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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 000-29311
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DYNEGY HOLDINGS INC.
(Exact name of registrant as specified in its charter)
Delaware 94-3248415
(State or other (I.R.S. Employer
jurisdiction Identification No.)
of incorporation or
organization)
1000 Louisiana, Suite 5800
Houston, Texas 77002
(Address of principal executive offices)
(Zip Code)
(713) 507-6400
(Registrant's telephone number, including area code)
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
All outstanding equity shares of Dynegy Holdings Inc. are held by its
parent, Dynegy Inc.
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DYNEGY HOLDINGS INC.
TABLE OF CONTENTS
Page
----
PART I. FINANCIAL INFORMATION
Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS:
Condensed Consolidated Balance Sheets:
June 30, 2002 and December 31, 2001.............................. 3
Condensed Consolidated Statements of Operations:
For the three months ended June 30, 2002 and 2001................ 4
Condensed Consolidated Statements of Operations:
For the six months ended June 30, 2002 and 2001.................. 5
Condensed Consolidated Statements of Cash Flows:
For the six months ended June 30, 2002 and 2001.................. 6
Notes to Condensed Consolidated Financial Statements.................... 7
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS........................................... 32
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..... 64
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.............................................. 65
Item 6. EXHIBITS AND REPORTS ON FORM 8-K............................... 65
EXPLANATORY NOTE
This quarterly report includes financial statements which have not been
reviewed by an independent public accountant under Rule 10-01(d) of Regulation
S-X. We expect that our independent public accountant, PricewaterhouseCoopers
LLP, will complete the quarterly review required by Rule 10-01(d) of Regulation
S-X following their re-audit of our historical financial statements for the
three-year period ended December 31, 2001. This three year re-audit will
address, among other items, the restatements to our historical financial
statements relating to the balance sheet, statement of operations and cash flow
statement impacts resulting from revisions in accounting for a structured
natural gas transaction referred to as Project Alpha and a $124 million pre-tax
charge relating principally to our natural gas marketing business, each as
further described in Note 1 to the accompanying financial statements. In this
regard, Arthur Andersen LLP, our former independent public accountant, has
advised us that its audit opinion relating to 2001 should no longer be relied
upon. As a result of the three year re-audit, there may be other revisions to
the Company's historical financial statements in addition to those described
above, some of which may be material. Dynegy expects to file amended reports
under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), for
each of the three years in the period ended December 31, 2001, as well as each
quarterly period contained therein. In addition, Dynegy expects to file amended
Exchange Act reports for the quarters ended March 31, 2002 and June 30, 2002.
These amended reports will be filed with the SEC following the completion by
PricewaterhouseCoopers LLP of the three year re-audit and, for the quarterly
periods during 2002, their subsequent review of the interim financial
statements for these periods.
DYNEGY HOLDINGS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited) (in millions)
June 30, December 31,
2002 2001
-------- ------------
ASSETS
Current Assets
Cash and cash equivalents........................................................... $ 322 $ 144
Accounts receivable, net of allowance for doubtful accounts of $114 million and $102
million, respectively............................................................. 3,631 3,592
Accounts receivable, affiliates..................................................... 59 202
Inventory........................................................................... 249 358
Assets from risk-management activities.............................................. 4,756 4,046
Prepayments and other assets........................................................ 437 1,254
------- -------
Total Current Assets............................................................. 9,454 9,596
------- -------
Property, Plant and Equipment....................................................... 9,723 6,882
Accumulated depreciation............................................................ (964) (810)
------- -------
Property, Plant and Equipment, Net.................................................. 8,759 6,072
Other Assets
Investments in unconsolidated affiliates (Note 10).................................. 818 809
Assets from risk-management activities.............................................. 4,493 2,330
Goodwill............................................................................ 1,601 749
Other assets........................................................................ 550 327
------- -------
Total Assets..................................................................... $25,675 $19,883
======= =======
LIABILITIES AND STOCKHOLDER'S EQUITY
Current Liabilities
Accounts payable.................................................................... $ 3,362 $ 3,370
Accounts payable, affiliates........................................................ 62 40
Accrued liabilities and other....................................................... 738 1,189
Liabilities from risk-management activities......................................... 4,516 3,547
Notes payable and current portion of long-term debt................................. 1,363 200
------- -------
Total Current Liabilities........................................................ 10,041 8,346
------- -------
Long-Term Debt...................................................................... 3,605 2,139
Other Liabilities
Liabilities from risk-management activities......................................... 4,107 2,072
Deferred income taxes............................................................... 579 651
Other long-term liabilities......................................................... 700 700
------- -------
Total Liabilities................................................................ 19,032 13,908
------- -------
Minority Interest................................................................... 104 970
Company Obligated Preferred Securities of Subsidiary Trust.......................... 200 200
Commitments and Contingencies (Note 11)
Stockholder's Equity
Preferred Stock..................................................................... 1,501 --
Additional paid-in capital.......................................................... 2,395 2,392
Accumulated other comprehensive income, net of tax.................................. 2 2
Retained earnings................................................................... 1,409 1,379
Stockholder's equity................................................................ 1,032 1,032
------- -------
Total Stockholder's Equity....................................................... 6,339 4,805
------- -------
Total Liabilities and Stockholder's Equity....................................... $25,675 $19,883
======= =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
3
DYNEGY HOLDINGS INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited) (in millions)
Three Months
