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 transportation 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 extract liquids from natural gas in our storage field and our pipeline systems that are sold at market prices. 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 natural gas 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 and
six months ended
December 31, 2016
and
2015
are included. All such adjustments are accruals of a normal and recurring nature.
The results of operations for the period ended
December 31, 2016
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 natural 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, 2016
.
(2) Accounting Pronouncements
Recently Issued Pronouncements
In May, 2014, the Financial Accounting Standards Board issued guidance revising the principles and standards for revenue recognition. The guidance creates a framework for recognizing revenue to improve comparability of revenue recognition practices across entities and industries focusing on when a customer obtains control of goods or services, rather than the current risks and rewards model of recognition. The core principle of the new standard is that an entity recognizes revenue when it transfers goods or services to its customers in an amount that reflects the consideration an entity expects to be entitled to for those goods or services. The new disclosure requirements include information intended to communicate the nature, amount, timing and any uncertainty of revenue and cash flows from applicable contracts, including any significant judgments. Entities will generally be required to make more estimates and use more judgment under the new standard. The guidance is effective for our quarter ending September 30, 2018.
As of December 31, 2016, we are evaluating our sources of revenue and are assessing the effect that the new guidance will have on our financial position, results of operations and cash flows. The conclusion of our assessment is contingent, in part, upon the completion of deliberations currently in progress by our industry, notably in connection with efforts to produce an accounting guide intended to be developed by the American Institute of Certified Public Accountants. In association with this undertaking, the American Institute of Certified Public Accountants formed a number of industry task forces, including a Power & Utilities Task Force.
Currently, the industry is working with the Task Force to address several items including 1) the evaluation of collectability from customers if a utility has regulatory mechanisms to help assure recovery of uncollected accounts from ratepayers; 2) the accounting for funds received from third parties to partially or fully reimburse the cost of construction of an asset and 3) the accounting for alternative revenue programs, such as performance-based ratemaking. Existing alternative revenue program guidance, though excluded by the Financial Accounting Standards Board in updating specific
guidance associated with revenue from contracts with customers, was continued without substantial modification. It will require separate presentation of such revenues (subject to the above-noted deliberations) in the statement of comprehensive income, effective at the same time that updated guidance associated with revenue from contracts with customers becomes effective.
Currently, a timeline for the resolution of these deliberations has not been established. Additionally, we are actively working with our peers in the rate-regulated natural gas industry to conclude on the accounting treatment for several other issues that are not expected to be addressed by the Power & Utilities Task Force. Given the uncertainty with respect to the conclusions that might arise from these deliberations, we are currently unable to determine the effect the new guidance will have on our financial position, results of operations, cash flows, business processes or the transition method we will utilize to adopt the new guidance.
In July, 2015, the Financial Accounting Standards Board issued guidance simplifying the measurement of inventory. The guidance requires inventory to be measured at the lower of cost or net realizable value. The guidance, effective for our quarter ending September 30, 2017, is not expected to have a material impact on our results of operations, financial position and cash flows.
In January, 2016, the Financial Accounting Standards Board issued guidance to improve the recognition, measurement, presentation and disclosure of financial instruments. The improvements include guidance on estimating fair value for financial instruments measured at amortized cost on the balance sheet, the classification of financial assets and liabilities on the balance sheet and reduced disclosure for the fair value of financial instruments recognized on the balance sheet at amortized cost. The guidance, effective for our quarter ending September 30, 2018, is not expected to have a material impact on our results of operations, financial position, cash flows and disclosures.
In February, 2016, the Financial Accounting Standards Board issued guidance revising the principles and standards for recognizing leases. The guidance requires a lessee to recognize on the statement of financial position a liability for the lease payments and a right-of-use asset representing the lessee's right to use the underlying asset for the lease term. The recognition and measurement of lease expenses have not significantly changed from previous guidance. The guidance is effective for our quarter ending September 30, 2018 and we are evaluating the impact the guidance is expected to have on our results of operations, financial position and cash flows.
Recently Adopted Pronouncements
In March, 2016, the Financial Accounting Standards Board issued guidance simplifying the accounting and disclosure requirements for share-based compensation, including the income tax consequences, classification of the awards as equity or liability and classification on the statement of cash flows. The guidance is effective for our quarter ending September 30, 2017; however, we have elected early adoption.
