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Under the Radar: Calpine Could Have Further to Fall


Friday column outlining the potential downside ahead for this merchant power producer prompted an overwhelming response, including a call from Calpine executives. I'd written the column because critics were questioning Calpine's stamina, despite the company's upbeat conference call last Thursday.

In a 90-minute interview, I discussed a host of the company's issues with Chuck Clark, senior vice president and corporate controller; Paul Posoli, senior vice president of Calpine Energy Services, the company's trading and marketing arm; Ron Walter, senior vice president of business development; and Rick Barraza, director of investor relations. Here's what transpired.

Powerful Growth

Calpine's fervent message is that its growth story remains strong, even as power demand moderates.

"It is our view there is not an oversupply situation," said Walter. "In 2000, the power reserve margin was only 9% in a business where traditionally 20% is considered a margin where you can reduce volatility and manage supply."

Calpine plans to continue building new generation to meet what it thinks will be growing demand, filling the void that may come when other merchant generators cut new development.

"You have seen a whole host of companies trimming generation projects," Walter said. "We view that as very short-range thinking and a very strong opportunity for Calpine. Nothing fundamentally has changed in the marketplace. We view this as an opportunity rather than a reason to get out."

However, Walter signaled flexibility if conditions change. "We are not trimming our objectives," he said. "We are at a goal of 70,000 megawatts by 2005. We could slow down and delay the programs if we see signals in the future, but we don't see that yet."

Earnings Issues

Calpine skeptics have raised concerns about the quality of the company's earnings. While it continues to be a major power-plant developer, Calpine now also depends more on profits from trading natural gas and power as well as on hedging strategies.

For example, according to its recent third-quarter report, filed with the

Securities and Exchange Commission

, a major portion of Calpine's growth came from power marketing.

"Our power-marketing activities contributed an additional $3,068.4 million due to increased price hedging and optimization activity as a result of the growth of CES

Calpine Energy Services and our operating plant portfolio during the nine months ended Sept. 30, 2001," according to the SEC filing.

While Calpine critics argue that trading growth isn't as predictable as direct generation sales, Calpine says the program strengthens its core assets. Calpine's trading business is different than that of most of its peers, as it trades almost exclusively from Calpine's asset base, Posoli added. "This is not a separate stand-alone trading group that is there to add gross margin by speculative trading," he explained. "It is totally integrated into our asset base. Ninety-nine percent of what we have done has been around our assets."

He added that the optimization opportunities provided by trading will benefit Calpine's bottom line. "We think we can add 150 to 200 basis points on our returns," Posoli said, indicating Calpine's focus on expanding the trading business to include trading outside the traditional asset base. "We will be major players in power markets by 2003; we will be trading in every market. We may begin to get active in markets before we are in those markets physically to get up to speed."

Another concern is that Calpine may face earnings shortfalls in its Canadian natural gas subsidiary.

"We don't see a scenario based on the forward curves now that would take an impairment hit," said Clark. "There may be an irrelevant field where they might face a charge at some price. We don't even see that happening, but I don't want to make a blanket statement that there wouldn't be a hit anywhere."

However, Clark wouldn't provide exact break-even points for natural gas that could lead to possible issues north of the border. "We don't want to do that, but they are well below where gas prices appear to be headed in the future," Clark said. The company expects natural gas to move back toward $3.50 per-million British thermal units over the next three to four years.

Counting Beans

Regarding mark-to-market accounting, the company adopted FASB 133 in January, which required Calpine to account for certain financial transactions on a mark-to-market basis. According to the company's third-quarter 10-Q, it had posted year-to-date gains of $83.8 million. "It is a very immaterial part of our business," said Posoli. "We are definitely not making accounting shifts to make our numbers."

In terms of its effective tax rate, which has been reduced this year, Calpine says it relates to the use of international deductions of interest expense and was well telegraphed to the analyst community earlier this year. "The tax benefits from interest deductions from operating in multiple countries has real economic value," said Clark.

It's No Enron

While skeptics may still raise valid questions about growth assumptions and earnings quality, this company probably won't morph into the next




Calpine execs say their company isn't very susceptible to Enron's woes. "Our netting agreement with Enron

an agreement that nets out all credits and debits between the companies provides a way for us to net out our exposure," said controller Clark.

A federal bankruptcy judge could decide that Calpine's universal offset agreement with Enron is not enforceable. (Such transactions allow trading parties to offset all debits and credits between them even though they may be governed by different contracts.) Barring universal offsets could increase losses at other energy-trading companies. If the judge indeed makes that call, Calpine and many other power trading firms will feel increased exposure, although Calpine doesn't view that scenario as likely.

Take a Chance

In Las Vegas or nearby? Show up Thursday at the Orleans Hotel and Casino Sportsbook, where yours truly will be on location for's

weekly Martini Chat. From 2 to 3 p.m. PST, we'll deliver the goods on Vegas: whether the casino economy has crapped out since Sept. 11, what great holiday deals exist on and off the Strip and a complete look at the early odds on the college bowl picture. And, of course, our ever-insightful group of market experts will be along to help you navigate through the final month of the year.

An hour before showtime, come visit one-on-one about anything on your mind: the markets, the Enron story and, heck, even a little craps talk. There will be plenty of


giveaways, too. If you're lucky, I'll even pull a lever for you and see if we can't win a buck or two.

Why not roll the dice and show up? Ka-ching!

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

Chris Edmonds.