In a deal that began with a phone call from one chairman of the board to another a day after Enron Corp’s third quarter earnings were released, Dynegy Inc. and Enron agreed to merge on Friday in a transaction estimated to be worth about $22 billion. In the process, Enron will lose its once stellar name, while the new company, which will keep the Dynegy trademark, will become the largest energy trading and marketing company in the world, with revenues expected to exceed $200 billion. The combined company also would have about $90 billion in assets. Through the third quarter of 2001, the two companies had gas sales of about 40 Bcf/d and power sales exceeding 500 million MWh, and their combined assets include more than 22,000 MW of generating capacity and 25,000 miles of pipe.

Under terms of the agreement, Enron shareholders will receive 0.2685 Dynegy shares per share of Enron common stock. Dynegy’s current stockholders, (including ChevronTexaco Corp.), will own approximately 64% percent and Enron’s stockholders will own approximately 36% of the combined company’s stock at closing. The combination is expected to be strongly accretive to Dynegy’s earnings in the first year and thereafter.

The deal came together beginning with a phone call from St. Louis, MO. Dynegy Chairman and CEO Chuck Watson, visiting family, said he called Enron Chairman and CEO Kenneth Lay from St. Louis after the related-party transactions came to light following the third quarter earnings announcement Oct. 16. “I called (on Wednesday, Oct. 17) to see if there was anything I could do to straighten the rumors out…to facilitate our ongoing business together” said Watson. The following Saturday, (Oct. 20) “Ken invited me over to his home, and we spent a few hours talking about this.” Negotiations began the following week.

“Probably three or four weeks ago I would not have expected this transaction to occur,” said Lay, who referred to the “barrage of negative articles,” which he said directed the investment community away from the strength of Enron’s core business. “However, because of the events of the last three or four weeks, it became clear to me that we had to strengthen our balance sheet…strengthen our liquidity…get the financial community to refocus on our core business, rather than some of events that have captured their attention.”

Enron, said Lay, “obviously, looked at several alternatives,” but in the end, it “quickly became clear to us that in the best interest of shareholders, it was best to do this transaction with Dynegy.”

The boards of both companies have unanimously approved the transaction, and ChevronTexaco, which owns approximately 26% of Dynegy’s outstanding common stock, agreed to invest a total of $2.5 billion into Dynegy. Of ChevronTexaco’s contribution, about $1.5 billion will be invested immediately in Dynegy to finance the equity infusion into Enron. The balance, estimated at another $1 billion, will be made at closing.

Dynegy will use the initial $1.5 billion to acquire preferred stock and other rights in an Enron subsidiary that owns the Northern Natural Gas pipeline. The funds will provide Enron with additional cash liquidity to support its operations. In the event that the merger is not completed, Dynegy will have the right to acquire 100% of the equity in the Northern Natural Gas subsidiary, thus providing Dynegy with the full value of its investment. ChevronTexaco will be granted rights to purchase an additional $1.5 billion in Dynegy common stock over a period of up to three years from merger completion.

Dynegy Chair and CEO Chuck Watson, President Steve Bergstrom and CFO Rob Doty will retain their positions in the new company. Greg Whalley, Enron’s current president and COO, will become an executive vice president, and all of the executives will comprise the Dynegy Office of the Chairman upon merger completion.

Lay said he had been asked by Watson to contribute, but Lay said, “This is Chuck’s team to run.” He said he would offer assistance when needed, but said he would not be part of the management team.

“This strategic combination strengthens the value of our existing core business franchises by uniting the two companies’ diversified global energy delivery networks, complementary wholesale strategies and strong marketing, trading and risk management capabilities,” said Watson. “In addition, the combination fuses our intellectual capital and technology infrastructure, advancing the new Dynegy’s status as a global energy merchant, with superior physical delivery capabilities and unparalleled experience navigating competitive markets for customers.”

The board of directors of the combined company will be comprised of 14 members. Dynegy’s 11 designees will include three from ChevronTexaco. Enron will have the right to designate a minimum of three board members.

Watson said with its “market-making capabilities, earnings power and proven strategic approach to wholesale markets, Enron is the ideal strategic partner for Dynegy. As a combined company, we will focus on leveraging our core skill sets and, as always, we will keep a strong balance sheet and straightforward financial structure as key priorities.”

Lay, who built Enron from a pipeline company to its former world-class status, said, “the merger protects Enron’s core franchise and enables the stockholders of both companies to participate in the tremendous upside of the combined enterprise. The company we are creating will have a strong balance sheet, a world-class merchant energy operation and ample liquidity. It will build upon the strength of our core wholesale gas and power franchise, and commercial and industrial energy business. It also will solidify Houston’s position as the energy capital of the world and join two companies with deep roots in the Houston community and the energy industry. I am personally committed to working with Chuck Watson, Steve Bergstrom and their colleagues in the months ahead to accomplish the merger and to build a solid foundation for future value creation.”

