S&P, Moody's, and Fitch tell why credit issues now rule the energy sector.
This year saw energy companies forced to make some grim choices-issuing new stock in falling markets, angering investors with dividend cutbacks, selling prized assets at fire sale prices. Some blame it on the rating agencies-the bond kings-who imposed tougher credit standards after the fall of Enron.
Various cash-strapped companies might even have faced bankruptcy if not for those 11th-hour, cash-raising measures, given the combination of falling credit ratings, a general collapse in the stock market and power prices, troubles with creditors, and government inquiries from the SEC and FERC.
Now, most see Dynegy's sale of its Northern Natural Gas Pipeline to MidAmerican as a stroke of luck-given the shortage of potential buyers-even if the $928 million sales price fell $600 million short of what Dynegy had paid initially. That's because the sale avoided a destructive downgrade during a debt refinancing, which surely would have set the dominoes in motion. Such an event could have allowed commercial banks to change the terms of credit lines, demanding more collateral.
Standard & Poor's reported in late August that "the biggest cloud facing the industry over the next 18 to 24 months is an estimated $30 billion of mini-perm debt that needs to be refinanced in the bank and capital markets." But most bankers now do not believe that energy companies will be able to find as much as $30 billion in financing-this year or next-as credit has become scarce. Not in recent memory has the industry seen so many credit downgrades, so quickly, or so often (see Bond Chart, p. 28). That means some tough decisions will have to be made.
Of course, it is no surprise that some have criticized the credit rating agencies themselves, saying they are responsible for intensifying the credit crisis for being so reactionary.
"I understand the outcome and behavior on a human basis," said one investment banker, speaking of the ratings agencies.
"[It's] a reaction to tread conservatively after having made a mistake on being too liberal, in respect to giving too much credit for underlying merchant growth that wasn't provable and didn't actually materialize."
These downgrades have shaken the market's confidence in the ability of the rating agencies to understand complex structures in a changing environment, says another banker. Furthermore, many executives charge that ratings agencies have not been even-handed or consistent in their approach to rating energy companies since last year.
"What are they doing internally that they weren't doing before?" asks yet another banker.
Yet according to a report issued in late August by Merrill Lynch, the ratings agencies haven't been doing anything differently than in previous economic downturns. In its study of ratings changes in high-yield securities, Merrill found that the bulk of downgrades in all periods could be explained by overall economic conditions. Only about 18 percent of the changes could be attributable to other factors, including inconsistencies in ratings as the agencies become more lenient or stricter in their analyses, according to the Merrill report. So, who is right?
Utilities: Promises Unfulfilled?
Ronald M. Barone, managing director for utilities, energy, and project finance at Standard & Poor's, says the industry's credit issues really go back five years, to when utilities wanted access to more capital, to fund non-regulated generation projects and generally to expand operations to take advantage of deregulating markets.
"They said it was going to be energy-related, mid-stream operations," Barone recounts. "It would be non-regulated generation and debt financed. 'Don't worry,' they said, 'we know it's more [debt], but the cash flows will come.' Five years is a long time to wait. Basically the rope we gave them to have the opportunity, there is not much rope left to it because they have turned that rope into a noose.
"This is a pre-Enron phenomenon. It all has to do with companies fail[ing] miserably in their approach to deregulating in terms of maintaining credit quality," says Barone. He points out that his firm was downgrading energy companies as early as the fourth quarter of 1999, as well as downgrading more than upgrading in 2000.
But industry observers point out it was not until the Enron debacle that ratings agencies felt compelled to downgrade below investment grade.
"Yes," Barone admits, "we felt they were investment grade last year. We always pointed out their challenge. If you look at almost every outlook statement, we mention in every case that due to growing non-regulated operations, the company's challenge was to maintain and improve cash flow coverage to measure the added business risk. While they were stable outlooks and investment grade, we always pointed out those risks. Again, [we gave] the companies the opportunity to improve upon themselves to enact their strategy."
Richard Hunter, managing director for global power at Fitch Ratings, suggests that ratings agencies gave energy merchants a long rope at first, and only later reined them in:
"The difference between this year and last year was that last year there was a far greater willingness for banks and other capital markets to grant what was really a new industry an enormous amount of access to the banks and capital markets.
"There was a lot of leeway granted to those companies. Some of the expansion plans were a little over ambitious. Some of them relied on favorable projections. There is a growing realization that power is a commodity and it was logical to expect a cycle," he adds.
