It’s too soon to tell whether Dynegy Corp.’s proposed merger with Enron Corp. will be approved by federal regulators, but the most critical problem may not be how big the two companies’ trading power will be, but how much Enron’s shrinks over the next few months, analysts noted last week. If Enron regains and retains the number one position it held just weeks ago, federal approval may be questionable; if Enron’s market share is diluted, the merger may stand a better chance of succeeding.

As it prepares for the long journey toward becoming one company, both Dynegy and Enron executives also met with the investment community last week to explain what the future holds, including speculation about the ongoing U.S. Securities and Exchange Commission (SEC) investigation, as well as expected cutbacks in some of Enron’s non-core operations.

The proposed $24 billion merger announced Nov. 9 is not expected to reach its conclusion before the third quarter of 2002, but already, analysts are pondering what the gas and power trading marketplace will be like with or without the innovative company. Questions also remain about what the energy trading landscape will look like at the end of 2002, and whether a new rival will step forward to claim Enron’s place, which up to now has been envied, but never copied.

What some see as the largest potential stumbling block to the merger is Enron’s share of the energy trading marketplace, which up until a few weeks ago appeared unsurpassed. Dynegy, which debuted its proprietary electronic trading platform Dynegydirect a few months after EnronOnline’s debut in November 2000, never attempted to compete with its downtown rival. However, a merger would give regulators their first look-see at the inner workings of the secretive trading marketplace.

The Enron-Dynegy merger should not run afoul of market power concerns in regards to its trading business if the measurement used is the Herfindahl-Herschman Index. The HHI is a popular measuring formula used by economists to determine market concentration. Applying HHI to second quarter 2001 results for the top 20 power marketers and top 20 natural gas marketers, shows neither market even comes close to the threshold level of 1,800, which signals concern that the market is so concentrated that an individual company could possess market power.

A calculation of the volumes sold by the top 20 gas marketers in the second quarter, produces a score of 676, while a similar calculation of the HHI formula using megawatts of power sold by the top 20 marketers produces a score of 763. While the Federal Energy Regulatory Commission has used the HHI in the past, going forward the Commission has said it may look at regional markets and use other measurements to determine market power.

In the second quarter 2001, Enron and Dynegy combined sold a total of 36.2 Bcf/d of gas, which represented 21% of the volumes sold by the top 20 gas marketers in North America (168.9 Bcf/d), according to a ranking by NGI . Enron was the top gas marketer with 25.3 Bcf/d and Dynegy was No. 6 with 10.9 Bcf/d. Statistics provided by Maryland-based Energy Performance Review (EPR) show that Enron and Dynegy combined sold 143,824 million kWh of power in the second quarter. That total represented 14% of the power sold by the top 20 largest power marketers (1,000,961 million kWh), according to EPR. Enron was in fifth place among power marketers with 73,724 million kWh sold, while Dynegy was in sixth place with 70,100 million kWh. A 35% market share for a single company is considered the threshold for market power concerns.

Energy analysts covering both Enron and Dynegy are weighing in on the proposed merger. Prudential Securities’ M. Carol Coale downgraded Dynegy to “hold” with a “moderate” risk from “buy” on Thursday, noting the share’s recent 19% increase that had exceeded the $45 price target, along with the “unknowns” that are part of its merger with Enron.

Coale said, “On paper, the merger looks good from an earnings accretion perspective,” but “we are still uncertain of (Enron’s) future earnings power and its ability to maintain investment grade credit ratings.” Based on what is now known, the analyst added that the “upside potential of the merger…is largely reflected in (Dynegy’s) stock.” However, Dynegy will likely have “restricted access to Enron’s books, and therefore, may be missing critical information.”

UBS Warburg’s Ronald Barone last Thursday rated Enron a “strong buy,” but he lowered projections for the fourth quarter to $.25 from $.40. The consensus estimate is $.45. Barone also reduced the 2002 projection to “reflect a more conservative outlook” to $1.65 from $1.95. Dynegy has already stated it assumes about $1.50 next year for Enron.

“If the merger with Dynegy were to run into obstacles (or fall through entirely), Enron shares could come under severe pressure as investors may question its ability to sustain liquidity (and normal business activities) for an extended period of time.”

