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November 21, 2001 



Enron Continues to Implode; 
Will the Dynegy Deal Proceed?



By Will McNamara
Director, Electric Industry Analysis






[News item from Reuters] Enron Corp. (NYSE: ENE) shares fell sharply in opening trade on Nov. 20 after the humbled energy giant warned it could be forced to pay by next week $690 million in debt triggered by a credit downgrade last week. The shares were down $1.16, or 12.8 percent, to just over $7.00 in early morning trade on the New York Stock Exchange. The stock was the biggest loser by percentage change and the second-most active stock on the NYSE. As of early morning trading on Nov. 21, Enron shares were priced at $4.85, reportedly their lowest level in nearly 10 years. 

Analysis: To paraphrase Shakespeare, "Oh, what a tangled web they weave when first they attempt to?" Wait, I better stop. When speaking about Enron, I am not prepared to finish that sentence, at least at this point. Enron has been accused of a lot of things over the last few weeks, but at this juncture an ongoing Securities and Exchange Commission (SEC) investigation has yet to reach any conclusion regarding deceptive financial reporting on the part of the Houston trader. Enron itself has admitted that its financial records from 1997 through the first half of 2001 "should not be relied upon." Nevertheless, perception is reality and the perception currently in the industry is that Enron is now taking a fall after getting caught following years of skirting the truth. While negative perception continues to cause damage to Enron's stock, perhaps of more current interest are the developments that are more grounded in reality. We know Enron has just lowered its third-quarter earnings, faces a stiff payment of $690 million (due within a week, in fact) and has cast doubt over its 4Q earnings potential. The question of the hour is whether these new financial hits will represent a "material adverse change" in the eyes of Dynegy, which still aims to buy Enron but wisely included an exit clause in its purchase contract. The other question is, what happens to Enron if Dynegy leaves it standing at the altar? A terminated marriage agreement would surely cause further reductions to Enron's already-weak credit standing, and it is unknown how the company could recover from another blow to its reputation. 

As has been the case since the first of October, the ongoing "fall of Enron" story is changing by the day. For background on Dynegy's proposed acquisition of Enron, and Enron's financial problems that precipitated the proposal, please see my 11/12/01 IssueAlert (available at www.scientech.com/rci <http://secure.scientech.com/issuealert/article.asp?id=987>). In the interest of time, let me summarize what is happening at this moment. Dynegy rode in as Enron's white knight and plopped down a $9-billion offer ($10 a share) to buy the company, which at the time represented a steal of a price considering that Enron was priced at almost $90 a share little more than a year ago. To some extent, this seemed like the final chapter in the Enron saga. In other words, the company had gone through a tumultuous year, hit its "rock bottom" but still planned to live happily ever after as part of Dynegy, Inc., its much-smaller rival. 

The developments just this week amount to a screeching brake that may in fact interrupt the nuptials between the two companies. For starters, on Monday (Nov. 19), Enron submitted its 10-Q report to the SEC (which was five days late, by the way). In the report, Enron dropped what have turned out to be several bombshells. First, Enron disclosed that, due to recent downgrades of its credit rating by agencies such as Moody's, Standard & Poor's and Fitch, it has to pay off or refinance by Nov. 26 debt it owes to a third party with which it has a partnership, or face nearly $4 billion in additional payments. Enron also has the option of finding new collateral to guarantee the debt. Enron would not disclose who owns the note, but we know that the limited partnership includes holdings in C.E.G. Rio, a Brazilian natural gas-company that Enron had planned to sell to raise about $250 million in cash. Note that just last week, various credit services lowered Enron's senior unsecured debt to one notch above junk status and warned that further downgrades may occur, which apparently prompted the call for the debt payment. Reportedly, if Enron does not make the $690-million payment by Nov. 27, investors will gain the right to immediately begin liquidating the asset for an amount equal to the note payable. Enron is presently scrambling to establish a "mutually acceptable" amendment with lenders to avoid having to issue payment on the debt. Along with the acknowledgement of the imminent payment of $690 million, Enron said that any further drop in its credit rating might necessitate further payments of $3.9 billion to other partnerships, the bulk of that figure going to Osprey Trust and Marlin Water Trust. 

Also in the new SEC filing, Enron increased its 3Q 2001 loss by 3 cents a share to 87 cents. Enron originally reported a 3Q loss of $618 million, but has now raised that figure to $664 million. As a minor bright side, Enron did increase reported earnings for the first nine months of 2001 by a penny to 20 cents a share, attributed to adjustments made after the quarter's end. However, looking forward, Enron warned that continuing credit worries and a decline in the value of some of its assets could take a further toll on fourth-quarter earnings. Enron also claims that, even still, the numbers contained in the 10-Q report are not necessarily final as they have not been reviewed by Arthur Andersen, the company's external auditor. Thus, further revision of the numbers could take place. 