Hunter concedes that it could well have been that the banks, the companies, and to some extent the agencies underestimated what point of the cycle the industry was at when ratings were being handed out to, effectively, new entities.
"I think Enron has focused people's attention very much on seeing what exactly in the trading business is generating money. I think for a long time there was an idea that the trading business was going to generate money because it existed."
Furthermore, Hunter believes there were a lot of management teams throughout the industry that were not used to gaining returns on capital in a competitive environment. Just the opposite-they were used to gaining returns on capital in a relatively uncompetitive environment, he says. Enron focused people's minds on how much capital is going into the business versus its return, and generally, focused the entire industry on how revenues were being generated, he says.
Echoing that idea is John C. Diaz, managing director for energy, at Moody's Investor Service. As he puts it, "the Enron debacle put a spotlight on the fragility of the merchant model.
"The cash flow of that model was weak … the returns that those companies were showing were primarily paper profits based on a lot of assumptions, and based on their ability to manipulate the accounting."
Diaz says Enron showed how credit was allocated among the traders, and the fundamental flaws in credit triggers that was highlighted by the Enron debacle. He remembers walking into a crowded room and asking several companies if they knew their exposure to credit triggers if they were downgraded:
"Nobody knew. Nobody could put a number on it."
Diaz recalls how utilities promised that their debt or leverage would never climb above a certain level. But it soon became clear that utilities could not hide behind their merchant affiliates and keep the holding company (or the regulated side) completely insulated from severe commodity price risk. Then the question changed: How would utilities issue the equity needed to get their balance sheets back in line?
Diaz explains that most of the downgrades that have occurred for utilities have been at holding companies with unregulated subsidiaries, reflecting higher leverage and greater risk.
Capital Structure: No Magic Bullet
Ratings agencies do not believe in the notion of an ideal capital structure.
"There is no ideal debt ratio. It depends what rating you want. If you decide that it is capital efficient to run as an AA-plus utility, you will have a lower debt ratio than if you decide you can run quite comfortably at BBB," says Hunter.
A better question, he adds, is what is the most appropriate rating for somebody who is seriously interested in expanding a merchant energy business?
"I think it is difficult to say that you can run an expanding and successful merchant energy business while being mid-to low-BBB range. We have heard that time-in and time-again from different market participants. They have all said we all thought we could do this with a solid BBB rating.
"The difference is that many integrated utilities with a solid BBB rating would have had higher leverage on average than other industrials. So, you are already talking about there is less headroom for them to take on exciting activities like merchant energy. You are probably looking at [needing] a single A rating to be trading energy."
When it comes to merchant energy trading, Diaz of Moody's says that first you have to get comfortable with the fact that the profitability is real, and that the accounting being shown is real and translated into cash profits. "Moody's has said that energy trading should be carried out by companies that have strong balance sheets and strong credits," he says.
"The problem with using a debt-to-capital ratio [to set an ideal capital structure for energy merchants] is because we have a low degree of confidence in the earnings that are being reported, which translates to a low degree of confidence in the equity the companies ultimately reports," Diaz says. "So using debt-to-capital becomes almost meaningless.
"The other part of the equation is that the debt the companies are showing on the balance sheet is not the entire picture, because there are a lot of off-balance sheet vehicles that have been used to acquire assets. The closest picture [to understand a company's capital structure] that we can generate is cash flow to debt," adds Diaz. But even that number would depend on how risky the business profile is, he says.
Barone concurs. He sees no ideal capital structure that ratings agencies are looking at; it all depends on the risks the company is taking. "There is nothing ideal from a credit rating perspective. You could be 80 percent leveraged and still have an A-rated company if the cash flow that was being brought in was sufficiently strong enough to cover the debt that you have."
In fact, as he explains, the credit rating agencies don't focus primarily on capitalization and debt leverage ratios. Instead, it is cash flow coverage of interest and cash flow coverage of total debt that plays a key role. The agencies look also at business risk, financing flexibility, and internal funding, he adds.
Regulated utilities also carry risk, Barone says.
"There are some regulated companies that face challenges because the regulated environment that they find themselves in is not as forgiving as it once was. Sierra Pacific and Nevada Power found themselves buying power at high prices and they didn't get recovery." But those companies are the exception, he says.
"Most utilities collect from one million ratepayers whose credit is pretty good on a whole. Uncollectibles usually count for one and one half percent of total revenue, if that. That is stable cash."
