The impact of Enron’s tailspin on the energy industry has been more severe than expected, Merrill Lynch analyst Carl Kirst said in a research note reviewing the investor exodus from merchant energy stocks last week and the actions taken by El Paso, Calpine, NRG, Mirant and others to quell investor fears.

Bowing under the weight of Securities and Exchange Commission attacks on the industry, several leading energy marketers saw their stocks drop precipitously last week. The walking wounded included Mirant (down about 36% by midday Friday from the prior Friday’s close), Calpine (-37%), Williams (-16%) and Dynegy (-17%), NRG (-14%), Aquila (-14%), El Paso (down 6%), and Reliant (-5%).

“We expected [the Enron breakdown] to be a black eye on the industry,” said Kirst. “However, the crisis of confidence has been particularly severe.”

When Enron filed for bankruptcy protection, Kirst expected there would be credit and liquidity risks among its peers as well as greater accounting scrutiny and possibly increased regulation. But the fallout appears to be deeper and more far-reaching than originally was anticipated with most companies of similar makeup taking repeated beatings in the stock market and coming under greater regulatory and congressional scrutiny.

Mirant, Calpine, NRG, El Paso and others took action last week to try and stem the negative tide of investor sentiment. On Wednesday after its stock had fallen more than 25% since the previous Friday despite no new strategic or financial news, Mirant CEO Marce Fuller was forced to reassure the market there was nothing of substaintial to warrant the decline. “We are concerned about this morning’s drop in stock price, but are unaware of any major new corporate developments, not previously disclosed, that would precipitate this drop,” she said. By Friday afternoon, Mirant shares had tumbled more than 35% from levels just one week earlier.

Mirant CFO Ray Hill reaffirmed the company’s credit quality and financial flexibility. He said Mirant expects to end the year with over $1 billion of available cash and credit lines. “As we have stated repeatedly, we manage our business with the financial flexibility to operate under a variety of capital market conditions. Our commitment to credit quality remains a cornerstone of Mirant’s business.” The company reiterated that it has no ratings related accelerations in its current corporate facilities. Mirant is rated Baa2 by Moody’s, BBB- by Standard & Poor’s, and BBB by Fitch, Inc.

Hill believes Mirant is well positioned within its ratings categories but acknowledges the “evolving nature of ratings criteria in light of recent developments in the sector.”

Mirant previously had disclosed material off-balance sheet financing, which consist of the Mirant Mid-Atlantic (MIRMA) lease facility and two lease facilities used to finance certain capital equipment. None of those facilities contain contingent equity commitments from Mirant, the company said. Unexpected off-balance sheet disclosures were what triggered a negative chain reaction that crippled Enron Corp.

El Paso said last week it would simplify its balance sheet to remove any off-balance sheet debt. In order to enhance its liquidity, the company also announced plans for $2.25 billion in assets sales by the second quarter in the Gulf of Mexico, Midcontinent and the Rocky Mountains (see related story).

“The credit requirements in our industry have changed and we have decided to implement a plan to respond proactively to that change,” said CEO William Wise. “In particular, last Friday (Dec. 7), one of the major credit rating agencies (Moody’s) announced a new posture toward ratings triggers in financings and we are addressing those changes (see NGI, Dec. 10). We are in a strong position to reduce liabilities quickly and simplify our capital structure. We have the assets, cash flow and liquidity from banks to prosper in this changed environment and move forward to secure an even stronger market position. We believe this plan positions us for 10-15% long-term earnings growth.”

Wise added that El Paso remains an “asset and cash flow-rich” company. He said the company’s assets have generated $4 billion in net operating cash flow year to date. “Our strategy continues to be centered around owning and operating quality assets, as evidenced by our ongoing investments in infrastructure across the energy value chain from pipeline expansions to power generation facilities.”

Independent power generator Calpine Corp. had a particularly rough week (see related story), which ended with Moody’s Investors Service lowering its senior unsecured rating to “junk,” or Ba1, from Baa3. Moody’s lowered Calpine’s ratings after reviewing the company’s near-term cash flow, liquidity sources and financial flexibility. The ratings remain under review for further downgrade pending arrangements to obtain additional financing.

After The New York Times ran an article on Dec. 9 comparing Calpine’s operations and financial structure to Enron’s, the company spent several days and two conference calls doing damage control. And just when it appeared it had finally won over investors and its stocks were rising again, Moody’s announced on Thursday it was placing the company and its affiliates on review for possible downgrade. Fitch did the same on Friday, noting that “questions have arisen regarding CPN’s ability to refinance $878 million of maturing zero coupon notes and to fund future capital requirements.”

