While Wall Street analysts and ratings agencies with post-Enron jitters were coming down hard on Dynegy Corp. Friday, traders in the market brushed aside the latest ratings changes, saying they had no problems with the veteran marketing company as a counterparty.
“Almost certainly we won’t change trading with Dynegy. They have too many assets to be in danger,” a source with a major marketer told NGI. Another large seller commented, “Dynegy is not at risk right now. If they got downgraded [to junk status], it would be a different story. But for right now they’re OK with us.”
Another long-time market-watcher, apparently exasperated with Wall Street, said they “saw no problem with Dynegy. It’s always been a straight-up company. [Apache Corp. Chairman] Raymond Plank hasn’t liked them for the last 10 years, maybe more. But that could be a good thing. And the analysts are spooked because they’ve been roasted over Enron, so they’re going overboard the other way with Dynegy. Makes you wonder if they’ll ever get it right.” (See related story in this issue for Plank’s recent comments.)
NGI checked in with the market after both Standard & Poor’s and Moody’s Investors Service suggested that negative news and ratings warnings would make counterparties back off or call for collateral.
The S&P said Friday that it downgraded and gave a negative outlook assignment to Dynegy and its subsidiaries on Wednesday (April 24), and that rating was the agency’s current view, already reflecting items the company explained on Thursday, including “concerns regarding issues in the 8-K filing and the write-down of goodwill associated with Dynegy’s telecommunications unit.”
Dynegy’s stock has lost about 45% of its value, from about $27 to a $14.90 close Friday, since the company held a teleconference Thursday to discuss its earnings projections scheduled for release April 30, as well as explain an informal inquiry being conducted by the Fort Worth office of the Securities and Exchange Commission regarding a natural gas contract last year. Following the Thursday announcements, Moody’s Investors Services said it was “reviewing” Dynegy’s ratings for a possible downgrade, and the stock sell off began.
In afternoon trading Friday, Dynegy was the biggest loser on the New York Stock Exchange, and one of the most actively traded issues, on volume of 19.38 million shares. The last time it closed lower than Friday was April 14, 1999 when the stock was $14.81.
Dynegy will be negotiating with its credit facilities in early May to renew $1.5 billion in revolving credit, which was set to expire in May. On Thursday, CFO Rob Doty said he did not think it would be a problem for the credit facilities to be renewed, however, any downgrades could lead to demands for collateral or higher interest terms.
What led to the assault on Dynegy last week was a teleconference of the executive team Thursday morning, when it announced it would revise its 2001 financial statements following a probe by two separate offices of the SEC concerning accounting procedures used in a natural gas contract last year. CEO Chuck Watson and his team attempted to clarify the details of the contract, as well as explain expected losses in its communications business and pipeline unit that forced the energy trader to lower its earnings guidance for the year.
Watson, who led a conference call for analysts surrounded by his executive team, including CFO Rob Doty and President Steve Bergstrom, said, “No one is more disappointed about some of the things we’ve talked about this morning” than he was, but Watson said he was “confident where we stand today” that the company had a strong future.
As soon as it can reconcile the accounting statements, which were formerly done by Arthur Andersen LLP, Watson said Dynegy will file Form 8-K with the SEC to disclose a change in the presentation of cash flow associated with “Project Alpha,” a physical gas supply transaction completed in April 2001. Entered into by subsidiary DMT Supply LP, the transaction consists of a five-year contract with ABG Gas Supply LLC, an unrelated third party, that gave Dynegy access to a significant long-term supply of physical gas, cash funding and a permanent tax benefit.
Under terms of the contract, DMT bought gas at a discount to market prices over the first nine months of the contract. For the remaining 51 months of the contract, DMT will purchase gas at a premium to market prices. ABG acquires the gas through standard New York Mercantile Exchange contracts to fulfill its sales commitments to DMT, which then takes title to the gas at Henry Hub and markets it to customers.
Doty explained that the transaction gave Dynegy a tax benefit of about $85 million, and $35 million in costs on a pre-tax basis last year. Dynegy originally classified the net cash inflow from the gas supply contract as operating cash flow in its quarterly and year-end financials. Activity under the contract resulted in net cash inflow of about $300 million in 2001.
A report April 3 by the Wall Street Journal about Project Alpha said Dynegy had “engaged in some complex accounting designed at least in part to buff its financial profile.” Following the report and other inquiries, Watson said he wasn’t surprised to get a phone call from the SEC, requesting information about the contract. The informal inquiry resulted in Dynegy officials meeting with the SEC Office of the Chief Accountant staff two weeks ago. At that time, Doty said the contract’s accounting was explained, and that the SEC staff had sent its concurrence with Dynegy’s contract details. As far as he knows, Doty said the DC inquiry has been resolved and is a closed matter.