RBC Capital Markets analysts thought Dynegy’s position going into the merger was well protected, rating its shares a “strong buy-average, but at some point, purchase of Enron shares may be a very attractive purchase to get into Dynegy shares.” RBC said, “as we see it, Dynegy has implemented several adequate provisions protecting itself if the transaction does not go through,” including its ability to pick up Northern Natural Gas if the deal falls through.

DRI-WEFA’s Shawn Intorcio predicted Thursday that the proposed merger between Enron and Dynegy will go through, but she noted there are a lot of “uncertainties,” adding it will only happen after a lot of scrutiny by federal regulators. “I think after the regulators look at the erosion of Enron’s position in the marketplace in the next few months…and it’s likely it will shrink, then it would be more likely to be approved.” With its combined annual revenue above $200 billion, that alone also would raise anti-trust concerns, she said.

The big question is what will happen to Enron’s trading abilities in the next few months. Until the merger is completed, Intorcio does expect to see diminished activity and competition in trading markets, which in turn will lead to price volatility if Dynegy’s merger with Enron is completed.

Intorcio said, “we’re still waiting to see if there are more skeletons in the closet. She said, “there is much speculation about the true financial condition of the company, and whether Enron’s current trading portfolio could leave it highly exposed financially.”

Some in the industry are questioning Enron’s financial solvency and how its potential end will ultimately affect the online trading business. “In the short-term, the negative effects of Enron’s financial woes are already being felt,” said Intorcio. “Many traders are worried about the credit risk and counterparty risk caused both directly and indirectly by Enron’s insolvency and decreased their trading activity in the Henry Hub market,” and she said there remain “many factors” that could cause the deal to unravel besides just the legal entanglements.

“With Enron’s absence, it is uncertain what company, if any, will step up to assume the role of market innovator,” said Intorcio. “Without a dominant leader, the pace of change in the energy trading market is expected to slow tremendously, creating somewhat static markets for less mature trading markets, such as electricity.”

There are other long-term implications to the loss of Enron. Along with its dominance in gas and power trading, Intorcio noted that “Enron played a critical role in pushing for market reforms and regulatory changes,” and “aggressively sought to develop and dominate the electronic trading market.” Since EnronOnline was launched in November 1999, the company has closed more than $1 trillion in transactions, and was “instrumental in expanding the trading markets” to include other commodities.

However, with Enron’s potential stumbles, other players and potential players may get a boost, she said. “The controversy… will not be all bad for the trading markets…Trading volumes have dropped off with many of Enron’s trading partners cutting their credit limits with Enron,” and near term, she expects “trading activity to continue to shift away” to many of Enron’s rivals, including IntercontinentalExchange (ICE).

Another possibility would be new players in the trading market, especially as Enron confronts its mountain of legal challenges. Some may debut proprietary systems, like Dynegydirect, while others with or without proprietary systems may pull together. “I think we might see more proprietary systems and maybe another consortium or something along those lines, like ICE, which allows small players to mitigate their risk. I do think we might see other players muscle in.”

In the meantime, Dynegy CEO Chuck Watson began making the obligatory house calls to institutional investors last week, checking in with investors in New York City, Denver and Chicago to explain the merger details. Among the investors Watson has contacted are Janus Capitol Corp., Invesco, Fidelity Investments, Alliance Capital Management and Morgan Stanley Dean Witter. All the groups hold either or both Enron and Dynegy shares.

However, whether Watson will visit the California Public Employees Retirement System (CalPERS) was questionable, said Dynegy. CalPERS is the largest pension fund in the United States, owning 3 million Enron shares. It has called on Enron’s board to step down if the merger is approved, citing allegations of self-dealing by Enron’s senior management.

Enron’s 4Q to be Down, Streamlining Operations

Meeting with the investment community last week, Enron Chairman and CEO Kenneth L. Lay was more candid than he’s ever been, noting that the company he had built had recently made some “very bad investments in its non-core businesses,” and as a result, the fourth quarter earnings will reflect that. However, Lay emphasized that “everything we know, you know.” Enron is expected to update guidance on its fourth quarter earnings in the next few weeks, but going forward, Lay said merger-bound Enron will go “back to basics” and focus on the core assets that had propelled the Houston-based company into the Fortune 100.

