The asset that Enron Corp. sold to Dynegy Corp. last November to briefly boost its liquidity became Dynegy’s salvation as well last week, after the distressed energy marketer said it would sell its entire stake in Northern Natural Gas Co. (NNG) to Berkshire Hathaway’s MidAmerican Energy Holdings Co. for $928 million in cash and the assumption of $950 million in outstanding NNG debt. Dynegy took a $600 million loss on the deal, but gained the liquidity it needed to not just continue to operate, but also convince investors likewise.

The transaction, announced last Monday, seemed to set off a week of mostly good news for Dynegy, and despite poor second-quarter earnings, the company received much needed public support from shareholder ChevronTexaco, and earned some respect from energy analysts. Investors appeared to respond, with the stock price slowly gaining after falling to an all-time low of 51 cents the week before.

Dynegy’s interim CEO Dan Dienstbier said the NNG sale was a “decisive step forward in our ongoing efforts to improve our financial and business profile. We are committed to achieve a level of financial viability that will create a renewed sense of market and customer confidence in our company.”

The sale also marked MidAmerican, which bought Kern River earlier this year, as an up and coming interstate pipeline company. Parent Berkshire Hathaway, controlled by Warren Buffett, also continued its quest into the energy marketplace last week after helping cash strapped Williams (which had sold it Kern River) by setting up a secured credit agreement that was backed with “substantially all” of the assets of its oil and gas subsidiary Barrett Resources. (see related story).

Standard & Poor’s, which downgraded Dynegy’s credit ratings in late July to “junk,” said the NNG sale would have no immediate effect on Dynegy’s credit quality, noting that it “helps to relieve some near term liquidity issues, since it provides a source of cash and relieves $450 million in maturities coming due in November 2002. However, the sale raises concerns regarding the repayment of a $1.5 billion obligation to ChevronTexaco,” S&P noted.

Dynegy borrowed $1.5 billion from ChevronTexaco last November to help get Enron back on its feet in exchange for a purchase option on NNG, which Enron owned at the time. The purchase option was initiated after Dynegy cancelled the merger, and the NNG transaction was completed in January (see NGI, Jan. 7). However, S&P noted that there has been no change in the repayment obligation due ChevronTexaco in November 2003. And despite the sale, S&P said its analysis determines that “Dynegy will be challenged to preserve an adequate liquidity position to meet its obligations over the next 18 months.”

The NNG sale also may be hampered by a new Federal Energy Regulatory Commission inquiry launched last Thursday about whether Enron may have inappropriately used the assets of two of its pipeline subsidiaries at the time — NNG and Transwestern Pipeline — to secure emergency loans of about $1 billion just weeks before it filed for bankruptcy last December. Some speculate that FERC’s concerns about the secured loans, which were raised during an audit initiated last January, could complicate the sale between Dynegy and MidAmerican (see related story).

Dynegy previously had planned a partial sale of NNG or a joint venture arrangement as part of its ongoing capital and liquidity plan. Dienstbier said the sale of a 100% stake in NNG will provide a greater source of funds than originally expected. Elimination of the NNG debt leaves Dynegy with only a $300 million maturity due in November and no other significant maturities until May 2003.

“Northern Natural Gas is a well-managed company with excellent assets,” said Greg Abel, president of MidAmerican. “They share our focus on customer service and operational excellence.”

Of note also is the fact that Berkshire Hathaway is based in Omaha, NE, as is NNG, and Dynegy’s interim CEO Dienstbier ran the pipeline out of Omaha for a number of years for Enron. The sale is subject to customary closing conditions, including Hart-Scott-Rodino approval, but is expected to be approved by the end of August. Upon completion, 1,100 Dynegy employees working for NNG will become MidAmerican Energy employees.

The 16,600-mile NNG pipeline extends from the Permian Basin in West Texas to the upper Midwest. NNG provides transportation and storage services to its customers and cross-haul and grid transportation between other interstate and intrastate pipelines in the Permian, Anadarko, Hugoton, and Midwest areas. Its storage capacity is 59 Bcf and its market area capacity is 4.3 Bcf/d.

Although some critics questioned whether Dynegy should sell a profitable asset, Dienstbier said it was all part of stabilizing the once prosperous company. “It’s awfully easy to get in a doom-and-gloom mood,” he said. “But I’m not pessimistic in our ability to complete our plan and move forward…Sometimes, you have to go home and say, ‘Hey, get a grip…This is a good, solid company,’ and we intend to be here when it is all sorted out.”

As part of its plan to achieve stability, Dynegy also may be negotiating with the Securities and Exchange Commission (SEC) about its questionable accounting practices. Although there were no comments from either side, the Wall Street Journal reported Friday that sources indicated negotiations were under way.

Dynegy reported second-quarter income on Tuesday, announcing it had a loss of $328 million, or 92 cents a share, compared with income of $146 million, or 43 cents a share, for the same period of 2001. Dynegy’s losses were attributed to lower natural gas prices and a sharp fall-off in its once prosperous trading unit, where results declined 93% from a year ago. The 2002 quarterly results include a pre-tax non-recurring charge of $499 million ($324 million after tax), which the company had already disclosed. Without the extra charges, Dynegy would have lost $4 million in the quarter, or only 1 cent a share.

If the company breaks even for the remainder of the year, earnings are estimated to be 41 cents, a steep drop from its previous 2002 guidance of $2.00-2.05. The revised guidance, said Dynegy, reflects “new capital and liquidity initiatives and takes into account lower commodity prices, reduced liquidity levels and weaker energy industry fundamentals.” Reported cash flow from operations for the first six months of 2002 totaled $375 million. The company confirmed its fiscal year 2002 guidance for cash flow from operations of $600 million to $700 million.

