Aquila Inc. shareholders went on a roller coaster ride last week as ILA share prices plummeted $8, or 36%, from the $22.25 close on April 26 to last Tuesday’s low of $14.26 and then rebounded back above $17 on waves of bad and then good news. Moody’s Investor Service posted an outlook negative on the company’s credit April 26, putting Aquila in danger of falling below investment grade. After reaffirming its commitment to maintain an investment grade credit rating, Aquila announced it would buy Cogentrix Energy Inc., a large independent power producer with 3,496 MW of diverse power generation assets, for $1.5 billion, including debt assumption. The purchase, which was viewed favorably by Wall Street, overshadowed a negative earnings report the company released the following day.

Aquila bought Cogentrix for $415 million in stock and equity-linked securities, as well as the assumption of $355 million of recourse debt and $770 million of non-recourse project-level debt. Aquila shares rebounded following a positive conference call, in which company management vowed to sell $500 million in assets and stop all merger and acquisition activity for the rest of this year. ILA shares still were down 6% at the end of the day Wednesday to $16.04.

The addition of a significant amount of generation under long-term power sales agreements is expected to reduce Aquila’s risk profile and provide needed cash to its operations, analysts and the company noted. The addition will nearly double Aquila’s current power generation portfolio of 3,655 MW in operation and under construction and further diversifies its portfolio by region, fuel type and technology. On closing, Aquila will have 85 power plants. The transaction is expected to be immediately accretive to earnings and will exceed its targeted investment returns.

“We believe this is the right asset at the right time and at the right price,” said CEO Robert Green. The company said 97% of Cogentrix’s net megawatts are under contract. After combining operations, Aquila’s total generation mix will be 70% contracted, an optimal position for balancing its targets for predictable cash flow and earnings while maximizing commercial optimization opportunities, the company said.

“It marries an industry-leading marketing, trading and risk management capability with the IPP leader in North America…,” said Green. “It balances our earnings profile going forward, reduces the risk profile of earnings and, we believe, positions us to be a premiere wholesale energy and risk management company going forward.”

Company officials said they had in-depth discussions about the acquisition with credit rating agencies and expected no negative impact. CFO Dan Streek said, “This should not have an impact on our ratings.” He noted Moody’s already has taken action and “that rating comment will stand [after] this transaction.

“As you might know, Moody’s currently rates Cogentrix Baa3, and that should not have an impact on our ratings,” said Streek. “Fitch also will confirm our ratings post this transaction at BBB-. S&P by the end of the day will not change our rating, which currently is at BBB, but they will put us on negative watch. They will also upgrade, or put on positive watch, the Cogentrix debt. We believe the interaction of strong cash flow, [and a] strong and stable earnings profile actually lowers our credit profile in terms of our debt,” said Streek. Maintaining an investment grade credit rating is critical to a healthy marketing and trading operation.

Merrill Lynch analyst Jonathan Arnold said he thinks “it’s a little odd” to expect the credit ratings agencies to stand pat with their ratings of Aquila, given what Moody’s did on Friday. “There’s a large amount of debt, but they are taking on contracted generation assets, so they are bringing in some stable, or at least predictable, cash flow with it. You might find that from the agency’s perspective that might improve things a little bit, or at least might not damage things.

“We’re already negative about their balance sheet, which is somewhat stretched, and they have a lack of earnings visibility and credibility,” said Arnold. “The trading business is a potential source of trouble. We’ve left our neutral rating on them out there as a response to the [April 26] Moody’s negative outlook.” He said it was too early to determine whether to change Merrill Lynch’s neutral rating on the company.

“I would also point out that their utility earnings are somewhere around $1.60, and their stock is trading at under 10 times utility earnings. If they turn out to be believable, and we have our doubts, then at nine times earnings it’s a massive discount. What’s going on in the trading business may matter less. In the meantime, though, all the credit issues related to trading are pretty worrying. They also have these surety bonds that would trigger cash collateral if they were to suffer a downgrade. Nevertheless, we think their stock fall was somewhat of an overreaction,” the Merrill Lynch analyst said.

Confirming Streek’s prediction, FitchRatings said last week that the outlook for Aquila is stable. Fitch currently rates Aquila senior unsecured debt BBB-. “Completion risk and risks associated with the weak financial condition of the general contractor are mitigated in part by the low acquisition price to be paid by [Aquila] and by other contract management practices Cogentrix has put in place,” Fitch said in its ratings note. “While the transaction will result in a modest increase in ILA’s financial leverage and moderate completion risks, the benefits of the acquisition relate to the strong base of contractual revenues and the opportunity to integrate the assets over the longer term with [Aquila’s] trading and risk management services.”

To help improve Aquila’s balance sheet going forward, Streek said the company will sell about $500 million in assets “although our list of assets that we’re considering is greater than that. Post this transaction, we will refrain from [merger and acquisition] activity, with the exception of our pending Quanta transaction, and we will have several initiatives to reduce costs.” He said the company’s global networks business will be downsized, and there are other cost reductions going on throughout the entire company.

