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October 16, 2001 


Dynegy Remains on a Roll as Earnings Soar 



By Will McNamara
Director, Electric Industry Analysis 


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[News item from Reuters] Power marketer and trader Dynegy Inc. (NYSE: DYN) announced that its third-quarter earnings hit the upper end of Wall Street expectations as its backbone wholesale energy business delivered strong returns. The company said earnings rose to $286 million, or 85 cents per diluted share, from $177 million, or 55 cents per diluted share, for the same period in 2000. Analysts polled by Thomson Financial / First Call had expected earnings in a range of 77 cents to 85 per share, with a mean expectation of 82 cents. 

Analysis: Dynegy has scored an impressive feat in beating its stellar financial performance over the course of 2000. Given the restrictions placed on power generators in California, general market upheaval and impact on the economy that has resulted from the events of Sept. 11, one might have expected Dynegy to see its earnings dip slightly compared to its 2000 performance. Quite to the contrary, Dynegy has emerged once again as a bright star in a rather bleak financial galaxy, demonstrating that its core focus on marketing and trading, along with a cautious approach into international markets and uncertain businesses such as telecom, is a winning strategy. Even in a weakened economy in which its own stock has fallen some 24 percent over the course of 2001, due in large part to market turmoil, Dynegy still stands out as a leader in the energy field, and almost single-handedly has kept energy stocks high on the radar screen of Wall Street. 

Dynegy's numbers command attention. In addition to its impressive 3Q report, during the first nine months of 2001 Dynegy has earned $571 million, or $1.69 a share, compared with $395 million, or $1.17, for the first nine months of 2000. Dynegy also has raised its earnings estimate for year-end 2001 to a range of $2.09 to $2.10 per diluted share from the $2.07 target set on Oct. 1. For 4Q and year 2002, Dynegy remains comfortable with its previously established target of 40 to 41 cents a share and $2.50 to $2.60 a share, respectively. The revised figures represent an increase of well over 30 percent for Dynegy's projections for 2000. Further, the company said that it remains confident that its projected earnings per share (EPS) growth rate over the next three years (through 2003) will average 20 percent to 25 percent. 

Without question, the vast majority of earnings increase at Dynegy is being derived from the company's Marketing and Trade unit, which Dynegy said accounted for more than 90 percent of the 3Q profits. In fact, out of the $286 million that Dynegy reported in the 3Q 2001 earnings, $263 million came from the marketing and trading division, representing an increase of 85 percent from 3Q 2000. Dynegy Marketing and Trade is engaged in a broad array of energy businesses, including the physical supply of and risk management activities around wholesale natural gas, power, coal, emission allowances, and weather derivatives. 

On the basis of the marketing and trade subsidiary, Dynegy is currently ranked as the fifth largest gas marketer in the country, and its ongoing success has resulted from a dual focus on natural-gas trading and power generation. For year-end 2000, Dynegy Marketing and Trade reported a 252-percent increase in recurring net income to $355 million, representing nearly 80 percent of Dynegy Inc.'s overall results. The segment's performance benefited from Dynegy's expanded North American natural-gas and power operations, including the integration of Illinova's unregulated generation assets, strong marketing, trading and risk management activities and a return to normal weather patterns. 

Clearly, this particular unit is the primary earnings driver for the entire company. In the third quarter, Dynegy Marketing and Trade's North American natural-gas volumes grew 12 percent to 11.0 billion cubic feet per day (Bcf/d), an increase from 9.8 Bcf/d during 3Q 2000. Also under the same unit, total power sales increased 86 percent to 90.5 million MWh in 3Q 2001, compared to 48.7 million MWh in 3Q 2000. This 86-percent jump in total physical power sales led to an 85 percent year-over-year increase in recurring income for the marketing and trade division. According to Dynegy, the higher volumes in both gas and power were the result of improved market liquidity, greater market origination, increased sales volumes on Dynegydirect, and incremental gas marketing in Canada. 

Part of the expansion of this business will be an ongoing penetration of the European trading market. However, Dynegy maintains that, unlike its direct competitor Enron, its European expansion is methodical and cautious. Dynegy recently expanded its Dynegydirect trading portal into the United Kingdom, but its penetration of this market has been much slower than Enron, which, according to Dynegy, tried to expand into the European market "in a hurry." Another Dynegy rival is Reliant Energy, which also expanded into Europe in advance of other companies and is now reportedly considering a sale of its electricity generation business in the Netherlands. 

The comparison that Dynegy has made between itself and Enron may be intentional. Along with being long-time Houston-based rivals, Dynegy must find its current success even sweeter considering the turmoil that has taken place at Enron over the last year. Of course, Enron lost its CEO Jeffrey Skilling just over a month ago when he resigned amid the company's diminished stock value and huge losses in the telecom sector. Enron released its own 3Q earnings report on Oct. 16. Enron's core wholesale trading and marketing division met targets and drove up profits by 35 percent. The company's earnings also rose to $393 million, or 43 cents a share, from $292 million, or 34 cents a share, in 3Q 2000. However, Enron posted a 3Q net loss as it faced $1.01 billion in charges, which included a $287 million write-down on its Azurix venture, $180 million from the restructuring of its broadband unit and $544 million in investment losses related to The New Power Company. What we know presently is that Enron's stock has dropped about 57 percent over the course of 2001, due to its troubled broadband sector, losses associated with its Dabhol subsidiary in India and overall downward market trends. 

If there is something that could be considered a blemish on Dynegy's current record, it may be its telecom business, known as Dynegy Global Communications, in which the company reported a $15 million loss for the third quarter. Dynegy Global Communications seeks to capitalize on the growing convergence between energy and communications sectors by building a broadband marketing and trading system. Dynegy has said that the loss is due to costs associated with developing its 16,000-mile bandwidth network, which reaches 44 U.S. cities and is expected to be completed in the four quarter. Unlike other power companies that are trying to exit the telecom sector (Reliant, for example), Dynegy still projects that it will find long-term success in this area, in part because it is taking a cautious approach toward expansion. Also, as another means of comparison with Enron, Dynegy's telecom business lost $15 million in the third quarter while Enron's broadband unit took a loss of $80 million. Another unit taking losses is Illinois Power, Dynegy's regulated transmission and distribution subsidiary, which reported a $15-million loss in 3Q 2001. Dynegy attributed this loss to a reduced industrial load. 

Perhaps the other area that may give pause to investors is Dynegy's engagements in the California market, which still remains unresolved. Dynegy is reportedly still owed about $320 to $325 million for power that was sold to the California utilities before the state government took over as the primary power purchaser. Despite Dynegy's best efforts to obtain the outstanding balance, and its confidence that it will ultimately be paid, the financially unstable condition of Pacific Gas & Electric Co. and Southern California Edison makes the timetable for any such payment quite uncertain. Also impacting Dynegy's California involvement are reports that California lawmakers want to renegotiate long-term agreements that the Department of Water Resources signed with various power suppliers, including Dynegy, earlier in the year. Wholesale prices have dropped considerably since the state of California signed the long-term contracts, and thus the state wants to renegotiate a better price for the power. Dynegy claims, however, that the contract it signed with the state contains legal protection for Dynegy's interests. 

Overall, however, Dynegy's 3Q financial report represents what is one of the few unqualified success stories in the energy industry. Stacked up against other companies that have struggled against the volatility of the nation's economy, Dynegy is clearly flourishing. Like other companies with heavy assets in generation, the fact that Dynegy's marketing and trading division is the primary profit driver for the company is not a revelation. What is perhaps more important is the diligent way in which Dynegy has methodically accumulated an arsenal of generation assets and expanded into new business lines with a very cautious approach. 


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