Growth Engine: Has It Sputtered?
The growth engine in the utility industry will probably be a more regulated business, says Barone. "You will probably see continued consolidation of both the merchant sector and the regulated sector, depending on the outcome of the repeal of the Public Utility Holding Company Act."
Barone believes that there will be fewer players tomorrow than there are today. "Everybody talks about the oil and gas companies, the banks, the Europeans. Who knows who is going to come in and sweep these firms up?"
Notwithstanding all this, Hunter contends that utilities will always be in trading-whether it is seen as trading or not.
"Utilities will have to have a trading function. Utilities have had a trading function for decades. Then there is a debate of whether you want one that looks after the native load and trades around that and then does a few trades for price discovery, or do you want to make a material business out of it," he says.
Look at some companies that have substantial generation capacity under contract like AEP, Entergy, or Duke-which could afford to be expanding the merchant energy side, he says. Then you have companies who don't have that substantial amount of physical capacity under lock and key, Hunter says.
"It all comes back to diversification. It's different if merchant energy is the sole business or it is part of the business such as risk management." Hunter believes that companies like Aquila that ramped down their trading business and sold assets may have overdone it. That is why that company is on credit watch, he says, because of their concern about the business that was left.
As to the outlook for growth, Hunter answers by turning the question around and asking how the agencies would have reacted:
"Let me answer this question by going to a parallel universe where the merchant energy traders were sailing happily along and 2002 had not happened as it did and Enron had not gone bankrupt. In addition, there had been no cancellation of new capacity, consumption boomed along."
"Would ratings agencies be upgrading companies because they were showing significant double-digit vast growth in the merchant venue?" asks Hunter.
"No, we wouldn't be. We would be saying OK, we would discount that because we can say that this is the product of a boom. We will go through a leaner period where they won't get that kind of income. The positive benefit of their growing their earnings through merchant trading wasn't going to impress us, and I can't imagine that it would have impressed our two competitors."
So Hunter believes that any conception of growth in the energy industry has to be seen in the larger context of the commodity cycle.
And what if power plant development is necessary to meet new demand in a few years?
The three ratings agencies say they wouldn't stand in the way-but would hold energy companies to post-Enron credit requirements. Diaz explains that many firms funded unregulated assets with the same type of capital structure they used to fund regulated assets.
"If indeed the demand was there, the question is whether there will be equity investors willing to fund either acquisitions or expansion of these assets. To the extent that there are, there would probably be debt investors that are willing to fund their portion. If indeed that happens, there probably would be funding available."
Downgrades: Remorse or Revenge?
Some executives have charged that ratings agencies are getting back at the energy sector for having had their trust broken and their reputation tarnished. Yet that charge earns a quick denial from S&P, Moody's, and Fitch. The agencies have insisted all along that they have remained consistent in their analysis of the energy industry. As noted earlier, a recent report from Merrill Lynch appears to support that claim.
At Moody's, Diaz says he wants the industry to understand that it is the companies that have gotten into the situation. Simply put, they had a lot of debt and their cash flow began to dry up because of changes in the fundamentals of the power market and the trading area, he says. That is no different than any other industry that goes through a recession or sees falling prices.
As far as its investors, Fitch's Hunter says there hasn't been a backlash to be bitter about. "We haven't had investors or old ladies appearing in the lobby with rolled up umbrellas banging us about the head saying, 'my life savings is gone. What were you guys doing?'"
But, he says, "We have had investors phone us up and say, 'we have specific credits that we are concerned about. Are you looking at this? What is your concern?'"
As to whether the agencies should feel remorse, S&P's Barone is blunt. "Everyone seems to say that. I don't see the argument on that. We don't care what they do. If they want to keep their credit rating they have multiple ways to try to do that. They can sell equity and they can pay down debt. If those avenues are closed to them, I don't see how that is the credit rating agency's responsibility."
According to Barone, all that S&P or any other ratings agency does is provide an opinion on the credit quality of the company.
"We are disinterested third parties. Bondholders can take our information to help price bonds that they buy, but I could give a damn if a company goes from an A rating to bankruptcy or bankruptcy to an A rating. Clearly, there is a larger social issue. You don't like seeing people lose jobs. You don't like seeing people lose investments in 401k's or retirements. As a good corporate citizen or as a moral individual you don't want to see those things. But it is not a factor in the ratings."