“In the unlikely event we were downgraded below investment grade (to Moody’s Ba1) at the Aquila Inc. level — and we have to remember we have separate ratings at the merchant level and at that level Moody’s rating is actually Baa2… — the collateral commitment that we would have associated with our commodity contracts is approximately $25 million, not a fairly large number. We also have some Australian debt, which if downgraded below investment grade could be critical to us, but wouldn’t necessarily be critical to us…[requiring] about $170 million.”

Green reiterated that Aquila “not only needs to hold [its] investment grade rating, we need to move up a few notches to at least a BBB+. The effort [we’ve mentioned] has a targeted improvement in [earnings before interest, depreciation and amortization] of $100 million. That’s a 10-15% improvement, and we believe that’s very achievable.”

Upon completion of the Cogentrix transaction, which is expected in the third quarter of 2002, Cogentrix operations will be combined with Aquila Merchant Services’ North American Capacity Services business. Immediately prior to the acquisition, General Electric Capital Corp. (GECC) or its subsidiaries will acquire 1,024 MW of qualifying facility power plant assets currently owned by Cogentrix in order for the plants to maintain their qualifying facility status under the Public Utility Regulatory Policy Act (PURPA). The acquisition is conditioned on Hart-Scott-Rodino clearance, approvals by the Federal Energy Regulatory Commission and completion of the asset sale to GECC.

The transaction initially will be financed with an acquisition bank facility underwritten by Credit Suisse First Boston. Aquila intends to refinance the acquisition facility with a combination of common stock and mandatorily convertible securities. Credit Suisse First Boston acted as exclusive financial advisor.

A day after announcing the favorable deal to buy Cogentrix, Aquila reported that lower commodity prices, a struggling economy and the mild winter led to a 40% drop earnings to $44.4 million. The company previously warned investors to expect a sharp drop in earnings. On April 19, Aquila lowered its full-year guidance for 2002 operating earnings per share to a range of $2.20 to $2.30 per share. Its earlier guidance was $2.83 per share.

The company said last week that first quarter diluted earnings per share of $0.32, were down 54% from $0.69 per share in the 2001 period. The poor quarterly comparison had a lot to do with the previous winter’s normal weather and a change in accounting for storage inventory this winter, Aquila noted. The company’s diluted earnings per share also were impacted by an additional 31.4 million diluted average shares outstanding in 2002.

“We are disappointed by our first quarter results,” said Green. “However, we did have a number of bright spots in the quarter, including the performance of our International Networks, Client Services and our European Wholesale Services businesses.”

The Merchant Services’ unit, however, showed a $57.9 million decline in earnings before interest and taxes (EBIT) from the first quarter of 2001, which was one of Aquila’s best quarters. About $28.7 million of the variance was attributed to a change in accounting for storage inventory. The change in accounting had little impact on 2002 results. However, if applied in first quarter 2001, EBIT would have been significantly reduced, the company said. Additionally, results were impacted by one of the mildest winters ever recorded, which significantly reduced opportunities, as well as by lower commodity prices and volatility. Volumes, however, continued to grow, both in terms of commodities and capacity, again placing Aquila in the industry’s top five competitors.

The merchant division Wholesale Services reported $28.4 million in EBIT for the first quarter 2002 compared to $62.4 million in first quarter 2001. And the Capacity Services division EBIT was $3.2 million compared to $27.1 million in first quarter 2001. The main factors impacting the year-over-year change for the Capacity division were a return to an expected spark spread (conversion of natural gas to electricity) environment, lower prices and volumes in the gas gathering and processing business, and new capacity payments, Aquila said.

Client Services reported its best quarter yet with EBIT of $19.2 million compared to $16.8 million in first quarter 2001. A number of significant structured transactions were closed during the quarter including a full-requirements contract with a Northeast utility, a number of GuaranteedGeneration transactions, and the first large GuaranteedBill transaction with a Midwest utility, Aquila said.

The first quarter results for its Global Networks unit were mixed. First quarter 2002 EBIT was $23.1 million less than first quarter 2001. While the domestic utility business was down $30.9 million from the prior year’s first quarter, the international portfolio provided a $7.8 million increase in EBIT. Key issues creating the shortfall for the domestic utility operations were warmer-than-normal weather, 2001 off-system sales to western markets in 2001, and an increase in other operating expenses.

In an effort to improve financial returns, Aquila announced its intention to restructure the utility business to a state-based structure and further decentralize decision-making. This new structure will allow state leadership more autonomy in managing the network business, plus create closer relationships with customers and communities. About 500 staff positions, mostly at its Kansas City, MO, headquarters will be eliminated. The reductions from these actions will be primarily in administration and support areas. Restructuring activities are expected to be completed by the end of July.

These cost cutting measures come on top of Aquila’s plan to sell $500 million in additional assets this year to help strengthen its balance sheet and its intention to cease all merger and acquisition activity for the remainder of the year.

©Copyright 2002 Intelligence Press Inc. Allrights reserved. The preceding news report may not be republishedor redistributed, in whole or in part, in any form, without priorwritten consent of Intelligence Press, Inc.