Lemon Laws Won't Save Dynegy

If you believe Dynegy's (DYN Quote) account of its planned purchase of energy-trading rival Enron (ENE Quote), it's getting a slightly damaged Mercedes for the price of a Pinto.

At face value, it appears to be a fabulous deal. Dynegy is acquiring a weakened-but-repairable competitor on the cheap. So what's not to like?

The problem is, Dynegy seems to be taking a rather sunny view of Enron's future. Recent earnings restatements and other revelations suggest Enron may actually be a junker when it comes to profitability, though Enron's disclosure practices make it impossible to know for sure. Then there are indications that Dynegy doesn't expect to write down the value of Enron assets by large amounts, which, if true, will certainly raise eyebrows, given the poor performance of many Enron businesses.

If Dynegy proves to have been optimistic in its merger math, investors may start betting against this deal. Such an outcome would increase suspicions that Dynegy rushed into this merger because an Enron collapse would've cratered its business.

Echoing statements from Dynegy executives on a Monday conference call, company spokesman Steve Stengel denied his company is doing the merger because it feared being damaged by an Enron collapse. Dynegy actually owes Enron money, rather than the other way 'round, he said. "Enron's core business is strong, and that was a key reason Dynegy undertook merger discussions with Enron," Stengel remarks.

Both stocks rose sharply Monday, Enron adding 61 cents to $9.24 and Dynegy rising $5.55, or 14%, to $44.31. Still, Enron remains 22% below Dynegy's implied acquisition price. The stock action suggests the market is deeply divided over the deal. The deep discount on Enron is a sign that the deal won't get done. Yet Dynegy's leap implies solid investor backing for the transaction and its economics. Until we know more about Enron's numbers, we won't be able to judge whether Dynegy investors are right to be bullish, however.

Strong Indeed

Among the deal's avid supporters were a number of sell-side analysts who are longtime Enron bulls. They particularly liked Dynegy's prediction that the combined entity, to be called Dynegy, would post earnings 35% above current 2002 estimates for stand-alone Dynegy. And these bulls point out that this accretion number doesn't include any merger synergies and it assumes Enron's 2002 earnings are $1.50, which is 25% lower than analysts currently expect.

Dynegy executives repeatedly stated Monday that they wanted to get rid of Enron's noncore operations and keep the trading business, which has contributed the lion's share of Enron earnings, as well as pipeline assets. Clearly, Dynegy believes that Enron's core trading business made real profits. How much of a leap of faith is that? A considerable one. As this column has noted, Enron doesn't make it possible to break out profit margins for trading, which is included in the wholesale line in Enron's income statements.

In fact, the wholesale line includes substantial asset gains, many of which are probably one-time in nature. Enron's deals with obscure partnerships gave a huge boost to profits, according to earnings restatements made last week. Don't forget that it's these partnership dealings that are under investigation by the Securities and Exchange Commission. Without them, and excluding one-time sales, Enron's traders may actually make very little.

Marky Mark

One fear was that Dynegy would have to mark down Enron's underperforming assets by billions of dollars. Charges erode equity. Lower equity would possibly mean a higher debt-to-capital ratio (calculated by taking debt as a percentage of total capital, or debt plus equity). If this ratio gets above 50% to 55%, rating agencies might consider downgrading Dynegy, which could deter counterparties from trading with it. But Dynegy expects the debt-to-capital ratio to be about 40% in the merged institution.

Somewhat implausibly, Dynegy's forecasts don't appear to factor in big markdowns in Enron equity. In the third quarter of next year, Enron's equity is expected to be $9.5 billion. That's only slightly below what it probably was at the end of this year's third quarter (Enron still hasn't released a third-quarter balance sheet). How can it not decrease over the next 12 months?

A person familiar with the matter says that Dynegy also expects to mark up Enron assets at the time of the deal's closing. These markups are expected to at least partially offset any markdowns, this person adds. But it's tough to identify any Enron assets that could qualify for hefty positive adjustments, while it's easier to point out assets that deserve negative ones. Dynegy needs to break out markups and markdowns and reveal which assets are being subject to the adjustments.

Dynegy's Stengel didn't comment on the question of equity writedowns.

By stretching too far in its assumptions, Dynegy may be trying to dress up a risky merger as a safe one. But a risky merger may, in Dynegy's view, have been preferable to having Enron go down. Again and again Monday, Dynegy execs said they've done their due diligence and they believe that there aren't any huge skeletons in Enron's closet that could upset the merger.

But contrast this stance with that of Standard & Poor's analysts, who said Friday that they would've downgraded Enron's debt to junk status if Dynegy hadn't agreed to buy Enron. One of the S&P analysts said Friday that they didn't have a full understanding of all the partnerships that Enron has been dealing with. If S&P, which, like other rating agencies, has been locked in deep and detailed discussions with Enron for weeks, doesn't know the effect of all the partnerships, how can Dynegy?

"Dynegy has been doing business with Enron for 16 years. We know them and they know us," Stengel replies. "We are comfortable with the due diligence we have conducted thus far and will continue to look at Enron and their operations in the coming weeks and months."

Until Dynegy comes up with more details, assume Enron is a Pinto.