Yet Barone admits he foresaw the future when Enron was teetering and S&P made the ultimate decision to lower them to non-investment grade:
"We knew it would trigger new credit requirements and knew bankruptcy was imminent." Did that worry him?
"I slept fine that night. I knew we were doing the right thing. We didn't delay the decision because of the looming bankruptcy… I have hated having to be defensive this year. I can't stress enough that all we are is an opinion provider." An opinion with the power to bankrupt companies, or restore them.
Investment bankers would like nothing more than to save their utility clients from bankruptcy. But that's a tall order. For today's energy firm, the possibilities are no longer endless.
George A. Schreiber, Jr., chairman, global power, at investment bank Credit Suisse First Boston, considers how to find buyers for power assets in a depressed market.
"If you look at the assets that are for sale, the listings goes on for pages and pages. The sellers are companies that need to improve their balance sheet and liquidity," Schreiber says.
"There are a lot of assets on the market. Some companies may be able to sell their generating asset that has a contract for the output at a greater value than a pure merchant power plant. [But] due to the decline in spark spreads, pure merchant plants are not nearly as valuable in the current market as original plans envisioned," he says. "Sellers are essentially at the mercy of the forward price curve."
In other words, buyers are scarce. There are few companies with strong balance sheets like Mid-American Energy, Southern, or TXU that could contemplate power plant purchases, but even they are being cautious. Beyond that, Schreiber identifies a few other candidates on the buy side: Blackstone Group, Texas Pacific, or Kohlberg, Kravis, Roberts & Co. (KKR).
Furthermore, some energy executives say they might even wait until some distressed companies go into bankruptcy before they swoop in on the assets-a strategy that bankers warn is riddled with problems.
James McGinnis, a managing director at investment bank Morgan Stanley, tells why.
"The intuition for corporate buyers is to stay away from assets being sold through a bankruptcy process, because there is only limited true bilateral negotiation ability. You have to bid in the context of a jump ball auction, with perhaps many tosses and re-tosses of the ball, and that takes a lot of time, effort, and negotiation."
As McGinnis explains, the deal often is not final in a bankruptcy until the judge and the credit committee has made the approval. "When you shake a hand in a transaction within a bankruptcy, it may not really be a meaningful exercise."
For example, McGinnis cites the bankruptcy process as why most potential buyers stayed on the sidelines when Enron initially tried to sell the Northern Natural Gas Pipeline. "Enron's advisors marketed the asset broadly, but buyers generally did their due diligence and then waited until Dynegy owned it (at a full purchase price) so that they could have a meaningful bilateral discussion with the new owner and reach closure," he says. "Other, more creative transactions might have been achievable outside of the bankruptcy process, but never saw the light of day."
George Bilicic, managing director at investment bank Lazard Frères, adds that private investors generally are not yet comfortable with energy sector risk. Schreiber recommends internal restructuring as an alternative: "Ideally, the first course utilities should pursue would be to reduce debt and improve liquidity through internal resources," he says.
"But this is not happening because some utilities are not making sufficient returns, primarily due to the decline in market prices, to generate the cash flow needed to improve their financial condition." In the alternative, he says, utilities must step into equity markets or look to sell assets.
Bilicic blames irrational exuberance in the unregulated merchant sector.
"As a general matter," Bilicic explains, "I do not believe that capital structures in the sector were designed with a view to what is now showing itself to be a cyclical industry. I don't think advisors and executives at companies and regulators understood particularly well when these capital structures were put into place that the unregulated segment of the utility industry would be subject to the intense cycles we are now seeing.
"This is not to suggest," he adds, "that there is blame to be assigned across the board. In fact, no one should necessarily be blamed for failing to predict this current cycle. However, I do believe that advisors to the sector share some responsibility for pushing the 'flavor of the month' to such an extent as they did over the past few years in the industry. This is particularly the case when one takes into account the unproven nature of the unregulated marketplace at the time these structures were developed."
Culling Excess Debt
The credit crisis has forced utility executives to revisit capital structure. The financial community is now discussing what model is holding up best.
At Morgan Stanley, McGinnis believes that merchant players should have less than a 50 percent debt-to-capital ratio, and that utilities ought to be around 50 percent to conform to the current credit environment. Most bankers privately concede that ratings agencies and lenders are pushing for a 50 percent ratio. Of course, the 50 percent debt-to capital ratio is not new to utilities. It's a step back to the past.
