Form 10-Q

SOUTHWEST GAS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Thousands of dollars)
(Unaudited)

The accompanying notes are an integral part of these statements.

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Note 1 - Summary of Significant Accounting Policies

Nature of Operations. Southwest Gas Corporation (the Company) is comprised of two segments: natural gas operations (Southwest or the natural gas operations segment) and construction services. Southwest purchases, transports, and distributes natural gas to customers in portions of Arizona, Nevada, and California. The public utility rates, practices, facilities, and service territories of Southwest are subject to regulatory oversight. The timing and amount of rate relief can materially impact results of operations. Natural gas sales are seasonal, peaking during the winter months. Variability in weather from normal temperatures can materially impact results of operations. Natural gas purchases and the timing of related recoveries can materially impact liquidity. Northern Pipeline Construction Co. (Northern or the construction services segment), a wholly owned subsidiary, is a full-service underground piping contractor which provides utility companies with trenching and installation, replacement, and maintenance services for energy distribution systems.

Basis of Presentation. The consolidated financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. In the opinion of management, all adjustments, consisting of normal recurring items and estimates necessary for a fair presentation of the results for the interim periods, have been made. It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the 2001 Annual Report to Shareholders, which is incorporated by reference into the 2001 Form 10-K, and the first quarter 2002 Form 10-Q.

Intercompany Transactions. The construction services segment recognizes revenues generated from contracts with Southwest (see Note 2 below). Accounts receivable for these services were $6.4 million at June 30, 2002 and $4.3 million at December 31, 2001. The accounts receivable balance, revenues, and associated profits are included in the consolidated financial statements of the Company and were not eliminated during consolidation in accordance with Statement of Financial Accounting Standards (SFAS) No. 71, “Accounting for the Effects of Certain Types of Regulation.”

Note 2 – Segment Information

The following tables list revenues from external customers, intersegment revenues, and segment net income (thousands of dollars):

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See separate discussion at Results of Natural Gas Operations.

Construction services earnings per share for the three, six and twelve months ended June 30, 2002 were relatively unchanged when compared to the same periods ended June 30, 2001. Stable earnings and revenues were primarily attributable to the retention and renewal of a high percentage of existing contracts during the twelve-month period.

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The following table sets forth the ratios of earnings to fixed charges for the Company:

Earnings are defined as the sum of pretax income plus fixed charges. Fixed charges consist of all interest expense including capitalized interest, one-third of rent expense (which approximates the interest component of such expense), preferred securities distributions, and amortized debt costs.

Results of Natural Gas Operations

Quarterly Analysis

Contribution from natural gas operations declined $9.5 million in the second quarter of 2002 compared to the same period a year ago. The impact of the merger litigation settlements, coupled with higher operating expenses and an unfavorable change to other income (expense), was partially offset by increased operating margin.

Operating margin increased $10 million, or ten percent, in the second quarter of 2002 compared to the same period in 2001. The increase was the result of general rate relief and customer growth, partially offset by the impacts of weather between periods. General rate relief granted in Arizona and Nevada during the fourth quarter of 2001 added $10 million of operating margin. The Company served 56,000, or four percent, more customers than a year ago, who contributed $5 million in incremental margin. Operating margin was reduced by $5 million between periods due to near record warm temperatures experienced throughout the Southwest during April 2002.

Operations and maintenance expense increased $1 million, or two percent, reflecting general cost increases and costs associated with the continued expansion and upgrading of the gas system to accommodate customer growth. Operations and maintenance expenses overall are expected to trend higher for the calendar year, consistent with the year-to-date results.

Depreciation expense and general taxes increased $2.7 million, or eight percent, as a result of construction activities. Average gas plant in service increased $197 million, or eight percent, as compared to the second quarter of 2001. The increase reflects ongoing capital expenditures for the upgrade of existing operating facilities and the expansion of the system to accommodate continued customer growth.

