Banc of America Securities (BOA) downgraded Dynegy Inc. to “sell” from “neutral” last week because of questions about the company’s future cash-flow generation. On the day of the downgrade Wednesday, more than 10 million Dynegy shares exchanged hands, and the stock fell more than 5%, falling slightly more through the rest of the week to close at around $4.85.

The downgrade came the same day that Dynegy filed a Form 8-K with the Securities and Exchange Commission regarding the completion of its Illinois Power (IP) sale to Ameren Corp. Dynegy said its 2004 guidance estimates, which were updated in July, assumed that the sale would close effective Dec. 31. Because of the early completion, Dynegy said it was “evaluating its 2004 guidance estimates in light of the earlier than forecasted closing of the sale, as well as other matters relating to its anticipated financial performance for 2004.” Dynegy plans to update its 2004 guidance on Oct. 28, when it releases its 3Q2004 results.

BOA analyst Anatol Feygin wrote in a note to clients that a major concern is that many of Dynegy’s power and natural gas midstream contracts will be expiring in the next year. “We have become increasingly wary of cash-flow generation capability in 2005 and beyond as favorable power contracts roll off and margins narrow in midstream.” The analyst called Dynegy’s market valuation relative to value and cash flow as “highly disproportionate.”

BOA set Dynegy’s target price at $3.50 and lowered earnings estimates for this year and in 2005. In 2006, BOA also is forecasting a loss of 34 cents/share. Dynegy has indicated that it will not release its earnings forecast for 2005 until December.

Since mid-summer, Dynegy’s share price has risen about 30%, which Feygin attributed to several factors. With the successful sale of IP, its regulated utility, along with reduced debt, investors expect the company to begin showing strong earnings in the next few quarters. However, even though the short-term position is “bright,” most of the Houston-based company’s assets have been sold, and there are few ways for the former energy merchant to generate solid growth.

“We give management credit for successfully executing a companywide restructuring,” wrote Feygin, but “we find it exceedingly difficult to see how Dynegy creates incremental shareholder value beyond 2004.” Dynegy has been able to capitalize on strong natural gas liquids prices, but those prices will be flat or fall in 2005, he predicted.

The BOA analyst noted that two of Dynegy’s remaining power contracts are scheduled to soon end, cutting a strong revenue stream. One contract with IP provided $485 million in revenue this year, according to BOA, which will decline to about $430 million in 2005. Another expiring contract in California, Westcoast Energy, which is a joint venture with NRG Energy (unrelated to the British Columbia utility subsidiary of Duke Energy), is expected to reduce Dynegy’s cash flow to $125 million.

Earlier this month, Dynegy CEO Bruce Williamson said that the company had been successful in its self restructuring to reduce costs, reduce debt and push its remaining debt forward, when power commodity prices are expected to recover. Debt has been reduced to $5.5 billion from $8.8 billion at the end of 2002, and Dynegy has “substantial liquidity and cash on hand, with some upside cash flow potential” from its gas liquids, midstream business. He said that the IP sale allows the company to pay down more debt, cut its basic costs more than in half and move into its simplified business model, with two lines of business, power generation and the natural gas midstream.

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