NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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(1)
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Nature of Operations and Basis of Presentation
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Delta Natural Gas Company, Inc. ("Delta" or "the Company") distributes or transports natural gas to approximately
36,000
customers. Our distribution and transmission systems are located in central and southeastern Kentucky, and we own and operate an underground storage field in southeastern Kentucky. We transport natural gas to our industrial customers who purchase their natural gas in the open market. We also transport natural gas on behalf of local producers and customers not on our distribution system and sell liquids extracted from natural gas in our storage field and on our pipeline systems. We have
three
wholly-owned subsidiaries. Delta Resources, Inc. ("Delta Resources") buys natural gas and resells it to industrial or other large use customers on Delta's system. Delgasco, Inc. ("Delgasco") buys natural gas and resells it to Delta Resources and to customers not on Delta's system. Enpro, Inc. ("Enpro") owns and operates production properties and undeveloped acreage.
All subsidiaries of Delta are included in the condensed consolidated financial statements. Intercompany balances and transactions have been eliminated. All adjustments necessary for a fair presentation of the unaudited results of operations for the three months and six months ended
December 31, 2013
and
2012
are included. All such adjustments are accruals of a normal and recurring nature, other than the December, 2012 reversal of interest previously accrued on a tax assessment, as disclosed in Note 13 of the Notes to Consolidated Financial Statements in our 2013 Annual Report on Form 10-K.
The results of operations for the period ended
December 31, 2013
are not necessarily indicative of the results of operations to be expected for the full fiscal year. Because of the seasonal nature of our sales, we generate the smallest proportion of cash from operations during the warmer months, when sales volumes decrease considerably. Most construction activity and gas storage injections take place during these warmer months.
The accompanying condensed consolidated financial statements are unaudited and should be read in conjunction with the financial statements, and the notes thereto, included in our Annual Report on Form 10-K for the year ended
June 30, 2013
.
(2) New Accounting Pronouncements
In December, 2011, the Financial Accounting Standards Board issued guidance requiring additional disclosure of the effect or potential effect of financial instruments and derivative instruments which have rights of setoff where an entity offsets the assets and liability of such instruments. The guidance, effective for our quarter ending
December 31, 2013
, did not require any additional disclosures with respect to our results of operations, financial position or cash flows, as we have no such financial instruments or derivative instruments.
In September, 2013, the IRS issued final regulations regarding the tax treatment of amounts paid to acquire, produce or improve tangible property, which update temporary regulations issued by the IRS in December, 2011. In 2014, the IRS plans to issue further guidance for specific industry sectors, including natural gas. The final regulations are effective for our tax year beginning July 1, 2014; however, we do not expect the final regulations to have a material impact on our results of operations, financial positions or cash flows.
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(3)
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Fair Value Measurements
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Our financial assets and liabilities measured at fair value on a recurring basis consist of the assets of our supplemental retirement benefit trust, which are included in other non-current assets on the Condensed Consolidated Balance Sheets. Contributions to the trust are presented in other investing activities on the Condensed Consolidated Statements of Cash Flows. The assets of the trust are recorded at fair value and consist of exchange traded securities and mutual funds. The securities and mutual funds are recorded at fair value using observable market prices from active markets, which are categorized as Level 1 in the fair value hierarchy. In fiscal 2014, upon changing investment advisors for the supplemental retirement benefit trust, we adopted a new asset allocation model which resulted in the reallocation of assets in the trust. The fair value of the trust assets are as follows:
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December 31,
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June 30,
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($000)
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2013
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2013
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Trust assets
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Money market
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115
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9
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U.S. equity securities
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309
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486
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Foreign equity securities
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135
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—
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U.S. fixed income securities
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115
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244
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Foreign fixed income securities
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35
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—
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Domestic real estate securities
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41
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—
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Inflation indexed securities
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114
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—
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864
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739
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The carrying amounts of our other financial instruments including cash equivalents, accounts receivable, notes receivable and accounts payable approximate their fair value.
Our Series A Notes, presented as current portion of long-term debt and long-term debt on the Condensed Consolidated Balance Sheets, are stated at historical cost. The fair value of our long-term debt is based on the expected future cash flows of the debt discounted using a credit adjusted risk-free rate. The credit adjusted risk-free rate for our 4.26% Series A Notes is the estimated cost to borrow a debt instrument with the same terms from a private lender at the measurement date. The fair value of our long-term debt is categorized as Level 2 in the fair value hierarchy.