Ended June 30,
---------------
2002 2001
------ -------
Revenues............................................................ $9,695 $10,670
Cost of sales....................................................... 9,492 10,323
Depreciation and amortization....................................... 100 68
Impairment and other charges (Note 5)............................... 32 --
General and administrative expenses................................. 69 89
------ -------
Operating income.................................................... 2 190
Earnings from unconsolidated investments............................ -- 61
Other income (Note 5)............................................... 67 31
Interest expense.................................................... (56) (34)
Other expenses (Note 5)............................................. (188) --
Minority interest expense........................................... (11) (13)
Accumulated distributions associated with trust preferred securities (4) (4)
------ -------
Income (loss) before income taxes................................... (190) 231
Income tax provision (benefit)...................................... (55) 72
------ -------
Net Income (Loss)................................................... $ (135) $ 159
====== =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
4
DYNEGY HOLDINGS INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited) (in millions)
Six Months Ended
June 30,
----------------
2002 2001
------- -------
Revenues............................................................ $18,069 $23,278
Cost of sales....................................................... 17,432 22,566
Depreciation and amortization....................................... 179 132
Impairment and other charges (Note 5)............................... 32 --
General and administrative expenses................................. 169 167
------- -------
Operating income.................................................... 257 413
Earnings from unconsolidated investments............................ 31 90
Other income (Note 5)............................................... 81 49
Interest expense.................................................... (106) (63)
Other expenses (Note 5)............................................. (192) (29)
Minority interest expense........................................... (21) (35)
Accumulated distributions associated with trust preferred securities (8) (8)
------- -------
Income before income taxes and change in accounting principle....... 42 417
Income tax provision................................................ 15 134
------- -------
Income from operations.............................................. 27 283
Cumulative effect of change in accounting principle, net (Note 7)... -- 2
------- -------
Net Income.......................................................... $ 27 $ 285
======= =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
5
DYNEGY HOLDINGS INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited) (in millions)
Six Months Ended
June 30,
--------------
2002 2001
----- -------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income........................................................................... $ 27 $ 285
Items not affecting cash flows from operating activities:
Depreciation and amortization.................................................... 178 126
(Earnings) Losses from unconsolidated investments, net of cash distributions..... 12 (72)
Risk-management activities....................................................... 99 236
Deferred income taxes............................................................ 6 78
Gas marketing charge (Note 5).................................................... 124 --
Other............................................................................ 19 (9)
----- -------
Operating cash flow before changes in working capital............................ 465 644
----- -------
Change in assets and liabilities resulting from operating activities:
Accounts receivable.............................................................. 38 819
Inventory........................................................................ (34) 34
Prepayments and other assets..................................................... 4 (213)
Accounts payable and accrued liabilities......................................... (106) (970)
Other, net....................................................................... (8) 71
----- -------
Net cash provided by operating activities............................................... 359 385
----- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures............................................................. (465) (1,252)
Investment in unconsolidated affiliates.......................................... (12) (30)
Business acquisitions, net of cash acquired...................................... (20) --
Proceeds from asset sales........................................................ 5 996
Affiliate transactions........................................................... 61 (119)
Other investing, net............................................................. -- (158)
----- -------
Net cash used in investing activities............................................ (431) (563)
----- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from long-term borrowings........................................... 496 496
Repayments of long-term borrowings............................................... (144) --
Net proceeds from short-term borrowings.......................................... 245 --
Net cash flow from commercial paper and revolving lines of credit................ (255) (50)
Other financing, net............................................................. (55) 178
----- -------
Net cash provided by financing activities............................................... 287 624
----- -------
Effect of exchange rate changes on cash................................................. (37) (7)
Net increase in cash and cash equivalents............................................... 178 439
Cash and cash equivalents, beginning of period.......................................... 144 32
----- -------
Cash and cash equivalents, end of period................................................ $ 322 $ 471
===== =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
6
DYNEGY HOLDINGS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the Interim Periods Ended June 30, 2002 and 2001
Note 1--Restatements
As a result of certain events, which are described below, Dynegy Holdings
Inc. ("Dynegy" or the "Company") engaged PricewaterhouseCoopers LLP
("PricewaterhouseCoopers") to re-audit its 1999 through 2001 consolidated
financial statements. Following completion of these re-audits, Dynegy intends
to file amended reports under the Securities Exchange Act of 1934, as amended
(the "Exchange Act"), for each of the three years in the period ended December
31, 2001, as well as each quarterly period contained therein. In addition,
Dynegy will file amended Exchange Act reports for the quarters ended March 31,
2002 and June 30, 2002 following completion of PricewaterhouseCoopers'
subsequent review of the interim financial statements for these periods. As a
result of these re-audits and reviews, there may be revisions to the financial
statements contained in the above-referenced reports, including this quarterly
report, which are in addition to the known revisions described below, some of
which could be material. The Company expects that the re-audit of its 1999
through 2001 consolidated financial statements will take at least the remainder
of the year to complete.
