Despite launching an ambitious restructuring plan to boost liquidity by $2 billion and carry it safely into 2003, Dynegy was hit with further downgrades by all three credit ratings’ services, and its stock dipped precipitously low as the week progressed.

The turnaround began Friday, when the company announced it had eliminated nearly $300 million in two controversial ratings triggers and also secured $250 million in credit, which quickly sent its stock up, something that had not happened for several days.

More announcements are expected in the days to follow, including a plan by year’s end to secure partners — or perhaps sell outright — its 16,600-mile Northern Natural Gas Co. (NNG) pipeline and gas storage facilities in the United Kingdom. Part of Dynegy’s plan to boost liquidity includes finding partners interested in a stake in the NNG pipeline, which Dynegy received from Enron Corp. earlier this year. Dynegy also is looking for partners for its U.K.-based natural gas storage and gas processing operation, which was purchased last November.

However, by mid-week, rumors were circulating that Dynegy may sell NNG outright as early as this week. Though unconfirmed, one possible buyer mentioned was TransCanada PipeLines Ltd.

The energy merchant also offered a preview of expected second quarter results to be released at the end of July, warning that because of market conditions, “previous management guidance on earnings no longer applies.” The period ending June 30 will “detail certain non-recurring pre-tax charges of up to $450 million related to the communications business, severance expenses, consulting fees and other charges,” it said.

Second quarter results will be about break even, COO Steve Bergstrom said last week. On average, Dynegy was expected to earn 21 cents a share in the quarter, and $1.35 for 2002.

Reaction to the restructuring plan was mixed on Wall Street. Fitch Ratings dropped the first bomb, lowering the company to “junk” status last Monday, almost immediately after the restructuring plan was unveiled; Standard & Poor’s followed with a downgrade as well, but still kept Dynegy’s investment grade rating. And after four days of pondering, Moody’s Investors Services on Friday also downgraded the company’s credit rating to junk.

Still, on Friday afternoon, after news of the ratings’ triggers being dropped and the $250 million in credit being secured, bargain hunters jumped in and brought Dynegy shares back up to $7.20, an 18% increase for the day.

Weighing in earlier in the week, Merrill Lynch analyst Carl Kirst noted the restructuring program to increase liquidity and reduce debt by as much as $2 billion was more than his $1.5 billion estimate. “Of note is not only what was included in the restructuring plan, but what was not,” said Kirst. “Staying true to its roots, there is no exit from the energy merchant business, nor is there any proposed exit/sell-down of the regulated Illinois Power,” which had been rumored.

Dynegy’s new CFO Louis Dorey reaffirmed earlier reports that the company has enough cash to meet its obligations — even if it were to lose its investment-grade ratings — noting that liquidity has stood between $900 million and $1 billion since the beginning of June. “The bottom line is that adequate is not good enough,” Dorey said. “We’re not looking for adequate — we’re looking for something that will be superior.” He said the company is committed to regaining a “BBB+” rating by the end of 2003. Cutting the company’s dividend in half beginning in the third quarter will save about $56 million, said Dorey, and will put the company in line with its peers. Dynegy has paid a quarterly dividend of 7.5 cents a share over the past two years.

Eliminating Ratings Triggers

What sent investors’ hopes up Friday was the successful execution by Dynegy to remove nearly $300 million in credit ratings triggers and to secure $250 million in new credit. It completed an amendment to the Catlin minority interest transaction (also referred to as “Black Thunder”), permanently removing a $270 million ratings trigger. The amended transaction includes cash amortization of $270 million over the remaining three years of the investment and a security interest. As part of the amendment, the Catlin transaction will move from minority interest to debt on Dynegy’s balance sheet on June 30.

Also Friday, West Coast Power LLC, a joint venture with generation assets in California owned equally by Dynegy and NRG Energy, has repaid bank borrowings from cash on hand in the partnership. The repayment resulted in a permanent elimination of the $31 million ratings trigger applicable to Dynegy. West Coast Power also entered into an amended $120 million bank facility that will be used to collateralize West Coast Power’s obligations. The facility has resulted in the release of approximately $100 million in letters of credit previously posted by Dynegy on behalf of West Coast Power. West LB acted as sole arranger, agent and book-runner for the transaction.

