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October 24, 2001 


Dynegy vs. Enron:
A "Tale of Two Companies" 



By Will McNamara
Director, Electric Industry Analysis 


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Facts: Dynegy Inc. (NYSE: DYN) beat expectations in the third quarter, reporting that its 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. This represented a 22-percent increase from 3Q 2000 and boosted the company's 2001 earnings estimate. Dynegy has a market capitalization of $14.5 billion. Its stock is currently trading at about $43 down from a 52-week high of $59, although it is important to note that for year-end 2000 the company's stock was one of the top performers among Standard & Poor's 500 companies with a total shareholder return of 218 percent. Dynegy employs 5,778 people. 

Enron Corp. (NYSE: ENE) reported $638 million in losses for the third quarter, after taking $1.01 billion in charges associated with several of its non-core businesses. The company's 3Q recurring net income (before the write-offs) increased 35 percent to $393 million, or 43 cents a diluted share, and revenue in the quarter rose to $47.6 billion from $30 billion in 3Q 2000. Enron has a market capitalization of $14.8 billion. Its stock is currently trading at about $16.0, which represents a six-year low for the company and is considerably lower than the peak of $82 hit in August 2000. Enron employs 20,600 people. 

Analysis: Dynegy closed out a banner year in 2000 and appears to still be on a roll in terms of its financial performance. In contrast, Enron faced an unprecedented year of turmoil, and is presently languishing in a low ebb, characterized by a strategic crossroads and heightened scrutiny of the company's financial reporting. While the two companies operate in the same market space of power trading and are fierce competitors, Dynegy-ironically the younger and smaller of the two companies-is an industry success story while Enron's status remains rather uncertain. The questions to be addressed in this article are: What is Dynegy doing "right"? What is Enron doing "wrong"? What lessons can other power and natural-gas marketers learn from this "tale of two companies"? 

Although they are often referred to as "cross-town rivals," Dynegy and Enron are worlds apart in terms of their competitive positions. Their divergent approaches to the global marketplace illustrate what could be the single-most important element related to their disparate positions at the end of 2001. Put more simply, the two companies have vastly different strategies, and-hindsight being 20/20-a strong argument can be made that Dynegy's strategy is the winner at this juncture. Throughout this article, I will focus on two key areas in which Dynegy and Enron differ dramatically. Those two key areas are the ownership of physical generation assets and the extent to which the companies have expanded (and invested) into non-core sectors. 

Both companies started out as natural-gas companies and converged into the power market in the 1990s. However, that is essentially where their similarities end, and over the last few years Enron and Dynegy have followed decidedly different paths. In an attempt to make the complex rather rudimentary, let me summarize the two paths this way: Enron does not believe it needs to own physical assets to be a success in the power and natural-gas trading sector; Dynegy, on the other hand, not only believes in the ownership of physical assets, but has set a goal that could ultimately establish the company as owning one of the largest generation arsenals in the industry. 

Let's look at the companies separately. We'll discuss Enron first since it is the older of the two. Enron readily admits that its strategy is difficult to define, but a close approximation is that Enron literally creates commodity markets so that it can deliver physical commodities to customers. The participation and success in commodity markets, according to Enron, does not necessitate ownership of physical assets. In fact, the company has routinely sold physical assets that are not considered to be strategic to its wholesale business. Rather, Enron has concentrated on developing a new philosophy of risk management excellence, in which it will merely buy and sell the commodities it needs to participate in trading venues. 

As an example, Enron bought Portland General (which owns 2,000 MW of generation and 41,600 kilometers of electric T&D lines) in 1996 as a way to launch its penetration of the West Coast power markets. When competition fizzled in that region, Enron put Portland General back on the sales block (a sale of Portland General to Northwest Natural is pending at this writing). Likewise in Europe, where it is one of the most prominent trading companies, Enron has disposed of generation assets such as Sutton Bridge in England and, unlike other U.S. competitors, has refrained from buying additional generating units in opening countries such as Germany and Italy. According to its most recent 10K report filed with the Securities and Exchange Commission, Enron owns or controls 2,015 MW of generating capacity (including joint ownerships), which is drastically lower than the average among other companies operating in the power trading sector. 

Dynegy's approach to the market is crystal clear and radically different from Enron's. In the words of CEO Chuck Watson, "Dynegy's long-term strategy is to focus on marketing and trading around physical assets, which supports earnings sustainability." Ever since going public in 1995, Dynegy has been on an acquisition binge, with each purchase significantly increasing its generation capability. Dynegy presently owns or controls about 27,000 MW of generating capacity in the United States, 26 gas-processing plants and 14,000 miles of pipelines, which are located in geographically competitive areas. The company's goal is to own or control 70,000 MW, or 10 percent of the U.S. market, within the next five years. Sometimes, Dynegy has acquired assets through partnerships with other companies such as NRG Energy, but just as often it has purchased assets independently. Most notably, when Dynegy acquired Illinova in early 2000, the purchase doubled Dynegy's generating capacity. Dynegy is now attempting to replicate this approach in Europe, where it is presently planning to purchase natural-gas storage facilities in England. Dynegy executives have argued that natural-gas storage is the best way to back up a natural-gas trading operation. There's no question that the approach is working. Out of the $286 million that Dynegy reported in the third quarter, $263 million of it came from the company's main wholesale business. 

