distribution revenues. Gas distribution revenues include natural gas costs, which are passed directly through to customers without markup, subject to ICC review, and revenue taxes, for which Nicor Gas earns a small administrative fee. These items often cause significant fluctuations in gas distribution revenues, and yet they have virtually no direct impact on gas distribution operating income.

A reconciliation of gas distribution revenues and margin follows (in millions):

   
Three months ended
 
Nine months ended
 
   
September 30
 
September 30
 
   
2006
 
2005
 
2006
 
2005
 
                           
Gas distribution revenues
 
$
226.7
 
$
241.5
 
$
1,775.6
 
$
1,692.6
 
Cost of gas
   
(108.0
)
 
(134.9
)
 
(1,258.8
)
 
(1,202.3
)
Revenue tax expense
   
(12.6
)
 
(11.9
)
 
(109.0
)
 
(109.2
)
Gas distribution margin
 
$
106.1
 
$
94.7
 
$
407.8
 
$
381.1
 

Gas distribution margin increased $11.4 million in the third quarter of 2006 compared with the corresponding prior-year period due primarily to the impact of the base rate increase (approximately $11 million assuming normal weather). Year-to-date 2006 gas distribution margin increased $26.7 million compared with the corresponding prior-year period due primarily to the impact of the base rate increase (approximately $36 million), partially offset by the negative impact of warmer weather than in 2005 (approximately $8 million decrease) and lower demand unrelated to weather (approximately $3 million decrease).

Gas distribution operating and maintenance expense. Gas distribution operating and maintenance expense increased $5.6 million to $56.6 million in the third quarter of 2006 from $51.0 million in the prior-year period due to higher company use gas ($4.1 million increase) and higher bad debt expense ($1.3 million increase). Year-to-date operating and maintenance expense increased $21.5 million to $199.9 million from $178.4 million in the prior-year period due primarily to higher storage-related gas costs ($15.4 million increase), company use gas ($11.0 million increase) and bad debt expense ($3.3 million increase), partially offset by lower payroll and benefit-related costs ($3.6 million decrease) and claims arising from normal operations ($4.2 million decrease).


26



Transfer, in the 2005 rate order, of recovery of certain storage-related gas costs from the PGA rider to base rates results in those costs being charged to operating and maintenance expense. Prior to the effective date of the rate order, these storage-related gas costs, which were zero and $11.1 million in the three and nine-month periods ended September 30, 2005, respectively, were charged to cost of gas and passed through to customers as part of the PGA rider.

Other gas distribution operating expenses. Mercury-related costs (recoveries), net reflect estimated costs, credits and recoveries associated with the company’s mercury inspection and repair program. During the first quarter of 2006, a mercury-related recovery of $3.8 million was realized. This net recovery resulted from a settlement reached with an independent contractor of Nicor Gas. Additional information about the company’s mercury inspection and repair program is presented in Item 1 - Notes to the Condensed Consolidated Financial Statements - Note 17 - Contingencies - Mercury.

Property sale gains and losses vary from year-to-year depending upon property sales activity. Nicor Gas realized a $0.6 million and $3.2 million pretax gain on the sale of property for the three and nine months ended September 30, 2006, respectively. The company continues to assess its ownership of certain real estate holdings.

Shipping operating expenses. Third quarter and year-to-date 2006 shipping segment operating expenses increased $5.3 million and $15.8 million, respectively, compared with the corresponding prior-year periods. Higher operating costs were attributable, in part, to higher fuel ($1.9 million and $6.3 million increases, respectively), employee-related costs ($1.2 million and $4.1 million increases, respectively), repairs and maintenance ($1.1 million and $2.4 million increases, respectively) and leased freight equipment ($1.0 million and $2.0 million increases, respectively).

Other energy ventures operating expenses. Third quarter and year-to-date 2006 other energy ventures operating expenses increased $6.2 million and $36.1 million, respectively, compared with the corresponding prior-year periods. These increases were due primarily to higher expenses at Nicor’s energy-related products and services businesses ($5.9 million and $34.7 million increases, respectively) reflecting a higher average cost of gas for the year-to-date period ($12.9 million increase), costs related to an increase in customer contracts ($1.9 million and $6.8 million increases, respectively), higher selling, general and administrative costs attributable to acquiring new customer contracts ($2.7 million and $6.2 million increases, respectively), and higher bad debt expense ($1.4 million and $2.4 million increases, respectively).

Litigation charges (recoveries), net. In the second quarter of 2006, Nicor recorded a $10 million charge (non-deductible for tax purposes) associated with the outstanding SEC inquiry. In July 2006, the company reached a tentative agreement with the staff of the SEC Enforcement Division in settlement of an anticipated civil action for a payment of $10 million. For more information, see Item 1 - Notes to the Condensed Consolidated Financial Statements - Note 17 - Contingencies - SEC and U.S. Attorney Inquiries.