However, after receiving the first inquiry about Project Alpha, the SEC Fort Worth office sent a letter to Dynegy also requesting information of the “facts and circumstances surrounding the transaction.” That investigation has not been completed, and Doty said he thought it could take several months. Watson said the company would cooperate fully.
Following the meeting with staff from the SEC Office of the Chief Accountant, “Dynegy decided to present the cash flow associated with the gas supply contract as a financing activity in its consolidated statement of cash flows.” The change in presentation will not alter the tax benefit recognized in 2001 nor the balance sheet.
Watson, who praised the company’s quick response to the probes, was emphatic in stating that “none of the elements” of Project Alpha were “of Enron-like special purpose entities.” Dynegy had already disclosed information about the contract’s specifics in its 2001 earnings statements, and “furthermore, it did not otherwise benefit the income statement.” He added that it was his “sincere hope that the full disclosure we’re providing brings this discussion to an end.”
In reaction to the recent reports concerning Project Alpha and losses in telecommunications — but before the teleconference Thursday — the S&P lowered Dynegy’s credit rating to BBB, down from BBB-plus. The downgrade resulted from Dynegy’s “exposure to risky energy marketing and trading businesses,” and the outlook is negative, S&P said. The rating is still investment grade, two levels above junk bond status.
Following the teleconference, Moody’s then said it was also reviewing the ratings of Dynegy and its subsidiaries for a “possible downgrade” because the reclassification of the $300 million to financing from operating cashflow would lower the company’s 2001 cash flow to $511 million, “which essentially covers dividends of $100 million and capital required to maintain its existing asset base of $400-500 million.”
Moody’s said, “given the company’s financial obligations in excess of $7.0 billion, including on and off balance sheet debt, minority interest and a portion of non-recourse project debt, coupled with the lack of transparency in the company’s financial disclosure and aggressive business strategy…sustainable recurring operating cash flow needs to improve significantly to support an investment grade rating,” Moody’s said. It added that ChevronTexaco’s ownership interest in Dynegy, its commercial relationships and board representation are “critical” to its rating, and “if those relationships weaken, additional negative ratings pressure will result.” It currently rates Dynegy’s senior unsecured debt at Baa3, one level above junk status, with a Prime-3 rating on its commercial paper.
In its earnings guidance, Dynegy expects to meet its first quarter projection of 41 cents, but the company reduced its profit forecast for the year to a range of $2.00-2.05, down from a previous forecast of $2.26. Analysts polled by Thomson Financial/First Call averaged an expected profit of $2.23 a share.
Doty explained the losses over the year will result from three non-recurring items: an already reported accounting provision related to a preferred security received from major shareholder ChevronTexaco, which will cost 2 cents; a $300 million charge for losses of between 16-18 cents in new subsidiary Dynegy Global Communications; and a charge of $13 million from its Northern Natural Gas pipeline unit, which it acquired from Enron Corp. earlier this year.
The communications unit losses include a writeoff for goodwill related to accounting changes under FAS 142, as well as miscellaneous investments in equipment, and a “substantial” portion of the charges will only affect this quarter. However, Watson said there was a “continuation of negative industry fundamentals,” which, combined with a problem with vendor shipments, had hurt the company’s newest business.
“I strongly believe we will be a survivor” in the telecommunications business, Watson said, adding he expects the sector to turn around this year. With its network already in place, Dynegy Global Communications had 25 customers at the beginning of 2002; it now has 75, he said.
Watson said it was “unreasonable to expect it to continue with losses,” but emphasized that the company would not allow the communications unit to be a “continuing earnings drain.” He said Dynegy was currently looking for a joint venture, alliances or partnerships to leverage the unit’s value, which he hopes to complete this year. Watson added that it was a “personal priority to stay focused on our core energy business.”
The Northern Natural Gas pipeline losses resulted from a financial review by Dynegy after it took over management from Enron in January. Doty said it was discovered that some of the natural gas had been borrowed and then sold and recorded as earnings, which on review, needed to be reflected as a liability. He said Dynegy had a commitment to redeliver the volumes, and said the loss in the unit was a one-time earnings event and would not impact the unit’s performance for the rest of the year.
