eSpeed: Potential Energy Shortage

The cottage industries that grew up around energy trading have taken a beating lately, and some wonder if there's more damage to come.

Earlier this month, software maker Caminus(CAMZ) blew up after being forced to slash its earnings estimates because of reduced orders from its power-merchant customers. Then Perot Systems (PER) found itself embroiled in controversy amid reports that its salesmen had pitched the company's computers as a way of gaming loopholes in the California energy market. (Perot denied the stories.)

In looking around for other potential victims, some eyes have fallen on Treasury brokerage eSpeed(ESPD), which has billed its energy trading platform Tradespark as a "revolution" in the energy markets that "caught on like wildfire."

With several energy traders backing off the business to preserve credit ratings, Tradespark and rival platforms like InterContinental Exchange could face declining transaction volume. In addition, some of the very energy merchants that are having credit problems are partners in Tradespark, including Williams(WMB) and Dynegy(DYN).

Evolving Market

Both El Paso(EP) and Williams recently announced plans to reduce the amount of resources they devote to trading. El Paso halved its trading staff and cut its investment allocation to the segment to $1 billion. Williams didn't specify the magnitude of its job cuts but dropped its investment allocation for the trading portfolio by one-third, to $1 billion from $1.5 billion.

More merchant energy companies could follow with their own cutbacks, analysts said. Dynegy(DYN) on Wednesday announced plans to cut an undisclosed number of jobs. The company didn't specify what departments the cuts would hit, and it has said that no significant changes in its business strategy are planned. But the company has also said it's working to increase its liquidity, while Moody's, which already rates the company just one notch above junk status, is reviewing it for a possible downgrade. (Moody's downgraded Williams to one rung above junk status a week before the company announced cuts to its trading business.)

"Anecdotal evidence from the companies has been that volumes have declined, mostly due to credit concerns," said Anne Falgoust, an analyst covering El Paso for Johnson Rice. One industry source, who preferred not to be named, estimated that after Enron's collapse, overall brokerage commissions from energy trading on the wholesale market fell to around $1 billion from $1.25 billion, and that considering recent developments, they could go as low as $750 million.

High Hopes

Investors were counting on Tradespark to deliver powerful earnings growth at eSpeed after a strong showing in the fourth quarter. When Enron collapsed, trading platforms like Tradespark and ICE got a significant boost as they poached volume from Enron's platform: Tradespark recorded an 81% jump in transaction revenue in the fourth quarter vs. a year earlier.

eSpeed's courageous fight back from Sept. 11 is well-known, and the company has posted solid profits the last two quarters on the strength of its robust government bond trading business. But management conspicuously reduced the already limited disclosure it makes about Tradespark concurrent with its most recent earnings report. Shares of eSpeed have lost almost a third of their value since then, falling to $10.01 recently from a six-month high of $13.97 on May 13.

"Overall, the velocity of trading in [Tradespark's] products has probably come down a little bit," said one analyst who preferred not to be named. "It certainly takes some of the bloom off the rose, as part of the premium that was driving eSpeed's stock into [first quarter] earnings was Tradespark," he said.

eSpeed said on its first-quarter conference call last month that its earnings projections take into account the weakness in the energy market, and an eSpeed spokeswoman says the company plans to deliver on those targets. The company is targeting per-share earnings in the second quarter of 11 cents to 12 cents, up from previous forecasts of 10 cents, and full-year earnings of 43 cents to 48 cents a share, from earlier projections of 40 cents to 47 cents.

Growth Opportunities

The spokeswoman emphasized that as energy trading continues to move from voice-based trading to fully electronic trading, there are enormous growth opportunities for Tradespark. Tradespark's chief operating officer, Robert Hayes, said he also thinks that while some participants are being eliminated from the energy market, others will join. "We understand that the market is having short-term difficulties, but we're very positive about the long-term participation in the market," he said.

Still, at least one industry executive thinks the trading market isn't likely to pick up from here in the near term. At a conference in New York, Dan Gordon, president of Allegheny Energy(AYE) unit Allegheny Energy Global Markets, said creditworthy counterparties are too few and balance sheets too weak, and that increasing regulatory scrutiny is adding too many political risks for energy trading volumes to make a comeback anytime soon.

"I don't see why these markets would have a reason to rebound in the very, very near future, absent some sort of dramatic change," Gordon said.

At about $10, eSpeed trades below the halfway point of its 52-week range of $4.60-$22.90. But with an earnings multiple of 22, the stock probably isn't impervious to more bad news.

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