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During the second quarter 2002, the Company recorded a net $14.5 million nonrecurring pretax charge related to the settlements of merger-related litigation. See Merger-related Litigation Settlements for additional information.

Other income (expense) declined $6.1 million between periods. The current period includes a $1.6 million reduction in interest income primarily earned on the deferred PGA account balances, a $1.5 million charge for a potential regulatory disallowance in California and a $2.5 million increase in merger litigation costs.

Six-Month Analysis

Contribution from natural gas operations declined $307,000 in the first six months of 2002 compared to the same period a year ago. The decrease was principally the result of the merger litigation settlements and increased operating expenses, partially offset by higher operating margin and improved other income (expense).

Operating margin increased $24 million, or nine percent compared to the same period a year ago. The increase was the result of general rate relief and customer growth, partially offset by the impacts of weather between periods. General rate relief granted in Arizona and Nevada during the fourth quarter of 2001 added $25 million of operating margin. Customer growth contributed $10 million of incremental operating margin. Differences in heating demand caused by weather variations between periods resulted in an $11 million margin decrease. Near record warm temperatures during April 2002 negatively impacted current period margin while the prior period benefited from temperatures which were on average seven percent colder than normal.

Operations and maintenance expense increased $6.1 million, or five percent, reflecting general increases in labor and maintenance costs, along with other operating expenses incurred to provide service to a steadily growing customer base.

Depreciation expense and general taxes increased $5.2 million, or eight percent, as a result of construction activities. Average gas plant in service increased $195 million, or eight percent, as compared to the first six months of 2001. The increase reflects ongoing capital expenditures for the upgrade of existing operating facilities and the expansion of the system to accommodate continued customer growth.

During the second quarter 2002, the Company recorded a net $14.5 million nonrecurring pretax charge related to the settlements of merger-related litigation. See Merger-related Litigation Settlements for additional information.

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Other income (expense) improved $1.7 million between periods. The current period includes a one-time pre-tax gain of $8.9 million on the sale of undeveloped property, partially offset by a $3 million reduction in interest income primarily earned on the deferred PGA account balances, a $1.5 million charge for a potential regulatory disallowance in California and a $2.1 million increase in merger litigation costs.

Twelve-Month Analysis

Contribution to consolidated net income decreased $9.1 million in the current twelve-month period compared to the same period a year ago. The impact of the merger litigation settlements, coupled with higher operating and financing costs, was partially offset by growth in operating margin and improvement in other income (expense).

Operating margin increased $30 million between periods. Customer growth, coupled with increased margin from electric generation and industrial customers during the second half of 2001, contributed $26 million in incremental margin, while rate relief added $30 million. Differences in heating demand caused by weather variations between periods resulted in a $26 million margin decrease. Warmer-than-normal temperatures experienced during the fourth quarter of 2001 and second quarter of 2002 negatively impacted margin by $13 million. Prior-period margin was $13 million higher than expected due to temperatures that were ten percent colder than normal.

Operations and maintenance expense increased $17.3 million, or seven percent, reflecting general increases in labor and maintenance costs, higher uncollectible expenses, and incremental operating expenses associated with providing service to a steadily growing customer base.

Depreciation expense and general taxes increased $11.5 million, or nine percent, as a result of additional plant in service. Average gas plant in service for the current twelve-month period increased $190 million, or eight percent, compared to the corresponding period a year ago. This was attributable to the upgrade of existing operating facilities and the expansion of the system to accommodate new customers.

During the second quarter 2002, the Company recorded a net $14.5 million nonrecurring pretax charge related to the settlements of merger-related litigation. See Merger-related Litigation Settlements for additional information.

Other income (expense) improved $5.6 million between periods. The current period includes a one-time pretax gain of $8.9 million for the sale of undeveloped property and a $3 million nonrecurring pretax gain on the sale of certain assets recognized in the fourth quarter of 2001. These gains were partially offset by a $1.2 million decrease in interest income primarily earned on deferred PGA account balances, a $1.5 million charge for a potential regulatory disallowance in California and a $3.2 million increase in merger litigation costs.