During the 1960s and 1970s, Schreiber recalls the ideal cap structure was thought to be 50 percent debt, 15 percent preferred stock, and 35 percent common stock.
"I would argue today that 50 percent is probably still a good number, but the preferred component is way too high. If you have any preferred at all it should more appropriately be in the range of five percent of total capitalization.
"The circumstances during those decades were that you could not sell all the common stock that was needed to support capital expenditures. That was the primary reason why preferred ratios reached such heights," Schreiber says.
Moreover, to reduce their debt to 50 percent debt-to-capital, Schreiber says utilities are still going out and selling stock to shore up the balance sheet, even if it may dilute other shares.
"If you need to raise common-and most of these companies do-just do it. It's best to figure that you will dollar average over a period of time, because this is not going to be the last common stock offering that you will ever do," he says.
He recalls the 1970s, when utilities were forced to issue massive amounts of common stock to support credit ratings in the face of large capital expenditure programs. Internal sources of funds were woefully inadequate and companies, in some cases, experienced up to 20 percent dilution as a result of such equity sales.
But at Lazard, Bilicic warns that utilities shouldn't obsess on preserving credit ratings-especially when it comes to the sale of core assets, and the ratings agencies themselves have trouble giving an accurate assessment of credit risk in the merchant sector.
"Executives could be making business decisions in response to reactions from ratings agencies that are not necessarily rational," he points out.
Bilicic also advises utilities not to risk the company's long-term health to boost short-term liquidity.
"Avoiding the pressure to divest core assets is a big challenge for companies that are looking to solve liquidity problems, because some of the most saleable assets are those assets that provide the greatest cash flow and credit support to the company," Bilicic adds.
Overall, bankers still favor the holding company model, with regulated and unregulated arms operating as subsidiaries. But Wall Street cautions that utilities must keep the two sides in balance. Bankers say both regulated and unregulated companies like Southern Company, TXU, Dominion, FPL, and Entergy performed relatively well under the circumstances. But some believe that Duke Energy's unregulated operations are much too large in relation to the regulated side.
Beyond that, McGinnis cites efforts to reduce short-term borrowing.
"There has been a move," he notes, "to extend the duration of their liability curve by going into the capital markets and raising longer-term debt to reduce reliance on commercial paper and its attendant rollover risk. One of our larger clients will be in the market shortly doing $1 billion in long-term debt financing, which is part of that trend. They are seeking 10, 15, even 30-year maturities, and will get attractive all-in rates."
Turning Sour on Growth
In the wake of Enron, accounting scandals, and earnings restatements, many investors are no longer interested in hearing about utility growth. Investors have just lost confidence, bankers say.
"The cloud hanging over the entire market is that the investors are just unsure that the numbers are telling them what the numbers are telling them," Schreiber adds.
In fact, the way utilities discuss growth will have to change.
"An investor today will typically discount a story that includes growth as the primary objective. If true return on invested capital is actually used as a key measuring criteria for a corporation's investment activity, then the investor will reward that corporation," McGinnis says. Today, what investors want is financial strength and steady earnings. Gone are the days where investors are expecting, or willing to believe, projections of 20 percent annual returns, he notes.
Caren Byrd, executive director at Morgan Stanley, says that a more realistic total return target is about eight to 10 percent, which incorporates yield plus growth. But a 10 percent return will only be achieved by a combination of regulated and unregulated operations, and asset acquisitions that make sense.
"They have to have the in-house capabilities to manage the assets that they are taking on," adds McGinnis.
He offers some advice: "Buy a pipeline, but only if you know how to run a pipeline. Buy a merchant power portfolio in the Pacific Northwest, but only of you get it at the right price and you know where you are going to sell the power.
"The market will not tolerate adventurism by integrated utilities in a large way in the energy-trading sphere," he adds.
Instead, says McGinnis, the investor interest is now coming from the value players.
"There is an implicit valuation hurdle that companies will have to go through to attract new money to their name. That new money will need to come from other funds. It will probably be value-plus growth. The return of the growth guys would be ideal, but it is going to be some time because they have been roundly disappointed."
But this new value emphasis carries its own unique risk.
"It is a bit of a worry," McGinnis notes, "because they will embed in their own forward model a fair value notion which may not be as attractive as what a yield-based investor might expect, or what an income-plus growth investor might expect."
The Next Merger Deal?