Finally, Dynegy secured $250 million in interim financing that provides immediate additional liquidity. The loan represents an advance on a portion of the proceeds from the expected sale of certain assets owned by Dynegy UK Storage. ABN AMRO Bank acted as sole arranger, agent and book-runner for the transaction.

Capital expenditures will be trimmed another $100 million for the rest of 2002, and there will be “limited and focused capital spending in 2003.” Dynegy had already announced earlier this year that it would reduce its capital spending plan by $1.25 billion this year. The workforce reductions announced last month, in which 340 employees were laid off — including about 16% of its energy traders — will save another $50 million a year, executives said. Also, Dynegy plans to sell between $300 million to $400 million in Illinois Power mortgage bonds to repay the outstanding debt of that utility, a move already approved by the Illinois Commerce Commission. Also scheduled are more asset sales worth about $200 million, but no details were provided on what has been earmarked.

During a conference call last week, CEO Dan Dienstbier, who replaced founder Chuck Watson in May, noted the criticism Dynegy received for not unveiling some type of restructuring plan when the job cuts were first announced two weeks ago, and long-time CFO Rob Doty resigned. However, he said Dynegy wanted to complete a “solid, sensible plan” that was doable. “We will be relentless in eliminating non-producing” assets, he added.

The emphasis going forward is on Dynegy’s core energy businesses. Dynegy plans to reduce its power trading, cutting about 50 energy traders from its Houston-based unit. In keeping with other energy merchants’ announced programs, Dynegy also plans to “further enhance accounting and financial disclosure,” with several measures to improve the “transparency and clarity” of its financial reporting, including the following:

“The current merchant energy environment requires us to focus on generating cash flow in the near-term, and our plan will help us accomplish that goal,” said Bergstrom. “Even in this environment, we have served our customers reliably, as we have done for the past 17 years. This is a testament to the strength of our asset-backed business model and our focus on the physical delivery of energy through our network. We believe that our global network of owned and contractually controlled assets, coupled with our proven capabilities to execute transactions around these assets, will continue to serve as the foundation of our merchant energy business.”

Credit Downgrades

Moody’s downgraded Dynegy to “junk” level because of concern “related to the company’s current liquidity position and operating cash flow that is expected to be weak relative to existing debt levels.” The senior unsecured ratings of Dynegy Holdings Inc. (DHI) the primary operating subsidiary, was lowered to “Ba1” from “Baa3” and the commercial paper rating was lowered to “Not Prime” from “Prime-3.” Moody’s also assigned a senior implied rating of “Ba1” to DHI. The senior secured rating of Illinois Power (IP) was lowered to “Baa3” from “Baa2,” the senior unsecured rating was lowered to “Ba1” from “Baa3” and the commercial paper rating was lowered to “Not Prime” from “Prime-3.”

Moody’s said the outlook was negative “primarily due to execution risk associated with the recently announced restructuring plan, a continuing lack of investor and counterparty confidence that has limited access to public debt markets and negatively impacted the company’s marketing and trading businesses, the increased likelihood of effective subordination due to higher levels of secured debt, and uncertainty surrounding FERC and SEC investigations as well as legal challenges from Enron related to the termination of the merger agreement.”

The ratings downgrade reflects a current liquidity profile that is considerably weaker than it has been historically. Dynegy currently has approximately $370 million available under its committed bank facilities and $325 million of cash on hand, with $350 million of debt maturities (including amortization) in July and other expected uses of cash that will further reduce liquidity.”

Moody’s said Dynegy’s restructuring plan is aimed at increasing liquidity to $2 billion by year’s end, “however, the plan is also largely dependent on proceeds from asset sales, with the largest component being a 50% share of NNG, an asset purchased with cash provided by ChevronTexaco. While a sale of NNG would enhance short-term liquidity, it remains unclear how much of the proceeds will ultimately go to ChevronTexaco to deal with the $1.5 billion in preferred securities potentially coming due in November 2003.”