The guidance changed the accounting for excess tax benefits and deficiencies, where previously the difference in compensation cost recognized for financial reporting purposes versus the deduction on the corporate tax return was recognized as additional paid-in capital to the extent the cumulative tax benefits exceeded tax deficiencies. Effective July 1, 2016, on a prospective basis, we recognize the effect of vested awards as discrete items in the period in which they occur with excess tax benefits and deficiencies recognized in the Condensed Consolidated Statements of Income as an adjustment to income tax expense. We do not have any previously unrecognized excess tax benefits which require a cumulative effect adjustment upon adoption. The guidance also requires the classification of excess tax benefits and deficiencies as an operating activity on the Condensed Consolidated Statements of Cash Flows, which has been adopted retrospectively and resulted in an immaterial reclassification between financing activities and operating activities on the Condensed Consolidated Statements of Cash Flows.
Entities may elect an accounting policy for forfeitures where they can either continue the current method of recognizing forfeitures based on the number of awards expected to vest or as forfeitures occur. We have elected to recognize forfeitures as they occur. The adoption of this accounting policy did not result in a cumulative effect adjustment.
The threshold increased for an award to qualify for equity classification where shares are redeemed to meet statutory withholding obligations. Shares can now be redeemed up to the maximum statutory tax rates in the applicable jurisdiction, rather than the minimum statutory tax rates. The adoption of this guidance did not result in a change in classification of the award requiring a cumulative effect adjustment.
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(3)
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Fair Value Measurements
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Our financial assets 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 exchange traded 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. 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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2016
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2016
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Trust assets
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Money market
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125
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44
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U.S. equity securities
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449
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435
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Foreign equity funds
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170
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168
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U.S. fixed income funds
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223
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223
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Foreign fixed income funds
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20
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19
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Absolute return strategy mutual funds
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147
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145
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Total trust assets
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1,134
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1,034
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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 long-term debt as well as the current portion of long-term debt on the Condensed Consolidated Balance Sheets, are stated at historical cost, net of unamortized debt issuance costs. 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 3 in the fair value hierarchy.
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December 31,
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June 30,
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2016
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2016
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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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50,426
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51,462
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51,923
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55,324
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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 through a combination of requirements contracts with no minimum purchase obligations, monthly spot purchase contracts and forward purchase contracts. We mitigate price risk related to the sale of natural gas by efforts to balance supply and demand. For our regulated segment, we utilize requirements contracts, spot purchase contracts and our underground storage to meet our regulated customers' natural gas requirements, all of which have minimal price risk because we are permitted to pass these natural gas costs on to our regulated customers through our natural gas cost recovery tariff.
None
of our natural 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 regulated sales of natural gas at tariff rates approved by the Kentucky Public Service Commission. Our customers are billed on a monthly basis; however, the billing cycle for certain classes of customers do not necessarily coincide with the calendar month-end. For these customers, we apply the unbilled method of accounting, where we estimate and accrue revenues applicable to customers but not yet billed. The related natural gas costs are charged to expense. At the end of each month, natural gas service which has been rendered from the date the customer's meter was last read to the month-end is unbilled. Unbilled revenues are included in regulated revenues and unbilled natural gas costs are included in regulated natural gas on the accompanying Condensed Consolidated Statements of Income. Unbilled revenues are included in accounts receivable on the Condensed Consolidated Balance Sheets. As of
December 31, 2016
and June 30, 2016, unbilled natural gas costs are included in deferred natural gas costs on the accompanying Condensed Consolidated Balance Sheets. Unbilled amounts include the following:
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December 31,
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June 30,
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(000)
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2016
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2016
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Unbilled revenues ($)
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5,057
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1,452
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Unbilled natural gas costs ($)
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2,103
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319
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Unbilled volumes (Mcf)
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480
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63
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(6) Defined Benefit Retirement Plan
Net periodic benefit costs for our trusteed, noncontributory defined benefit retirement plan for the periods ended
December 31,
2016 and 2015, 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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2016
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2015
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2016
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2015
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Service cost
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255
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251
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510
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502
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Interest cost
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263
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289
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526
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578
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Expected return on plan assets
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(406
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(409
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(812
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)
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(818
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Amortization of unrecognized net loss
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237
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94
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474
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188
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Amortization of prior service cost
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(21
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(22
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(42
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)
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(44
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)
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Net periodic benefit cost
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328
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203
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656
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406
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In August, 2016 and October, 2016 discretionary contributions of $
1,000,000
and $
500,000
were made, respectively, to the defined benefit retirement plan.