Dynegy entered into a structured natural gas transaction known as Project
Alpha in April 2001. As described in a Current Report on Form 8-K dated April
25, 2002 (the "Form 8-K"), Dynegy decided, after consultation with the Staff of
the SEC, to present the cash flow associated with the related gas supply
contract as a financing activity in its Consolidated Statements of Cash Flows
for 2001. Following the disclosure in the Form 8-K and in connection with a
further review of Project Alpha, Arthur Andersen ("Andersen") informed the
Company that it could no longer support its tax opinion relating to the
transaction. Andersen's change in position was based in part on its conclusion
that the reclassification of $300 million in cash flow from operations to cash
flow from financing lessened the factual basis for the opinion. Dynegy's
financial statement recognition of the tax benefit in 2001 was based
principally on the Company's assessment of the relevant issues, as corroborated
by Andersen's tax opinion. After the withdrawal of Andersen's tax opinion,
management concluded that sufficient support to include the income tax benefit
for financial statement presentation purposes no longer existed. Additionally,
as a result of further discussions with representatives of the SEC Division of
Enforcement, Dynegy will include in its restatement of its 2001 and 2002
financial statements the consolidation of ABG Gas Supply LLC, one of the
special purpose entities sponsored by Dynegy in the transaction.
The impact of Project Alpha restatement items on Dynegy's financial
statements are expected to be as follows:
. Previously reported operating cash flow for the year ended December 31,
2001 will be reduced by approximately $300 million with a corresponding
increase to financing cash flow;
. Previously reported operating cash flow for the six-month period ended
June 30, 2001 will be reduced from $385 million reported herein to
approximately $277 million, with a corresponding increase in financing
cash flow from the $624 million reported herein to approximately $732
million;
. Retained earnings at December 31, 2001 will be reduced by approximately
$79 million in relation to the balances previously reported by the
Company;
. Previously reported net income for the three-month period ended June 30,
2001 of $159 million will be reduced to approximately $132 million;
. Previously reported net income for the six-month period ended June 30,
2001 of $285 million will be reduced to approximately $258 million;
. Reported balance sheets for each Exchange Act reporting period in 2001
(beginning with June 30, 2001) will reflect a reclassification of
approximately $300 million from either minority interest or liabilities
7
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
from risk-management activities (or a combination of the two) to debt,
depending on the specific reporting period; and
. Reported balance sheets for each Exchange Act reporting period in 2002
will reflect a reclassification of approximately $300 million from
Liabilities from Risk-Management Activities to debt.
The Company's Condensed Consolidated Statements of Cash Flows for 2002 reflect
(and in all future Exchange Act filings will reflect) the cash flow associated
with the related gas supply contract as financing cash flow rather than
operating cash flow.
Andersen, Dynegy's former independent public accountant, has advised that
its audit opinion relating to 2001 should no longer be relied upon as a result
of the pending restatements relating to Project Alpha. The balance sheets,
statements of operations and cash flow statements for periods ended in 2001 and
2002 to date contained in Dynegy's Exchange Act reports have not been adjusted
to reflect the impacts of the restatements relating to Project Alpha. These
changes will be reflected in the amended Exchange Act reports once the
re-audits and reviews are completed by PricewaterhouseCoopers.
Please see Note 11 below for a description of the ongoing investigations by
the SEC and U.S. Attorney relating to Project Alpha. Note 11 also includes a
description of related shareholder litigation.
In addition to financial statement activities related to Project Alpha,
Dynegy recognized a pre-tax charge in Other Income and Other Expense of
approximately $124 million ($80 million after-tax) in the second quarter 2002
related principally to a balance sheet reconciliation project undertaken by the
Company at the beginning of 2002. The charge largely relates to the Company's
natural gas marketing business and is believed to have accumulated over a
number of years. As a result of the charge and the current inability of the
Company to allocate this charge to specific accounting periods, the Company
decided to extend the re-audits of its financial statements to each of the
three years in the period ended December 31, 2001, as described in the first
paragraph above. If necessary, the Company will correct prior period financial
statements based on the results of these re-audits.
Dynegy expects that one of the issues to be addressed in the re-audits is
hedge accounting under Financial Accounting Standards Board ("FASB") Statement
of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended ("Statement No. 133"). Please
see Note 7 for further discussion.
Note 2--Accounting Policies
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with the instructions to interim financial
reporting as prescribed by the SEC, except as provided in the Explanatory Note
on the Table of Contents. These interim financial statements should be read in
conjunction with the consolidated financial statements and notes thereto
included in the Company's Annual Report on Form 10-K for the year ended
December 31, 2001 (the "Form 10-K"), as filed with the SEC. The Company is a
wholly owned subsidiary of Dynegy Inc.
The financial statements include all material adjustments, which, in the
opinion of management, are necessary for a fair presentation of the results for
the interim periods, except for the specific items described in Note 1. Interim
period results are not necessarily indicative of the results for the full year.
The preparation of the
8
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
condensed consolidated financial statements in conformity with generally
accepted accounting principles requires management to develop estimates and
make assumptions that affect reported financial position and results of
operations and that impact the nature and extent of disclosure, if any, of
contingent assets and liabilities. Actual results could differ materially from
those estimates. Certain reclassifications have been made to prior period
amounts in order to conform to current year presentation.
