Analyst’s roundtable: State of the sector

Don Diaz, Contributing Editor

What are the make or break issues facing the power industry? Looking back six months, as well as looking forward the same amount of time, what do the sector’s insiders perceive as the most crucial challenges? I spoke to a few key members of this select group in order to attempt to answer these questions. The result is a scope of sector concerns that meld to produce an overall pulse of the industry.

Reliant Energy’s “spokesperson” was very helpful, but would only speak to me under the condition that name and title be withheld. Given the current environment in the merchant energy sector, this precaution is understandable and underscores the risks of supplying undiluted insights amid the backdrop of still volatile regulatory and market issues, as well as the prospects for re-employment within the sector.

That said, the firm’s spokesperson cited liquidity as the most pivotal issue facing Reliant in the past six months and for the foreseeable future.

The firm narrowly escaped bankruptcy by completing a $6.2 billion financing package in March, which restructured $5.9 billion of existing debt. The firm “was very close to seeking protection (filing bankruptcy) ahead of this deal.” In order to avoid bankruptcy court, Reliant was forced to re-package the bulk of its debt, extending maturities to four years on the yield curve while paying huge interest charges. The majority of its debt, a $3.8 billion term loan, and a $2.1 billion revolving line of credit due March 15, 2007, were refinanced at LIBOR (London Inter Bank Offering Rate) plus 4 percent, with an additional $300 million new line of credit due Dec. 15, 2004, financed at LIBOR (1 month LIBOR was 1.3-1.28 percent on the date the refinancing package was closed) plus 5.5 percent. These interest charges amount to the corporate finance equivalent of pawnbroker rates, some 370 to 400 basis points (100 basis points equal 1 percent point) above the level “solid” industrial names pay for their credit. The fact that Reliant paid 550 (5.5 percent) basis points for a mere $300 million for a term of less than two years reveals the enormity (or scarcity) of the cash flow problem it’s facing. Still, Reliant should be commended for its resourcefulness in obtaining much-needed operational capital.

Executive vice president of TXU Corp., Tom Baker, echoed similar sector concerns, stressing that the industry would experience “further shake-outs and balance sheet strengthening.” The firm also recently completed a refinancing package totaling $600 million at a rate of LIBOR plus 175 basis points, plus an additional “commitment fee” of 30 basis points, as well as an “utilization margin” of 25 to 50 basis points.

Baker said that the main issue his firm is tasked with is “balancing upstream supply with downstream demand.” He said the firm has never engaged in the speculative trading that was the downfall of former sector members; rather TXU employs its trading efforts in order to hedge its supply and demand issues. Baker said going forward TXU would continue to focus on its core “pipes and wires” businesses while exiting businesses that do not fit this model.

The firm recently announced plans for the sale of its telecommunications company, TXU Communications, which the firm expects to complete in mid-2004. Baker said the proceeds of the sale will be used to pay down debt, namely of Pinnacle One, a wholly owned subsidiary of TXU and holding company for the firm’s telecomm ventures. Baker said that the pending sale will “help secure the firm’s leadership position in the energy business in Texas and Australia.”

He added that further staff reductions would also likely continue to play a role in the company’s effort to maximize profitability. Baker said that as many as 30 of the company’s officers have been furloughed along with roughly 1,100 employees in the past 12 months.

“Cash flow and debt to equity ratio will also be enhanced by dividend reductions and asset sales.” Additionally, TXU will look to “further reduce duplication of effort,” citing planned and implemented “process improvements” focused on growing cost effectiveness. Baker also commented that TXU and its competitors would be forced to produce cleaner, stronger balance sheets in the near-term in order to obtain the financing necessary to “site new facilities” needed to meet future consumer demand.

Jack Hawks, vice president of Public Affairs with the Electric Power Supply Association (ESPA), and Douglas Austin, ESPA’s senior analyst and writer, also provided valuable insight into the regulatory issues facing the sector. Hawks and Austin highlighted the ongoing congressional debate on the future role of FERC’s governing authority. “At the end of the day, the key issue is whether FERC will have the ability to conduct and keep orderly business. This is most crucial with respect to FERC’s role in the development and sound establishment of regional transmission organizations (RTOs). FERC’s main goal and congressional mandate should allow for stable system and market operations at the regional level. Of course, there are some entities out there that don’t want FERC to able to do any of these things so it’s still up in the air as to what FERC’s final role will be. In our opinion, the industry needs to shore up market and regulatory uncertainty, especially in the wholesale sector.”

Hawks said the industry should also be especially cautious of firms with poor credit ratings that are looking to expand production facilities. “These firms have recently engaged in the a sort of hedge against future production costs by obtaining contracts to deliver power long before that production is available. In a typical scenario, a firm will obtain 100 to 1,000 delivery contracts, employing them as a form of collateral in order to obtain financing to expand production. When these deals go south, it’s the consumer that’s left holding the bag.”

Hawks said that one of the most promising developments in the industry is the entry of new market players with solid balance sheets. “The entry of non-traditional market participants can only add liquidity to a cash-starved sector. The end result will benefit not only the merchant energy sector, but more importantly, the end consumer.”

Diaz is an independent industry analyst with 15 years experience in the financial and energy markets. He may be contacted at ddiaz2@houston.rr.com.

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