Reliant Resources Inc. (RRI), wobbling as a stand-alone retail and wholesale services company, revealed Tuesday that a review of its energy trading activities has identified a series of four related natural gas financial swap transactions that should not have been recorded.

The transactions decreased RRI net income by $13 million in 2000 and increased net income by the same amount in 2001. After meeting with its independent auditors and the Securities and Exchange Commission, RRI determined that a restatement would not be required, but it will file an additional footnote disclosure as an amendment to its 2001 Form 10-K/A.

“We are extremely disappointed that these transactions were done, and we are going to take whatever actions are necessary to restore our credibility in the marketplace,” said CEO R. Steve Letbetter. He said the “employees directly responsible were some of the same employees involved in previous structured financings who are no longer with the company.”

RRI did not identify which employees were involved in the additional sham transactions, however, last May, RRI fired two employees who had orchestrated “round-trip” transactions, which accounted for about 10% of its trading revenues over the past three years (see Daily GPI, May 14). A few days later, two of RRI’s top executives also resigned (see Daily GPI, May 17). A review of all of RRI’s energy trading is expected to be completed soon, Letbetter said, and he does not expect to report any additional discrepancies.

Understating that RRI had a “significant number of challenges ahead, most notably refinancing,” Letbetter and his executive team then laid out the quarterly earnings by segment, offered guidance through this year and into 2003 and attempted to define all of the financial transactions under way to maintain liquidity and stability in the market.

The company also revised downward expected earnings for 2002, to “adjust our business given the current market conditions,” said Letbetter. RRI now expects earnings for the year to fall between $1.45-$1.55 a share, down from a previous guidance of $1.65-$1.85 a share. Total earnings this year are expected to range between $940 million and $1 billion, with net interest expense between $265 million and $275 million. In retail, RRI expects to earn between $650 million and $680 million; wholesale between $285 million and $310 million; and Europe between $5 million and $15 million.

Going forward, RRI lowered 2003’s earnings outlook, and now expects to earn between 90 cents and $1.10 a share, with total earnings of $980 million, with $640 million in retail; $300 million in wholesale; and $40 million in Europe. Net interest expense next year is expected to be about $430 million at current rates.

CFO Mark Jacobs, who came on board in August, said it was “difficult” to compare the third quarter of this year with 2001, when wholesale markets were exceptionally strong. RRI earnings per share (EPS) for the quarter were 20 cents, on net income of $58 million, compared with EPS of 71 cents on income of $214 million for the third quarter of 2001.

In the third quarter, RRI recorded “significant unusual charges” that totaled $153 million, or 52 cents, which included the deregulation of the Texas electric market, as well as separation from CenterPoint Energy. In the third quarter of ’01, results included an after-tax charge of $28 million, or 9 cents EPS to exit the telecommunications business. Excluding the charges net income for the quarter totaled $211 million, or 72 cents a share, compared with $242 million or 80 cents a year earlier.

RRI was hit by the same train that slammed its peers — the decline in wholesale earnings and weak market conditions. An increase in interest expense from its acquisition of Orion Power Holdings, plant cancellations, a plant closure and severance costs also dropped the earnings for the quarter, said Jacobs. However, he noted that continued strong performance in retail operations in Texas, which opened to competition last January, as well as contributions from Orion assets, partially offset the losses.

Letbetter also noted that RRI was “unique within the merchant energy sector because we have a large and profitable retail business in Texas, which helps to offset the effects of the very unfavorable market conditions that continue to plague the wholesale energy industry. Our retail business has benefited from a sound market structure in Texas and good execution on the part of the retail team. This has enabled us to maintain strong operating earnings although our reported earnings were negatively affected by several unusual charges.”

By segment, RRI’s retail produced earnings before interest and taxes (EBIT) of $235 million, compared to a loss of $8 million a year earlier — mostly because of the opening of Texas to competition. Jacobs explained that RRI has been impacted by Texas deregulation legislation, which requires an affiliated retail electric provider to make a clawback payment in 2004, not to exceed $150 per customer, if 40% of the residential and small commercial customers’ load in the affiliated transmission and distribution utility’s service territory has not switched to an alternative electric provider by the end of 2003. The clawback is individually calculated for the two customer classes.

During the quarter, RRI recorded an $89 million, pre-tax, non-cash charge for a portion of the clawback payment the company expects to make to CenterPoint Energy in 2004. RRI currently estimates the total clawback payment will be $155 million to $185 million, and it will record the remainder of the estimated obligation in the fourth quarter of 2002 and in 2003 as the related revenues are recognized. The company does not anticipate making a clawback payment for the small commercial customer class.

In wholesale, EBIT for the quarter was $119 million, compared to $402 million for the third quarter of 2001. Unfavorable market conditions, which resulted in lower operating margins from power generation operations and trading and marketing. Increased depreciation expense, including a $37 million impairment charge related to turbines, also contributed to the decline. In addition, third-quarter EBIT was negatively impacted by a $21 million increase in a reserve for anticipated refunds to be ordered by the Federal Energy Regulatory Commission relating to California operations, and by employee severance costs of $6 million.

The European energy segment had a loss before interest and taxes of $13 million in the third quarter of 2002, compared to a loss of $4 million in the same period of 2001. The loss resulted from a reorganization charge of $8 million in the quarter, as RRI winds down its widespread Euro operations and consolidates in the Netherlands.

Late Tuesday, RRI successfully refinanced three syndicated bank credit facilities for Orion Power Holdings Inc., Orion Power MidWest LP and Orion Power New York LP. RRI’s refinancing deadline was Monday, but the company was able to extend it for one day. The refinancings, which total $1.57 billion in commitments, provide a three-year extension of maturities. Interest rate swaps totaling $950 million related to Orion Power MidWest and Orion Power New York were also extended. After the application of Orion cash on hand, the new commitment amounts total $1.33 billion of term loans ($974 million at Orion Power MidWest and $353 million at Orion Power New York) and $105 million of revolving credit facilities ($75 million at Orion Power MidWest and $30 million at Orion Power New York).

Pricing on the new facilities was set at LIBOR + 2.50% in the first 12 months, LIBOR + 2.75% from 12 to 18 months, LIBOR + 3.25% from 18 to 24 months and LIBOR + 3.75% thereafter. In addition, the participating banks will receive up-front fees amounting to 1.5% on the Orion Power New York debt and 1.0% on the Orion Power MidWest debt.

In exchange for the three-year extension, the lenders were provided a cross-collateralization, whereby the Orion Power MidWest facility was given a second lien on the assets of Orion Power New York, and vice versa. Other than the allowance of a $24 million dividend to pay the November 1 coupon on the Orion Power Holdings 12% Notes, “further dividends will be substantially limited by covenants in these new credit facilities,” said RRI in a statement.

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