Note 3--Liquidity and Industry Conditions
During 2002, a number of events negatively impacted Dynegy as well as the
merchant energy industry in general. These events have resulted in downgrades
in the Company's credit ratings to non-investment grade by each of the major
rating agencies and a reduction in available liquidity resulting from a
combination of lower than expected cash flow from operations, reduced access to
sources of capital and increased collateralization of its trading and
commercial obligations. The credit ratings downgrades have limited and will
likely continue to limit significantly the Company's ability to refinance its
debt obligations and to access the capital markets and will likely increase the
borrowing costs incurred by the Company in connection with any refinancing
activities. The Company's financial and operating flexibility is likely to be
similarly reduced as a result of restrictive covenants and other terms that are
typically imposed on non-investment grade borrowers. The Company has
significant debt maturities over the next 12 months, which are further
described in Note 9 below. Additionally, the increased collateralization of the
Company's trading and commercial obligations has decreased capital otherwise
available to satisfy the Company's debt service, debt maturities and other
obligations.
In response to these events, on June 24, 2002 Dynegy Inc. announced a $2
billion capital plan designed to enhance liquidity and reduce debt. Pursuant to
this capital plan, Dynegy negotiated the elimination of $301 million in credit
ratings triggers relating to its financings and completed several interim
financings. On July 28, 2002, Dynegy entered into an agreement to sell Northern
Natural Gas Company ("Northern Natural") to MidAmerican Energy Holdings Company
("MidAmerican") for $928 million in cash, subject to adjustment for working
capital changes.
The closing of the Northern Natural sale and the execution of the remaining
elements of the Company's capital plan are expected to provide sufficient
near-term liquidity for the Company. The Northern Natural sale is expected to
close in August 2002 and is subject to customary closing conditions, including
expiration of the Hart-Scott-Rodino waiting period, and the continuation of
certain transition services to Northern Natural. The remaining elements of the
capital plan are subject to a number of risks including factors beyond the
Company's control. These factors include, among others, market conditions for
asset sales, the timeliness and ability to obtain required regulatory
approvals, ongoing investigations and litigation, and the effect of commodity
prices and continued contraction in the markets in which the Company operates,
which may negatively impact its operating cash flow. The Company also must seek
to rationalize its customer and risk-management business either through the
formation of a joint venture or an alternative strategy that would reduce
Dynegy's capital commitments to this business.
As is discussed in greater detail in "Management's Discussion and Analysis
of Financial Condition and Results of Operations," the Company's liquidity will
be improved by the closing of the Northern Natural sale. Dynegy has no
significant maturities prior to April 2003 and believes that its current
liquidity will be sufficient to meet the collateral requirements of its
business through the expected closing of the Northern Natural sale. However, a
delay in the closing of the Northern Natural sale or other adverse developments
affecting the Company's liquidity could materially adversely affect Dynegy's
financial condition. If Dynegy is unable to
9
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
complete the Northern Natural sale in the near term or other elements of its
strategy prior to the second quarter 2003, it may be forced to consider other
strategic alternatives or a possible reorganization under the protection of
bankruptcy laws.
The accompanying unaudited condensed consolidated financial statements have
been prepared assuming that the Company will continue as a going concern. This
basis of accounting contemplates the recovery of the Company's assets and the
satisfaction of its liabilities in the normal course of conducting business,
which in turn is dependent upon the Company's ability to consummate the
Northern Natural sale and successfully execute its capital plan as well as the
performance of the Company's operations for the foreseeable future. Management
believes that actions presently being taken relative to the Company's capital
plan and other strategic alternatives should enable the Company to meet its
obligations in a manner consistent with this accounting treatment.
Note 4--Changes in Accounting Principles
In July 2001, the FASB issued Statement of Financial Accounting Standards
No. 142, "Goodwill and Other Intangible Assets" ("Statement No. 142").
Statement No. 142 discontinues goodwill amortization over its estimated useful
life and provides that goodwill is subject to at least an annual fair-value
based impairment test. The Company adopted Statement No. 142 effective January
1, 2002. The changes in the carrying amount of goodwill for each of Dynegy's
reportable business segments for the six-month period ended June 30, 2002 are
as follows (in millions):
Wholesale Dynegy Transmission
Energy Midstream &
Network Services Distribution Total
--------- --------- ------------ ------
Balances as of January 1, 2002..................... $733 $16 $ -- $ 749
Cumulative effect of change in accounting principle -- -- -- --
Goodwill acquired during the period................ -- -- 887 887
Purchase price adjustments......................... (7) -- (28) (35)
---- --- ---- ------
Balances as of June 30, 2002....................... $726 $16 $859 $1,601
==== === ==== ======
Goodwill acquired during the period relates to the acquisition of Northern
Natural, the previously announced sale of which is further described in Note 6
below. The purchase price adjustments relate to the United Kingdom natural gas
storage assets purchased in late 2001 and to the acquisition of Northern
Natural in early 2002.
The following table sets forth what Dynegy's net income would have been in
the three- and six-month periods ended June 30, 2001, if goodwill had not been
amortized during those periods, compared to the net income (loss) Dynegy
recorded for the three- and six-month periods ended June 30, 2002 (in millions).
Three Months Six Months
Ended Ended
----------- ---------
2002 2001 2002 2001
----- ---- ---- ----
Reported net income (loss)..... $(135) $159 $27 $285
Add back: Goodwill amortization -- 3 -- 6
----- ---- --- ----
Adjusted net income (loss)..... $(135) $162 $27 $291
===== ==== === ====
10
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
In August 2001, the FASB issued Statement of Financial Accounting Standards
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
("Statement No. 144"). Statement No. 144 addresses the accounting and reporting
for the impairment or disposal of long-lived assets and supersedes FASB
Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of" and APB Opinion No. 30, "Reporting the
Results of Operations--Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions." The Company's adoption of Statement No. 144 on January 1, 2002
did not have any impact on its financial position, results of operations or
cash flows.