Dynegy declined to offer 2003 earnings guidance. Dienstbier said the energy merchant business is “changing too rapidly” to make a realistic assessment so far ahead. He said he thinks there will be a lot of changes within the sector before the end of the year.

“Clearly, times are tough for the entire industry,” said Dienstbier. Going forward, he said, will be the “stabilizing period.” The CEO noted that the quarterly results were “consistent with our previously announced goal to manage for cash as we execute our capital and liquidity plan.” He said results were substantially affected by the decline in realized commodity prices and lower liquidity levels. Now, he said, Dynegy will be “focused on running our businesses efficiently, managing our costs and generating cash.”

Asked to detail the challenges facing the entire energy merchant sector, long-time COO Steve Bergstrom declined, saying it would take too long. “If you look at all of the challenges, it would take a day to go through. We’ve got to get some stability in this industry. Our goal on risk management is to break even for the rest of the year. This is the worst quarter…the third quarter should be better. We can’t extrapolate across the year, but the entire environment should be much different in the third and fourth quarter. It looks like things are bottoming out, and I don’t think things can get materially worse. We can at least cover our costs, and we’ve taken out a bunch of costs with the trading business, and we’ll start seeing the impact of those costs coming down in the third quarter as well.” Dynegy continues to seek a marketing and trading partner with strong credit that will back its trading expertise.

Most of Dynegy’s cash flow at this point is coming from its hard assets, including its power plants and storage facilities. The largest cash flow generation for subsidiary Illinois Power comes in the third quarter, said Bergstrom. “We’ve done quite a few things over the past month to manage the cash. What we’re not worried about is cash.” Bergstrom said that the company continues to have a “modest increase” in its marketing and trading business, but most of it is original business where the collateral has been posted.

Once the sale of NNG closes, said Dienstbier, “it will give us liquidity. It will certainly be different at that time…The sale of Northern Natural is a huge step, and it gives us some breathing room.”

To improve its financial reports, Dynegy will enhance their transparency and clarity. Among other things, additional information will be provided to investors beginning with the second-quarter earnings in its SEC filing. Included will be operating cash flow disclosure by segment and segregated financial contribution (a non-GAAP term defined as revenues less costs of sales, plus earnings for unconsolidated investments) among earnings generated from regulated operations, term contracts, fee-based operations, other assets and marketing and trading operations. In addition, Dynegy will provide a single schedule that reconciles the financial effects of risk management activities to the company’s balance sheet, income statement and cash flow statement.

Following last week’s announcements, the research team at Credit Suisse First Boston recommended Dynegy as a “strong buy,” but it reduced its 2002 earnings estimate to 50 cents a share, down from 95 cents. For 2003, the analysts reduced its estimate on Dynegy to $1 from $1.20. Cash flow estimates are $1.75 for 2002 and $2 for 2003.

“Our valuation thesis for Dynegy looks for a near-term recovery to our ‘distressed asset value’ of $3.50 per share,” said the analysts. “Our longer-term target of $12 per share represents ‘utility multiples’ of 12X earnings per share and 5.5X cash flow.”

For the second quarter, Dynegy’s Wholesale Energy Network reported recurring net income of $11 million, a 93% decrease compared with $150 million for the same period of 2001. The asset businesses, including generation and storage, reported recurring operating income, after the impact of general and administrative expenses, depreciation and amortization, of $57 million in the second quarter 2002, a 16% decrease compared with $68 million in the second quarter 2001. These results reflect lower earnings from the company’s generation assets because of lower power prices. The decline was partially offset, however, by the addition of Dynegy Storage, the company’s natural gas storage and gas processing facilities in the United Kingdom, which contributed $15 million in operating income in the second quarter 2002. Earnings from unconsolidated investments were also impacted by reduced power prices.

Customer and risk management activities, which include controlled assets, marketing and trading, had a recurring operating loss, following the deduction of general and administrative expenses, depreciation and amortization, of $48 million in the quarter, compared with $96 million in recurring operating income in the second quarter 2001. “These results reflect reduced energy trading and wholesale origination activities associated with less market liquidity and Dynegy’s lower credit ratings,” the company said in a statement.

Dynegy Midstream Services, which consists of the North American midstream liquids processing and marketing business and worldwide natural gas liquids marketing and transportation operations, reported a recurring net loss of $4 million in the quarter, compared with recurring net income of $10 million for the same period a year earlier. Lower natural gas liquids prices and liquidity levels in global energy markets impacted this segment.

Dynegy’s regulated transmission and distribution segment net income was up, standing at $15 million for the second quarter, compared with $6 million a year ago. The segment’s performance benefited from the brief addition of NNG, which had recurring operating income of $14 million after expenses. The unit also benefited from the performance of subsidiary Illinois Power (IP), which reported recurring operating income of $50 million after expenses, depreciation and amortization. IP had lower costs because of above-normal weather in its service territory, said Dynegy.

The company’s communications segment, Dynegy Global Communications, which was launched during the fourth quarter 2000, reported a $26 million loss in the quarter. However, the reduced earnings from equity investments were offset by cost containment and improved revenues. Dynegy’s 16,000-route-mile, optically switched mesh network now reaches 44 U.S. cities. Management has already announced that it intends to reduce its financial exposure to this segment, and has written off all of its balance sheet investment with the second quarter charge. Dynegy said it would continue to maintain its operations in order to meet current customer commitments and obligations, but did not give details about the business segment’s future.

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