“We fully understand and regret that the combination of events led to a loss in investor confidence,” said Lay, and “we will take the steps necessary to address all of these matters.” Although no specifics were offered to reflect the expected downturn in fourth quarter earnings, Enron’s current executive team, including President Greg Whalley and CFO Jim McMahon, joined Lay to address shareholder concerns about how the company plans to boost investor confidence.

“The recent events…I believe to be temporary,” said Whalley, who will become an executive vice president in the Dynegy merger, but he admitted that the disclosures regarding writedowns and inaccurate earnings figures over a four-year period will have a “negative impact on fourth quarter profitability.”

Noting that Enron was “halfway through the quarter,” Whalley said it was still “too early to tell what the impact will be on operational results.” He said the fourth quarter also would be negatively impacted by severance costs and restructuring costs, which he said would be addressed as the company prepares its budget for 2002. “I remain optimistic that the actions we have taken over the last few weeks have substantially answered the questions on credit” and other issues.

Whalley also is optimistic that confidence in Enron’s operations has begun to grow. “We have seen an improvement in the relationship with our counterparties this week,” said Whalley. “The current transaction level is lower but it has remained strong and there is growing acceptance [of] our stability.” He did not have specific figures on the trading activity, but said it was improved from what the company had seen last week before the Dynegy announcement late Friday. He added that he expected the trading activity to “return to normal levels later this week or sometime next.”

As explained by Whalley, Enron has begun to regroup, and is dividing its assets into three segments: core, non-core and those businesses under review. The core businesses, he explained, are Enron’s “consistent franchise businesses” where the company holds an advantage, including its natural gas pipeline assets, wholesale natural gas business in North America and Europe and retail operations. In the core assets, Whalley said Enron had “no intention to downsize.”

However, non-core assets, those that “do not provide value to the core assets,” which are primarily part of Enron’s global assets and the failing broadband segment, will be streamlined.

“We have $8 billion in investments in these non-core [businesses] and the return is dismal,” Whalley said, emphasizing that Enron plans to “exit these businesses in an orderly fashion” to generate “billions in cash” which will be used to repay debt and to redeploy into its core assets.

Businesses defined as being under review, said Whalley, are those that Enron believes “have strong future prospects, however, under the current environment, we will look at each” to determine both near- and long-term earnings and cash generation. Those assets under review include “primarily the wholesale business outside of gas and power,” including energy-related and industrial activity assets. Whalley said Enron planned an in-depth assessment of each business and would then determine whether it should “extend more resources” or get rid of them.

CFO McMahon, whom Lay said has been directed to righting Enron’s financial stability, said that Tuesday Enron had received $1.5 billion from Dynegy as an equity investment. When added to the $3 billion in credit extended three weeks ago, commitment letters of secured credit lines, and the nearly $800 million in asset sales expected to close by the end of this year, McMahon said investors should have “much more confidence” in the company’s access to daily liquidity.

“The company’s over leveraged…that’s just a fact, said McMahon. “We needed to raise equity cash and in this environment, we cannot raise public equity capital very efficiently, so obviously, we have gone to other sources as a means to get the balance sheet on the road to a healthier level…and combined with our asset sales, we feel confident that over time, we will get this company back to where it ought to be.”

SEC Filings Detail Merger

In the several documents filed with the SEC last week, Enron spelled out specifically the terms of the merger, noting in one filing that until the merger closes as expected in the third quarter of 2002, “we will continue to deal with one another on a commercial level as competitors, just as we have done in the past,” including its operation of EnronOnline, the leading electronic trading platform in the world.

Enron noted in one of the SEC filings that EnronOnline will continue operations until the transaction closes. As far as the impact on counterparty trading with Dynegy, Enron said that until the deal closes, Dynegydirect and EnronOnline will “remain separate companies and will keep confidential trading information confidential.” Once the merger is completed, Dynegy COO Stephen Bergstrom said Monday during a conference call that he thought that the new company would use a hybrid of the two electronic trading platforms.

“EnronOnline is larger than Dynegydirect,” said Bergstrom. “We expect to use the best of both.” The EnronOnline platform, which has, since its inception in November 1999 been the market leader, has become the backbone of the trading industry around the world. It handles an average $2.5 billion in natural gas, power and crude oil transactions daily. In the third quarter of this year, Dynegydirect reported $10 billion in notional transactions.