Accounting Principles Not Yet Adopted. FASB Statement No. 143. Also during
2001, the FASB issued Statement of Financial Accounting Standards No. 143,
"Accounting for Asset Retirement Obligations" ("Statement No. 143"). Statement
No. 143 requires that the fair value of a liability for an asset retirement
obligation be recognized in the period in which it is incurred with the
associated asset retirement costs being capitalized as a part of the carrying
amount of the long-lived asset. The Company is evaluating the future financial
effects of adopting Statement No. 143 and will adopt the standard effective
January 1, 2003.
FASB Statement No. 145. In April 2002, the FASB issued Statement of
Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4,
44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections"
("Statement No. 145"). The adoption of Statement No. 145 effective January 1,
2003 is not expected to impact the Company.
FASB Statement No. 146. In July 2002, the FASB issued Statement of
Financial Accounting Standards No. 146, "Accounting for Exit or Disposal
Activities" ("Statement No. 146"). Statement No. 146 addresses issues regarding
the recognition, measurement and reporting of costs that are associated with
exit and disposal activities, including restructuring activities that are
currently accounted for pursuant to the guidance that the Emerging Issues Task
Force ("EITF" or the "Task Force") has set forth in EITF Issue No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)." The scope of Statement No. 146 also includes (1) costs related
to terminating a contract that is not a capital lease and (2) termination
benefits that employees who are involuntarily terminated receive under the
terms of a one-time benefit arrangement that is not an ongoing benefit
arrangement or an individual deferred compensation contract. Statement No. 146
will be effective for exit or disposal activities that are initiated after
December 31, 2002, although early adoption of the standard is allowed. If the
Company had adopted Statement No. 146 early, it would not have affected the
Company's accounting for restructuring activities which occurred in the second
quarter 2002.
EITF Issue 02-3. In June 2002, the EITF reached consensus on two of three
issues presented in EITF Issue 02-3, "Accounting for Contracts Involved in
Energy Trading and Risk Management Activities" ("EITF Issue 02-3"). First, the
Task Force concluded that all mark-to-market gains and losses on energy trading
contracts (whether realized or unrealized) should be shown net in the income
statement, irrespective of whether the contract is physically or financially
settled. In addition, the Task Force concluded that an entity should disclose
the gross transaction volumes for those energy trading contracts that are
physically settled. Beginning in the third quarter 2002, Dynegy will present
all mark-to-market gains and losses on a net basis and will expand its
volumetric disclosures to comply with the consensus. Additionally, in
accordance with the transition provisions in the consensus, comparative
financial statements will be conformed to meet the requirements mandated by the
Task Force. This change in accounting classification will have no impact on
operating income, net income, earnings per share or cash flow from operations.
11
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
The second consensus reached by the Task Force related to required
disclosures regarding energy trading operations. The Task Force agreed to
clarify the application of APB Opinion No. 22, "Disclosure of Accounting
Policies" and SOP 94-6, "Disclosure of Significant Risks and Uncertainties" to
an entity's energy trading operations by requiring that entities disclose the
applicability of EITF Issue 98-10, "Accounting for Contracts Involved in Energy
Trading and Risk Management Activities," the types of contracts that are
accounted for as energy trading contracts, a description of the methods and
significant assumptions used to estimate the fair value of various classes of
energy trading contracts and the sensitivity of its estimates to changes in the
near term. The Task Force indicated that additional disclosure regarding the
fair value of contracts, aggregated by source or method of estimating fair
value and by maturity date, would also be meaningful. The Company will assess
its disclosures with respect to these matters.
The third issue addressed by the Task Force in EITF Issue 02-3 deals with
the recognition of unrealized gains and losses at inception of an energy
trading contract (commonly referred to as dealer profit). The Task Force
reached no consensus on this issue, and the issue was assigned to a working
group for resolution by the end of 2002. It is not possible to predict how the
working group will resolve issues related to the recognition of dealer profit.
Further, it is unclear how the working group will address the accounting
transition resulting from adoption of new guidance. Three transition
alternatives exist in practice. These transition alternatives include: (a) a
retroactive restatement to eliminate dealer profit recognized in previous
periods; (b) a cumulative effect adjustment for a change in accounting
principle, which eliminates the recognition of previous periods' dealer profit
in the current period; or, (c) as a prospective change, eliminating the
recognition of dealer profit on future transactions but leaving past
transactions unaffected.
Finally, it is unclear whether the scope of the working group's activities
will include a comprehensive conclusion regarding the appropriateness of the
use of models as a fundamental method for valuing transactions when market
quotations are unavailable. Should the Task Force issue definitive guidance on
any one or all of these issues, it will impact Dynegy. However, the extent of
the financial impact to Dynegy, if any, cannot be predicted with any degree of
certainty until the scope of the Task Force's conclusion is known and the
transition alternative is determined. If the Task Force prefers a retroactive
or a cumulative effect transition alternative, then Dynegy's historical
financial position and results of operations will be impacted negatively. If
the Task Force prefers a prospective transition alternative, then Dynegy's
current financial position will be unaffected and the impact to future
operations in the near term is not expected to be material (largely as a result
of a reduction in these types of transactions in the marketplace).
