Merrill Lynch analysis of power company capital structures favors AES, Calpine, TXU

By Ronda Fears

Nashville, April 22 - Power and utility companies have been on the upswing - both in their stocks and bonds - and there are considerable opportunities across the capital structure, according to Merrill Lynch & Co. analysts, which authored a special report and held a conference call on the topic Tuesday.

Analysts in the report were from Merrill's convertible, equity, high-grade and high-yield research departments, including Yaw Debrah, head of the U.S. convertible research team, and high-yield analyst David Silverstein.

After making the full swing between the high hopes and then the tough reality of a deregulating industry, with bouts of trouble injected by the California Energy crisis and the downfall of the biggest name in the group, Enron, there are signs of a revival, the analysts said.

From the Oct. 9 bottom, the S&P electric utilities index is up 24.8%, they note, and bonds have been boosted by a dramatic tightening in credit spreads.

"Some of this was a function of general improvements in credit spreads and the stock market since that time," the analysts said.

"However, we also believe actions taken by companies and the industry have helped. These include reduced capital spending, equity issuances and dividend cuts - all of which have provided better credit support."

Strengthening bond markets has allowed companies to issue new debt and wean away from a reliance on bank lines.

Also, more of the legal and regulatory issues associated with California and merchant energy trading are on their way to being resolved. Moreover, the analysts noted, there have been signs of a renewal in the energy trading market, with better credit companies entering the business, new accounting rules and improved disclosures and some revival in volatility driven by higher gas prices.

Most recently, a number of successful bank line have been renewed at terms that were not as onerous as many had expected, they noted. They also noted that new investors such as hedge funds have been willing to provide liquidity to companies if the banks are not.

AES

"We believe that AES is on a clear path toward financial recovery. The company has successfully addressed near-term liquidity issues and is moving in the direction of restoring value for equity holders," the analysts said.

"We are convinced that AES' myriad of businesses produce sufficient cash flow and value to cover AES' debt and preferreds with some reasonable value left over for equity holders."

However, given limited disclosures on its business, the analysts said it is tougher to assess the level of equity value and how quickly it can be restored.

Thus, the analysts are neutral on the stock but very bullish on AES bonds with a bias to the higher returns provided by the senior subordinated notes and the convertible bonds. For the more risk-tolerant investors, they also like the convertible preferreds as a more leveraged play on AES returning to stability.

"AES has a more solid liquidity position with only a modest level of required debt maturities in the next couple of years. Available cash flow is being deployed to retire secured and other debt, and this de-levering is a meaningful component of earnings growth over the next couple of years," the analysts said.

"We believe that in the next year or two, issues that have weighed heavily on the stock - including Brazil, Argentina, Venezuela and Drax - should decline in importance. Although the AES business and financial model is not as transparent as we would like, we believe that the company has equity value.

"Restoring a reasonable growth component to the story and clearing away the Latin American overhangs would be important catalysts for better stock valuation."

Investors can pick up yield by moving down the capital structure of AES, particularly with the converts and a capital structure swap out of the senior notes into the convertible bond or junior subordinated notes for convertible preferreds is suggested.

AES has one convertible bond and two convertible preferreds outstanding.

The 4.5% convertible unsecured junior subordinated debentures due 2005 has no optionality and should be viewed as a fixed-income instrument. The bond was issued in 1998 with a premium of 21% when AES stock was trading at $44.63. At 81 versus $4.41 for the common, the conversion premium has expanded to 395.9%. The issue's yield to maturity of 14.4% is comparable to other AES notes of similar subordination.

The AES Trust VII 6% convertible preferred due 2008 is suitable for high-yield investors who are comfortable with AES' credit. It was issued in 2000 with a premium of 25% when AES stock was trading at $74. The primary focus for holders of this convert should be AES' overall liquidity and its ability to pay the dividend. At 30 versus $4.41 for the common, the issue has a conversion premium of 529.3% and current yield of 10% with yield-to-maturity at 18.8%.

The AES Trust III 6.75% convertible preferred due 2029 provides investors with adequate return for the extra risk they are taking in moving down the cap structure. It was issued in 1999 with a conversion premium of 23% when the common was at $57.19. At 25.95 versus $4.41 for the common, the issue has a conversion premium of 313.9% and current yield of 13% with a yield to maturity of 13.6%.

Calpine

"We believe that CPN's situation is riskier than AES in the near term as key asset sales and financings are still critical to ensure sufficient liquidity this year," the analysts said.