Interestingly, there does not seem to be a big question about whether or not Enron can pay the $690-million debt obligation. Enron apparently has secured an additional $2 billion in loans from J.P. Morgan Chase and Citigroup in the last week. In fact, within the current SEC filing, Enron says that is has $1.2 billion of domestic cash consisting of the lines of credit and net collections. Thus, some investors are reassured by the belief that Enron has the cash on hand to make the $690-million payment if it is unable to renegotiate terms with lenders. According to the SEC filing, Enron also intends to sell off $8 billion in non-core businesses that are performing "below acceptable rates" and would use the proceeds to pay off debts, although this money would probably not be immediately available. 

Again, however, there is a perception element to this development that should be noted. Enron has been accused of financing partnerships in the past in such a way as to keep them off the company's balance sheets. Apparently, this non-disclosure was done so that Enron could grow quickly without adding too much debt to its own books or diluting the value of its stock. As has been well documented, Enron is already in the midst of an intense SEC investigation regarding potential conflict-of-issues involving its former CFO. News about other financial deals that may not have been fully disclosed is clearly making investors even more nervous about Enron's stock. 

As I said, the question of the hour is whether or not Enron's new problems will cause Dynegy to reconsider its offer. As usual, the answer all depends on who you ask. Dynegy is remaining mum and referring all questions about Enron's financial status to Enron. Investors are rather mixed on the question. Some say that the facts disclosed in the 10-Q report do not dramatically change Enron's position from what it was when Dynegy launched its acquisition and that the current drop in Enron's stock is just a knee-jerk response to the media hype surrounding the story. Further, those who diminish any potential impact say that Enron is still a liquid company and has money coming in from various sources. Thus, it should have no trouble making the $690-million payment. From a broad perspective, so one theory goes, Dynegy is still getting a great deal in Enron due to its staggering drop in stock price, and the acquisition remains valuable to Dynegy as it will position the combined company as North America's biggest marketer and trader of natural gas and electricity. 

In contrast, other investors point to the fact that since the purchase agreement was signed, Enron's stock has fallen an additional 32.5 percent, which weakens the original acquisition agreement. In addition, if Enron follows through with the $690-million payment next week or secures additional financing to front this cost, both options alter the company's financial position from when Dynegy made its original offer, which could be construed as a "material adverse change." 

Another interesting development indicates that Enron may no longer be the company that Dynegy agreed to purchase. New reports indicate many energy trading companies are now unwilling to sell power or natural gas to Enron for fear about the company's credit concerns. Such companies are now particularly reticent to sell power to Enron for next-day delivery. What this means in practical terms is that other trading companies may be gaining Enron's market share, which could diminish the value in the trading market that had attracted Dynegy to Enron in the first place. In addition, Enron's once-stellar energy trading business could now become reduced or collapse altogether. 

Questions have been raised why Dynegy is not doing more at this time to help Enron out of its financial mess. Of course, under the acquisition agreement Dynegy already committed to providing an immediate $1.5-billion asset-backed equity infusion into Enron to help the company with its current financial woes, which will be followed by an additional infusion of $2.5 billion into the combined company by ChevronTexaco, which owns 27 percent of Dynegy. However, some traders apparently have wondered why Dynegy has not done anything about Enron's diminishing ability to secure power on the open market. Traders claim that Dynegy could step in and buy power from sellers on the behalf of Enron, in a strategy known as "sleeving." The fact that Dynegy has not chosen to take this step has been an indication to some observers that it is only willing to go so far in its pursuit of Enron. 

In addition, Enron shareholders launched a lawsuit on Nov. 12 in state court in Houston to prevent the merger with Dynegy from happening. The petition reportedly alleges that Enron directors breached their fiduciary duties by agreeing to sell the company at too low a price and without adequate consideration of other alternatives. Enron said it will defend its decision in court. 

Moreover, Dynegy was smart to include an exit clause in the acquisition agreement. The clause reportedly allows Dynegy to walk away from Enron if any material adverse change occurs related to the outcome of the SEC investigation, possible litigation against Enron, balance sheet strengths, and earnings forecasts. Certainly the latest developments disclosed in Enron's 10-Q filing with the SEC impact the company's balance sheet strengths and earnings forecasts, so a case could be made that Dynegy would have grounds to terminate the acquisition. Clearly, this pending deal hinges on the developments that will take place over the next few weeks. Dynegy ultimately will have to weigh the pros and cons of its acquisition offer for Enron and determine if the once-golden company still represents a great deal, or if pursuing the purchase would cause more trouble than it is worth. 


An archive list of previous IssueAlert articles is available at
www.scientech.com <http://secure.scientech.com/issuealert/> 


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