Analysts Say SEC Probe Threatens Reliant Spinoff

It's only the first day of summer, but already it's feeling a little sticky for investors in Reliant Energy (REI Quote).

The energy trader has been poised to spin off the rest of its 83%-owned Reliant Resources (RRI Quote) energy marketing unit this summer in a move that would bolster Reliant Energy's balance sheet. The spinoff is vitally important for Reliant as it seeks to placate credit-rating agencies and secure new funding.

But late Thursday, Reliant Resources said the Securities and Exchange Commission had ratcheted up its probe of the company's energy-trading practices to a formal investigation, giving the agency subpoena power and generally raising the case's profile. Analysts and investors said the development could derail the spinoff or at least make it more difficult for Reliant Energy to whip its financials into shape.

"I've been concerned that overall market conditions would affect the spinoff," says Carol Coale, an analyst at Prudential Securities in Houston. "Now, more specifically for Reliant, there's the SEC inquiry escalating into a formal investigation."

Reliant Resources and Reliant Energy said they were "optimistic" the spinoff would proceed as planned and that the companies would continue to cooperate with the investigation. Both stocks dropped modestly, Reliant Energy sliding 16 cents to $16.84 and Reliant Resources dropping 42 cents to $8.88.

Confessional

Given the sweeping crackdown on the energy merchant sector, which is under federal scrutiny for possible business and accounting shenanigans, analysts on Friday expressed little surprise that the SEC's probe into Reliant Resources has taken this turn. But they did raise questions about possible repercussions that are unique to the company.

Reliant Energy needs the SEC's blessing to spin off its remaining 83% stake in Reliant Resources, a subsidiary that sells energy to deregulated markets. The parent company sold 17% of Reliant Resources during an initial public offering last summer, and it plans to entirely sever its regulated businesses from its deregulated businesses this year.

The SEC began examining Reliant Resources after the company confessed last month to making meaningless "round-trip" energy trades that tacked 10% onto its revenue from 1999 to 2001.

Absent a restructuring, Reliant would be a "significantly more levered" company, Coale says. Needless to say, in this environment that's not an event investors would be happy about.

"They may have to take action to avoid a credit downgrade -- and the standard formula has been asset sales and equity issuance," Coale says.

Investment-grade ratings are crucial for companies participating in the capital-intensive energy-trading business. Reliant is currently clinging to a rating one notch above junk status, but short-sellers are predicting a possible downgrade at any time. Such a downgrade, they said, could derail the spinoff and leave the parent company saddled with $4.3 billion in Reliant Resources debt.

In Like a Lyons

David Burks, an analyst at J.J.B. Hilliard/W.L. Lyons, said the SEC investigation itself may prove enough to trigger a downgrade.

"A number of companies have been downgraded lately, and one of the reasons cited is that they are subject to an SEC investigation," Burks said. "This could certainly have an adverse effect on things."

News of the SEC investigation comes as Reliant scrambles to renew a $4.7 billion credit facility by July 12. The company has disclosed in regulatory filings that the negotiations could hit roadblocks if its long-term credit quality deteriorates.

Reliant Resources has already encountered stiffer terms from its lenders. The company disclosed Monday that it may be forced to post assets as collateral in order to renew an $800 million revolving credit facility that expires in August.

Energy merchants industrywide are struggling to renew generous credit lines they once took for granted. CMS (CMS Quote) this week settled for a one-month extension on its old credit facility when a renewal failed to materialize. A Dynegy (DYN Quote) subsidiary, faced with unfavorable terms from lenders, resorted to converting its maturing credit facility into a term loan. And other companies -- including Mirant (MIR Quote) and Williams (WMB Quote) -- are still anxiously waiting in line for credit renewals of their own.