Williams Companies shares jumped 5% last Tuesday and ended the week up 11% at $9.86/share after Merrill Lynch analysts Steve Fleischman and Sam Brothwell resumed coverage of the company with a “Buy” rating and a $12/share 12-month price target.

Also, Merrill Lynch bond analysts improved their recommendations on Williams’ bonds to “overweight.”

The equity analysts said Williams has “ample liquidity and solid free cash flow generation prospects” that should allow it to restore its balance sheet and produce “substantial earnings growth” through leverage reduction between now and 2005.

“Williams is arguably the energy sector’s best turnaround story with a clearly defined business strategy, solid liquidity and ample growing free cash flow that enables substantial debt reduction by 2005 in our view,” the analysts said in a research note. “Williams currently sits on roughly $3 billion of cash and we estimate free cash flow totaling almost $1 billion in 2004 and 2005.”

They added that another $1.1 billion in cash will become available in Feb. 2005, and easing working capital needs due to declining collateral requirements from a smaller energy marketing and trading operation and other changes could mean even more cash available.

“We estimate that even $100 million of debt reduction adds about $0.01 incremental [earnings per share]. Our above consensus $0.85 2005 [earnings projection for Williams] reflects the effects of $2 billion in debt reduction above scheduled maturities.

“In our view, downside is protected by net asset value in the $8[/share] area. Multiple expansion is likely as the balance sheet improves and WMB continues working to exit energy marketing and trading,” the equity analysts added.

They said Williams’ growth will be driven by infrastructure development in the deepwater Gulf of Mexico and a low-risk drilling program in the Rockies. “This drives high [capital expenditures] for the next couple of years but should yield solid returns in a robots natural gas environment.”

The risks to reaching Merrill Lynch’s $12/share price target in 12 months, they said, are lower natural gas prices, high leverage and continued overhang from marketing and trading.

Meanwhile, the bond analysts said they now regard Williams as a “core holding in the Power and Energy space” because of its “strong liquidity prospects combined with the expectation of continued deleveraging prospects.”

The analysts said they expect Williams to have “investment grade characteristics by the end of 2005. The company’s bonds currently trade in the 7.6% yield area versus the overall high-yield market in the 8.5% area.

Williams had $13 billion in debt as of June 30, but the analysts expect that to fall to $8.6 billion and possibly as low as $5.9 billion by the end of 2005.

The company has been building significant amount of cash on its balance sheet through asset sale this year. In total asset sales have added $2.4 billion in cash proceeds, including the most recent $214 million sale of a natural gas liquids fractionation, storage and distribution system at a plant in Redwater, AB to Provident Energy Trust. The sale closed this week. Williams said it expects to record a pre-tax gain of $83 million in the third quarter related to the Redwater transaction. The sale will also release an additional $14 million cash in the first quarter of 2004 for product prepayments that will be returned to Williams.

The company continues to market other holdings in Canada for possible sale in 2004. These assets consist of more than 5.5 Bcf/d of gas processing capacity from Williams’ interests in three straddle plants — Cochrane, Empress 2 and Empress 5.

“Although WMB’s cash flow from operations in 2003 of $874 million will be below its expected $1.03 in capital expenditures, we expect the company to turn free cash flow positive in 2004, growing to $625 million in 2005,” the fixed income analysts said.

An even greater improvement would be seen if Williams would exit the power trading and marketing business, they said. That would reduce the company’s risk profile and probably would trigger the company’s return to investment grade, the analysts said.

“Our sense is that WMB remains very active in trying to sell the business either in whole or in part. We expect this process to take some time.”

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