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Content-Type: text/plain; charset=us-ascii Content-Transfer-Encoding: 7bit X-From: Mark Koenig X-To: Steven J Kean X-cc: X-bcc: X-Folder: \Steven_Kean_June2001_4\Notes Folders\Discussion threads X-Origin: KEAN-S X-FileName: skean.nsf ---------------------- Forwarded by Mark Koenig/Corp/Enron on 01/04/2001 08:41 AM --------------------------- firstcall.notes@tfn.com on 01/04/2001 11:27:59 AM To: mark.koenig@enron.com cc: Subject: SQUEEZING BLOOD FROM A STONE: SEEKING CLARITY IN THE CALIF. CR... (Part 1 of 2) FIRST CALL RESEARCH NETWORK 08:07am EST 04-Jan-01 Salomon Smith Barney (Raymond Niles 212-816-2807) AES DYN SQUEEZING BLOOD FROM A STONE: SEEKING CLARITY IN THE CALIF. CR... (Part 1 of 2) SALOMON SMITH BARNEY Industry Note Power & Natural Gas SQUEEZING BLOOD FROM A STONE: SEEKING CLARITY IN THE CALIF. CRISIS January 4, 2001 SUMMARY * California utilities (PCG, EIX) threaten bankruptcy in Raymond Niles face of cash squeeze and decision by California Public 212-816-2807 Utilities Commission to grant a 7%-15% rate increase ray.niles@ssmb.com versus the 20%-30% hoped for by the utilities. Two key points: * (1) Based on the companies' statements, we think there is material risk that the California utilities will declare bankruptcy, although this still remains the least likely outcome, in our view. We maintain our 3H (Neutral, High Risk) rating on PCG at the present time. * (2) We recommend investors hold the course on Energy Merchants and Competitive Generators. Favorable long-term fundamentals remain in place. Ultimately, we think a market-oriented solution will favor these companies, but anticipate near-term uncertainty as the California situation plays itself out. Companies with most to least California exposure are: CPN, SOE, DYN, NRG, DUK, REI, AES, ENE. TWO MESSAGES TO INVESTORS (1) Worry about the California electric utilities: PCG and EIX. Material bankruptcy risk exists for these companies. Although we do not think it is the most likely outcome, we think the risk of a bankruptcy has been heightened by the small rate increase proposed by the California Public Utilities Commission. Even if bankruptcy does not occur, we think that the California utilities will continue to be challenged by weak balance sheets and ongoing cash flow concerns if adequate rate increases are not enacted. (2) Hold the course on the Energy Merchants and Competitive Generators. The long-term fundamentals for these companies remains firm, in our view. For the generators, we forecast 20%-25% higher power prices, nationwide, in 2001 vs. 2000. At the same time, we see the "spark spread", or the spread between power (revenues) and gas (costs) widening by several percentage points during the same time period. Both of these factors are positive for earnings. For the marketers, the opportunity to hedge and manage energy price risk has only been heightened by the turmoil in California. We also remain bullish on these companies. Exposures of Generators to California Power Markets (Megawatts) Company Rating/Px Total California % of Total AES# 1-H $52 29,798 4,100 13.8% CPN# 1-H $42 5,912 1,355 22.9% DYN# 1-H $51 8,804 1,400 15.9% NRG# 1-H $28 13,500 1,586 11.7% SOE# 1-H $28 14,622 3,185 21.8% ENE# 1-H $80 3,000 60 2.0% DUK*# 2-M $83 9,285 3,615 38.9%* REI*$# 3-M $43 12,869 3,767 29.3%* *DUK and REI also have extensive regulated utility operations, so there corporate financial exposure to California is far less than the percentages indicated WHAT LIES AHEAD? POINTS TO CONSIDER: (1) Someone must pay for the cost of power in California. Currently, natural gas prices are around $20 per mcf or million BTU's, which equates to electricity prices north of $200 per megawatt-hour. This reflects the cost of burning gas to create electricity, and does not consider other costs, such as pollution emissions, operating and maintenance costs, and the capital costs of plant investment. (2) The long-term problem in California (and elsewhere in the country) will not be solved without the construction of new power plants. All the bellyaching in the world about high wholesale power prices will not solve the problem, which is: California does not have enough power plants. The wholesale price of electricity reflects supply and demand. There are not enough electrons in the state's power grid. More electrons will come either from new plants (power generation) or marketing (shipping more electricity into the state). We also think concomitant infrastructure must be enhanced, such as natural gas pipeline and electric transmission capacity. (3) The generators and marketers are solving the problem. Companies such as Dynegy, Enron, El Paso Energy, Duke Energy, Calpine, Southern Energy, AES, NRG Energy and others are either building the plants and/or marketing the power and natural gas that will, in the long run, "solve" California's power crisis. In fact, the high prices they are receiving for power and gas are both the incentives and the reward for them to do so. In our view, if sufficient new generating capacity is built in California, the wholesale price of power will fall. We think if policies were enacted today to facilitate the construction of new plants, by 2002 power prices could be materially lower than they are today. (4) Re-regulation would only lengthen and deepen the power crisis in California. Capping wholesale power prices, imposing windfall profits taxes or other "punitive" measures will not cause a single new power plant to be built or a single new electron to be sold in the state. Such measures would dis- incentivize new plant construction and actually lengthen the crisis. We already think that the threat of re-regulation has