October 24, 2008
An undertow resulting from the financial services clamor is dragging down its second utility victim: Reliant Energy, which had seen its stock value dissipate by more than 50 percent and which had been forced to put all or part of itself on the auctioning block.
The chaotic economic climate is due in some measure to market psychology. Clearly, the loose lending practices of the last five years have taken their toll. But at some point, the economy will stabilize and the demand for all products and services will rise, soaking up excess supplies. Uncertainty persists, however, leaving investors and consumers in limbo -- a lingering pessimism that has pushed stock indices to their lowest levels in years.
Of particular concern now is whether Reliant -- and before that Constellation Energy -- are uncommon situations or whether they will become part of a broader trend. About five years ago, those marketing and trading operations associated with utilities were left for dead. But low interest rates and a rebounding economy allowed such companies to restructure their debts and to live on. Just as they have gotten their legs, however, they could take another beating.
To be clear, Reliant and Constellation do not appear to be indicative of other unregulated utilities. In the case of Reliant, wholesale price spikes in Texas effectively knocked out some competitors there while the after-effects of Hurricane Ike in September have taken a toll on the Houston-based retailer by diminishing electricity demand. Altogether, the company cut its profit outlook by $800 million, $350 million of which is attributed to its retail business with the balance of it being credited to its wholesale business.
As was the case with Constellation, Reliant has a desperate need for more liquidity -- the good faith money needed to execute trades. Reliant has been forced to raise $1 billion in new capital to replace a credit agreement it had with Merrill Lynch. That situation is similar to that of Constellation, which sold out to Berkshire Hathaway because it lost its credit lines and had to raise money to preserve its favorable bond ratings. However, Reliant has just entered into an agreement with First Reserve Corp. and GS Loan! Partners to raise much of the needed funds. The news caused a big bum p up in its stock.
"Reliant really doesn't want to end up like Constellation," says Barry Abramson, Wall Street analyst with Gabelli & Co. in Rye, N.Y. "I don't know how it can hang on. But if it can get the liquidity it needs, albeit at higher prices, it will be able to survive. Paying high short-term interest rates is a better option than being forced to sell their entire future at a low price. I am concerned this trend could spread. But much of the fear is the result of market psychology and not really because of a big change in fundamentals."
Integrated utilities have stable cash flows but are hardly considered to be cash cows, particularly when compared to Warren Buffett who has billions sitting in the bank. Besides, most power companies must expand their infrastructure, comply with environmental mandates and replace their graying workforce. So, who might come to the rescue of any ailing utility?
All Options
Two possibilities: The first is that utilities go into a defensive posture and come up for air once the storm has passed. At this point, they would use their resources to grow their enterprises to meet expected future demands. The second is that the strongest of the group could use their wealth to buy assets at bargain prices -- the Warren Buffett model.
Reliant, with its recent market capitalization of $2 billion, might be an attractive supplement to one of the industry stalwarts: American Electric Power, Dominion Resources, Duke Energy, Exelon Corp., FPL Group or Southern Company. Those companies are always looking for ripe opportunities.
"You have to assume there are some large diversified utilities that might have the financing ready to buy a company this size," says Abramson.
Reliant owns 15,000 megawatts based along the east cost and California and Florida. Its retail operations, with 1.8 million customers, are located in Texas. In 2004, it sidestepped bankruptcy in large measure because its strong retail business served as a hedge against the risks that its wholesale business posed.
Now the company says that it is exploring all of its options, which means that it wants to sell its unregulated retail operations and focus on its wholesale power generation business. Indeed, the risks associated with trading around such assets have risen. Credit markets have not only dried up but also the number of investment banks supplying the necessary collateral to execute trades has fallen.
The issue becomes even more exacerbated if company credit ratings are downgraded, necessitating even more collateral. That's Reliant's big fear as Fitch Ratings revised its outlook of the company from "stable" to "negative" while Standard & Poor's cut its actual bond rating, although it still gives the retail operation a "stable" forecast.
Panic, overall, is spreading. First it was Constellation. Now it's Reliant. But their cases differ from those in the post-Enron era. During that time, unregulated generators couldn't sell their power at prices high enough to cover their debts. By comparison, they currently have a thirst for the required liquidity to support their trading operations. Their choices: scale back and hang on or sell out to the highest bidder.
"It's not a fire sale at this point and hopefully it won't get to that," says James Halloran, Wall Street analyst for National City Bank in Cleveland. "I have to believe that if the 'street' smelled blood, then it would be all over that."
Bad news is plentiful. But the pessimism will dispel. Demand will eventually resume and businesses will subsequently expand. It's an uneasy period and one that calls on most utilities and their customers to hold their cash until the coast is clear.
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Ken Silverstein EnergyBiz Insider Editor-in-Chief
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