The issue of asset ownership is probably the central defining difference between Enron and Dynegy, and its significance should not be overlooked. It is not difficult to make a case that supports Dynegy's approach. Owning physical assets often enables a trading company to gain information in the course of operating power plants that can help the company to gauge markets and anticipate small changes in price. In other words, by controlling the actual output of generation instead of just being involved in buys and sells, a trader such as Dynegy will theoretically know what the load is going to be in a particular region, how much power can be produced to meet that load and when shortages might occur. In addition, in markets that are short on infrastructure, it may be difficult for a trader to participate in the market unless they actually have ownership of physical assets in the region. By the same token, those companies that do control physical assets often have greater communication with grid operators, and possible insight to spreads (the difference between various energy prices). In fact, Dynegy's CEO Watson fully acknowledges that his company excels at being able to trade around the volatility of price, and being capable of resolving balances when shortages exist. This may be more difficult for a company such as Enron to accomplish when it has no physical generation of its own to meet discrepancies in power bids. Dynegy's strategy of acquiring both natural-gas pipelines and power plants also gives it the flexibility to trade on both commodities. 

On the other side of this argument, a case could be made that Enron's approach provides more flexibility in reacting to trading volatility. Certainly, by investing less in power generation facilities, Enron has less capital on the line when compared to a company like Dynegy. Under a scenario when market prices suddenly drop, a company such as Enron that does not have heavy capital invested in power generation could actually fare better than an asset-laden company because Enron does not face the pressure to meet the fixed payments of a generation facility. Asset-heavy companies also may find that their earnings could be impacted by the investment in generation facilities in times of extreme price volatility. As the industry becomes increasingly focused on bottom-line results, this could be seen as a potential concern for investors. Further, some would argue that Enron's approach of establishing purchasing contracts with various parties to meet its buy and sell requirements is the rough equivalent of owning a generation facility. What Enron gains by this approach is the presumed flexibility it has by not being tied down to a specific generation unit and being able to build its own portfolio. 

Consequently, the issue of asset ownership can perhaps be considered the "great debate" among power traders. However, although Dynegy's overall performance in the third quarter was better than Enron's, that does not necessarily provide a clear endorsement of Dynegy's strategy toward acquiring new generation facilities. Keep in mind that Enron's 3Q losses resulted primarily from non-recurring charges related to its non-core businesses (broadband and water in particular). Without these charges, Enron's core wholesale trading business continues to perform well. This is a point that CEO Ken Lay has been quick to reiterate to investors. "Our 26-percent increase in recurring earnings per diluted share shows the very strong results of our core wholesale and retail energy businesses and our natural-gas pipelines," Lay said. "The continued excellent prospects in these businesses and Enron's leading market position make us very confident in our strong earnings outlook." 

Moreover, perhaps even more than ownership of physical assets, the key issue that played a role in the current disparity between Dynegy and Enron earnings in the third quarter is the companies' approach to developing new lines of business. Telecom is a perfect example to illustrate the point. Enron, which prides itself as usually gaining a first-strike advantage, plunged into the telecom sector well ahead of other energy companies. Under the leadership of then-CEO Jeffrey Skilling, Enron sunk large sums of capital into purchasing broadband capacity on the expectation that the market would quickly become lucrative. Now Lay admits that the company "could have gotten into the broadband business with less capital" and that Enron "spent too much too soon" in this sector. Nevertheless, Enron recorded an $80-million non-recurring write-down for restructuring its broadband unit in the third quarter and is presently attempting to stop the bleeding in this sector by reducing future costs in this sector to $40 million a quarter. 

Dynegy took a much more cautious approach toward expanding into the telecom sector and made a comparatively small amount of investment when compared to Enron. Dynegy has likewise been impacted by the slowdown of the telecom sector, but in the third quarter took a $15-million loss in its broadband business compared to the $80-million loss that Enron reported. However, Dynegy clearly specializes in marketing and trading two commodities (electricity and natural gas) and seems to add other businesses in a very methodical way that merely supplements its core business. 

It is also important to note that Enron gained the first-strike advantage when it developed EnronOnline, an electronic trading exchange. In fact, Enron was the first to create such an exchange in the energy space, well ahead of its competitors. Dynegy later followed this trend with creating Dynegydirect. The two exchanges are different in terms of their trading standards, but it is important to acknowledge that in this particular case Enron was successful in launching into the electronic trading space well ahead of its competitors. The latest available information indicates that EnronOnline has recorded transactions that exceed $590 in notional value. Since its inception in November 2000, Dynegydirect has recorded $33 billion in notional transactions. 

At this juncture, Dynegy and Enron are very different with regard to their approaches toward financial reporting. Enron, which has often been accused of not providing a balance sheet to investors, is currently struggling from a serious image problem as the Securities and Exchange Commission pursues an investigation of possible mishandling of funds by Enron's CFO. To my recollection, no one has ever accused Dynegy of not providing a balance sheet, and thus the company's status with investors is arguably more solid. As I don't expect either company to radically alter its competitive strategy any time soon, my projection is that (at least in the near term), we will continue to see a wide disparity in Wall Street performance between Dynegy and Enron. That is not to say that anyone should count Enron out of the game. As noted, the company's core business of wholesale business remains strong, but clearly has been tainted by the impact of other non-core businesses. That doesn't mean Enron is down permanently, but it will have to find a way to strike a better balance between the businesses that it does best and those businesses that former CEO Jeffrey Skilling believed were advantageous. 

In many ways, the comparison between Dynegy and Enron is rather like the tortoise and the hare parable. I am sure you can guess which company is the tortoise and which is the hare in this analogy. The race between the two is far from over, although Dynegy is taking the lead at this point, based on its more methodical approach. What will be fascinating to observe is how both companies continue to adapt to changes in the marketplace and possibly modify what up to this point have been adamantly espoused philosophies. 

  _____  

Correction statement to 10/23 IssueAlert on European trading: 

According to a news report from Reuters, the U.S.-owned Entergy-Koch Trading was listed as a publicly traded company. I was informed by my contact at Entergy that Entergy-Koch Trading is a limited partnership company and not publicly traded. I apologize for any confusion this error might have caused. 

  _____  


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