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November 12, 2001



Dynegy and Enron
Announce Merger 



By Will McNamara
Director, Electric Industry Analysis


[News item from Reuters] Dynegy Inc. (NYSE: DYN) agreed on Nov. 9 to acquire rival Enron Corp. (NYSE: ENE) for some $9 billion in stock, underlining the dramatic reversal of fortunes for the Houston-based energy trading giant that was valued last year at nearly $80 billion. Enron's stock fell sharply in the past month due to investors' concerns about murky transactions that sparked an investigation by U.S. regulators and damaging downgrades by credit rating agencies. The merged company will retain the Dynegy name. It will have annual revenues of more than $200 billion and assets worth $90 billion, including more than 22,000 megawatts of electricity generating capacity and 25,000 miles of natural-gas pipelines. It will be North America's biggest marketer and trader of natural gas and electricity, positions previously held by Enron.

Analysis: Well, it's now official. The announcement of what presumably will be the final chapter in the Enron saga came with much fanfare at the end of last week. It is indeed a dramatic end. Enron, the maverick and innovative company that has often been credited for literally creating deregulated markets in the energy industry, will no longer exist after what has been a very quick and unbelievable fall from grace over the last several months. Dynegy, the slow and methodical company that took a more traditional approach toward success, is making a stunning acquisition of its formal rival and locking in much of the industry market share of Enron. Can there be any doubt that this is the energy industry's manifestation of the tortoise and the hare parable? Enron has clearly lost the race to Dynegy, but is making a smart choice to be bought, considering its desperate circumstances and the unlikelihood of its regaining financial strength on its own. For Dynegy, this acquisition is a major win, as the combination will create the biggest and strongest energy merchant in the world. 

There are so many interesting dimensions to this mammoth deal. Before addressing some issues related to the approval of the deal, let's establish some of the key points of the merger agreement. There have been some mixed reports, but it is generally believed that Dynegy is buying Enron for about $10 a share, quite a steal considering that just over a year ago Enron was trading at close to $90 a share and had a market value of nearly $70 billion. Under terms of the agreement, Enron shareholders will receive 0.2685 Dynegy shares per share of Enron common stock. Dynegy's current stockholders (including ChevronTexaco Corp., which currently owns 27 percent of Dynegy) will own approximately 64 percent of the combined company, while Enron's stockholders will own approximately 36 percent of the combined company's stock at closing. 

In addition, Dynegy will provide an immediate $1.5-billion asset-backed equity infusion into Enron to help the company with its current financial woes, followed by an additional infusion of $2.5 billion into the combined company by ChevronTexaco. Chuck Watson, chairman and CEO of Dynegy, will retain his position at the new company. Steve Bergstrom, president of Dynegy, and Rob Doty, chief financial officer, will retain their positions at the new company. It is not presently known what role, if any, Ken Lay, current CEO of Enron, will hold at the new company. 

Of course, this acquisition could not have taken place if Enron had not fallen into a very vulnerable spot this year. Quite literally, Enron was pushed into this deal because it was running out of cash, its stock had tanked and its credit ratings were slashed to near junk levels, all within the last several weeks. Enron's decline over the course of 2001 has been the result of losses in its telecom sector, losses from its involvement in India, the departure of its former CEO Jeffrey Skilling, a Securities and Exchange Commission (SEC) investigation into some of its business practices, and lack of investor confidence about Enron's honesty in its financial reporting. This last point gained validity last week when Enron announced that it had overstated earnings by 20 percent over the last four years and investors should disregard the company's financial statements from 1997 through the first half of 2001. The restating of its earnings for the last five years sliced $591 million from Enron's reported profits. In addition, Enron revised its debt upward in each year from 1997 to 2000. At the end of 2000, Enron's debt was $10.86 billion, $628 million more than it had previously reported. By not reporting this debt earlier, Enron presumably was able to maintain a stronger credit rating than it would have had the accurate records been disclosed. 

The key value for Dynegy in this acquisition is Enron's successful energy trading business. In addition, Dynegy could also find synergies in Enron's retail unit, Enron Energy Services and EnronOnline, the company's electronic trading unit. Dynegy has a similar trading site known as Dynegydirect, which was launched after Enron gained the first-strike advantage in this market space. Details are still emerging, but it would make sense if Dynegy opted to not purchase other units under Enron's business structure, such as the company's water and telecom businesses, which are losing money. Dynegy has its own telecom unit, which has also lost money this year, so it may not want to expand in this slow-growing sector at this time. Vivendi Environnement, a French company that has expanded into various lines of business, has reportedly expressed interest in the remaining subsidiaries of Azurix, Enron's struggling water subsidiary. Note that Enron sold Azurix North America to American Water Works. 