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Net interest deductions increased $2.9 million, or four percent, due primarily to incremental borrowings to finance construction expenditures.

Income tax expense in the current period includes $2.5 million of income tax benefits recognized in 2001 associated with the resolution of state income tax issues. The prior period includes $4.4 million of income tax benefits recognized in 2000 associated with the favorable resolution of certain federal tax issues and the statutory closure of open federal tax years.

Rates and Regulatory Proceedings

Nevada General Rate Cases. In July 2001, Southwest filed general rate applications with the Public Utilities Commission of Nevada (PUCN) seeking approval to increase annualized revenues by $21.7 million in its southern Nevada rate jurisdiction and $7.7 million in its northern Nevada rate jurisdiction. In November 2001, Southwest received approval from the PUCN to increase rates by $13.5 million, or five percent, annually in southern Nevada and $5.9 million, or five percent, annually in northern Nevada effective December 2001. In January 2002, the PUCN settled several open issues in the case regarding rate design. Changes included increasing the residential basic service charge by $2.00 per month in both jurisdictions, which should improve revenue stability in Nevada. The changes were effective February 2002 and did not impact the amount of rate relief granted.

California General Rate Cases. In February 2002, Southwest filed general rate applications with the California Public Utilities Commission (CPUC) for its northern and southern California jurisdictions. The application seeks annual increases over a five-year period beginning January 2003, which cumulatively amount to $6.3 million in northern California and $17.2 million in southern California. For 2003, an annualized $2.7 million, or 13 percent, revenue increase was requested for the northern jurisdiction and an annualized $6.7 million, or eight percent, revenue increase was requested for the southern jurisdiction. Additional smaller annual revenue increases are proposed in the subsequent years of the application through 2007.

In July 2002, the Office of Ratepayer Advocates (ORA) filed testimony in the rate case recommending significant reductions to the rate increases sought by Southwest. The ORA did concur with the majority of the Southwest rate design proposals including a margin tracking mechanism to mitigate weather-related usage variations. Hearings are scheduled to begin in August 2002 with a decision expected by year-end. The last general rate increases received in California were January 1998 in northern California and January 1995 in southern California.

Arizona Capacity Issues. Southwest arranges for transportation of gas to its Arizona service territories exclusively through the El Paso Natural Gas Company (El Paso) pipeline system. In its Arizona service territories, Southwest receives the contractual benefit of being a full-requirements shipper on the El Paso system. The capacity needs of a full-requirements shipper are met before those of other shippers. Certain filings by El Paso with the Federal Energy Regulatory Commission (FERC) during 2001 prompted non full-requirements shippers to file a complaint with the FERC. This complaint alleges among other things that unlimited rights of full-requirements shippers cause damage to other shippers because there is insufficient pipeline capacity to serve all firm requirements for all shippers.

Virtually all of El Paso’s customers in Arizona, New Mexico and Texas are full requirements customers, while El Paso transports natural gas for its customers in California and Nevada subject to a specific maximum daily quantity, or contract demand limitation. Over the past two years, the demand for natural gas on the El Paso system has risen; primarily due to increased electric power generation fuel needs and market area growth. As a result, shippers are increasingly having their available quantity reduced.

In May 2002, the FERC issued an order requiring that full requirements service be terminated as of November 2002. In addition, it was ordered that full requirements transportation service agreements would be converted to contract demand-type service agreements as of November 2002, and that the full requirements customers would have an opportunity to negotiate an allocation of the system capacity determined by El Paso to be in excess of the capacity needed to fully serve the contract demand shippers. If the customers fail to agree upon an allocation, then the FERC will establish an allocation methodology for the customers. Management believes that although it is difficult to

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predict the impact of the FERC action on Southwest, sufficient capacity will probably be available on the El Paso system to serve the needs of Arizona customers. However, additional costs are likely to be incurred to acquire such capacity. It is anticipated that these additional costs would be collected from customers, principally through the PGA mechanism.