Note 5-- Restructuring and Impairment Charges
During the second quarter 2002, the Company recognized a $194 million
pre-tax ($126 million after-tax) charge principally related to the impairment,
write-off or obsolescence of certain assets and an accrual for severance
related to a corporate restructuring. The charge primarily relates to the
impairment of certain investments in securities of entities engaged in
technology-related ventures, a write-off of net assets related principally to
the Company's gas marketing business and a severance charge related to a plan
of restructuring of the Company's operations. The pre-tax charge, which was
substantially non-cash in nature, consisted of the following (in millions):
Impairment of technology investments $ 26
Gas marketing charge................ 124
Severance charge.................... 32
Write-off of other obsolete assets.. 12
----
$194
====
12
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
At June 30, 2002, the valuations of certain technology investments were
assessed as a result of industry and other factors . These investments were
originally entered into in order to leverage existing commercial relationships
or as a means of expanding new relationships. Historically, the Company viewed
these investments as strategic and core to Dynegy Inc.'s technology strategy.
These investments include ownership in public and private companies and
investment funds focused in the technology sector. Accordingly, Dynegy expected
to hold these investments for the long-term and viewed trends in the sector as
cyclical. The continued downturn in the technology sector during the second
quarter 2002 combined with Dynegy Inc.'s decision to pursue a managed exit from
its telecommunications business resulted in a decision to recognize an
impairment charge relative to these investments. After recognition of the
impairment, values for these investments represent expected realizable value at
June 30, 2002. The $26 million pre-tax ($17 million after-tax) charge was
recorded in Earnings of Unconsolidated Affiliates in the accompanying Condensed
Consolidated Statements of Operations for the three and six months ended June
30, 2002.
The non-cash gas marketing charge is the result of a balance sheet review
and reconciliation process started early in 2002. Management believes the
charge is largely associated with the process of reconciling accrued to actual
results principally in its natural gas marketing business and that it
accumulated over a number of years. Accrual accounting for natural gas
marketing involves the estimation of gas volumes bought, sold, transported and
stored, as well as the subsequent reconciliation from estimated to actual
volumes. The $124 million pre-tax ($80 million after-tax) charge was recorded
in Other Income and Other Expenses in the accompanying Condensed Consolidated
Statements of Operations for the three- and six-month periods ended June 30,
2002. Please read Note 1 above for additional information regarding the
previously announced re-audit of Dynegy's 1999-2001 financial statements.
The Company recognized a pre-tax charge of approximately $32 million ($21
million after-tax) for severance benefits for approximately 309 employees who
were from various segments and included all staffing levels, including the
Company's former Chief Executive Officer and Chief Financial Officer. The
charge is included in Impairment and Other Charges in the accompanying
Condensed Consolidated Statements of Operations. No severance amounts were paid
as of June 30, 2002, thus the entire amount is included within Accrued
Liabilities and Other in the accompanying June 30, 2002 Condensed Consolidated
Balance Sheet.
The remaining pre-tax non-cash charge of $12 million ($8 million after-tax)
relates to the retirement of partially depreciated information technology
equipment and software replaced during the quarter with new system applications
and arrangements as well as miscellaneous deposits that are not expected to
provide future value. The charge was recorded in Other Expenses in the
accompanying Condensed Consolidated Statements of Operations for the three and
six months ended June 30, 2002.
During the three months ended March 31, 2002, the Company incurred an $18
million pre-tax ($13 million after-tax charge associated with a commitment to
deliver gas assumed in the acquisition of Northern Natural. The pre-tax charge
is included in the accompanying Condensed Consolidated Statement of Operations
for the six months ended June 30, 2002.
Note 6--Business Combinations and Other Acquisitions
In November 2001, Dynegy Inc. acquired 1,000 shares of Series A Preferred
Stock ("Series A Preferred Stock") in Northern Natural for $1.5 billion. In
connection with the investment, Dynegy acquired an option to purchase all of
the equity of Northern Natural's indirect parent company. Dynegy exercised its
option to acquire the indirect parent of Northern Natural in November 2001 upon
termination of Dynegy's merger agreement with
13
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Enron Corp. ("Enron"), and the closing of the option exercise occurred on
January 31, 2002. Enron retained an option to reacquire Northern Natural, which
expired unexercised on July 1, 2002.
On July 28, 2002, Dynegy executed an agreement to sell Northern Natural to
MidAmerican for $928 million in cash, subject to adjustment for working capital
changes. Under the terms of this agreement, MidAmerican is expected to acquire
all of the common and preferred stock of Northern Natural and to assume all of
Northern Natural's $950 million of debt with a fair value of approximately $890
million. The transaction is expected to close in August 2002 and is subject to
customary closing conditions, including Hart-Scott-Rodino approval. No
assurance can be given as to the timing of such approval or the consummation,
if at all, of the transaction. Because Dynegy paid approximately $1.5 billion
for Northern Natural, Dynegy expects to incur a significant loss associated
with the sale.