In 2005, the company recorded a $29.4 million pretax recovery from an insurance carrier related to costs previously incurred by Nicor in connection with a securities class action and a related shareholder derivative action which were previously settled and a $0.5 million pretax net recovery which was comprised of a shareholder derivative action settlement ($3.5 million) and a related Directors and Officers insurance recovery ($4.0 million). For more information, see Item 1 - Notes to the Condensed Consolidated Financial Statements - Note 17 - Contingencies - Other.




27



Interest expense. Interest expense of $11.1 million in the third quarter of 2006 increased $0.5 million from the corresponding 2005 period due to higher estimated interest on income tax matters ($0.9 million increase). Interest expense of $35.5 million for the nine-month period ended September 30, 2006 increased $2.7 million over the corresponding prior-year period due to higher average borrowing levels ($2.2 million increase) and higher average interest rates ($0.6 million increase).

Higher average borrowings were attributable, in part, to a $40 million two-year senior unsecured term loan obtained in December 2005 and used to fund a portion of the repatriation of cumulative undistributed foreign earnings of Tropical Shipping in connection with the American Jobs Creation Act (the “Jobs Act”). As of September 30, 2006, $12 million of this term loan remained outstanding.

Equity investment income, net. Equity investment income increased for the three and nine-month period ended September 30, 2006 over the corresponding prior-year periods due primarily to the $2.4 million gain on a sale of an equity investment recognized in the third quarter of 2006.

Interest income. Interest income increased $0.9 million and $3.6 million for the three and nine-month periods ended September 30, 2006, respectively, over the corresponding prior-year periods due primarily to higher investment balances and higher average rates.

Income taxes. In December 2005, the company repatriated $132 million under the Jobs Act. Effective January 2006, the company reorganized certain of its shipping and related operations. The reorganization allows the company to take advantage of certain provisions of the Jobs Act that provide the opportunity for tax savings subsequent to the date of the reorganization. Generally, to the extent foreign shipping earnings are not repatriated to the United States, such earnings are not expected to be subject to current taxation. In addition, to the extent such earnings are expected to be indefinitely reinvested offshore, no deferred income tax expense would be recorded by the company. For the three and nine-month periods ended September 30, 2006, income tax expense has not been provided on approximately $6 million and $17 million, respectively, of foreign company shipping earnings that are expected to be indefinitely reinvested offshore. In connection with these activities, a net income tax benefit of approximately $6 million was recorded in the first quarter of 2006 from the elimination of certain deferred taxes. The company expects to incur approximately $5 million in current tax expense associated with these activities, of which approximately $3 million has been recognized in the first nine months of 2006.

The company’s effective income tax rate for the remainder of 2006 is estimated to be approximately 29 percent resulting from the ongoing benefit of untaxed foreign shipping earnings, recognition of certain tax credits and the amortization of excess deferred taxes. During the first nine months of 2006, the effective income tax rate was 25.1 percent. The lower rate for the first nine months reflects the recognition of additional tax benefits related to the first quarter 2006 reorganization of the company’s shipping and related operations and second quarter 2006 favorable adjustments associated with tax audits (which occur in the ordinary course of business) offset, in part, in the second quarter of 2006 by the non-deductible $10 million charge associated with the company’s outstanding SEC inquiry. For the first nine months of 2005, the effective income tax rate was 30.6 percent which reflected the effects of recording 2005 net litigation recoveries and earnings thereon ($29.9 million) at the company’s marginal tax rate of approximately 40 percent as well as miscellaneous third quarter tax benefits ($1.5 million). The effective income tax rate for the quarters ended September 30, 2006 and 2005 was 30.3 percent and 51.3 percent, respectively. For the quarter ended September 30, 2005, in addition to the impact of miscellaneous tax benefits ($1.5 million), the quarter’s effective income tax rate increased due to changes in forecasted annual income. Such change was not significant for the year-to-date period, but did have a disproportionate impact on the third quarter effective income tax rate as the income before income taxes was relatively low.


28
 


Nicor Inc.
                 
Gas Distribution Statistics
                 
                   
                   
   
Three months ended
 
Nine months ended
 
   
September 30
 
September 30
 
   
2006
 
2005
 
2006
 
2005
 
Operating revenues (millions)
                         
Sales
                         
Residential
 
$
136.8
 
$
152.4
 
$
1,207.5
 
$
1,140.7
 
Commercial
   
29.8
   
36.0
   
275.2
   
255.0
 
Industrial
   
2.7
   
4.3
   
31.9
   
34.9
 
     
169.3
   
192.7
   
1,514.6
   
1,430.6
 
Transportation
                         
Residential
   
6.1
   
4.8
   
21.9
   
19.1
 
Commercial
   
14.7
   
11.5
   
57.7
   
51.0
 
Industrial
   
10.7
   
10.4
   
29.1
   
29.4
 
Other
   
1.1
   
1.0
   
2.0
   
8.6
 
     
32.6
   
27.7