“Our relationship with Enron puts us in a unique position to recognize the significant value in and potential of its core wholesale marketing and trading capabilities,” said Bergstrom. “The combination will continue to pursue an asset-backed trading strategy and look for opportunities to continually expand our energy network.

Referring to the problems that have escalated in the past three weeks to bring Enron to its knees, Bergstrom said that Dynegy was “aware of Enron’s announcements with regard to related party transactions and accounting restatements. We believe Enron has begun to address these issues in a responsible manner, and that they will not detract from the value of Enron’s core business.”

Enron’s Whalley admitted that “few of the options” Enron had considered to going forward offered the “earnings potential and immediate synergies that a merger with Dynegy could deliver.” He said that the cash infusion will give Enron “immediate liquidity, which we believe will enable the company to maintain its investment grade credit rating and grow its energy marketing and trading franchise and other core businesses.”

The business combination will be accounted for as a purchase of Enron by Dynegy. At closing, Dynegy will adjust the historical book value of Enron’s assets and liabilities to their respective fair values. The merger is expected to be “strongly” accretive to Dynegy earnings in the first year and thereafter. With this transaction, Dynegy management establishes its conservative initial guidance for 2002 for the combined companies on a full-year pro forma 2002 basis of $3.40 to $3.50 recurring diluted earnings per share, an accretion of 35%, or $0.90 to $0.95 per share, to current Dynegy shareholders before taking into account expected merger synergies and cost savings.

While Dynegy continues to evaluate areas for potential synergies, management estimates that the combined company will realize $400 million to $500 million in recurring annual pre-tax savings as a result of the merger from the continued disposition or winding down of non-core businesses in the Enron portfolio, elimination of duplicate activities, improved operating efficiencies and lower capital costs.

The combined company is expected to adopt an initial annual dividend of $0.30 per share, subject to financial conditions, results of operations and capital requirements.

The alliance, which only a month ago would have been unthinkable, came together last week after Enron had reported an 8-K statement to the U.S. Securities and Exchange Commission (SEC), which restated its earnings for the past four years. Read the complete Enron filing.

Among other things revealed in the filing was news that Enron had fired Ben Glisan, its managing director and treasurer, and Kristina Mordaunt, managing director and counsel of an Enron subsidiary, both apparently with stakes in one of Enron’s questionable limited partnerships. Four other former Enron employees are also believed to have been partners in LMJ1, one of the limited partnerships started by Fastow, which participated in transactions with Enron. Fastow, who had set up many of the transactions, was given a leave of absence in October.

“Enron now believes that Mr. Fastow received in excess of $30 million relating to his LJM management and investment activities,” the company said in the filing.

Acknowledging the issues that came to light in the third quarter earnings announcement Oct. 16, when Enron a $1.2 billion cut in shareholder equity to reflect the additional debt, the filing last week required Enron to reduce its net income by $96 million to $9 million for 1997, by $113 million to $590 million for 1998, and for 1999 and 2000 by $250 million and $132 million, respectively. Net income increased by $17 million for the first quarter of this year and by $5 million for the second quarter.

Dynegy had been waiting to see how the credit ratings agencies would be affected by the restatement of earnings. On Friday, Moody’s Investor Services on Friday morning, downgrading the long- and short-term debt level of Enron. Moody’s cut its senior unsecured debt ratings to Baa3 from Baa2, and cut the company’s rating for commercial paper to Not Prime from Prime-2. One more cut to the long-term ratings would take the ratings to the junk level and make it more difficult for Enron to issue debt and run its business, said a Moody’s analyst.

Once the Moody’s report was released, Dynegy’s deal became more transparent, and began having an effect on trading activity from Enron’s end. Through most of last week, things appeared to be normal, or at least no one was talking about it. However, following the 8-K release and the Dynegy announcement, traders began to talk.

“EOL (EnronOnline) usage seems to be dropping off as Enron problems continue,” said one trader. “It has contributed to some lack of liquidity and seems to have been going on for some time.” Another trader said he agreed that “EOL activity is slipping while ICE is picking up.” ICE, otherwise known as the Intercontinental Exchange, has run neck-and-neck with Enron on trading in the past few months.

“A lot of people are getting skittish about having Enron as the sole counterparty on EOL,” said another trader.

Credit Suisse First Boston analyst Curt Launer was one of many analysts last week who said a Dynegy deal would be a good move for the company. Calling it “very favorable,” Launer said Dynegy’s “strong financial and industry position” and ChevronTexaco’s stake “make its interest and potential upside from a deal relatively clear. Our initial analyses favor the earnings per share and growth implications of a combination.” Launer said the deal would be accretive to Dynegy by more than 25% over the company’s 2002 estimate because of cost saving assumptions and combined businesses.

Still to come is approval by shareholders of both Dynegy and Enron, and is conditioned on approvals of the Federal Energy Regulatory Commission and the SEC, as well as the Hart-Scott-Rodino waiting period.

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