A whole new wave of problems could be ready to zap

FirstEnergy

(FE) - Get Report

.

The Ohio-based utility is feeling the heat following last week's record blackout, as transmission problems tied to its own infrastructure apparently triggered a chain of events that left millions of people across the Northeast and Midwest without power. But industry observers say the massive outages came as the company was already overloaded with serious challenges, including potential credit downgrades and regulatory fines.

While FirstEnergy has staunchly defended itself, some experts are already bracing for events that could further weaken the company's deteriorating financial condition. Merrill Lynch analyst Steven Fleishman warned Monday that FirstEnergy could see its stock tumble, its access to capital wither, its credit ratings cut and its credibility suffer because of the company's role in the blackout.

"This would be bad news for any utility, but is particularly significant for FirstEnergy," said the analyst, who cut his rating to neutral from buy.

Even analysts who left their buy recommendations intact weighed in with some words of caution.

"If FirstEnergy were to be found negligent ... it could be liable for all of the direct economic damage caused by the outage to its customers," wrote Bernstein analyst Hugh Wynne, who just raised the stock from perform to outperform less than two weeks ago. "Failure to provide ... service is grounds for a complaint and can result in a liability of treble the injury to the customers or other parties."

Wynne estimated the potential damages at $1.5 billion to $1.8 billion and said he was unsure how much of that would be covered by insurance. Meanwhile, Lehman Brothers analyst Daniel Ford, who maintained his overweight rating on the stock, cautioned that there is "no need to rush on buying" the shares with so much uncertainty about the company's legal exposure.

FirstEnergy shares, which peaked at $38.90 just six weeks ago, took a fresh blow on Monday. Blame for the blackout, coupled with the company's failure to file financial statements, sent the stock spiraling 10% to $27.51.

Blame Game

By now, FirstEnergy has repeatedly denied full blame for the blackout. Instead, the company has called for a full investigation and pointed to other problems outside its own network that could have fueled the outages.

"From the preliminary data we are gathering -- and based on what others are providing -- it is clear that the transmission grid in the Eastern Interconnection, not just within our system, was experiencing unusual electrical conditions at various times prior to the event," FirstEnergy said in a prepared statement Monday. "What happened on Thursday afternoon is a very complex situation, far broader than the power line outages we experienced on our system."

Some industry experts, who expressed little surprise about the blackout, agreed that FirstEnergy -- or any single company -- should not shoulder all the blame for the failure. They pointed instead to a regulatory system that makes transmission upgrades optional, and often too expensive, for cash-strapped utilities.

"They're not going to spend the money unless they can get a return on their investment," said Cody Graves, a former utility regulator who now leads a company that helps customers save money in deregulated energy markets. "No company is just going to say, 'I'll spend the money and make it up in current

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utility rates. ... And no state regulator wants to increase the rates."

Graves ultimately believes problems will persist as long as regulation of the transmission business remains at the state level. Only by shifting that responsibility to the Federal Energy Regulatory Commission, he said, can the country begin to mandate the necessary transmission improvements that will prevent multistate blackouts.

Karl Miller, whose firm operates a joint venture with an independent transmission company, has also called for federal intervention. But Miller hopes to see government officials separate the transmission systems from utilities altogether.

"The vertically integrated utilities have proven that they will not spend the capital necessary to upgrade their systems, nor will they open their transmission systems to available and competitive generation capacity in the market," said Miller, a partner at Miller McConville Christen Hutchison & Waffel, a partner of transmission company Trans-Elect.

For FirstEnergy, such investments -- now more pressing than ever -- couldn't come at a less opportune time.

Dirty Laundry

Just hours before Thursday's massive blackout, Moody's warned that it was reviewing FirstEnergy's credit rating for a possible cut.

The ratings agency offered a laundry list of concerns. It cited fresh weaknesses in FirstEnergy's business performance and free cash flow. It pointed with continued disdain to a debt load, totaling $12.5 billion, that's even higher than the industry average. And it expressed ongoing concern about a power outage at the company's Davis-Bease nuclear plant that's been a sore spot for months.

Early last year, federal officials shut down the plant after discovering corrosion that could have led to a serious nuclear hazard. Although the company has since remedied the problem, it is still awaiting federal approval to reopen the plant. In the meantime, the shutdown is hurting its bottom line. The company has spent hundreds of millions of dollars on repairs and replacement power this summer alone. And the added expenses have come at a time when the company is supposed to be paying down its massive debt load.

Wynne, for one, believes FirstEnergy now has little choice but to issue significant new equity in order to keep its investment-grade rating and satisfy the mounting obligations that lie ahead. Bracing for a $1 billion stock offering this fall -- and heavy investment in transmission upgrades -- Wynne has cut his forecast for FirstEnergy's 2004 earnings by 23 cents to $2.77 a share.

He continues to recommend the stock because he likes the company's cash flow. But he's clearly worried about FirstEnergy's involvement in the blackout.

Neighboring utility

AEP

(AEP) - Get Report

"successfully isolated its system from FirstEnergy's and, as a result, suffered only a few isolated outages," Wynne pointed out. "Any suspicion that FirstEnergy responded sluggishly to the line trips could be heightened by comparing the reactions of other local utilities."

For now, Wynne has already declared FirstEnergy's confession about an alarm malfunction a "damaging" one. For its part, the company has warned against a sudden rush to judgment, while pledging to root out the cause of the massive power failure.

"These are very complex issues that will take time to analyze and work through," said FirstEnergy CEO Peter Burg. "We are committed to working with the North American Electric Reliability Council and everyone else involved in the effort to determine exactly what events in the entire affected region led to the outage and to help in efforts to ensure this does not happen again."