PGA Filings

Arizona PGA Filings. In Arizona, Southwest adjusts rates monthly for changes in purchased gas costs, within pre-established limits. In January 2002, Southwest filed an advice letter with the ACC to eliminate a temporary rate adjustment surcharge, which was otherwise set to expire at the end of the second quarter of 2002. This action was taken in recognition of moderating gas costs and projections of PGA balancing account activity. The filing was approved effective February 2002, and reduces revenues by $31.9 million annually with no reduction to margin.

Nevada PGA Filings. In December 2001, Southwest submitted an out-of-cycle PGA filing to the PUCN for a $29.2 million decrease for southern Nevada customers. In January 2002, an additional decrease of $13.9 million was requested. The total of the two filings, $43.1 million, was agreed to in a settlement among all parties and approved by the PUCN effective February 2002. The filings were made in advance of the scheduled annual date to allow customers to receive the benefit of decreases experienced in natural gas costs. PGA changes impact cash flows but have no direct impact on profit margin. In June 2002, Southwest filed its annual PGA, which requested no change in effective rates for either the southern or northern Nevada rate jurisdiction. The annual PGA is expected to go to hearing during the fourth quarter of 2002.

California Order Instituting Investigation (OII). In July 2001, the CPUC ordered an investigation into the reasonableness of Southwest natural gas procurement practices and costs from June 1999 through May 2001, and related measures taken to minimize gas costs beyond May 2001. During the third quarter of 2001, Southwest filed a detailed report and testimony with the CPUC on these matters for both its northern and southern California service territories. The OII resulted from complaints by southern California customers about the size of monthly PGA rate increases that were necessary due to the unusually high cost of natural gas during the winter of 2000-2001. In regards to the southern California jurisdiction, the ORA and County of San Bernardino recommended disallowances of $7.3 million and $11.7 million, respectively. No issues were raised related to the northern California rate jurisdiction. The proposed disallowances were based solely on decisions by Southwest not to purchase additional gas for storage during the winter of 2000-2001. Hearings were held in January 2002. Southwest defended its decisions related to storage, based on testimony which demonstrated that injecting additional volumes of natural gas into storage during the 2000 injection season (April through September) could not be economically justified based on market conditions and price forecasts that existed at the time decisions were made.

During May 2002, the Administrative Law Judge issued a proposed decision and the Presiding Commissioner issued an alternate decision (AD) related to this matter. The proposed decision recommended that Southwest be disallowed $3.2 million, while the AD recommended a $5.8 million disallowance. Both draft decisions concluded that Southwest should have had a higher gas storage inventory level than it had going into the winter of 2000-2001. During July 2002, a second AD was drafted by another Commissioner, recommending a disallowance of nearly $1.5 million. Although Southwest continues to assert that no disallowance is warranted in the proceeding, an estimated $1.5 million liability was recognized in its second quarter 2002 financial statements based on management’s belief that a disallowance will be ordered. All three proposed decisions are scheduled to be on the Commission’s agenda during late August 2002, at which time the Commission may act or postpone action until a later date.

Merger-related Litigation Settlements

Litigation in Arizona related to the now terminated acquisition of the Company by ONEOK, Inc. (ONEOK) and the rejection of competing offers from Southern Union Company (Southern Union) was recently resolved. For additional background information, see Item 3 “Legal Proceedings” in the 2001 Form 10-K filed by the Company with the SEC.

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In August 2002, the Company reached final settlements with both Southern Union and ONEOK related to this litigation. The Company will pay Southern Union $17.5 million to resolve all remaining Southern Union claims against the Company and its officers. ONEOK will pay the Company $3 million to resolve all claims between the Company and ONEOK.

