Fossil Fools at Dynegy

The Company: The major electric-power generator Dynegy.
The Filing: A Form 8-K filed on June 17, 2008.
The Finding: Dynegy announced $300 million in new credit financing, with availability contingent on natural gas prices rising above $13 per million BTUs. But few long-term natural-gas or liquid-fuel supply agreements in a rising commodity environment combined with a strained balance sheet will crimp Dynegy's ability to make strategic acquisitions.

The Gist: While its competitors in the power-merchant space lock in revenue streams with long-term hedge positions, Dynegy's strategy is to capture opportunities for short- and medium-term value by selling forward -- no more than three years -- electrical output from its base load facilities. The company is well positioned to capture margin benefits by controlling pricing power as demand continues to increase (leading to higher kilowatt/hour pricing) and supply remains relatively stable.

A key component to higher margins is an affordable supply of fuel to run its plants.

Most of Dynegy's midwest coal facilities are fixed through 2010 and all rail costs are contracted through 2013. Offsetting this core advantage, however, is the company's exposure to rising natural gas prices, as few of its gas-fired plants--representing 70% of power sales-- have laddered contracting positions.

On the first-quarter earnings call, CFO Holli Nichols said liquidity stood at $1.5 billion as of March 31. This is misleading. Debt and lease obligations of $6.8 billion and a non-investment grade bond rating of "B" forced the company to post $1.2 billion as required collateral, limiting Dynegy's financial flexibility in planning for and reacting to business and industry changes.

The Question: With the balance sheet overburdened by debt, how is Dynegy in a stronger position to support its commercial strategy-including asset purchases - when the aforementioned letter of credit will be needed to secure natural gas supplies above prices of $13 per million BTUs?

David Phillips

David Phillips has more than 25 years' experience on Wall Street, first as a financial consultant and then as an equity analyst for several investment banking firms. He sifts through SEC filings for his blog The 10Q Detective, looking for financial statement soft spots, such as depreciation policies, warranty reserves and restructuring charges. He has been widely quoted in outlets such as BusinessWeek, The International Herald Tribune, Investor's Business Daily, Kiplinger's Personal Finance, and The Wall Street Journal.

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