All the signs in the energy merchant sector point to “falling business plans” for a couple of companies, “if not bankruptcy,” said Standard & Poor’s credit analyst Peter Rigby in a report last week on the future prospects for traders. “Few doubt that one or more energy merchant companies may soon file for bankruptcy. Signals are appearing and getting stronger.”

He noted that energy traders possess many of the same symptoms for underperforming companies that were identified by PricewaterhouseCoopers a few years ago, including declining credit ratings, poor financial results, profit warnings, working capital problems, violation of banking agreements, worsening bank relationships, negative press coverage, delays in publishing financial reports, abrupt changes in senior management and sagging per-share prices.

“When viewed against the fortunes of U.S. energy merchants, such as Dynegy Inc., Enron Corp., NRG Energy Inc. and The Williams Cos. Inc., among others, PricewaterhouseCoopers’ symptoms of underperformance raise concerns. Although no one symptom necessarily indicates an imminent bankruptcy, investors should be wary of any company showing too many of the…warning signs,” said the S&P report, called “Is Time Running Out for U.S. Energy Merchant Companies?”

S&P expects the pattern of earnings losses among energy merchants to continue, said Rigby. With “little or no recovery” anticipated in competitive wholesale power prices until at least 2003, the high level of construction of new gas-fired generation plants (still more than 100,000 MW) and few older plants retiring, “the prospects for stronger earnings seems elusive.”

The prospects for improved liquidity is equally as elusive, the S&P report said. “Falling power prices, increased collateral calls and near-term maturities are causing severe liquidity constraints” for a number of energy merchants. “Cash flow for the next few years for energy merchants may fall below companies’ forecasts, thus increasing their reliance on external sources of liquidity. But for many the capital debt markets are all but closed to new debt issuance or even refinancing of mini-perm loans from banks,” it noted.

In addition to the write-downs that banks took last year as a result of the Enron bankruptcy, “the overhang of nearly $50 billion of construction loans and mini-perm debt has driven the banks from this sector, thus making credit even scarcer,” the report noted.

The flight of the banks from the sector could be especially nettlesome for Dynegy, NRG and Williams, whose very survival will depend on their ability to maintain adequate levels of liquidity over the next 12 months as their bank loans mature. “Even though these companies and others are making progress on asset sales and obtaining time extensions and waivers on bank loans and the posting of collateral, their liquidity remains problematic,” Rigby said.

With banks tightening their purse strings, some energy merchants have had to pledge “considerable assets” to obtain new bank lines, Rigby said. “Calpine Corp., for instance, had to pledge virtually everything that was not already pledged to secure prior debt-holders to secure a new $2 billion bank line after banks refused to extend unsecured credit. CMS Energy Corp. and Williams have also had to pledge assets to renew bank lines.” In the current environment, bank loans to energy merchants are becoming “increasingly more expensive and the covenants are more onerous.”

Energy merchants “have been furiously trying to reverse their fortunes,” the report said, adding that some have made “measured progress” and others “still struggle.” The preserving or building of immediate liquidity while not sacrificing long-term cash flow will likely be the key to most turnarounds, it noted. In sizing up a company’s turnaround prospects, S&P advised investors to look for asset sales, cancellation or delay of construction plans, cost and staff cutting, winding down or eliminating certain lines of business, capital restructuring, debt repayment and equity issuance.

“Some companies have had remarkable success in selling off assets, such as Dynegy, Williams, Mirant Corp. and Edison Mission Energy; others are finding prospective buyers still waiting for lower prices or greater desperation from sellers,” the S&P report said. “Mirant and Edison Mission Energy got an early start in asset sales last year before the market for power plants became flooded and the potential field of buyers shrank. Dynegy and Williams have sold core pipeline assets to MidAmerican Energy Holdings Co. at discounts to book value.

“Although the asset sales gave the sellers immediate liquidity, the sales of such key, profitable assets necessarily raise concerns about the long-term economic viability of the sellers. The AES Corp., Calpine, CMS, Dynegy, El Paso Corp., Edison Mission Energy, Mirant, NRG, PG&E National Energy Group Inc. and Williams are still inundating the market with assets for sale. If buyers continue to wait, prices will likely fall — a poor omen for sellers trying quickly to raise cash.”

As for delaying or canceling projects, S&P said companies such as Calpine, Duke Energy Corp. and Mirant “have saved billions of dollars of capital expenditures that would have outstripped their funding capabilities.” But the key question “may indeed be is this too little, too late?” The staff-cutting measures by several energy merchants “may only be buying [them] some additional time before the inevitable arrives.”

Citing the industry’s “mass exodus” from trading in recent months, S&P noted it “had always been skeptical of the long-term sustainability of trading, particularly at the levels that companies forecast, and, therefore, rarely included significant trading revenues in its credit analyses.”

Energy merchant companies that “are able to restructure their balance sheets and pay down debt may stand a chance of reversing their diminishing profitability. But reducing debt, particularly for those with liquidity problems, may be difficult,” it said. Faced with a liquidity crunch, companies will most likely want to hold on to cash rather than retire their debt, S&P believes.

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