Enron Plunges, but Dynegy Will Suffer, Too

Regardless of what happens to the merger, both sides are clearly in deep.
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In the

Enron

(ENE)

endgame, both players look set to lose.

The other player is energy trader

Dynegy

(DYN)

, which this month agreed to buy Enron. Since the deal was announced, Enron's fundamentals have rapidly deteriorated, making Dynegy's offer look ridiculously generous. But even if the deal gets done at more advantageous terms, Dynegy will struggle to revive a disembowled Enron and absorb its hefty debt load.

Making matters worse, Dynegy could suffer just as much if it backs out of the deal. Without a merger, Houston-based Enron almost certainly goes to the wall, causing disruption, stress and profit-sapping change in the energy market. How can Dynegy not get wounded in that environment? The stock market doesn't seem to agree, however; Dynegy shares remain above their predeal levels.

Wishful Thinking

A Dynegy spokesman says his company can post annual earnings growth of 20% to 25% over the next two years even without Enron. He declined to comment on the merger negotiations, except to say that Dynegy is "continuing its due diligence" of Enron. An Enron spokesman declined to comment on deal talks.

Where do things stand as of Monday evening? Well, the deal looks increasingly unlikely to happen (at least on the terms of Nov. 9). After a sickening slide last week, Enron tanked again Monday, dropping 15% to $4.01. Current deal terms have Dynegy paying around $10.50 an Enron share based on its current stock price. A 60% gap says the deal won't get done. But, as the world and his wife now know, the deal needs to go through for Enron to maintain the investment grade credit rating necessary for its survival.

Clearly, every hour counts in this fast-unwinding situation. Enron's core trading business is in deep trouble as power market players cut exposure to the company, draining it of precious cash.

As a result, two options exist from here. The first is a rescue effort involving Dynegy, the rating agencies and bank creditors like

J.P. Morgan Chase

and

Citigroup

, working to revise the merger agreement and find more cash to buy Enron time. This could involve changing the stock-swap ratio to give Dynegy a cheaper price, with the banks possibly extending debt and joining with other investors to inject equity.

The other scenario has Dynegy, after seeing the cash hemorrhage and the skeletons in the closet, deciding to back out altogether, leaving Enron with no rescuer and no future. But Dynegy's resilient stock price suggests that the market hasn't grasped the impact an Enron bankruptcy would have on Dynegy and other trading firms.

Don't be at all surprised if, any moment now, we see one last attempt to salvage Dynegy's rescue merger with new terms. Several banks are exposed to Enron and, presumably, they will try almost anything -- including extending debt -- to keep the company afloat. By keeping deeply distressed Enron at an investment-grade rating, rating agencies such as Moody's have shown themselves willing to bend to the banks' wishes, so they will probably capitulate again if pressured by bank honchos.

Be Careful What You Wish For

But swallowing Enron would hardly be good for Dynegy, which appears to have underestimated the former's problems.

Amazingly, just a couple of weeks back, the company expected Enron to make $1.50 per share in 2002. Goldman Sachs is now expecting 50 cents, even if the merger gets done. If Dynegy ended up paying, say, $3 a share for Enron, people would no doubt hail that as a low-enough price to cover worsened fundamentals, legal liabilities and any nasty surprises that could spring from Enron's notoriously murky books. But recall that Dynegy also would be taking on Enron's $13 billion of debt. Include the debt in some return-on-capital calculations and the deal still looks untenable.

Alternatively, Enron may be deteriorating too fast to save. That's also bad for Dynegy. The damage done to the company by depleted energy market activity has been recognized, as has the risk that an Enron collapse could leave Dynegy dangerously unhedged on many of its trades. What does that mean and why is it dangerous? Let's say Dynegy agreed to buy power from Company X over a period of time and then sell it to Enron. If Enron goes down, its obligation to buy from Dynegy obviously disappears, but Dynegy can't easily back out of the commitment to buy power from Company X.

And there's another potential risk that the market really hasn't recognized. Enron allegedly was very aggressive in booking upfront profits on forward market deals. An Enron spokesman declined to comment on that allegation. Those deals had to be done with other trading houses, possibly Dynegy.

In other words, Enron's ways may have contaminated the whole market because, as we are frequently told, Enron

was

the energy market, just as

Drexel Burnham

was

the junk bond market in the '80s. In Enron's absence, many of the aggressive deals may have to be unwound. Meanwhile, auditors, in a frantic bid to cover their behinds, would start telling trading companies to be a lot more conservative in how much profit they book on forward deals. Suddenly, fat margin deals evaporate and earnings estimates get slashed.

Checkmate -- for both sides.

Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to

peavis@thestreet.com.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.