Northern Natural was consolidated with Dynegy's operations beginning
February 1, 2002. The following table reflects certain unaudited pro forma
information for Dynegy for the periods presented as if Dynegy's acquisition of
Northern Natural had taken place on January 1, 2001 (in millions, except per
share data).
Three Months Six Months Ended
Ended June 30, June 30,
--------------- ---------------
2002 2001 2002 2001
------ ------- ------- -------
Pro forma revenues................................................. $9,695 $10,778 $18,127 $23,561
Pro forma income (loss) from operations before change in accounting
principle (Notes 4 and 7)........................................ (135) 176 58 348
Pro forma net income (loss)........................................ (135) 176 58 350
Note 7--Commercial Operations, Risk Management Activities and Financial
Instruments
Provisions in Statement No. 133, as amended, affect the accounting and
disclosure of certain contractual arrangements and operations of the Company.
Under Statement No. 133, as amended, all derivative instruments are recognized
in the balance sheet at their fair values and changes in fair value are
recognized immediately in earnings, unless the derivatives (which are not a
part of the Company's marketing activities) qualify and are designated as
hedges of future cash flows, fair values or net investments or qualify, and are
designated, as normal purchases and sales. Derivatives treated as normal
purchases or sales are recorded and recognized in income using accrual
accounting.
The nature of the Company's business necessarily involves certain market and
financial risks. The Company routinely enters into financial instrument
contracts in an attempt to mitigate or eliminate these various risks. These
risks and the Company's strategy for mitigating these risks are more fully
described in Note 3 to the Form 10-K.
Changes in stockholders' equity related to derivatives for the six-month
period ended June 30, 2002 were as follows, net of tax (in millions):
Balance at December 31, 2001............. $ 12
Current period changes in fair value, net (3)
Reclassifications to earnings, net....... (27)
----
Balance at June 30, 2002................. $(18)
====
14
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Accumulated other comprehensive income, net of tax is included in
Stockholders' Equity on the Condensed Consolidated Balance Sheets as follows
(in millions):
Statement No. 133, net.............................................. $(18)
Currency translation adjustment..................................... 20
Unrealized loss on available-for-sale securities, net............... --
----
Accumulated other comprehensive income, net of tax, at June 30, 2002 $ 2
====
Other comprehensive income is as follows (in millions):
Six Months
Ended
June 30,
---------
2002 2001
---- ----
Net income................ $27 $285
Other comprehensive income -- 29
--- ----
Total comprehensive income $27 $314
=== ====
Additional disclosures required by Statement No. 133, as amended, are
provided in the following paragraphs.
Effective January 1, 2001, the Company adopted Statement of Financial
Accounting Standards No. 133, "Accounting for Derivative Instruments and
Hedging Activities," as amended, realizing an after-tax cumulative effect gain
of approximately $2 million.
The Company enters into various financial derivative instruments which
qualify as cash flow hedges. For derivatives treated as hedges of future cash
flows, the effective portion of changes in fair value is recorded in other
comprehensive income until the related hedged items impact earnings. Any
ineffective portion of a hedge is reported in earnings immediately. Instruments
related to the Company's customer and risk-management and midstream liquids
businesses are entered into for purposes of hedging forward fuel requirements
for certain power generation facilities, locking in future margin in the
domestic midstream liquids business and hedging price risk in the global
liquids business. Interest rate swaps are used to convert the floating interest
rate component of certain obligations to fixed rates.
Dynegy recognized a charge of less than $1 million relating to hedge
ineffectiveness, during the six months ended June 30, 2002, and no amounts were
excluded from the assessment of hedge effectiveness related to the hedge of
future cash flows. Additionally, no amounts were reclassified to earnings in
connection with forecasted transactions that were no longer considered probable
of occurring.
The balance in other comprehensive income at June 30, 2002 associated with
these cash flow hedges is expected to be reclassified to future earnings,
contemporaneously with the related purchases of fuel, sales of electricity or
liquids, payments of interest and recognition of operating lease expense, as
applicable to each type of hedge. Of this amount, approximately $13 million
loss, net of taxes, is estimated to be reclassed into earnings over the
12-month period ending June 30, 2003. Actual amounts ultimately reclassed to
earnings over the next 12 months could vary materially from this estimated
amount as a result of changes in market conditions.
15
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
The Company also enters into derivative instruments which qualify as fair
value hedges. For derivatives treated as fair value hedges, changes in the fair
value of the derivative and changes in the fair value of the related asset or
liability are recorded in current period earnings. The Company uses interest
rate swaps to convert a portion of its fixed-rate debt into variable-rate debt.
During the six months ended June 30, 2002 and 2001, there was no
ineffectiveness from changes in fair value of hedge positions, and no amounts
were excluded from the assessment of hedge effectiveness. Additionally, no
amounts were recognized in relation to firm commitments that no longer
qualified as fair value hedge items.
The Company has investments in foreign subsidiaries, and the net assets of
these subsidiaries are exposed to currency exchange-rate volatility. The
Company uses derivative financial instruments, including foreign exchange
forward contracts and cross currency interest rate swaps, to hedge this
exposure. For derivatives treated as hedges of net investments in foreign
operations, the effective portion of changes in the fair value of the
derivative is recorded in the cumulative translation adjustment. For the six
months ended June 30, 2002, approximately $42 million of net losses related to
these contracts were included in the cumulative translation adjustment. During
the six months ended June 30, 2002, ineffectiveness from changes in fair value
of net investment hedge positions was immaterial. There were no net investment
hedges for the six months ended June 30, 2001.
