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Dynegy's 2Q Profit Up on Midstream Sale

Dynegy Inc. last week reported second quarter net income of $32 million (8 cents/share), a huge jump from the $2 million (1 cent/share) it reported for the same period a year ago. Most of the year-over-year increase was attributed to a $125 million deferred tax valuation allowance resulting from its anticipated sale of its midstream natural gas business, which was announced earlier this month (see NGI, Aug. 8).

The earnings news did not sit well with investors in trading last Monday when the earnings were announced, but analyst Gordon Howald said Dynegy's downward trend was temporary, and said it was most likely related to uncertainty about Dynegy's remaining power business instead of fundamental weakness in the company.

"You're seeing a lot of moving parts here," said Howald. "All the numbers they're putting out are causing a lot of people anxiety, and markets don't like uncertainty." Dynegy's quarterly results could have been better, but Howald said its remaining business should do well now that wholesale power margins are improving in most of the United States.

"There's nothing that should be driving it back down to $3...because business is good. It's out of the trough," said Howald.

With the sale of the midstream unit for $2.48 billion to Targa Resources, Dynegy expects a gain of $815 million, which will push full-year earnings to $400-410 million. The earnings would erase a previous guidance, which had the company losing $395-410 million this year.

CEO Bruce Williamson, who presided over a conference call with analysts, said the sale of the midstream unit will give the company money to pay down debt and redefine the company for investors. The midstream sale also may make Dynegy more attractive as an acquisition.

"It will put Dynegy in a much better position as a pure power-generation play," Williamson said.

Discounting the gain from the midstream sale, Dynegy's continuing operations in the second quarter would have lost 30 cents/share, well above Wall Street forecasts, which had put the losses at 12 cents/share for the quarter.

Williamson said Dynegy's "generation is doing better than expected," crediting "hot weather, clearly in the Midwest and Northeast," as a driver for the Power segment's strong earnings. Dynegy built its coal inventories "ahead of time," and he cited "overall growth and increased demand" for the business, which operates in 12 states.

In its Power segment, earnings before interest, taxes and depreciation and amortization (EBITDA) were $75 million, compared with $132 million in 2Q2004. However, the year-over-year decrease was attributed to lower equity earnings from West Coast Power as a result of a contract expiration with the California Department of Water Resources in December 2004. In 2Q2004, the company recognized earnings of $47 million from West Coast Power, compared with $1 million for this quarter.

Power generation benefited from increased volumes in nearly all regions where the company operates. Volumes in the Midwest increased 11% from a year ago, and energy supplied to AmerenIP under Dynegy's two-year power purchase agreement was more than 35% higher. However, incremental energy sold to AmerenIP under the power purchase agreement, which expires at the end of 2006, "is priced significantly below current on-peak market prices, resulting in reduced margins for the Midwest region quarter-over-quarter," the company said.

Reduced margins in the Midwest region were largely offset by improvements in the Electric Reliability Council of Texas (ERCOT) region, where reserve margins have fallen from 30% in 2004 to 17% in 2005 because of the retirement of older units by other market participants. Stronger weather-driven demand in ERCOT resulted in higher power prices and improved spark spreads during the second quarter of 2005. Additionally, the company's ERCOT facility, the 610 MW CoGen Lyondell combined-cycle plant, benefited from a baseload contract that allows it to capture additional ancillary service revenues from the marketplace.

In the Northeast region, volumes were slightly higher, largely as a result of the 1,021 MW Independence combined-cycle facility, which the company acquired in the first quarter. Volumes generated by the company's 1,210 MW Roseton dual fuel-fired intermediate facility were lower due to compressed margins given the higher costs of fuel oil relative to power prices.

EBITDA from the midstream business was $64 million, compared with $99 million in 2Q2004, which included a $36 million pre-tax gain related to the sale of the company's interest in the Indian Basin Gas Processing Plant. Last year's results also included a $6 million gain on sales of natural gas liquids held at below-market costs, as well as financial contributions made by the Sherman Gas Processing Plant, which was sold in 4Q2004.

Gross natural gas liquids volumes processed by the company's field and straddle plants in the quarter increased 9% to 86,600 bbl/d, compared with 79,700 bbl/d in 2Q2004. Field processing volumes of 58,000 bbl/d, a 5% increase over the previous year when adjusted for noncore asset sales, were attributed to stronger activity in the company's Permian Basin and North Texas regions. In addition, the operation of the company's Barracuda, Lowry and Stingray gas processing facilities on the Louisiana Gulf Coast contributed to straddle plant volumes of 28,600 bbl/d, a 21% increase from a year ago.

In the customer risk management business, Dynegy reported a $15 million loss, compared with earnings of $90 million in 2Q2004. Dynegy said the business, including obligations associated with its remaining power tolling arrangements and gas transportation arrangements, "will continue to have a negative effect on its consolidated results of operations and cash flows until the related obligations have been satisfied or restructured. The company remains open to opportunities to assign or renegotiate the terms of these arrangements."

At the end of the second quarter, Dynegy's liquidity was $765 million. This consisted of $358 million in cash on hand and $407 million in unused availability under the company's $700 million revolving bank credit facility. The decrease in liquidity as compared to the $968 million balance on March 31 related to the payment during the second quarter of $175 million as part of the company's shareholder class action litigation settlement.

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