Standard & Poor’s reported last Wednesday that at least 23 companies in the United States and Europe — including Aquila Inc., Dominion Resources Inc., Dynegy Inc., Mirant Corp., Reliant Resources Inc., PG&E National Energy Group and Williams Cos. — have credit triggers that could lead to a liquidity crisis if they had a credit ratings downgrade or they missed other financial targets. Of the companies considered most vulnerable to a cash drain, S&P found more than half of those surveyed are energy businesses.

Certain credit events that pull the credit triggers force the affected companies to post collateral or pay back debt sooner than expected. The biggest concern now is a “credit cliff,” a spiral in credit quality touched off when a company has to post collateral or pay back debt after a trigger is tripped.

U.S. energy companies identified by S&P with a potential “credit cliff” include the following: Aquila, BBB/Watch Neg/A-2; Black Hills Corp., BBB/Stable/A-2; Dominion Resources, BBB+/Stable/A-2; Dynegy, BBB/Watch Neg/A-3; Halliburton Co., A-/Watch Neg/A-2; Mirant, BBB-/Stable/A-3; Petroleum Geo-Services ASA BBB-/Watch Neg; PG&E National Energy Group Inc., BBB/Stable; Philadelphia Gas Works, BBB/Watch Neg; Reliant Resources, BBB/Watch Neg/A-2; Semco Energy Inc., BBB/Negative; and Williams Cos., BBB+/Watch Neg/A-2.

Dynegy, which has faced closer scrutiny in recent weeks, has disclosed two triggers in detail in its 2001 annual report, including a two-year-old partnership with an entity called Black Thunder. Catlin LLC is a non-commercial Dynegy agreement that is tied to a $270 million credit ratings trigger. It holds Dynegy’s Midwest generation assets, including Illinova.

However, S&P noted that companies not close to a ratings trigger are not in imminent danger. For example, Dynegy’s Catlin trigger would require a downgrade to “junk” status by both S&P and Moody’s. Dynegy’s current credit rating is two notches above junk at S&P and one notch above junk at Moody’s. Both are now conducting reviews of Dynegy’s status (see related story).

Although credit ratings analysts with S&P and Moody’s Investor Services say Catlin-type deals are regularly done and considered “industry practice,” energy analysts, including Carl Kirst of Merrill Lynch are concerned that Dynegy will continue to face “significant headline risk news” for the foreseeable future. Kirst downgraded Dynegy on Wednesday to “Neutral” from “Strong Buy,” and said “major positive developments” may not transpire for three or four months. However, Dynegy is a “long-term survivor,” said Kirst.

In another research note, Kirst said that while he believes Williams has the “capacity to remain BBB equivalent, it may be at too high a price. In conjunction with our fixed income analyst, we believe the most likely outcome is that WMB will undergo a one-notch credit downgrade to BBB-. From there, WMB would likely seek a partner on its long-term energy merchant origination business. Such a ring-fence of a portion of its energy merchant business will mean the loss of some earnings potential — we estimate $0.25/share. While many scenarios yet exist, we are reducing our ’02/’03 [earnings per share estimate on Williams] to $2.00/$2.40 from $2.25/$2.65 to take this possibility into account.”

Ronald Barone, who is a managing director for S&P and is also an energy analyst for UBS Warburg, said that when companies go below investment grade, “that triggers a heavy need for collateral.” Barone’s company coverage includes the energy trading sector, including the companies listed. He also covered Enron Corp. before its bankruptcy.

Since Enron’s bankruptcy, the credit ratings agencies have stepped up their review of many energy companies’ balance sheets and company information to understand more about how their businesses work. Triggers in Enron’s complex financial agreements forced it to pay back almost $4 billion in debt when its debt rating was cut to junk, and that cash drain led to a quick bankruptcy filing.

According to the S&P and Moody’s Investor Services, no company would be downgraded only for having triggers, because the agencies are aware of the triggers and have factored them into the ratings. However, all of the credit rating services, including Fitch, are encouraging companies to disclose all information in their annual reports and federal filings. Ratings agencies usually have more access to a company’s financial information than other analysts.

Many companies have not been routinely disclosing triggers in their annual reports. Energy companies usually have more triggers because of their greater use of off-balance sheet financings, S&P said. It also noted that about 10% of the companies contacted have not responded to the survey.

