For Energy Traders, Dilution Beats Extinction

As chastened credit analysts bear down on the energy industry, companies like El PasoEPG and MirantMIR have been forced to shore up their balance sheets. To do so, they're issuing millions of shares of new equity, diluting shareholder ownership and cutting earnings for 2002 and beyond. Analysts say it's a small price to pay for survival.

Pressured by the fallout from EnronENE, a weak economy and warmer weather, energy merchants have recently taken a number of measures to raise cash and to shore up their balance sheets. One of the steps has been the issuance of millions of stock shares.

"This will dilute earnings and slow growth next year, but these guys didn't have much of a choice," said Gordon Howald, analyst at Credit Lyonnais. "Every company has to do the exact same thing to guarantee a higher credit rating because if you don't have that, no one will trade with you."

On Friday El Paso became the latest in a string of companies to announce that it would sell additional stock. The firm hopes to raise $750 million from the sale, but John Olsen, an analyst at Sanders Morris Harris, estimates that this will cut earnings by about 10 cents a share in 2002.

Meanwhile, Mirant sold 60 million new shares Thursday, just one day after Moody's Investors Service cut the firm's credit rating to junk status. While the stock sale raised $759 million in cash, the dilution will cut 2002 earnings per share by 65 cents to between $1.90 and $2.00, the firm said.

DynegyDYN also announced Thursday that it raised $494 million from a previously announced stock sale. As a result, the firm cut its 2002 earnings forecast to $2.30 from a previous estimate of between $2.30 and $2.35.

In addition, CalpineCPN sold $1 billion of 4% convertible senior notes late Wednesday after Moody's downgraded the firm's credit rating to junk status. Friday, UBS Warburg analyst Ronald Barone reduced his 2002 estimate on the stock to $1.91 from $2.10.

And Williams Co.WMB will issue $1 billion of mandatory preferred stock, which should reduce earnings by 11 cents a share, according to Prudential Securities analyst Carol Coale.

Powerless

Shareholders typically don't get to vote on whether companies can issue additional stock if the total outstanding shares are below the authorized number. Still, analysts said the distribution of shares should reassure stock investors and debtholders, as well as trading partners, that these companies are taking the appropriate steps to improve their financial standing.

"It's a tradeoff," said Martin Malloy, an energy analyst with Hibernia Southcoast Capital. "At this time, there's a lot of focus on the balance sheet, raising cash and maintaining liquidity."

Mark Easterbrook, an analyst at RBC Capital Markets, said the speed with which companies are taking action is a reflection of rating agencies changing the way they look at the sector.

"Debt-to-capital ratios rose during deregulation and balance sheets became overlevered," he said, "but after the Enron debacle, agencies want to see something more conservative."

The increase in outstanding equity coupled with a reduction in capital spending should cut earnings growth rates by 3% to 5% over the next three years, he added.

Still, since rating agencies have raised their standards, analysts say these measures are pragmatic. "Is it an expensive price to pay? No," said Olsen of Sanders Morris Harris. "Ultimately it will make the industry a lot safer and put it on a better footing."

Tough Times Aren't Over

While the outlook for the industry is brighter for the long term, several analysts believe the next few months could be tough. "I think it's too early to step up to the plate," said Credit Lyonnais' Howald. "Many investors have gotten burned by the group, and you're not seeing the momentum guys anymore."

Howald believes the group will be out of favor for a while, but said most of the bad news is already in the stocks. "We're just not going to see big valuations any more. They're a thing of the past."

According to Merrill Lynch, there are three paths that the utility sector could take from here: It could either see a solid rebound, continue to "muddle through" or witness a liquidity crisis.

"We believe the muddle-through phase is most likely in the future," the firm said.

While power prices remain under pressure and weakness in the economy should hamper 2001 and 2002 earnings, current depressed prices "more than reflect the muddle-through scenario," Merrill Lynch added.

Dynegy has fallen 55% this year, while El Paso and Williams have each fallen 38%. Calpine has shed 67%, and Mirant has lost 50% of its value.