"Moreover, while CPN's assets and contracts have sufficient value to cover debt holders over the long term, it is less clear whether there is value left for equity holders and, if so, how much.

"Calpine's asset value will be much more sensitive to changes in power market conditions given its sizable merchant generation exposure - the longer the market downturn, the tougher it will be to preserve value for equity holders."

For purposes of the study, the analysts assumed that Calpine is successful in raising some $800 million from leases and project financings in second quarter, and in discussing liquidity they assume the company will be successful in rolling over its $5.5 billion of secured bank facilities maturing in 2003 and 2004.

For the equity, the analysts said positive news on liquidity could provide support in the near term, but actions to enhance liquidity/credit will be dilutive to equity holders.

Similarly, they are not enthusiastic about the Calpine convertible preferreds, with no recommendation on the three issues.

"While our debt analysts believe that CPN's assets and contracts have sufficient value to cover debt holders, it is much less clear whether there is value left for preferred holders," the analysts said.

"Hence at this time, while we are overweight the convertible bond, we cannot recommend purchase of the trust preferreds."

But they are bullish on Calpine bonds, including the 4% convertibles due 2006, saying, "We believe liquidity issues will be resolved and that asset value should cover the debt over the long term."

Given the significant yield advantage of the convertible, offset by the 9.375 point premium at which the 4% convertible bonds trade relative to Calpine's benchmark senior notes, the analysts noted a potential bullish hedge trade is to sell the 8.5% notes due 2011 and buy the 4% convertible bonds.

From October 1999 through December 2001 Calpine raised $2.4 billion in proceeds with the convertibles. Due to the drastic decline in Calpine stock since then, the converts' combined market value has declined to $1.5 billion.

The Calpine 4% convertible senior unsecured notes due 2006 has no optionality and should be viewed as a fixed-income instrument. It was issued in 2001 with a conversion premium of 23.0% when the stock was at $14.69. The issue is putable at par on Dec. 26, 2004, with the option to pay this put in cash, stock or a combination of the two. At 75.375 versus $4 for the common, the issue has a conversion premium of 240.5% and a 22.3% yield-to-put.

The analysts noted that the 4% convertible bond ranks equally with the 8.5% straight bonds due 2011, yet are trading at a significantly wider spread. The 8.5s current bid price of 66 produces a yield to maturity of 16.35% and an implied option-adjusted spread of 1,308 bps. This compares to the yield to put of 22.3% and an implied spread option-adjusted spread of 2,108 bps on the convert.

In addition, the 8.5s have a longer maturity.

"Because of the company's option of potentially paying the put in stock, investors are currently significantly discounting the value of this put," the analysts noted.

"Other investor fears include the possibility of a restructuring, in which the convertible would get the same recovery as the straight debt, though the convertible is trading at a higher dollar price today than the straight bond."

The analysts suggest a hedge trade to swap from 8.5% straights to the 4% convert, and note that the downside in this case will be limited to price compression between the debt instruments. Alternatively, if the company satisfactorily addresses its liquidity challenges, holders of the 4% convertible bonds may be offered an exchange proposal that would improve its attractiveness. This could include an increase in the coupon, a partial payment, the elimination of the stock payment option, an increase in the conversion ratio or other scenarios, the analysts said.

Duke Energy

Duke Energy is the utility and its Duke Capital holds all its unregulated businesses as well as its regulated pipelines.

"While Duke's utility and pipelines businesses provide strong and stable cash flows, the company made sizable investments in merchant generation, trading, international and midstream gas that are all earning very low returns right now," the analysts said.

"As a result, DUK's credit metrics have weakened, particularly the cash flow ratios at Duke Capital. Moody's recently placed all Duke's ratings on review for downgrade and we believe that it is critical that DUK maintain investment-grade ratings at Duke Capital (currently Baa2.).

"Our view is that DUK will ultimately need to issue more equity and potentially reduce the dividend to support Duke Capital's credit."

A sell recommendation is made for Duke Energy shares, with the analysts noting credit concerns at Duke Capital, an expected equity issuance and a possible dividend cut.

They are also underweight the bonds, again noting very weak credit metrics at Duke Capital absent some help from the parent.

A sell recommendation also is made for the two mandatory convertibles - the 8% and 8.25% issues - noting the negative view on the common stock, high conversion premiums and limited upside potential. For outright investors, the analysts said there are superior mandatories elsewhere in the utilities sector.

However, the analysts said there is an attractive arbitrage trade in buying Duke Capital bonds and selling Duke stock.