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December 31,
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June 30,
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2013
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2013
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Carrying
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Fair
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Carrying
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Fair
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($000)
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Amount
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Value
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Amount
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Value
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4.26% Series A Notes
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55,000
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52,908
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56,500
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55,150
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(4)
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Risk Management and Derivative Instruments
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To varying degrees, our regulated and non-regulated segments are exposed to commodity price risk. We purchase our natural gas supply primarily through forward purchase contracts. We mitigate price risk by efforts to balance supply and demand. For our regulated segment, we have minimal price risk resulting from these forward natural gas purchases because we are permitted to pass these gas costs on to our regulated customers through the gas cost recovery rate mechanism, approved quarterly by the Kentucky Public Service Commission.
None
of our gas contracts are accounted for using the fair value method of accounting. While some of our natural gas purchase contracts and natural gas sales contracts meet the definition of a derivative, we have designated these contracts as normal purchases and normal sales.
We bill our customers on a monthly meter reading cycle. At the end of each month, gas service which has been rendered from the date the customer's meter was last read to the month-end is unbilled.
Unbilled revenues and gas costs include the following:
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December 31,
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June 30,
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(000)
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2013
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2013
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Unbilled revenues ($)
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7,105
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1,435
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Unbilled gas costs ($)
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3,976
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390
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Unbilled volumes (Mcf)
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524
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47
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Unbilled revenues are included in accounts receivable and unbilled gas costs are included in deferred gas costs on the accompanying Condensed Consolidated Balance Sheets. Unbilled revenues are included in regulated revenues and unbilled gas costs are included in regulated purchased gas on the accompanying Condensed Consolidated Statements of Income.
(6) Defined Benefit Retirement Plan
Net periodic benefit costs for our trusteed, noncontributory defined benefit retirement plan for the periods ended
December 31,
2013 and 2012, include the following:
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Three Months Ended
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Six Months Ended
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December 31,
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December 31,
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($000)
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2013
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2012
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2013
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2012
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Service cost
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256
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279
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512
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558
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Interest cost
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259
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228
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519
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456
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Expected return on plan assets
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(392
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(394
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(784
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(789
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Amortization of unrecognized net loss
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86
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154
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171
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308
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Amortization of prior service cost
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(22
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(22
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(43
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(43
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Net periodic benefit cost
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187
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245
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375
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490
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Notes Payable
The current bank line of credit with Branch Banking and Trust Company permits borrowings up to
$40,000,000
, all of which was available as of
December 31, 2013
and
June 30, 2013
. The bank line of credit extends through
June 30, 2015
. The interest rate on the used line of credit is the
London Interbank Offered Rate
plus
1.15%
. The annual cost of the unused bank line of credit is
.125%
. We were in compliance with the covenants of our bank line of credit during all periods presented in the condensed consolidated financial statements.
Long-Term Debt
Our Series A Notes are unsecured, bear interest at a rate of 4.26% per annum, which is payable quarterly, and mature on December 20, 2031. We are required to make an annual $1,500,000 principal payment on the Series A Notes each December. The following table summarizes the remaining contractual maturities of our Series A Notes by fiscal year:
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($000)
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2014
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—
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2015
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1,500
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2016
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1,500
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2017
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1,500
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2018
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1,500
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Thereafter
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49,000
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Total long-term debt
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55,000
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Any additional prepayment of principal by the Company is subject to a prepayment premium which varies depending on the yields of United States Treasury securities with a maturity equal to the remaining average life of the Series A Notes.
We were in compliance with the covenants of our 4.26% Series A Notes for all periods presented in the condensed consolidated financial statements.
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(8)
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Commitments and Contingencies
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We have entered into an employment agreement with our Chairman of the Board, President and Chief Executive Officer and change in control agreements with our other
four
officers. The agreements expire or may be terminated at various times. The agreements provide for continuing monthly payments or lump sum payments and the continuation of specified benefits over varying periods in certain cases following defined changes in ownership of the Company. In the event all of these agreements were exercised in the form of lump sum payments, approximately
$4.2 million
would be paid in addition to continuation of specified benefits for up to five years. Additionally, upon a change in control, all unvested shares awarded under our Incentive Compensation Plan, as further discussed in Note 12 of the Notes to Condensed Consolidated Financial Statements, would immediately vest.
We have entered into forward purchase agreements for natural gas purchases beginning in
January, 2014
and expiring at various dates through
December, 2014
. These agreements require us to purchase minimum amounts of natural gas throughout the term of the agreements. These agreements are established in the normal course of business to ensure adequate gas supply to meet our customers' gas requirements. These agreements have aggregate minimum purchase obligations of
$200,000
and
$140,000
for our fiscal years ended
June 30, 2014
and
June 30, 2015
, respectively.
We are not a party to any material pending legal proceedings.