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, 2016
and
June 30, 2016
. The bank line of credit extends through
June 30, 2017
and we anticipate renewal of this line by June 30, 2017. The interest rate on the used bank line of credit is the
London Interbank Offered Rate
plus
1.075%
. The annual cost of the unused bank line of credit is
0.125%
.
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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2017
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—
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2018
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1,500
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2019
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1,500
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2020
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1,500
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2021
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1,500
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Thereafter
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44,500
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Total long-term debt
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50,500
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Any additional payment 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.
With our bank line of credit and Series A Notes, we have agreed to certain financial and other covenants. Noncompliance with these covenants can make the obligations immediately due and payable. We were in compliance with the financial covenants under our bank line of credit and 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
$4.7 million
of wages would be paid in addition to continuation of specified benefits for up to five years. Additionally, the agreements provide for a reimbursement of excise taxes levied on such payments and a gross-up of income taxes attributable to the reimbursement. If all agreements were exercised by the officers, approximately
$15.3 million
would be paid, which includes wages, benefits, unvested shares awarded under our Incentive Compensation Plan and any tax gross-ups.
We are not a party to any material pending legal proceedings.
As of December 31, 2016, we have entered into forward purchase agreements for a portion of our non-regulated segment's natural gas purchases through
December, 2017
. The agreements require us to purchase minimum amounts of natural gas throughout the term of the agreements. The agreements are established in the normal course of business to ensure adequate natural gas supply to meet our non-regulated customers' natural gas requirements. The agreements have aggregate minimum purchase obligations of
$397,000
and
$151,000
for our fiscal years ending
June 30, 2017
and
June 30, 2018
, respectively.
The Kentucky Public Service Commission exercises regulatory authority over our retail natural gas distribution and transportation services, which includes approval of our rates and tariffs. Their regulation of our business includes setting 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 distribution and transportation services. The Kentucky Public Service Commission has historically utilized cost-of-service ratemaking where our base rates are established to recover normal operating expenses, exclusive of natural gas costs, and a reasonable rate of return on our rate base. Rate base consists primarily of our regulated segment's property plant and equipment, natural gas in storage and unamortized debt expense offset by accumulated depreciation and certain deferred income taxes. Our regulated rates were most recently adjusted in our 2010 rate case and became effective in October, 2010. We do not currently have any matters before the Kentucky Public Service Commission which would have a material impact on our results of operations, financial position and cash flows.
Our Company has two reportable segments: a regulated segment and a non-regulated segment. Our regulated segment includes our natural gas distribution and transportation services, which are regulated by the Kentucky Public Service Commission. Our non-regulated segment includes our natural gas marketing activities and the sales of natural gas liquids. The non-regulated segment produces a portion of the natural gas it markets to its customers. The division of these segments into separate revenue generating components is based upon regulation, products and services. Both segments operate in the single geographic area of central and southeastern Kentucky. Our chief operating decision maker is our Chief Executive Officer. We evaluate performance based on net income of the respective segment.
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, 2016
. Intersegment 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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2016
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2015
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2016
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2015
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Operating Revenues
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Regulated
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External customers
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12,046
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10,873
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17,888
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16,708
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Intersegment
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919
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918
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1,572
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1,590
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Total regulated
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12,965
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11,791
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19,460
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18,298
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Non-regulated
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External customers
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6,891
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|
5,800
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|
11,557
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|
10,359
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Eliminations for intersegment
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(919
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)
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(918
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)
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(1,572
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)
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(1,590
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)
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Consolidated operating revenues
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18,937
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|
16,673
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29,445
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27,067
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Net Income
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Regulated
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1,965
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|
1,702
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1,466
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|
1,185