"For investors willing to accept our thesis that Duke Energy will eventually take the steps necessary to shore up the credit profile of Duke Capital, we recommend the purchase of Duke Capital bonds and the sale of Duke Energy common," the analysts said.

"In our opinion, DUK will not allow Duke Capital to go below investment grade because it would be too costly to operate the business at that rating level. As we have seen with other energy merchants, a below investment-grade rating requires companies to post large amounts collateral.

"Furthermore, it makes it difficult to sign long-term contracts. This trade will perform well if Duke issues common and/or cuts the common dividend in order to keep Duke Capital rated investment grade."

Moreover, the analysts suggest investors swap out of Duke Capital bonds and into TXU Energy.

TXU

TXU faced a credit crisis after the bankruptcy of its subsidiary TXU Europe last year but by reducing its dividend and issuing significant amounts of new equity, TXU was able to maintain its U.S. businesses at stable mid-BBB credit ratings, the analysts noted.

"A recent bond offering at TXU Energy and an expected bank line renewal in late April should help to further strengthen TXU's credit and liquidity situation," they said.

"We see significant de-levering potential over the next two years, which should allow value to rapidly accrue to equity holders."

The analysts suggest buying TXU shares, noting improved credit and liquidation along with more deleveraging expected and some earning upside potential.

They are overweight TXU Energy bonds, citing strong credit metrics and also noting the bonds trades wide for a stable investment-grade power company, but are neutral on debt at TXU's regulated utility Oncor due to much tighter credit spreads.

TXU Corp. has two mandatory convertibles currently outstanding - 8.125% and 8.75% issues - both alternatives to TXU's equity with lots of equity sensitivity. Convert investors give up some of TXU common's upside participation, but receive a higher coupon in return, the analysts added.

There is a buy recommendation on the 8.125% mandatory, due to an attractive current yield and risk/reward, but the analysts are neutral on the 8.75s despite its higher current yield due to a less favorable risk/reward profile and more complicated structure.

On a capital structure trade, they recommend long TXU Energy bonds and short TXU Corp. bonds as they view TXU Corp. essentially subordinated to the TXU Energy risk, yet trading at tighter spreads. At a spread of 225 basis points over Treasuries, TXU Energy trades to a yield of 6.2%. By comparison, the TXU Corp. 6.375s of 2006 trade in the 104-105 context, for a yield of 4.98% and a spread of 209 bps.

TECO Energy

"TECO has a number of stable utility and non-regulated businesses, overshadowed by large untimely investments in merchant generation. The company has issued significant amounts of equity, sold assets with more in process, and recently cut the dividend," the analysts said.

"Nonetheless, we continue to see risk of severe earnings deterioration and potential further credit erosion. Ultimately, TECO may need to choose to walk away from its merchant power plants."

The analysts also noted on the conference call that TECO was downgraded late Monday to a high-yield rating by Moody's Investors Service.

Even under a scenario where the non-recourse debt is eliminated, however, the analysts said they see TECO's equity value only in the $7 per share area. Similarly, the TECO converts appear significantly overpriced, even with a lower common dividend.

The analysts have a sell recommendation on both the stock and converts.

"We see little upside for this convert under any scenario," the analysts said.

"It appears as though investors are focusing only on the issue's current yield and have overlooked its total return potential - or lack thereof."

The TECO mandatory is 32% rich at current levels and even if the common dividend was entirely eliminated it would still be 22% rich, the analysts said.

"We believe that the recent actions taken by TE are more beneficial to bondholders than stockholders. In particular, TE has strengthened its liquidity with the dividend cut and new bank line but is still facing a deteriorating earnings outlook," the analysts said.

"Furthermore, we believe that the ultimate TE actions to fix its merchant generation situation would be favorable for fixed-income investors and dilutive for shareholders. However, the next key event that will move spreads is the magnitude of any Moody's downgrade.

"Accordingly, we recommend investors play the TECO name by selling the stock and buying the bonds on any weakness that could follow Moody's action.

"We remain concerned about the high debt leverage at the TECO holding company, in the absence of a significant de-levering plan," the analysts said. "Furthermore, it is facing potentially significant impairment charges. The company still has not completely addressed how it is going to reduce its merchant generation exposure, in our view."

Positively, they noted, however, TECO has taken several steps to enhance its liquidity position, including obtaining a new unsecured bank line and reducing the common dividend by 46%

The analysts have a marketweight recommendation on TECO's bonds, noting the bonds have made a significant move over the last several weeks. For example, they said the 7s of 2012 have gone from 81.5/83.5 a month ago to 94/95, and note the spread is now 400 bps over on the offered side.

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