The energy marketplace, investors and credit analysts appeared to have little faith in Dynegy’s ability to turn its deteriorating financial picture around last week. The three credit ratings agencies cut the merchant not once but twice, the stock fell as low as 51 cents a share at one point, and counterparties were apparently ditching the company for safer ground. By Friday, buoyed by rumors that its subsidiary Illinois Power Co. may be close to being sold, optimism was up, albeit slightly, with more buyers than sellers — the price gained as much as 20 cents at midday.

However, Dynegy may see how much momentum it can carry on Tuesday, when its second-quarter earnings announcement and resulting teleconference is scheduled (www.dynegy.com). Dynegy saw its share price massively eroded last week, first on Tuesday when it dropped 64% of its value, and again on Thursday, when almost 35 million shares traded hands and brought it down to a mere 51 cents. Average daily trading volume is 7 million shares; on Tuesday, volume was 33 million.

Even though investors have rushed to sell, energy analysts overall have yet to abandon the company. Ratings among a core group of 16 equity energy analysts remained positive, with 14 recommending “hold,” one “strong buy,” and one “underperform.” There were no “sell” recommendations from the 16, who cover Dynegy on a regular basis and include A.G. Edwards & Sons Inc., Banc of America Securities LLC, CIBC World Markets Corp., Credit Suisse First Boston Corp. (CSFB), JP Morgan, Lehman Brothers, Merrill Lynch, Prudential Securities, Salomon Smith Barney Inc. and UBS Warburg.

CSFB’s Curt Launer stood by his rating of “strong buy.” And Prudential analyst Carol Coale said Dynegy still had three months before any of its debt maturities were due — plenty of time, she said, to try and turn things around. She rates the stock a “hold.”

However, not all analysts agree. Zacks Investment Research on Thursday added Dynegy to a list of four other stocks that it recommended should be “sold or avoided for the next one to three months.” Dynegy, said the analyst, “continues to face questions concerning its liquidity. In fact, the company admitted that it may need help from a financially sound partner. Analysts haven’t wasted any time in showing their disdain for the company’s current situation. Estimates have been plunging sharply since the beginning of the year with Dynegy barely meeting estimates in the last two quarters. With no relief in sight, Dynegy looks like a company riding on the wrong track at this time.”

Dynegy, which was the first energy marketer when predecessor Natural Gas Clearinghouse was formed almost 18 years ago, made perhaps the strongest statement yet Tuesday that its energy trading business has hit the skids. CEO Dan Dienstbier admitted that “a strong investment grade rating will be required for this business to be successful in the future.”

Management is now “exploring strategic options” for the business, which could include creating an “independently rated joint venture” for its once well regarded trading arm. Dynegy also revised its fiscal 2002 operations cash flow to a range of $600-700 million, down from its previous estimate of $1 billion. Current liquidity ranges between $800 million and $850 million.

Dienstbier said that the board of directors indicated that it was “satisfied with both the speed of execution and progress we have made on our capital and liquidity plan,” and attributed the reduced guidance to the downturn in its marketing and trading activities, “partially the result of industry conditions, and lower-than-expected prices for power, natural gas and natural gas liquids. The same fundamentals have also impacted Dynegy’s liquidity.”

On Friday, rumors began circulating that Ameren may be negotiating with Dynegy to buy Illinois Power Co. (IP). A St. Louis radio station and the St. Louis Post-Dispatch Friday even reported that it may be a “done deal.” Dynegy nor Ameren would comment, but speculators thought it sounded good on paper. Ameren is in healthy shape financially, with record second-quarter earnings. It now is close to completing a deal to Peoria, IL-based Cilcorp Inc. from AES Corp. for $1.4 billion. Another potential buyer mentioned was Exelon, which also has Illinois customers. One source said that Ameren and Exelon may even be considering splitting up the IP assets to avoid regulatory problems.

