Aquila Paying for Loan-Fueled Reprieve

Aquila ( ILA) has paid so much for breathing room that, in the end, it may have no money left for anything else.

UBS Warburg analyst Ronald Barone warned Thursday that Aquila must continue to sell off assets just to meet its debt obligations through the end of next year. After that, Barone predicted, Aquila will run out of cash and face another liquidity crisis like the one it just escaped -- but with few assets left to sell.

Ultimately, Barone believes Aquila will be cash flow negative by 2005 and, therefore, sees no value in the company's shares using traditional cash flow analysis. Even by adding up the pieces of Aquila, he concludes that the company is worth just $2 a share -- or 36% less than the $3.13 the stock last fetched before his Thursday morning report.

While Barone's new $2 target price is higher than his old one of $1.50, established when Aquila's immediate risks looked greater, the analyst has clearly cooled on the stock. He lowered Aquila's rating from neutral to reduce on Thursday because of his dim long-term outlook for the company.

"Put simply, Aquila's significant debt burden and obligation under its gas pre-pay contract will in our opinion be too great for its core domestic utility operations to support once it has disposed of all its other assets," Barone wrote. "As a result, Aquila's long-term prospects are limited and could include a restructuring at some point."

The stock tumbled 8.9% on the report, opening at $2.85 before clawing back above $3 later Thursday. The dip interrupted a breathless rally that had tripled Aquila's share price since liquidity fears peaked in March.

Trend Watching

Some optimistic investors immediately compared Aquila's downgrade to a bearish call last fall on Dynegy ( DYN). On Halloween, Prudential analyst Carol Coale issued a frightening report calling for Dynegy investors to "take what little value is left off the table," as she dropped coverage of the company in anticipation of a likely bankruptcy.

Coale's report carried some weight with investors who remembered her as one of few analysts who recommended selling Enron before the company went bankrupt. Her call also coincided with a decision by Chevron-Texaco ( CVX), Dynegy's largest shareholder, to write off almost all of its investment in the flailing energy company. The two bearish signals sent Dynegy plunging 15% to 68 cents in a single day.

But the stock has never closed that low since. Instead, Dynegy has gone on to reassure investors with a simplified business strategy and surprising profits that have turned the stock into an "eight-bagger" in just over half a year. Shares of Dynegy continued to inch up, tacking on 6 cents to hit $5.09 on Thursday.

Some of the industry's most troubled players -- including Williams ( WMB) and El Paso ( EP) -- have posted similar gains. Still, industry critic Karl Miller insists that the sector's woes are far from over.

"This market does not fix the problem," said Miller, a former industry executive who now leads a power acquisition firm. "These companies are still going to fall down very, very hard."

Shaking Off the Rust

But for now, some immediate dangers have clearly passed. As recently as March, Forbes ranked six utilities and energy merchants -- including Aquila, Allegheny Energy ( AYE), CMS ( CMS) and El Paso -- among its top 10 list of likely bankruptcy candidates. But companies throughout the sector have since gone on to refinance loans and put off reckoning day a while longer.

For Aquila, that means paying more than 10% in interest and fees annually. Barone estimates that those costs, coupled with merchant-related losses, will push Aquila to a full-year loss of 55 cents a share. While he expects annual losses to narrow to 25 cents a share in 2004 and 2005, he foresees no improvement in the company's cash-generating ability.

Indeed, he expects things to only get worse.

"Due to its asset sales program, we expect Aquila will continue to generate cash and pay down debt over the next 18 months," he wrote. "However, we forecast Aquila will be cash flow negative in 2005 and beyond."

On average, most analysts recommend holding the stock. No one recommends buying it.

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