had the perverse effect of raising wholesale power prices by dis-incentivizing sales into the state. OUR INVESTMENT CONCLUSIONS First, the long-term outlook for competitive energy suppliers is favorable. They are supplying a commodity in short supply. As long as the supply-demand balance, and price volatility remain, we expect strong earnings visibility from this core group of companies. We especially recommend accumulating positions in these companies ahead of the summer peak electricity earnings season. Second, attempts to re-regulate or "punish" energy wholesalers could create near-term volatility in the stocks; we recommend buying on such weakness. Given our long-term view, we do not think that attempts to re-regulate will be successful. In fact, by doing so, policymakers would merely lengthen and deepen the crisis that already exists. Also, recognition that the wholesale market is working well in other regions, such as Texas, would only stimulate a debate that would lead to ultimate removal of any controls, in our view. Price 1/3/01 2002 2002 LTG 2002 Company SYM Rating Target Price EST P/E EST PEG M Energy Merchants Enron Corp.# ENE 1H $100 79.88 1.98 40.3 20% 2.0 Duke Energy # DUK 2M $95 82.75 5.10 16.2 10% 1.6 El Paso Energy# EPG 1H $80 70.25 3.70 19.0 15% 1.3 Dynegy Inc.# DYN 1H $70 51.31 2.25 22.8 20% 1.1 Power Producers Southern Energy# SOE 1H $37 27.94 1.35 20.7 25% 0.8 Calpine Corp.# CPN 1H $60 41.75 1.58 26.4 35% 0.8 AES Corp.# AES 1H $85 51.75 2.50 20.7 30% 0.7 NRG Energy# NR 1H $40 27.56 1.70 16.2 25% 0.6 # Within the past three years, Salomon Smith Barney, including its parent, subsidiaries and/or affiliates, has acted as manager or co-manager of a public offering of this company. WHAT'S AHEAD? NEAR-TERM EVENTS Near-term, we await several events. Each of these has the potential for creating trading opportunities in the stocks. (1) Decision by S&P and Moody's on whether to downgrade the debt of PCG and EIX. They have threatened to lower the ratings on both companies to "junk" status (i.e., below investment grade) if the CPUC does not grant a sufficient rate increase. We think that the 7%-15% rate increase proposed by the CPUC is probably not sufficient to please the rating agencies, and that a debt downgrade is likely. We think a debt downgrade is largely priced into the stocks, but the action still could create volatility. (2) An emergency legislative hearing is underway. This hearing is deciding, among other measures, whether to impose a "windfall profits tax" or other punitive measures on the wholesale energy suppliers. Given what we said above, we think such a move could hurt the energy suppliers, but only on a near-term basis. We would recommend buying on such weakness. An action that would be positive, in our view, would be any move by the legislature to address the root cause of California's problem: the restrictive policies that make it difficult to build plants in the state (e.g.: pollution rules, siting permits, etc). (3) Decisions by the utilities on whether to declare bankruptcy. The utilities suffer from a negative cash flow, and have incurred over $8 billion in incremental costs to pay for power. Their cash gross margin is negative because they receive a low (regulated) price for retail power and pay a high (unregulated) price for wholesale power. The utilities' lenders are watching carefully to see if any rate increase proposed by the CPUC is sufficient to address this imbalance before they will lend more money on a short-term basis. If the utilities cannot get short-term funding, we think insolvency is a likely eventuality, in our view. We still think bankruptcy is the least likely outcome, and for that reason, a bankruptcy announcement would have a negative effect on the stock prices of the utilities as well as the wholesale energy suppliers. (4) Final decision by the CPUC on their proposed rate increase. A final decision on the 7%-15% proposed increase will be made today. If the CPUC decides to go with a higher or more favorable rate increase, this would be positive for the utilities and marketers.. (5) Credit risk to suppliers - worst case analysis. The generators and marketers who sell power to the California utilities have significant credit risks associated with those exposures. The figure below attempts to quantify those risks, which could result in a one-time earnings hit. The figures we have calculated are a worst-case analysis, in our view, and any actual exposure are likely to be much less. First, these risks will only become a reality in the case of the utilities' bankruptcy. Second, even given this worst-case bankruptcy scenario, the generators and marketers will likely be treated favorably in the bankruptcy case, given their status as trade creditors (30-45 day receivables). Third, based on our conversations with these companies, they have already taken steps to mitigate these exposures by tightening credit limits, requiring payments in cash, etc. 12/00 MWHs Produced @ Exposure @ Potential EPS CA MW 40% factor $200 Price Exposure Raymond Niles 212-816-2807 First Call Corporation, a Thomson Financial company. All rights reserved. 888.558.2500 Note ID: 320970 ------------------------------------------------------------------------------ To update your order or to receive research on other companies, please call your Account Manager at (800) 262-6000. ------------------------------------------------------------------------------ Thomson Financial Investor Relations TEL: 800-262-6000 75 Wall Street, 18th Floor FAX: 212-363-3971 New York, NY 10005 EMAIL: firstcall.notes@tfn.com First Call is a registered trademark of the First Call Corporation
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