Investment bankers live and breathe mergers and acquisitions. So Schreiber says merchant energy firms should consider buying a regulated cash cow, as Dynegy did when it bought Illinova.
Utilities, too, might look for safety in a merger partner.
"You'll see companies like Conectiv and PEPCO merging delivery companies. But they might be interested in somebody like ConEd, which has sold off all of its generation," explains Schreiber. "Then you could match up two basically urban utilities where management is comfortable managing the delivery of power into an urban area, and there are economies of scale to be achieved there."
Schreiber adds that international companies like E.ON, who wants to get into the market, may want to build off its LG&E acquisition.
With the strength of their capital structure, a foreign acquirer could bring instant credibility in the market, and the industry would be comfortable trading and doing business with them.
"There is a wide range of activity swirling around the market. Successfully completing transactions will depend on the values of the assets, the regulatory construct and, in the case of international players, the value of the dollar," he says.
Conversely, Lazard's Bilicic believes that energy merchants should, if they can, tough out the down cycle and wait for at least some recovery before thinking about a merger, so they don't have to deal from a position of weakness.
"If you look at generation assets, they have a historically low value now because of power price expectations. While it doesn't look particularly good right now, the value of many of these assets should recover as power price expectations improve, and so should their liquidity problems," he says.
McGinnis says Morgan is thinking about merger deals that focus on financial stability and investor confidence.
"We are looking" he explains, "at mergers of company-to-company or the purchase of the assets of other companies." All are driven by the desire to get bigger and gain competitive attributes, such as size, financial strength, and the trust of investors. "If you have those things," McGinnis says, "you are going to be in a good position in the next five years."
Reliant Resources sticks to its guns.
The plan to take the unregulated merchant energy trading business from Reliant Energy and tie it with 1.7 million formerly regulated retail customers of the old Houston Lighting & Power under the new nameplate of Reliant Resources seemed like a good idea.
Especially two years ago, when merchant energy was hot.
That would give Reliant's merchant arm a built-in customer base-a different model from other merchant firms, whose fortunes are solely tied to wholesale markets. It would position Reliant both upstream and downstream-like ExxonMobil, which counts on retail gasoline outlets to weather those sharp oil price swings.
But Reliant today is pushing a merchant business plan at a time when investors are pulling back. The company has had to do business with its credit ratings downgraded to junk status, has had to restate earnings due to its involvement in "round-trip" trading, and has massive debts that are coming due this year. It faced a $1 billion bank note in October, and a total of $6 billion worth of payments in the next 12 months.
Of course, Reliant Resources says it has double the liquidity to meet its obligations. The company's CFO, Mark Jacobs, a former investment banker at Goldman, Sachs, believes that the market will eventually come around. Call him a true believer.
"What is fundamentally different is the balance with our retail business. As you are probably aware we have an unregulated retail business here in Texas that acts very much as an offset to our declining wholesale business. Look at where this company started the year in terms of earnings forecasts. Compare that relative to other [merchant] companies in our sector," he says.
But Reliant Resources estimates are down only by 20 percent, he says. The reason, he explains, is that while his wholesale business has suffered along with everybody else's, his retail business is making a lot more money than expected. It is the opposite position from the wholesale. "So, if wholesale prices go down, you make less money in the wholesale business, [and] we make more money in the retail business," Jacobs adds.
"My view here, and no disrespect to Duke and others, but at the end of the day [if you mix] that type of business with a merchant business that has cyclical earnings, you are neither going to have fish or fowl.
"I think you are seeing that in spades. Look at how Duke has traded now-which used to have a several multiple point price-to-earning (P/E) advantage over every other company in the utility space. Who is the king now? Southern, because Southern split off Mirant, and Southern is this purely regulated utility. At the end of the day, I think that is what you are going to see. A lot of these companies that have pursued merchant strategies under the regulated umbrella are going to figure out that is not what the investor base wants."
With a promise of earnings in the 10 to 15 percent range over the next five years, Reliant stands out for investors with a hearty appetite for risk. But first, you gotta believe.
Xcel Energy stands by its merchant subsidiary.
Xcel Energy was a proud corporate parent. Just two years ago, the company basked in the glory of its double-digit earnings wonder, its merchant energy subsidiary NRG. But now power market prices have dropped. Xcel must take the good with the bad-and worse.
"We certainly are not going to go far enough to put the utility at risk. In fact, we are willing to let NRG go bankrupt if that is the right answer or not," says Richard Kelly, who is being pushed closer and closer by lenders to make a decision on that score.
