Bad Math at Calpine Adds Up to Sell

I always find the debate about the equity side of Calpine's structure interesting because most investors seem to ignore the fact that the bond market is saying there will hardly be any value left for unsecured debt in the event of a bankruptcy. For instance, Calpine's unsecured bonds with an 8.5% coupon due in 2008 are currently yielding 40% vs. the 10-year Treasury's sub 4.60% yield.

Given that the equity holders have less of a claim on assets than the unsecured debt holders, the bond market is signaling that even with the best of all outcomes for Calpine in its upcoming legal proceedings with debt holders, the equity still would be worthless in the event of a Chapter 11 filing.

Back on the numbers, Calpine once again disappointed investors on many fronts. First, its EBITDA excluding one-time and non-cash items failed to cover its interest expense. Second, the company ran a cash deficit from operations that was substantially below its EBTIDA, a sign of glaring earnings quality issues. Last, the company has backed away from its long-held plan to retire $3 billion in debt by the end of 2005, which should tell investors just how tight liquidity is at Calpine.

The company has a very meaningful date in court on Nov. 11, when a judge will listen to Calpine's second lien holders about the way Calpine spent more than $300 million in cash from the sale of its natural gas assets in July. The bondholders believe Calpine's use of the cash -- to buy natural gas to fire its plants -- is a violation of the debt indentures that limit the uses of cash from the sale of designated assets that act as collateral for bond holders.

The company is fighting to get its hands on the remaining $395 million sitting in the account so it can continue buying natural gas in the open market to fire its plants. Second lien holders claim the company is essentially burning through their collateral.

The outcome of this case will be a key factor in what Calpine does next. It is widely believed by analysts and investors that if Calpine wins the case, it will sell its California assets -- also designated assets -- for $2 billion to $3 billion and use the cash to fund operations. If Calpine loses, it will be hard pressed to fund its liabilities in 2006 and 2007.

At this point, I see no reason to hold a position in Calpine.