The SEC filings also disclosed that Enron’s broadband business has been written down, “so what remains is the $600 million network. These assets are included in the transaction with Dynegy.” It also disclosed in the filings that it plans to complete its headquarters building in downtown Houston, which would fall into Dynegy’s hands when the transaction is complete.

As far as what happens once the merger is completed, Enron noted that the new company could possibly split its regulated and deregulated businesses, but said that was still to be determined. Also, “some elimination of positions is almost inevitable in this type of merger, and one of the key tasks will be to identify the optimal structure and resourcing of the merged company.” Enron added that it hopes to “address any need for employment reductions through attrition and reduced hirings. We cannot rule out involuntary separations, but we have not targeted a specific number at this time.”

In one of the filings, an e-mail to Enron employees by Lay dated Nov. 9, the day of the announced merger, Lay said, “I ask you to consider the enormously bright future of the newly formed company,” Lay wrote. “Rather than closing doors, we are opening new ones, as this deal enables the customers and shareholders of both companies to participate in the tremendous benefit of the combined enterprise, including our market reach, financial strength and industry experience. Together, we will be a new merchant powerhouse.”

If other entities are interested in acquiring Enron, the SEC filing notes that “if the Enron Board receives an unsolicited offer that it determines is better for its shareholders than this transaction, Enron may terminate this transaction, pay the break-up fee, and pursue the competing bid.”

However, in certain circumstances Dynegy may also call the deal off — but still gain a handsome piece of Enron’s company. In return for Dynegy’s $1.5 billion investment through its shareholder ChevronTexaco, Dynegy has the right to acquire Enron’s pipeline subsidiary, Northern Natural Gas. If it cancels the deal without citing any material adverse change in Enron’s business, Dynegy might lose $350 million as provided in the merger agreement. However, the $1.5 billion investment would stand and Dynegy could take the pipeline regardless.

Under certain circumstances, Dynegy may convert its equity stake in Northern Natural Gas into an equity stake in Enron, instead of its right to purchase an indirect 100% interest in Northern Natural Gas. Enron noted, “Northern Natural Gas will remain an important member of the Enron family. If the merger is terminated, Dynegy has a right to acquire Northern Natural Gas, subject to a repurchase right of Enron.” Dynegy will own preferred stock in Northern Natural Gas “unless and until the merger is terminated and Dynegy exercises its right under certain circumstances to purchase 100% of Northern Natural Gas.”

In a related SEC filing Tuesday, a document disclosed the terms of Chairman Lay’s ability to gain at least $60.3 million in severance if he waits to leave his positions after his company’s sale with Dynegy Corp. is completed. According to Schedule 14A documents filed with the SEC, Lay, scheduled to retire in December 2005, would be entitled to receive a lump sum plus any related tax penalties for an “excess parachute payment.”

An Enron employment contract with Lay, amended twice in the last two years, provides for employment through Dec. 31, 2005, and notes that in the event that Lay terminates his employment within 60 days of a “change of control,” he may receive a lump sum payment equal to the number of full calendar years remaining under the term of the agreement multiplied by $20.2 million.

However, following meetings with some of his management team, Lay announced last week that he would forego the severance package.

Watson Confident of Deal

Dynegy’s Watson told the investment community last week he was “90% sure” that the risk/reward ratio in the planned merger with Enron made it “clearly worth doing the deal,” because the issues that decimated the former market leader were with its non-core businesses. Explaining that his team had “adequately bracketed the downside,” as the deal fell together over the past few weeks, Watson said he could not be “99% positive,” but noted that the upside was “substantial,” and said he had a “good deal of confidence…that we’ll be absolutely fine here.”

Once the merger of Dynegy with Enron is successfully completed, the new Dynegy will become the “primary market player in all markets,” but there will be a significant difference in how the company moves forward, noted Dynegy CFO Rob Doty. Enron’s financial-backed trading strategy will merge with the “strong asset base” of Dynegy’s.

Ben Schlesinger, whose company Schlesinger & Associates analyzes the energy industry, said last Monday that the big problem in the merger is “whether these two companies are able to pull together…to harness what’s there.” He said the “two parties are clearly leaders,” but theoretically, they will have to streamline their operations. “Both books are fairly strong,” he said, and once their efficiencies are put together, the new company will offer “stable returns.” In the “very short term,” however,

Schlesinger said there will be moves to other traders.

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