Debt-laden and cash-poor energy merchants with few prized assets left to sell should consider selling stock — if they have access to the capital markets. The equity sales would only have a “neutral to mildly negative” effect for many companies, according to a new study.

Independent credit researcher CreditSights analysts found that for many companies, issuing equity could actually be positive. Analyst Dot Matthews offered Aquila Inc. as an example. Reportedly, Aquila is having trouble selling its 80% stake in UK-based Midlands Electricity, apparently rejecting bids from Scottish and Southern, YTL Corp. and Macquarie/United Utilities because “they would barely have covered Aquila’s $1.7 billion in debt.”

“Like many of its brethren, Aquila is having difficulty selling assets for more than book value, as many of the plum properties have already been picked. Unless there is a major turnaround in electric prices and asset valuations both in the U.S. and globally, many troubled companies will have great difficulty selling assets to pay down debt in the coming year.” Instead, CreditSights analysts found that a better solution, at least for now, would be to sell stock.

“A funny thing has happened to utility equity and fixed income investors during these troubled times in the sector,” according to the study. “Their interests have actually converged so that both camps are favoring companies with low debt/capital ratios.” Companies with lower debt to capital ratios “generally have higher ratings and tighter spreads, but, at the present time, they also have higher P/Es (price-to-earnings).”

Matthews noted that the reverse was true in 2000, and the study suggests “that many utilities can issue stock and pay down debt without harming equity. In fact, our data indicates that the P/E should actually rise as debt/capital falls.”

CreditSights discovered the equity issue during an analysis in December on what utilities noted investor Warren Buffett could be considering next (see Daily GPI, Dec. 17, 2002 ). “Our data gave us some results that seemed anomalous. When looking at 2003 expected P/E ratios, we noticed that the higher P/E ratios corresponded with lower debt/capital numbers. This seemed counter-intuitive…because equity generally likes to have less dilution and more opportunity to lever earnings. Yet, in this particularly stressful time in the industry, both debt and equity investors seem to be looking for the same thing: safety.”

CreditSights then reviewed what effect issuing equity would have on several companies. The study assumed an 8% interest rate on debt being paid down and a 35% tax rate for all. Analysts also determined the amount of equity that would have to be issued to lower debt by 500 basis points, calculating the net dilution to earnings, including interest cost savings and taxes.

“While, in all cases, the equity issuance was dilutive, the one point rise in P/E that our 2002 numbers suggest would occur boosts the stock price an average of 4.6% in 10 of the more levered names,” Matthews said. “A 5% reduction in debt/capital would be a meaningful improvement for all but the most conservatively capitalized names in our sector, and those companies are already getting the benefit of their conservatism from equity buyers anyway.”

Matthews said that for the “shakier names,” an actual debt reduction would help to convince investors and perhaps the ratings agencies, that “they have, or are getting, their finances under control.” She noted that several “wounded ducks” can’t expect to access the capital markets through debt or equity, but most would “definitely” benefit from an equity infusion. “We think it is worth a try,” she added.

Companies analyzed and used in the CreditSights study were NiSource, DPL Inc., Nstar, PSEG, KeySpan, NUI Corp., PPL Corp., Alliant Energy, Progress Energy and Black Hills Corp. On average, a 500 basis points debt reduction would impact the listed companies’ share price 4.7%: PPL’s moved up 6.3% as the highest of the group; PSEG was up 6%; DPL moved up 5.9%; and Alliant was lowest at 2.9%.

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