The Kentucky Public Service Commission exercises regulatory authority over our retail natural gas distribution and transportation services. Their regulation of our business includes approving the rates we are permitted to charge our regulated customers. We monitor our need to file requests with them for a general rate increase for our natural gas and transportation services. They have historically utilized cost-of-service ratemaking where our base rates are established to recover normal operating expenses, exclusive of gas costs, and a reasonable rate of return. We do not have any matters pending before the Kentucky Public Service Commission which would have a material impact on our results of operations, financial positions or cash flows.
Our Company has two reportable segments: (i) a regulated segment that distributes and transports natural gas and (ii) a non-regulated segment that participates in related ventures, consisting of natural gas marketing, natural gas production and sales of natural gas liquids. Virtually all of the revenues recorded under both segments come from the sale or transportation of natural gas, or sales of related natural gas liquids. The regulated segment serves residential, commercial and industrial customers in the single geographic area of central and southeastern Kentucky. Price risk for the regulated segment is mitigated through our gas cost recovery clause, approved quarterly by the Kentucky Public Service Commission. Price risk for the non-regulated segment is mitigated by efforts to balance supply and demand. However, there are greater risks in the non-regulated segment because of the practical limitations on the ability to perfectly predict demand. In addition, we are exposed to price risk resulting from changes in the market price of natural gas, natural gas liquids and uncommitted gas inventory of our non-regulated companies.
The reportable segments follow the same accounting policies as described in the Summary of Significant Accounting Policies in Note 1 of the Notes to Consolidated Financial Statements that are included in our Annual Report on Form 10-K for the year ended
June 30, 2013
. Intersegment transportation revenues and expenses represent the natural gas transportation costs from the regulated segment to the non-regulated segment at our tariff rates. Operating expenses, taxes and interest are allocated to the non-regulated segment.
Segment information is shown in the following table:
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Three Months Ended
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Six Months Ended
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December 31,
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December 31,
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($000)
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2013
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2012
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2013
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2012
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Operating Revenues
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Regulated
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External customers
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16,512
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13,299
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22,407
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19,040
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Intersegment
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1,113
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1,082
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1,938
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1,876
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Total regulated
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17,625
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14,381
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24,345
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20,916
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Non-regulated
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External customers
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9,299
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8,808
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16,445
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14,519
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Eliminations for intersegment
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(1,113
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(1,082
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(1,938
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(1,876
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Consolidated operating revenues
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25,811
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22,107
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38,852
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33,559
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Net Income
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Regulated
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2,486
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2,311
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2,197
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2,065
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Non-regulated
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649
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938
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1,017
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1,025
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Consolidated net income
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3,135
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3,249
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3,214
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3,090
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(11)
Earnings
per Common Share
The following table sets forth the computation of basic and diluted earnings per share:
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Three Months Ended
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Six months ended
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December 31,
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December 31,
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2013
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2012
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2013
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2012
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Numerator - Basic and Diluted ($000)
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Net income
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3,135
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3,249
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3,214
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3,090
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Dividends paid
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(1,322
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(1,237
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(2,642
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(2,473
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Undistributed earnings
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1,813
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2,012
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572
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617
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Percentage allocated to common shares (a)
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99.5
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%
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99.6
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%
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99.5
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%
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99.6
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%
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Allocated to common shares:
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Undistributed earnings
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1,804
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2,004
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569
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615
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Dividends paid
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1,315
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1,232
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2,629
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2,463
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Net earnings available to common shares
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3,119
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3,236
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3,198
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3,078
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Denominator - Basic and Diluted
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Weighted average common shares (b)
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6,923,073
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6,845,078
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6,905,036
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6,832,344
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Net earnings per common share ($)
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Basic
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.45
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.47
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.46
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.45
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Diluted
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.45
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|
.47
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.46
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|
.45
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(a) Percentage allocated to common shares - weighted average
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Common shares outstanding
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6,923,073
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6,845,078
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6,905,036
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6,832,344
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Unvested participating shares (c)
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35,000
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28,667
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35,000
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28,667
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Total
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6,958,073
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6,873,745
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6,940,036
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6,861,011
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Percentage allocated to common shares
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99.5
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%
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99.6
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%
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99.5
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%
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99.6
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%
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(b) Under our incentive compensation plan, recipients of performance share awards received unvested non-participating shares, as further discussed in Note 12 of the Notes to Condensed Consolidated Financial Statements. Unvested non-participating shares become dilutive in the interim quarter-end in which the performance objective is met. If the performance objective continues to be met through the end of the performance period, these shares become unvested participating shares as of the fiscal year-end. The weighted average number of unvested non-participating shares outstanding during a period is included in the diluted earnings per common share calculation using the treasury method, unless the effect of including such shares would be antidilutive. As of both
December 31, 2013
and
2012
, there were
39,000
unvested non-participating shares outstanding which are not dilutive as the underlying performance condition had not yet been met. Therefore, for the periods presented, the diluted weighted average shares outstanding are the same as the basic weighted average shares outstanding.