In addition, the company has a $300 million revolver that matures in November 2002 and $1.6 billion of credit facilities maturing in April and May 2003. Given that DHI renewed its old $1.2 billion 364-day facility at a level of $900 million with no term-out option and chose to exercise the term-out option in the $300 million IP facility, Moody’s believes future renewals are likely to be done at lower commitment levels under more restrictive terms and conditions. Therefore, refinancing risk has increased and Moody’s will evaluate any potential impact on ratings when those facilities are renewed.”

Moody’s downgrade also considered the company’s “reduced operating cash flow expectations for 2002 coupled with high financial leverage, and the likelihood that operating cash flow in 2003 may not be materially better. Previous operating cash flow estimates of $1.2 to $1.3 billion have been cut to approximately $1.0 billion, driven by a combination of weak power markets, reduced marketing and trading activity and asset sales.” It said it believes “there is a reasonable chance Dynegy’s operating cash flow could fall short of the $1.0 billion expected. Additional negative cash flow pressure could also come from the company’s telecom business, which continues to consume cash.”

Moody’s said it recognized that a portion of the energy merchant’s cash flow comes from its physical assets, long-term contracts and fee-based businesses, ” but some of these activities are still subject to volatility in volumes, which does impact cash flow. Furthermore, the level of operating cash flow accounted for by these activities is not consistent with an investment grade rating given Dynegy’s current debt levels. Dynegy’s current debt obligations include; $6.2 billion on balance sheet (including Catlin & Project Alpha), $2.2 billion off balance sheet (operating leases, synthetic leases, non-recourse), and $200 million preferred stock.”

Also, “while Moody’s continues to expect ChevronTexaco and Dynegy to work to renegotiate the terms of the preferred securities in a manner that will not be detrimental to Dynegy’s liquidity, it remains an obligation that must be dealt with. Furthermore, Moody’s believes there is a good possibility that at least a portion of the proceeds from the planned sale of 50% of NNG will ultimately go to ChevronTexaco.”

Finally, Moody’s continues to consider ChevronTexaco’s ownership interest, commercial relationships, and board representation critical to Dynegy’s ratings. If those relationships weaken, additional negative ratings pressure will result.”

Fitch Ratings downgraded last Monday, sending Dynegy Holdings Inc.’s senior unsecured debt rating to “BB+” from “BBB.” In addition, Fitch downgraded Dynegy Inc.’s indicative senior unsecured debt to “BB+” from “BBB-.” The short-term ratings for Dynegy Holdings and Dynegy Inc. have been lowered to “B” from “F3,” and the ratings will remain on “Rating Watch Negative,” where they were originally placed on Nov. 9, 2001. In addition, ratings for affiliated companies Illinois Power Co. and Illinova Corp. have been lowered and remain on “Rating Watch Negative.”

Fitch said, “while elements of the plan reduce consolidated debt and improve liquidity, the ratings downgrades are appropriate for Dynegy Inc.’s expected financial position and are reflective of a moderate degree of execution risk and the continued negative overhang from the SEC’s investigation of accounting and trading issues, ongoing [Federal Energy Regulatory Commission] inquiries, and potential litigation exposure. The Rating Watch Negative status is likely to continue until key elements of the plan have been executed.”

S&P weighed in Tuesday, lowering Dynegy Inc.’s long-term corporate credit ratings one notch, which still keeps the company at investment-grade level. The outlook is “negative,” down from “CreditWatch with negative implications,” said S&P.

“Dynegy’s business plan, growth potential, and sustainability of cash flows no longer support a triple-‘B’-plus corporate credit rating,” said S&P credit analyst John Kennedy. “Importantly, current ratings do factor in expectations for improving credit protection measures. Still, given the firm’s aggressive financial and business strategies, Dynegy’s balance sheet and credit protection measures could be subject to duress if business plans, which include increasing the profitability of merchant energy marketing activities, are slow to materialize.”