Dynegy’s Catlin agreement is one of two deals tied to Dynegy’s credit ratings scrutinized in recent weeks. As explained in the 2001 annual report, it accounts for $270 million of a possible $301 million in cash collateralization, which would be triggered only if the senior unsecured debt ratings for subsidiary Dynegy Holdings fell below investment grade with both S&P and Moody’s.

Dynegy formed Catlin in June 2000 after acquiring Illinova Corp. Catlin is a joint venture with Black Thunder, a third-party investment entity, which is financed by an undisclosed financial institution. Dynegy holds the minority interest, and invested $100 million into Catlin, while Black Thunder invested $850 million. According to Dynegy’s annual report, if Catlin fails to earn a “preferred return” as promised to the financial institution by 2005, Dynegy may either liquidate the assets, or buy out the $850 million investment by 2010.

Moody’s analyst John Cassidy, while calling Catlin “in effect a financing,” said if there was a trigger event, Dynegy would not “walk away from those assets.” Instead, Dynegy would refinance, or repay the $850 million. One possible source would be Dynegy’s 26% shareholder ChevronTexaco.

“We consider the effective leverage at Dynegy to be greater than the amount reported on the balance sheet,” Cassidy said. Moody’s is not aware of any other entities like Catlin of meaningful size within Dynegy’s accounting. S&P also knew about Catlin when it rated Dynegy because its analysis looked at “all the obligations Dynegy has.”

Both Moody’s and S&P noted that Dynegy’s accounting method is “consistent” with industry practice. Cassidy said, “There are others in this sector with similar structures,” but added he would like to see more disclosure. “It’s difficult to see what the companies’ obligations really are.” S&P analyst Todd Shipman said generation businesses are often in separate affiliates because “regulators prefer it this way.”

Catlin, according to the annual report, has “limited recourse” to Dynegy, “with such recourse building over time to a maximum of $270 million in 2005. As of Dec. 31, 2001, recourse to Dynegy was approximately $35 million. However, if the projected cash flow is insufficient, “Dynegy may be required to make an additional capital contribution of $60 million to Catlin. The $60 million contingent obligation expires on Dec. 31, 2002.”

The Securities and Exchange Commission (SEC) launched a formal probe of another of Dynegy’s financings, Project Alpha, which is not a triggered-event transaction. There have been few details about whether the SEC is reviewing other operations within the Houston-based energy marketer. It also has several informal inquiries into other energy companies’ operations, including those of Reliant and CMS Energy Inc., and Congress has also called for more investigation of how energy companies account for their transactions.

Dynegy CFO Michael Mott said, “Black Thunder has an equity interest and an equity like participation… A lender has rights that accrue under lending arrangements” in the event of restructuring or bankruptcy, and Black Thunder does not have those rights. However, at the heart of the current controversy is that the trigger information was only included in the 2001 annual report. “We expanded our disclosure, and we will disclose even more” in the quarterly filings, Mott said.

Merrill Lynch’s Kirst said Dynegy’s “own company specific issues” have been compounded by the increasingly negative news throughout the entire sector. “Perception will continue to be the primary driver behind the stock price, and our view is that negative news flow on both the stock and the sector as a whole will outweigh the long-term fundamentals for the foreseeable future. Even if Dynegy’s ship begins to settle, we believe the stock is likely to linger in the current $9 range…absent any major positive developments.”

Kirst also lowered Dynegy’s earnings per share outlook for 2002 to $1.35 from $2.00, and 2003 to $1.50 from $2.45. “We believe this is what Dynegy could earn even if both Moody’s and S&P go to junk debt ratings — a worst-case scenario in our opinion.”

Dominion said the chances are “extremely remote” that an operating or financial problem would trigger mandatory repayment provisions contained in a $665 million note financing its Dominion Fiber Ventures unit. CFO Thomas N. Chewning said the $665 million note “represents only 2.6% of the company’s total capitalization and has been reviewed by major credit rating agencies, including Standard & Poor’s, from the outset. S&P reaffirmed our strong BBB+ credit rating on May 14.”

“Moreover, the provision would only require mandatory repayment in the event Dominion experienced an unlikely two-notch downgrade in its credit rating in addition to a decline in its share price to under $46, which would need to be sustained for 10 consecutive days.

“We consider either circumstance remote and the combination of both to be extremely remote. In fact, the company is operating at superior levels of efficiency, has growing cash flows, and is successfully strengthening its balance sheet through the issuance of new equity, equity-linked securities and creation of new credit facilities.”

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