While an asset sale would be one of Dynegy’s objectives, it still faces a lot of hurdles, especially from the credit rating agencies. The Houston-based company has taken weeks of losses and downgrades, and last week took it on the chin more than once after Standard & Poor’s Rating Services, Moody’s Investors Service and Fitch Ratings downgraded the company not once but twice, to “B” status. (A rating of “C” indicates that the company may have difficulty meeting its obligations.) Because of the downgrades, Dynegy subsidiary IP pulled out of a $325 million mortgage bond sale that was scheduled to close Tuesday, and said IP “hopes” to complete the sale later in the third quarter.

“While we are certainly disappointed, we understand the agencies’ views and remain committed to re-establishing an investment grade credit profile,” Dienstbier said of the rating agencies’ actions.

The Houston-based energy marketer’s cash flow deterioration “continues unabated,” noted S&P, with the core merchant energy business now expected to decline even further “because it is likely industry counterparties are engaging in only low-margin spot gas transactions, a trend that is expected to continue.” S&P analyst John Kennedy said, “Given counterparty unwillingness to transact in little more than spot gas trades, Dynegy’s cash flow potential has weakened.”

In addition, he said, “Dynegy has been unable to execute on asset divestitures, including the expected partial monetization of Northern Natural Gas, which further exacerbates credit difficulties. The rating action at Northern Natural reflects Standard & Poor’s view that the sale is uncertain and therefore Northern Natural’s creditworthiness is commensurate with the consolidated credit rating of Dynegy.”

Some cash collateral calls have been demanded, according to S&P, and Dynegy’s available sources of liquidity have diminished slightly. “As evidenced by its inability to quickly sell assets or access capital markets, Dynegy’s liquidity position is tenuous.

Several near-term obligations are “on the horizon,” said the analyst, with about $750 million in debt and bank facilities ($300 million at Dynegy and $450 million at Northern Natural) due to mature or expire by Nov. 2002, and a $1.5 billion preferred stock right being held by Dynegy’s largest shareholder, ChevronTexaco Corp., which is redeemable in November 2003. “In addition, Dynegy’s plan to solidify its balance sheet faces significant execution risk in several areas, including its launch of a master limited partnership, Dynegy Energy Partners, expected to provide $200 million in additional capital. The ability to execute this transaction is highly questionable under current market conditions.”

S&P also has “lingering concerns regarding the firms’ ability to access capital markets and/or execute asset sales necessary to preserve an adequate liquidity position to meet its obligations over the next 18 months. A demonstrated ability to achieve these goals could result in ratings stability.”

Fitch cut Dynegy and its subsidiaries as well, noting that its current analysis reflected a “continued weakening in the company’s credit profile…Based on available information, Fitch is unable at this time to have a high level of confidence in estimates of sustainable cash from operations, other than from the regulated electric and gas pipeline operations.” Dynegy’s “capital market conditions continue to worsen and the negative over-hang…and potential litigation exposure have not abated. Therefore, Dynegy’s ability to successfully execute its restructuring plan has become less assured.”

To allow for execution risk, Fitch’s stress case analysis around the Dynegy restructuring plan assumed no new equity financing at Dynegy or its planned master limited partnership (MLP), and additional near-term cash uses of $300-400 million relating to collateral postings. “However, the inability to complete the IP [Illinois Power] secured bond financing is an adverse change from Fitch’s prior stress case.”

Unlike S&P, which was concerned about debt maturing later this year, Fitch concluded, “there are no material debt maturities or anticipated extraordinary cash drains other than potential collateral postings until November 2002 when a $300 million revolver at Dynegy and a $450 million secured loan at Northern Natural Gas Co. come due. By that time Dynegy plans to have sold assets and issued units at its MLP, but Fitch notes that there is heightened execution risk.”

Moody’s said its “ratings downgrade reflects a current liquidity profile that remains significantly below levels seen earlier this year and below levels projected as recently as June. The steps taken by Dynegy to enhance liquidity thus far have largely addressed immediate liquidity needs, and…have fallen short of addressing needs looming in early 2003.” Dynegy also may face an additional challenge in meeting its revised 2002 earnings projections, it said.

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