Credit analyst: Take bond market under-reaction to TXU news as chance to exit

By Ronda Fears

Nashville, Tenn., Oct. 7 - The moderate response in the credit markets to TXU Corp.'s warning, which prompted a 40% drop in the stock, is a chance for fixed-income investors to sell, according to Carol Levenson, director of research at Gimme Credit.

"We think the bond market underreacted to Friday's news and we would take advantage of this by exiting this paper," Levenson said in a report Monday.

The deregulated utility landscape has turned ugly and the latest company to discover this is TXU Corp. (Baa3/BBB+), with the culprit in this case not the lousy domestic merchant energy environment but an equally lousy wholesale energy market in the U.K.

Thanks largely to TXU's vow not to spend more than $700 million propping up its European subsidiary, the rating agencies have viewed the parent and the U.S. subsidiaries as somewhat insulated from the woes abroad. Moody's changed TXU's outlook to negative and Fitch Ratings cut the TXU Europe unit to junk.

"We're not certain this situation can be so perfectly quarantined," Levenson said.

"The 40% drop in TXU's stock price in the past week impairs the company's financial flexibility and is bound to put pressure on TXU to spend its cash in more shareholder-friendly fashion. Moreover, the company has $1.3 billion in commercial paper outstanding and its access to this market could be limited after last week's scare.

"That could leave TXU more dependent on its bank facilities, and we fear a goodwill or other significant charge and/or prolonged earnings weakness could bring TXU close to violating its bank loan covenants. Finally, we don't see TXU pulling the plug on its European subsidiary."

The rapidly deteriorating credit quality of TXU Europe raises questions about how far its woes can trickle up the organization chart and affect the parent and its domestic subsidiaries, the analyst said.

TXU's revised guidance represents a 25% shortfall from prior expectations and a meaningful drop in projected earnings and cash flow of $300-$400 million both this year and next year.

"Although TXU has been making great strides in reducing its debt through asset sales and equity and hybrid securities issuance, the company's balance sheet is still more leveraged than we'd like to see it, given its heightened business risk and lower cash flow predictability," Levenson said.

At June 30, she said leverage, including convertible trust preferreds as debt, was still in the high 60s and free cash flow for the first half was negative by nearly $600 million. Using the new earnings forecast for next year, she projects fixed charge coverage without further debt reduction will be just over 2x.

On the liquidity front, she estimates cash and available credit capacity has been depleted by around $1 billion since the end of June and short-term debt is still well over $2 billion.

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