El Paso Trimming Sails for Turnaround - TheStreet

El Paso

(EP)

is working on a new self-portrait.

The company, long criticized for its complexity, has painted a "fairly simple" picture of its future. Going forward, the company plans to focus on "providing natural gas and related energy products in a safe, efficient and dependable manner." Meanwhile, it will tone down the flashier businesses -- such as energy trading -- that colored its meteoric rise and fall in recent years.

In an early critique on Monday, investors gave El Paso's blander long-term picture a positive review. Shares of the company jumped 9% to $7.35 in heavy trading.

"The plan is clear, achievable and is the first step to making El Paso a strong natural gas provider that generates long-term value for our shareholders," announced Doug Foshee, who was hired two months ago as El Paso's turnaround CEO. He said the plan is "the road map for the future of El Paso."

From now on, El Paso will rely on its two core businesses -- pipelines and production -- to produce more than 75% of its earnings before interest and taxes. It plans to use excess cash, much of it generated through asset sales, to reduce its $21 billion debt load to $15 billion by 2006. In the end, it expects to maintain current EBIT -- despite a smaller asset base -- as interest expense declines over the next two years. By 2006, it plans to deliver normalized annual profits of between 75 cents and $1.10 per share.

"We can earn around $1 per share solely through organic means," Foshee said, while acknowledging that the company will face "significant milestones along the way" to its 2006 targets.

In the meantime, El Paso -- hurt by trading losses and falling production -- is expected to earn profits of just 18 cents a share this year.

Hurdles

To achieve its goals, El Paso acknowledged that it must clear four important hurdles.

First, it must complete billions of dollars worth of asset sales within the next couple of years. Foshee said the company got a "heck of a good ... head start" with a major sale announced along with the long-range plan on Monday. The company has inked a deal to merge

GulfTerra

(GTM)

, its master limited partnership, with

Enterprise

(EPD) - Get Report

in a transaction that should net El Paso $1 billion to pay down debt.

The two parties described the transaction as a "merger of equals" that will create a "tremendous midstream company" ranking as the second-largest MLP of its kind. Although El Paso will maintain a significant interest in the MLP -- through its 50% ownership of the managing partner and a large stake in the MLP itself -- some analysts had previously suggested that the asset should be kept.

"Our best guess on midstream is that some, if not all, of the LP units will be considered for sale, but the GP

general partner interest in GulfTerra will be retained," Lehman Brothers analyst Richard Gross wrote last week. "Selling ...

the interest in GulfTerra works well from debt/EBITDA (earnings before interest, taxes depreciation and amortization) perspective but hurts transition to free cash flow."

El Paso has nevertheless pledged to generate between $200 million and $400 million in free cash flow by 2006, even after investing sufficient capital in its two core businesses. But the company must clear its second hurdle: turn around one of those core businesses -- exploration and production -- in order to meet its goals.

Last month, El Paso rocked the market with news of a stunning decline in its production business. The company has since shed its production supervisor and laid out plans to revamp its overall production strategy.

On Monday, Foshee acknowledged that production -- once a nominal part of El Paso's business mix -- had evolved into a "significant driver" of earnings growth at the company. But he indicated that some of that growth had "come at the expense of creating value" for shareholders. Thus, he said, the company will adopt a more sustainable strategy going forward.

"We'll get the ship righted," he said. "And we'll win your confidence back in this area."

El Paso plans to focus on investment returns, rather than production growth, going forward. The company is counting on coalbed methane projects, in particular, to fuel a turnaround.

But Gross, for one, sees a "tough, slow road" ahead.

"Coalbed methane projects generate significant value and return the highest net-present-value per dollar of capital of almost any of El Paso's opportunities," Gross noted last month. "However, the production impact in the year of these expenditures is nominal, with levels only growing over time."

Gross predicted, and the company has since confirmed, that production levels still have to "touch bottom" before a turnaround can begin.

Stretching

In the meantime, El Paso faces a third hurdle of cutting costs and hopes to achieve $150 million in cost savings -- on top of the $445 million already identified -- as it works to create a "fit-for-purpose organization." It also plans to grow its healthier core business, natural gas pipelines, by up to 5% annually after a relatively flat period next year.

"We need to right the production ship and grow the pipelines," Foshee said. "If you look at the long term, our performance in these two businesses largely determines our share price."

But Gross has already predicted that El Paso's pipeline business could be in for a hit.

"While we don't expect pipeline sales or spending cuts initially," he wrote on Friday, "both are inevitable, we think."

Gross is also braced for a cut to the dividend.

"We don't think it makes much sense to lay out $100 million in dividends," he noted, "and would not be surprised to see these payments reduced to a nominal level or eliminated altogether."

In the meantime, El Paso faces a fourth hurdle of reorganizing its operation, and will continue to rely on a few smaller businesses -- including energy marketing and trading -- going forward. Although it hopes to liquidate its current trading book by the end of 2004 -- and sell most of its domestic power business before then -- the company said it will continue to market and trade around its physical assets in the future.

"We are saying today that we're staying in the marketing business," CFO Dwight Scott confirmed on Monday.

Still, the company insisted that its overall structure will change immensely. El Paso's current organization, which includes a large holding company and five separate divisions, could not allow the company to "get to the promised land," Foshee said. So El Paso will now become a "much leaner" operation, featuring just a regulated and an unregulated division, that refines the company's focus and makes comparisons to its peers much easier.

Standard & Poor's was not impressed. The ratings agency promptly cut El Paso's credit, pushing it further into junk territory, after the company detailed its plans. S&P pointed to El Paso's production turnaround as particularly crucial and noted that "considerable risks remain."

Days earlier -- before El Paso even issue its plan -- Gross predicted serious challenges as well.

"We think management will present a program that says, 'Bear with us. We're going to take our medicine,'" wrote Gross, who has an equal-weight rating on El Paso shares. The "plan is likely to be several steps back for more steps forward. ... The road to recovery will be long and arduous."