“A quick-growing capital intensive company, Calpine has acquired a significant debt burden in anticipation of later cash flow generation,” Moody’s said on Friday. “The company must now, however, operate, carry out ongoing expansion and service this debt burden in the face of modest operating profits. Furthermore, the company’s financial flexibility has been reduced as evidenced by investors’ materially lowered earnings expectations and the company’s resulting fallen stock price.”

Moody’s expects Calpine’s operating profitability to suffer from the warmer than normal heating season and lower power prices. “In addition, investor concern has increased throughout the entire energy sector,” Moody’s said.

NRG is in the same boat and has taken steps to try and change the situation. Since Moody’s placed it on review for possible downgrade to junk status earlier this month because of cash and liquidity concerns, the company has announced plans to cut spending by $900 million in 2002 and received $300 million in equity from parent Xcel Energy. Like Calpine, NRG has big plans for new power generation and asset purchases that depend on capital markets for execution.

“The capital markets have effectively been shut down for many of our energy merchants and unregulated power companies as equity and debt values have plummeted,” Merrill Lynch’s Kirst said. “We believe investor concerns are primarily threefold: 1) profit growth/accounting/earnings quality, 2) balance sheet and liquidity concerns and 3) near-term earnings outlook given a multitude of challenges at hand.

“One of the broadest concerns has probably been the profit growth/accounting of the sector,” Kirst added. “FAS 133 mark-to-market accounting, while intended to enhance disclosure, has in many places done more harm than good. While problems do exist, mark-to-market itself is necessary — and vital — to managing risk. To combat earnings complexity and uncertainties, we expect companies to provide more disclosure on their MTM gains/losses, duration of their book (and hence timing of cash flow recognition) and ultimately the greater use of cash flow valuation for merchant activities in conjunction with the more traditional P/E.”

But chief among the near term concerns is leverage and liquidity. With little to no access to the capital markets, “the issue of perception versus fundamentals is moot,” he said, and “over the foreseeable future, balance sheet strength and cash generation will be key. As we learned with Enron, a trading business is only as good as its credit and credibility.”

If that’s not bad enough, the heating season has been mild, prices are low and the economy is struggling to recover. There is much “uncertainty regarding the long-term marketing business,” Kirst admitted.

Raymond James & Associates analyst Fred Schultz said the perfect storm of events, including the panic on Wall Street and the scrutiny in Washington, likely will lead energy merchants to develop more balanced portfolios of hard assets and marketing and trading in the near future.

Schultz said he has long compared Enron to the Evil Empire because of the bad example the company set for the other companies in the energy complex. “We believe Enron’s involvement in the energy complex created a false sense of security for many market participants who watched as trading volumes grossly outpaced the advancement in actual physical production.”

He noted that each quarter, companies book marketing and trading revenues of more than $100 billion, yet bottom line figures total only in the hundreds of millions. “For example last quarter the top five power marketers tallied quarterly revenue of $92 billion and posted a completely under whelming $410 million in net income,” he said. “That’s and eye-popping 0.44% (less than one-half of 1%), a terrible return on investment especially given the risk involved. Much like the 1980s, every now and again you have to sit down and have a reality check.”

It’s about time for the market to begin rationalizing where capital is employed each day, he said. Trading firms leveraging billions to make millions “ought to be passed over, given the bumpy outlook for 2002.” Instead investors should look to those companies that are beefing up their physical presence in the market with hard assets.

The marketing and trading business is going to shrink, said Schultz. “Suffice it to say, we believe the eventual winner [of the gas marketing crown] will behold a kingdom that will certainly not grow as fast, nor be as liquid, as the one that included Enron.” And the companies that catch the investor’s eye will be those that focus on adding hard assets rather than rapidly growing their trading and marketing volumes.

He expects another wave of mergers and acquisitions in the wake of the Enron catastrophe, as marketing and trading companies come to the realization that hard physical assets are much more desirable than heavily leveraging a balance sheet to a trading desk.

“We believe the fall of Rome could in fact spur a much needed round of merger and acquisition (M&A) activity, as well as lead the energy complex toward significantly improved balance sheet profiles,” said Schultz.

Kirst said there’s a possibility a lot of this could blow over because of the vital roles that these companies play in the economy. “Longer term, we continue to see risk management as not only a viable but necessary business as we believe large gas and power end-users, producers, utilities and munis transitioning through deregulation will continue to need their long term energy exposure and risk managed.

“The most likely scenario is a greater return of activity once the capital markets settle down. While sector risk has clearly been on the rise, we believe at current historically low P/E multiples valuation for the [energy merchant companies] is compelling. At the current depressed prices, we believe most valuations more than reflect any potential earnings risks. Downside risk would likely be liquidity crisis driven.” Kirst is maintaining Strong Buys on Dynegy and Williams and a Buy on El Paso.

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