Aquila shares slipped 5% on Friday to $2.69 after UBS Warburg analyst Ronald J. Barone lowered his rating on the company to “Reduce 1” from “Neutral 2.” Barone warned investors that the company has sacrificed its future earnings potential despite its efforts to avoid a liquidity crisis so far this year through asset sales, debt refinancings and exiting the energy trading business.

The combination of its large high interest debt and a gas pre-pay deal make it unlikely that Aquila will be cash flow positive after 2005, Barone said. “As we believe Aquila will not be cash flow positive for the foreseeable future, a discounted cash flow analysis suggests Aquila shares have no value,” he said in a research note.

“Put simply, Aquila’s significant debt burden and obligation under its gas prepay contract, will in our opinion, be too great for its core domestic utility operations to support once it has disposed of all of its other assets.”

Under the gas pre-pay contract, Aquila accepted an up front cash payment and took on the obligation to deliver gas to municipal utilities through 2011. The annual cash outflow and margin loss associated with the contracts is about $140 million and $51 million, respectively, according to Barone.

“They got the cash flow up front and now they have to pay it back,” he explained in an interview. Their high interest debt payment and the prepay contract are going to “overwhelm them. The banks probably will live with this, but eventually they may have to do some restructuring, renegotiate something with the debt holders, but possibly not a formal bankruptcy filing.”

The company has decimated its earnings potential. By the end of 2004, Barone expects Aquila to have sold off nearly all of its assets except its core utility operations in the United States, which are expected to post about $185 million in EBIT this year. Aquila has announced plans to sell off all of its international assets. Barone said he expects the company to raise about $1.1 billion by year-end 2004 through the sale of its assets in Australia and Canada.

It already has announced plans to sell the Australian assets but has not made a final decision on the Canadian utility business, which Barone values at about a net $673 million. He also gives the $56 million sale of its share of Midlands Electricity in the United Kingdom about a 50% chance of being completed as currently structured. Under that deal, which was announced two weeks ago, bondholders would have to accept 86% of the nominal value of their bonds (see NGI, May 23).

In addition, Barone believes the sale of nearly all of its merchant power plants and 1,000 MW of its contracted capacity, offset by construction costs for its 510 MW Goose Creek facility and expenses for the Elwood and Acadia tolling deals, will net only about $84 million.

“Our forecast assumes that Aries [a 580 MW Missouri power plant co-owned with Calpine] is the only remaining merchant power plant in Aquila’s portfolio in 2005.” And Barone places a negative $50 million value on that plant.

Through its exit of energy trading, Aquila is expected to reduce margin requirements by about $245 million.

“Despite the approximate $1.4 billion of cash sources outlined above, we expect Aquila will paydown only $1 billion of debt through 2004 due to continuing operating losses, high capital expenditure requirements and the cash drain from the company’s gas pre-pay contract. As a result we believe interest costs will remain modestly above $200 million in 2005 and the company will continue to post losses” and generate negative cash flow.

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