On a positive note, Kennedy said, “Dynegy’s critical mass in the gathering and processing business provides high cash flow potential, albeit at higher risk, due to the commodity price risk associated with absolute liquid prices. Consequently, strong commercial risk management skills help smooth out this unit’s profits and soften possible losses.” Also, its “large physical marketing presence in the key Mont Belvieu product hub and its complementary wholesale propane marketing business provides access to liquid physical markets in which to hedge commodity price risk. Dynegy’s midstream business segment benefits from its significant downstream activities, including fractionation, storage, and transportation of natural gas liquids, which are primarily fee-based.”

UBS Warburg energy analyst Ron Barone sees several risks for Dynegy going forward, despite its restructuring plan. He said, “Trading losses and unfavorable changes in the regulatory environment of the natural gas and electricity industries” pose risks for Dynegy, as well as a downgrade to “non-investment grade status by all of the agencies…for a sustained period of time,” as well as a substantial pullback from customers doing business with the company.

“With the plan public, all eyes now turn to the rating agencies,” Merrill Lynch’s Kirst said. “We believe the stock at current levels likely reflects a ‘split’ investment/non-investment grade credit rating. While we see Dynegy’s plan as achievable, it remains to be seen whether it will be sufficient for both Moody’s and S&P to retain an investment grade rating.”

Northern Natural Gas

NNG is, for now at least, owned by Dynegy, after Enron allowed its June 30 deadline on an option to repurchase the pipe passed. Enron’s Stan Horton, who chairs the bankrupt company’s transportation services division, informed employees via e-mail last Wednesday that Dynegy would take over the pipe July 1. Once in Dynegy’s hands, would the pipe be sold outright? Dynegy did not comment, but if such a plan is being considered, Calgary-based TransCanada would be a strong candidate.

If Dynegy were to sell the pipeline outright — instead of partnering with another company — it would bring the cash-poor merchant at least $2 billion. TransCanada, headquartered in Calgary, currently has a network of about 38,000 kilometers of pipeline that transports most of Western Canada’s natural gas production to markets in Canada and the United States. The company has long wanted more of a presence in the United States, and last fall proposed a deal with National Fuel Gas Co. to build a new 215-mile, 30-inch diameter natural gas pipeline project that would provide initial capacity of 500 MMcf/d from Dawn, ON to the Ellisburg-Leidy area in Pennsylvania (see NGI, Sept. 10, 2001).

Since Dynegy took over the pipe, it has actually lost money on the deal, because most of NNG’s income typically comes in the third and fourth quarters.

Enron still may be involved with the pipeline in some capacity, an Enron employee told NGI . Apparently, Enron’s interim CEO Stephen Cooper has been working on a joint venture to allow Enron to continue to operate the pipe. The Enron employee said that there have been discussions with Dynegy, but apparently no deals was expected to be announced before the June 30 deadline.

Dynegy Energy Partners — The MLP

Interest in Dynegy’s proposed master limited partnership (MLP) Dynegy Energy Partners LP, appears to be growing, after the company filed with the SEC Friday to increase the initial public offering (IPO) by more than one million units. Dynegy plans to raise additional capital by selling $250 million of gas midstream assets to the MLP, which will be involved in fractionation, storage, terminalling, transportation, distribution and marketing natural gas liquids in North America.

The IPO is expected to be approved by the SEC by the third quarter. Dynegy spokesman John Sousa said Friday that he could not comment on reaction to the partnership, but again reiterated it “remains in the quiet stages” pending federal approval. An estimated price range for the IPO was not disclosed in the filing, which will be underwritten by Lehman Brothers Inc.

The net proceeds from the IPO include repaying $167.2 million owed to Dynegy Inc. and its affiliates, according to the filing. Only $1.7 million of the net proceeds will be kept to use as working capital, while another $14.8 million will fund planned capital expenditures, the filing said. Dynegy and some of its affiliates will be the general partners.

According to the SEC filing, underwriters increased the IPO to 10 million common units from the original 8.75 million. The filing indicated that the common units represent limited partner interests. The 10 million common units offered include 8.7 million units offered to the public and 1.3 million units granted to the underwriters to cover over-allotments. The company has applied to list the common units on the New York Stock Exchange under the symbol “DEP.”

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