(c) Additionally, certain unvested awards provide recipients of the awards all the rights of a shareholder of Delta including a right to dividends declared on common shares. Any unvested shares which are participating in dividends are considered participating securities and are included in our computation of basic and diluted earnings per share using the two-class method unless the effect of including such shares would be antidilutive. As of
December 31, 2013
and
2012
, there were
35,000
and
29,000
unvested participating shares outstanding, respectively.
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(12)
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Share-Based Compensation
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We have a shareholder approved incentive compensation plan (the "Plan"), which provides for compensation payable in shares of our common stock. The Plan is administered by our Corporate Governance and Compensation Committee of our Board of Directors, which has complete discretion in determining our employees, officers and outside directors who shall be eligible to participate in the Plan, as well as the type, amount, terms and conditions of each award, subject to the limitations of the Plan.
The number of shares of our common stock that may be issued pursuant to the Plan may not exceed in the aggregate
1,000,000
shares. As of
December 31, 2013
, approximately
833,000
shares of common stock were available for issuance under the Plan, subject to the limitations imposed by our Corporate Governance Guidelines. Shares of common stock may be available from authorized but unissued shares, shares reacquired by us or shares that we purchase in the open market.
Compensation expense for share-based compensation has been recorded in the non-regulated segment and included in operation and maintenance expense in the Condensed Consolidated Statements of Income based on the fair value of the awards at the grant date and is amortized over the requisite service period. Fair value is the closing price of our common shares at the grant date. The grant date is the date at which our commitment to issue the share-based awards arises, which is generally when the award is approved and the terms of the awards are communicated to the employee or director. We initially recognize expense for our performance shares when it is probable that any stipulated performance criteria will be met. For the three months ended December 31, 2013 and 2012, share-based compensation expense was
$227,000
and
$204,000
, respectively. For the six months ended December 31, 2013 and 2012, share-based compensation was
$713,000
and
$571,000
, respectively.
For the
six months ended December 31, 2013
and
2012
, excess tax benefits of
$30,000
and
$26,000
, respectively, were recognized as an increase to premium on common shares on our Condensed Consolidated Balance Sheets, which decreased our taxes payable as the deduction for income tax purposes exceeds the compensation expense recognized for financial reporting purposes. These excess tax benefits can be utilized to offset tax deficiencies related to share-based compensation in subsequent periods.
Stock Awards
For the
six months ended December 31, 2013
and
2012
, common stock was awarded to virtually all Delta employees and directors having grant date fair values of
$350,000
(
17,000
shares) and
$264,000
(
12,000
shares), respectively. The recipients vested in the awards shortly after the awards were granted, but during the time between the vesting dates and the grant dates the shares awarded were not transferable by the holders. Once the shares were vested, the shares received under the stock awards were immediately transferable.
Performance Shares
For the
six months ended December 31, 2013
and
2012
, performance shares were awarded to the Company's executive officers having grant date fair values of
$801,000
(
39,000
shares) and
$844,000
(
39,000
shares), respectively. The performance share awards vest only if the performance objectives of the awards are met, which are based on the Company's earnings per common share for the fiscal year in which the performance shares are awarded, before any cash bonuses or share-based compensation.
Upon satisfaction of the performance objectives, unvested shares are issued to the recipients and vest equally over a three-year period beginning the August 31 subsequent to achieving the performance objectives as long as the recipients are employees throughout each such service period.
The recipients of the awards also become vested as a result of certain events such as death or disability of the holders. The unvested shares have both dividend participation rights and voting rights during the remaining terms of the awards. Holders of performance shares may not sell, transfer or pledge their shares until the shares vest. As of
December 31,
2013
and
2012
, there were
35,000
and
29,000
unvested performance shares outstanding, respectively, for which the performance objectives have been satisfied.
Our performance shares have graded vesting schedules, and each separate annual vesting tranche is treated as a separate award for expense recognition. Compensation expense is amortized over the vesting period of the individual awards based on the probable outcome of meeting the performance objectives. For the three months ended December 31, 2013 and 2012, compensation expense related to the performance shares was
$227,000
and
$204,000
, respectively. For the six months ended December 31, 2013 and
2012
, compensation expense related to the performance shares was
$363,000
and
$307,000
, respectively.