The deal is subject to regulatory reviews and shareholder approval from Dynegy and Enron shareholders. Dynegy shareholder approval may be contingent upon any possible downgrades on its long-term debt that Dynegy could encounter with the purchase of Enron. At this juncture, it does not appear that Dynegy will be downgraded, but this is a fast-changing story and conditions could change abruptly. Financing the deal may also be an issue, even with the infusion of capital from ChevronTexaco. Dynegy reportedly has $3 billion worth of debt and has a market capitalization of $11.7 billion. Thus, Enron's own more substantial debt may be too significant for Dynegy to absorb, a concern that may cause Dynegy shareholders to veto the deal. This issue could be helped if Dynegy only elects to purchase some of Enron's assets and if there is some repair work done on Enron's balance sheets. 

The issue of regulatory approval could be difficult, as the combination of the two huge companies may cause regulators to be concerned about market power and antitrust issues. The review of this merger will be unprecedented, considering that the wholesale natural-gas and electricity trading market is still fairly young. Certainly, a deal of this magnitude has not previously occurred in the deregulating energy industry. It is not presently clear which regulatory agency will be involved in the review, although the Federal Energy Regulatory Commission (FERC), the Federal Trade Commission and the Justice Department could all be involved. FERC would most likely become involved only if the acquisition includes the transfer of a physical asset, such as a pipeline. FERC may not become involved if the deal is structured solely as an exchange of stock. Not involving FERC would be more advantageous for Dynegy and Enron as the timeline for approval would be significantly shorter. 

An issue that most likely will be at the top of the list of review items for regulators would be the extent to which the combination of Enron and Dynegy would hold market power in the natural-gas trading space, which could pre-empt market entry by other competitors. The combined company would be considerably larger than its nearest competitors. Scope and scale are considered the top competitive assets in the trading sector, and the combination of Dynegy and Enron will certainly have those assets in abundance. It will fall on regulators to determine if the combined company is so large that it precludes other competitors from emerging into the same space. 

To say that this deal is a sweet victory for Chuck Watson is an understatement. The two rival companies followed very different paths to success. Enron, under the leadership of Jeffrey Skilling in particular, espoused an unorthodox belief that the company did not need to own physical assets in order to achieve success in the energy-trading space. Dynegy, on the other hand, approached the market from the opposite perspective, and diligently acquired diverse generation assets across the United States and internationally to support its trading operation. Up until the start of 2001, it appeared that Enron's strategy was the more successful of the two. Enron, with $100 billion in revenues and $1 billion in profits in 2000, ranked fifth on Fortune 500's list of largest U.S. companies. In contrast, Dynegy ranked 54 on the same list and had $29 billion in revenues and $500 million in earnings. However, 2000 turned out to be Dynegy's year and the success continued into 2001, the very year that would bring Enron's downfall. Enron's problems culminated in $638 million in losses in the third quarter, after taking $1.01 billion in charges associated with several of its non-core businesses. Taken with the other factors plaguing the company, Enron became exceptionally vulnerable and prone to a takeover, which has now provided Dynegy with a strong gain. 

The purchase of Enron will literally quadruple Dynegy's size and should immediately provide an accretive earnings contribution. Further, Dynegy claims that it expects a 15- to 20-percent annual earnings growth over the next three years following its planned acquisition of Enron. If it gains all of the necessary regulatory approvals, Dynegy will become the undisputed market leader in the energy industry, with annual revenues of $200 billion and $90 billion in assets. The company will have 22,000 MW of generating capacity, which moves its closer to the previously established goal of accumulating 70,000 MW by 2005. In other words, the combined company will dwarf any other competition in the trading sector and be considerably ahead of its nearest competitors such as Mirant or Duke Energy in terms of size, resources and assets. 

Word of the acquisition caused Enron's shares to increase some, one of the few upward bumps that the company had experienced in the last few months. Shares of Enron rose 44 cents, or 5.2 percent, to $8.85 in mid-day trade on the New York Stock Exchange on Nov. 9. As of early morning trade on Nov. 12, Enron shares were priced at $9.40. Shares of Dynegy gained $2.24, or 5.8 percent, to $41 in early trade on the New York Stock Exchange. 


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