The reduction in Dynegy’s ’02 full-year forecast includes expectations of an additional per-share loss of between 10 cents and 12 cents from the telecommunications business. The losses will reduce annual earnings by 16-18 cents. Dynegy also said it will take reductions of 5-6 cents a share on expected Northern Natural earnings because it did not receive a contribution as expected in January.
In the second quarter, Dynegy cut its forecast to 30-35 cents, down from 44 cents, and reduced its third quarter forecast to 80-85 cents, down from 95 cents. Fourth quarter earnings are expected to range between 45 and 50 cents. Dynegy will release its first quarter 2002 earnings on April 30.
When asked Friday how the company was responding to the plethora of bad news, spokesman John Sousa was upbeat. He said the company remained “healthy, vibrant and viable” with a reminder that it had a proven business model and strong assets. Sousa also affirmed that the company’s core energy businesses were “performing very well…we have strong liquidity and cash flow to operate our business.”
Mike Mott, Dynegy’s controller and a senior vice president, said the recent events followed a “solid business purpose…to acquire a gas supply,” which he said was done in a tax-efficient way for the company. “There are no sweetheart deals,” said Mott, who explained that no Dynegy employees were involved and there were no affiliates of the company involved.
S&P analyst John Kennedy affirmed the company’s liquidity in his report. “Dynegy currently has about $1.7 billion of cash and available bank facilities that have no material adverse change clauses embedded in the agreements,” Kennedy said. “Although about $1.5 billion of these bank lines expire by May 20 and the firm may face more onerous terms to extend or renew its bank agreements, Dynegy does have a 364-day term-out provision on its bank lines, which could mitigate some of the near-term concerns over its liquidity position. However, if this additional debt became a permanent component of the firm’s capital structure, and not repaid or replaced with equity in the intermediate term as would be expected, ratings would likely be lowered.”
Kennedy said the agency had “often observed that rating triggers limit a company’s flexibility and can amplify the seriousness of credit quality deterioration and contribute to a ratings cliff.” Dynegy, he said, had “exhibited commercial strength in its wholesale energy merchant business,” but noted that a “lack of counterparty confidence could result in lower trading volumes, which could, in turn, affect the firm’s financial performance.”
Dynegy saw its stock downgraded by several analysts last week, including Bank of America, to market perform from buy; JP Morgan Chase, to market perform from long-term buy; Salomon Smith Barney, to neutral from buy; Wachovia Securities to market perform from strong buy; and Credit Lyonnais, to hold from add. Credit Lyonnais had rated Dynegy a buy just two weeks ago. All of the downgrades noted an ongoing review of Dynegy’s credit rating by Moody’s.
UBS Warburg analysts James Yannello, Ronald Barone and Jonathan Stark also lowered their rating to hold from strong buy, noting that “the reduction reflects the recent string of surprises from the company which have now substantially eroded its once industry-leading credibility. In short, we have seen too much, at one time, at the wrong time.”
Moreover, they said, “the rating reflects conflicting signals from management on the ultimate destiny of its telecom unit which — though we appreciate its optionality — has evolved, in our view, into a distraction for the company and the Street. Finally, the reduction reflects our desire for more clarity on the ratings agencies’ views of Dynegy, as all maintain a negative bias toward its debt.” UBS Warburg’s parent, UBS AG, took over Enron’s online energy trading system in a deal completed in January.
However, not all of the analysts were down about Dynegy. Analysts led by Curt Launer at Credit Suisse First Boston said they expect Dynegy to recover “as it becomes clear that its merchant business unit continues to perform, and is not the source of the earnings decline.” They maintained their “strong buy” rating, with a “modest reduction” in the target price to $40 from $42, using a 16 profit-to-earnings target on its 2003 earnings per share.
Merrill Lynch on Friday reiterated its “strong buy” recommendation, and Goldman Sachs & Co. upgraded Dynegy to market outperform from market perform. Merrill analyst Carl Kirst said Thursday’s market reaction, when Dynegy’s stock dropped 30%, was “justified,” but said, “we are also on guard against whipsawing opinions on…overwhelming negative psychology. The question is, where do we go from here?”
S&P’s Kennedy said, “a lack of market confidence or the risk that another rating agency would lower Dynegy’s credit ratings to non-investment grade could spur liquidity issues, as counterparties demand increases in collateral to maintain trading relationships.” He said liquidity positions “can become stressed due to ratings triggers embedded within securities and trading contracts. This liability could exceed $300 million, the bulk of which would be used to collateralize Dynegy’s netted wholesale trading book.” Kennedy said the ratings agency would continue to monitor Dynegy’s liquidity position and flexible financing needs for current and contingent liquidity and collateral requirements.
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