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Non-regulated
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479
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|
101
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|
520
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|
94
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Consolidated net income
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2,444
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|
1,803
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|
|
1,986
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|
|
1,279
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(11)
Earnings per Common Share
The following table sets forth the computation of basic and diluted earnings per common 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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2016
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2015
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|
2016
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|
2015
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Numerator - Basic and Diluted
($000)
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Net income
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2,444
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|
|
1,803
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|
|
1,986
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|
|
1,279
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Dividends paid
|
(1,478
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)
|
|
(1,455
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)
|
|
(2,955
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)
|
|
(2,908
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)
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|
Undistributed earnings (loss) (a)
|
966
|
|
|
348
|
|
|
(969
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)
|
|
(1,629
|
)
|
|
|
|
|
|
|
|
|
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Allocated to common shares:
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|
|
|
|
|
|
|
|
Undistributed earnings (loss) (a)
|
965
|
|
|
347
|
|
|
(969
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)
|
|
(1,629
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)
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|
Dividends paid (b)
|
1,477
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|
|
1,449
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|
|
2,953
|
|
|
2,896
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|
|
Earnings allocated to common shares
|
2,442
|
|
|
1,796
|
|
|
1,984
|
|
|
1,266
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|
|
|
|
|
|
|
|
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Denominator - Basic and Diluted
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Weighted average common shares (c)
|
7,119,169
|
|
|
7,067,864
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|
|
7,109,666
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|
|
7,054,910
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|
|
|
|
|
|
|
|
|
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|
Earnings per Common Share - Basic and Diluted
($)
|
.34
|
|
|
.25
|
|
|
.28
|
|
|
.18
|
|
|
|
|
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(a) Percentage allocated to common shares:
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Weighted average:
|
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|
|
|
|
|
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Common shares outstanding
|
7,119,169
|
|
|
7,067,864
|
|
|
7,109,666
|
|
|
7,054,910
|
|
|
Unvested participating shares outstanding (d)
|
3,999
|
|
|
30,300
|
|
|
—
|
|
|
—
|
|
|
Total
|
7,123,168
|
|
|
7,098,164
|
|
|
7,109,666
|
|
|
7,054,910
|
|
|
|
|
|
|
|
|
|
|
|
Percentage allocated to common shares
|
99.9
|
%
|
|
99.6
|
%
|
|
100.0
|
%
|
|
100.0
|
%
|
|
|
|
|
|
|
|
|
|
|
Undistributed earnings (loss) (
$000
)
|
966
|
|
|
348
|
|
|
(969
|
)
|
|
(1,629
|
)
|
|
|
|
|
|
|
|
|
|
|
Allocated to common shares
|
965
|
|
|
347
|
|
|
(969
|
)
|
|
(1,629
|
)
|
|
|
|
|
|
|
|
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|
(b) Represents dividends paid on common shares, exclusive of unvested participating shares.
(c) Under our Incentive Compensation Plan, recipients of performance share awards receive 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, as further discussed below in Note (d). 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 stock method, unless the effect of including such shares would be antidilutive. As of
December 31, 2016
, and 2015 there were
41,000
and
39,000
unvested non-participating shares outstanding, respectively, which were not dilutive as the underlying performance conditions have not been met.
(d) Certain awards under our shareholder approved incentive compensation plan, as further discussed in Note 12 of the Notes to Condensed Consolidated Financial Statements, provide recipients of the awards all the rights of a shareholder of Delta including the 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, 2016 and 2015 there were
4,000
and
30,300
unvested participating shares outstanding, respectively, which were excluded from the computation of earnings allocated to common shares, as the holders of the unvested participating shares do not have a contractual obligation to share in losses.
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(12)
|
Share-Based Compensation
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We have a shareholder approved incentive compensation plan (the "Plan"), that 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, 2016
, approximately
751,000
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. Upon vesting, the Plan allows for withholding a number of shares equal in fair value to the taxes required to satisfy statutory withholding requirements.
Compensation expense for share-based compensation is recorded 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. Forfeitures of awards are recognized as they occur. For the three months ended
December 31, 2016
and
2015
, share-based compensation expense was
$9,000
and
$69,000
, respectively. For the
six months ended
December 31, 2016
and
2015
, share-based compensation expense was
$273,000
and
$315,000
, respectively.
Stock Awards
For the
six months ended December 31, 2016
, common stock was awarded to Delta's eight outside directors having a grant date fair value of
$247,000
(
9,600
shares). 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, 2016
and
2015
, performance shares were awarded to the Company's executive officers having grant date fair values of
$1,056,000
(
41,000
shares) and
$787,000
(
39,000
shares), respectively. The performance shares 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 in one-third increments each August 31 subsequent to achieving the performance objectives as long as the recipients are employees throughout each such service period.
Unvested shares of executive officers while still employed by the Company will fully vest upon them attaining the age of sixty-seven. The recipients of the awards also become vested as a result of certain events such as death or disability of the holders or a change in control. 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,
2016
and
2015
, there were
4,000
and
30,300
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, 2016
and
2015
, compensation expense related to the performance shares was
$9,000
and
$69,000
, respectively. For the
six months ended December 31, 2016
and
2015
, compensation expense related to the performance shares was
$26,000
and
$145,000
, respectively.