Collateral calls for $1.1 billion to $1.3 billion arrived on schedule after Moody's Investor Service and Standard & Poor's lowered NRG's debt rating to junk status this summer. The company, which has said it cannot pay its lenders, won a 25-day waiver on the collateral payments in August, pushing the deadline back to September 13. But at press time, there were no reports on whether NRG had won an extension.
NRG has about $9 billion total debt, or a debt-to-capital ratio of 80 percent. Its highly leveraged structure precludes it from a "life-saving" merger.
How did Xcel get to this point? Some have asked why didn't Xcel let NRG go bankrupt sooner?
"The real question that people keep asking is why did you bring them back in February, why didn't you let them go bankrupt in February? Knowing what I know now, I would probably do the same thing again," Kelly says.
"NRG has some very good assets in some very good markets and in time will be profitable."
But is Xcel pouring good money after bad?
"We at Xcel have put a lot of money into NRG," Kelly admits. "Look at it when NRG was in the process of being downgraded and the stock was going down. We owned 74 percent of them. Letting them go bankrupt means that we would lose for the Xcel shareholder all the value of NRG, which would be $2.6 billion."
Certainly, the collapse in prices has been a major problem for NRG, which counted on stable prices in buying up power plants that utilities sold off.
"The price 18 months ago was $300 per kilowatt-hour," Kelly notes. "Today it is $25 to $30. We financed [these plants] with high leverage, which we were encouraged to do. When the price went from $300 to $30, there was not enough money left." Of course, if NRG could be salvaged, and its bad assets sold off, Kelly believes the company could continue to contribute three to five percent growth, along the two to three percent growth expected from Xcel. But that's a big "if." Kelly sees NRG as victim of a perfect storm.
"The reason the price dropped is that when California happened-many states decided not to restructure, and so there weren't the assets to buy anymore. Then when Enron came around it became a credit crisis and then demand went down, and the price of gas went down. So, the profits started to deteriorate. Just about anything that could go wrong went wrong."
Parenting in a nutshell.
Duke Energy insists it is different.
When talking about his company or about valuing his company, Robert Brace resists being boxed, pigeonholed, or pinned-down. He doesn't seem to be comfortable with comparisons of Duke Energy to others in the industry. "Duke Energy is different than everybody else," seems to pierce every statement he makes.
Ask Brace whether Duke Energy would be willing to dump the company's energy trading division to preserve the company's investment grade credit rating (as some companies have had to do) and Duke Energy's CFO goes on the defensive.
"That's a hypothetical question that I think will not come to pass. Other companies are in different positions. We have a lot of balance in our portfolio. Total Duke Energy North America (DENA) [merchant trading operations] is only one part of the company. It's not all of our company, and only one part of the DENA operation relates to trading and marketing, and only one element of the trading and marketing relates to the risk element," he says, quite passionately.
"So, I accept that market investors are not terribly enthralled by trading and marketing, and arguably they were over-enthralled with it a year or so ago. We don't look at it as better or worse. We have always said that our trading and marketing operation was there to enhance returns from our power plants, not to take speculative positions in the market and try to make profits out of nothing," he says.
Brace goes one step further, saying that closing the trading business is not only a trade-off that Duke is not required to make, but a trade-off that he says would not make sense in terms of Duke's overall business.
"Our trading operations trade around our assets, and we have to sell the power from the plants and you need a trading operation to do that effectively," he warns.
But press him on what he would do if his credit rating was at risk, and Brace deflects the question.
"In terms of maintaining our [investment grade] credit rating, we have said that we believe having a premium credit rating is the right place for Duke to be. We said this last year and the year before that when it wasn't so popular."
The company announced last month that its earnings expectations would be materially lower in 2002 and 2003 based on continued weakness in Duke Capital's merchant energy subsidiary, DENA. That led credit rating agency Moody's to place the parent's ratings on review as well.
Duke Energy then announced the deferral of construction on three merchant plants, and said it would undertake further capital expenditure reductions and asset sales to bolster the company's overall liquidity position.
For his part, Brace doesn't seem unhinged. He views Duke's prospects through a larger lens.
"Returns are down in the market in which we operate, and we have pulled back because of that. We are looking at a reduced growth rate, but that is part of the normal market cycle."
Spoken like an a typical merchant energy trader.
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