The net after-tax impact of the settlements was a $9 million, or $0.28 per share, charge and was reflected in the second quarter 2002 financial statements. Prior to 2002, the impact to Company financial results for merger litigation costs was not significant as most defense costs were reimbursed by insurance. However, recently the Company exhausted its first layer of insurance coverage and began filing claims with a different insurance provider for reimbursement under its second layer of coverage. The Company and the insurance provider are in dispute over the type of coverage and whether it applies to the Southern Union settlement or related litigation defense costs. Because of this dispute, the Company recognized the full amount of the Southern Union settlement in the second quarter charge. Management cannot predict the amount, if any, of insurance cost reimbursement the Company may receive.

Recently Issued Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” SFAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. The asset retirement obligations included within the scope of SFAS No. 143 are those that are unavoidable as a result of the acquisition, construction, development, or normal operation of long-lived assets. The standard requires that a legal obligation associated with the retirement of tangible long-lived assets be recognized as a liability when incurred. When a liability for an asset retirement obligation is initially recorded, the entity capitalizes a cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Entities are also required to recognize period-to-period changes for the liability related to asset retirement obligations resulting from the passage of time and/or revisions to either the timing or the amount of the original estimate of undiscounted cash flows. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss. Upon initial application of SFAS No. 143, entities are required to recognize the following items in the statement of financial position: a liability for any existing asset retirement obligations adjusted for cumulative accretion to the date of adoption of SFAS No. 143, an asset retirement cost capitalized as an increase to the carrying amount of the associated long-lived asset, and accumulated depreciation for the capitalized cost. SFAS No. 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002, with early adoption encouraged. Management has not yet quantified the effects of the new standard on the financial position or results of operations of the Company.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145 rescinds SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt,” and an amendment of that Statement, SFAS No. 64, “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements.” The rescission of SFAS Nos. 4 and 64 is effective for fiscal years beginning after May 15, 2002. All other provisions of SFAS No. 145 are effective for transactions entered into, or financial statements issued, after May 15, 2002. The effective portions of the standard were adopted without impact during the second quarter of 2002 and management believes the remaining portions of the new standard will have no material effect on the financial position or results of operations of the Company.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 requires that a liability be recognized at fair value for a cost associated with an exit or disposal activity when the liability is incurred. Exit or disposal activities include a sale or termination of a line of business, the closure of business activities in a particular location, the relocation of business activities from one location to another, changes in management structure, and a fundamental reorganization that affects the nature and focus of operations. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. Management believes the new standard will have no material effect on the financial position or results of operations of the Company.

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Forward-Looking Statements

This report contains statements which constitute “forward-looking statements” within the meaning of the Securities Litigation Reform Act of 1995 (Reform Act). All such forward-looking statements are intended to be subject to the safe harbor protection provided by the Reform Act. A number of important factors affecting the business and financial results of the Company could cause actual results to differ materially from those stated in the forward-looking statements. These factors include, but are not limited to, the impact of weather variations on customer usage, customer growth rates, natural gas prices, the effects of regulation/deregulation, the timing and amount of rate relief, changes in gas procurement practices, changes in capital requirements and funding, the impact of conditions in the capital markets on financing costs, acquisitions and competition.

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PART II - OTHER INFORMATION

ITEM 1.        LEGAL PROCEEDINGS

Merger-related Litigation Settlements

Litigation in Arizona related to the now terminated acquisition of the Company by ONEOK and the rejection of competing offers from Southern Union was recently resolved. For additional background information, see Item 3 “Legal Proceedings” in the 2001 Form 10-K filed by the Company with the SEC.

In August 2002, the Company reached final settlements with both Southern Union and ONEOK related to this litigation. The Company will pay Southern Union $17.5 million to resolve all remaining Southern Union claims against the Company and its officers. ONEOK will pay the Company $3 million to resolve all claims between the Company and ONEOK. The net after-tax impact of the settlements was a $9 million, or $0.28 per share, charge and was reflected in the second quarter 2002 financial statements.

ITEMS 2-3.    None

ITEM 4.         SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Annual Meeting of Shareholders was held on May 9, 2002. Matters voted upon and the results of the voting were as follows:

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ITEM 5.        OTHER INFORMATION

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