Standard & Poor’s Ratings Services upgraded its opinion on Dynegy Inc. last week, and investors responded, after the company offered an upbeat, investor-inspiring earnings forecast on Tuesday that beat Wall Street expectations.

Dynegy estimates 2003 earnings to range between 8-15 cents per share, or $465-500 million before interest and taxes. Liquidity as of Dec. 31 stood at $1.47 billion, which held close to its position on Nov. 14, when liquidity totaled $1.497 billion.

S&P was impressed, changing its recommendation on the stock from “Avoid” to “Hold.” Analysts said, “We now expect DYN to refinance $1.3 billion in bank debt due in April/May. Free cash flow should cover $550 million in other debt obligations, leaving $1.5 billion of unsecured debt to be refinanced in November.

“Before tolling losses, we project $350 million ’04 free cash flow. We now see odds of ultimate bankruptcy below 50%, making DYN, at under 30% of book a plausible speculation for very aggressive investors.” The ratings agency endorsement was just about the first of that rare breed seen by Dynegy or any of the beleaguered energy companies in over a year.

CEO Bruce A. Williamson, who had confidently led an hour-long analyst conference call Tuesday morning surrounded by his executive team, said the start of the new year had “created an even greater sense of commitment” on three major initiatives:

Following the conference call, Dynegy’s shares soared. Opening the day Tuesday at $1.42, Dynegy gained 64 cents on the day, up more than 45% to close at $2.06. Dynegy had not closed above $2 since Sept. 6, 2002, when it closed at $2.07. For the rest of the week, investors remained optimistic but cautious. At midday Friday, Dynegy was trading in the $2 range.

“While we still have some of those past issues to address, I assure you that we will do so thoroughly and as expeditiously as possible,” said Williamson. “Dealing with these issues…by stepping up and taking responsibility for them also demonstrates our commitment to instill a new culture at Dynegy.”

He noted that 2002, which was forgettable for many energy companies, had ended up on some “very positive notes” for the company, including Illinois Power’s (IP) $500 million mortgage bond offering; the sale of its international liquid petroleum gas business; and reaching a settlement with the Commodity Futures Trading Commission on improper reporting of energy trades by former employees.

Transparency, said the CEO, “is vitally important to the entire leadership team as we work to rebuild stakeholder confidence,” and he detailed the “issues” still to be concluded by the company. Among them is the three-year re-audit, which is being performed by PricewaterhouseCoopers. Williamson said the re-audit is proceeding and is expected to be completed in the first quarter. Restated historical financial information was refiled in November, and the re-audit and 2002 quarterly review could require additional restatements.

“It’s important for us to take responsibility for these issues as a company and then to move the company forward with clarity,” he said, adding that given the asset focus and simpler business model, additional restatements “should not affect guidance” given on Tuesday.

Financial analysts who follow Dynegy said following the call that whether the former energy merchant will make it depends on its investors and financial institutions. John Olson, chief investment officer for Sanders Morris Harris in Houston, said Dynegy’s progress to date was on the “right road,” adding it was a “matter of whether the banks and everyone else” would let them reach their destination.

Christopher R. Ellinghaus, a Williams Capital analyst, called Dynegy’s liquidity position “fairly impressive,” but noted that it “remains insufficient to meet mid-year maturities.” Dynegy “will be in a decent cash position in which to negotiate a roll-over of maturing credit lines, but still remains at the mercy of the banks.”

Credit Lyonnaise analyst Gordon Howald called the company’s outlook “a little bit rosy” for both estimated prices and bank renegotiations. However, he said, “the key point here is, it appears that they are going to make it through at least November 2003. Going from a company that appeared to be very likely to file for bankruptcy, Dynegy is now a company that has a pretty good shot at surviving 2003.”

As of Dec. 31, Dynegy’s liquidity included $915 million in cash ($137 million in escrow relating to the IP bond offering to be received by mid-January), $1.4 billion in bank lines and $258 million of remaining liquid inventories — less $228 million of draws against bank lines and $878 million in letters of credit posted for collateral. The letters of credit are principally to third-party aspects of the company’s marketing and trading business, according to Williamson.

Dynegy’s liquidity position, added the CEO, does not include about $130 million of inventory already sold to “creditworthy customers.” Those funds are expected also this month. In addition to maintaining its liquidity in the fourth quarter of 2002, Dynegy also reduced its bank exposure and debt by $850 million. And by the end of this month, Dynegy expects to repay another $100 million in debt.

Williamson praised the entire company for working together to maintain liquidity through the fourth quarter. “While other companies are talking about handling their problems, and banks are concerned about their exposure to companies and the energy sector as a whole, Dynegy is executing its plan and simultaneously reducing our bankers’ exposure.”

Going forward, the CEO detailed 2003 earnings guidance, which beat Wall Street forecasts by at least five cents. Beginning this year, Dynegy will report three operating segments and a corporate/discontinued operations group. Major assumptions in the 2003 plan include the following:

In its earnings guidance for Dynegy Generation, earnings before interest and taxes (EBIT) are expected to be $305-315 million. Williamson noted that 70% of its 2003 operating margin plus equity earnings is under contract with “creditworthy customers…not hedged via a trading book or some other so-called hedge position that can change over time.” The forecast does not assume changes to its California Department of Water Resources contract or any reversal of reserves against outstanding receivables in the state.

“From a commodity pricing perspective, our forecast portfolio weighted average on-peak power price forecast for 2003 is approximately $36.” Williamson said the forecast is “highly regionalized,” with the overall price based on forward curves for each applicable region: ComEd $30.00; Cinergy, $31.50; Zone G, $50.00; Southern, $32.50; ERCOT, $40.50; and SP 15, $45.25).

The EBIT forecast for Dynegy Midstream Services, which includes both upstream and downstream operations, is expected to range between $160-170 million.” The CEO noted that earnings will be driven by gas liquids prices, the fractionation spread and gas production volumes. Earnings, which are expected to be flat compared with 2002, were forecast with price assumptions of $4.00/Mcf for gas and $27.00/bbl of oil. (The 12-month futures strip on Tuesday was $4.75.)

Regarding its still major stockholder ChevronTexaco, which holds a 26.5% stake in Dynegy, Williamson affirmed that Dynegy will continue a long-term agreement through 2006 to process its gas, provide natural gas liquids marketing services, and supply feedstock to their refineries and chemical plants.

ChevronTexaco also holds a $1.5 billion convertible preferred obligation, which comes due in November. Williamson said he was “confident that ChevronTexaco preferred is not likely to be converted to common stock under the existing terms,” but added that if it the shares were converted to common stock (368 million preferred to 420 million fully diluted), the guidance estimate would only lose 1 cent, falling in the range of 7-13 cents earnings per share.

For IP, Dynegy expects to see EBIT of $185-195 million, noting that the service territory operates in one of the “most favorable regulatory structures in the country.”

Finally, within its corporate unit, Dynegy expects an EBIT loss of between $180 million and $185 million.

This year, Williamson said the company expects to have “very strong operating cash flow” of about $1.2 billion to $1.3 billion. By segment, Dynegy Generation would have $340-$350 million; Dynegy Midstream, $195-205 million; IP, $100-110 million; and corporate, $595-600 million.

With the unwinding of its energy marketing business, Dynegy will see a cash roll-off of the trading book, and a return of “significant amounts of collateral.” Gas in storage during that time will be withdrawn, and “we will manage out of existing gas and power positions.”

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