As part of the re-audit process (see Note 1), Dynegy expects the criteria
for and interpretation of hedge accounting under Statement No. 133 to be one of
the issues addressed. During the six-quarter period ended June 30, 2002, Dynegy
accounted for certain derivative transactions as hedges of its generation
facilities. If Dynegy's accounting treatment relating to Statement No. 133 were
to change as a result of the re-audit, the income recognized over the six
quarters may be re-allocated within the period. Cash flow for the six-quarter
period would remain unaffected by any change in the timing of income statement
recognition.
Note 8--Capital Leases
In response to the initiatives currently underway at the FASB, on June 28,
2002 the Company unilaterally undertook actions, the effect of which altered
the accounting for some of its existing lease obligations and anticipated lease
obligations relating to assets under construction. These actions included the
delivery of guarantees of lessor debt in certain existing leases of power
generation facilities. In addition, the Company notified certain lenders of its
intent to purchase power generation facilities that are currently under
construction and that were expected to be placed in synthetic leases upon
completion of their construction. As a result of these actions, approximately
$528 million of obligations due in 2005 to 2007 were brought on-balance sheet.
This non-cash action resulted in an increase to Property, Plant and Equipment
and a corresponding increase in Long-Term Debt on the Company's June 30, 2002
Condensed Consolidated Balance Sheet. These obligations were previously
reported as lease obligations in the footnotes to the Company's financial
statements and in the Commercial Financial Obligations and Contingent Financial
Commitments tables in the Form 10-K. In addition, actions taken by the Company
relating to assets under construction required the reclassification of
approximately $673 million from Prepayments and Other Assets to Property, Plant
and Equipment on the Company's June 30, 2002 Condensed Consolidated Balance
Sheet. Property under capital leases of $528 million is included in Property,
Plant and Equipment and is amortized over the useful life of the asset, which
approximates 40 years.
16
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
The following is a schedule of future minimum lease payments under capital
leases together with the present value of the net minimum lease payments as of
June 30, 2002 (in millions):
Six months ending December 31, 2002........ $ 6
Year ending December 31:
2003.................................... 13
2004.................................... 13
2005.................................... 176
2006.................................... 186
2007.................................... 185
----
Total minimum lease payments............... 579
Lease: Amount representing interest........ (51)
----
Present value of net minimum lease payments $528
====
Note 9--Debt
As of August 12, 2002, the Company's debt maturities through December 31,
2003, inclusive of letters of credit issued under revolving credit facilities,
were as follows: remainder of third quarter 2002--zero; fourth quarter
2002--$59 million (not including a $450 million secured line of credit at
Northern Natural that will be assumed by MidAmerican in the sale of Northern
Natural, as further described in Note 6 above); first quarter 2003--$219
million; second quarter 2003--$1,534 million; third quarter 2003--$22 million;
and fourth quarter 2003--$22 million. Please read "Management's Discussion and
Analysis of Financial Condition and Results of Operations-- Liquidity and
Capital Resources" for a discussion of the Company's current liquidity and
capital plans.
In July 2002, the Company completed a $200 million interim financing,
bearing interest at LIBOR plus 1.38 percent. This loan matures in January 2003
and is secured by interests in Dynegy's Renaissance and Rolling Hills merchant
power generation facilities.
In June 2002, the Company completed a $250 million interim financing,
bearing interest at LIBOR plus 1.75 percent. This loan matures in June 2003 and
represents an advance on a portion of the proceeds from the expected sale of
certain of the Company's United Kingdom natural gas storage facilities.
Dynegy completed an amendment to the Catlin Associates, LLC minority
interest transaction (also referred to as "Black Thunder") in June 2002, which
permanently removed a $270 million obligation which could have been triggered
by declines in Dynegy's credit ratings. The amended agreement requires a
subsidiary of Dynegy to amortize $275 million over the remaining three years of
the transaction. The subsidiary has already paid approximately $73 million of
the amortization. Quarterly maturities are approximately $20 million through
the first quarter 2005. In addition, Dynegy agreed to grant mortgages on the
midwest generation assets covered by the transaction, post a letter of credit
to secure a contingent obligation expiring December 31, 2002 and make certain
structural changes to enhance the security of the third-party lenders involved
in the transaction. As a result of this amendment, $796 million related to
Catlin Associates, LLC was reclassified from Minority Interest to debt on
Dynegy's Condensed Consolidated Balance Sheets at June 30, 2002.
17
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Also in June 2002, West Coast Power, LLC ("West Coast Power"), a joint
venture owned equally by Dynegy and NRG Energy with generation assets in
California, repaid a non-recourse project financing with cash on hand within
the joint venture entity. This payment eliminated a $31 million obligation
triggered by declines in Dynegy's credit ratings. Concurrent with the
retirement of the project financing, West Coast Power entered into an amended
$120 million bank facility consisting of a $100 million letter of credit
facility that will be used to collateralize West Coast Power's obligations, a
$10 million term loan and a $10 million working capital facility. The facility
has resulted in the release of approximately $100 million in letters of credit
previously posted by Dynegy on behalf of West Coast Power.
Dynegy incurred upfront fees aggregating approximately $19 million in
connection with the interim financings, Black Thunder amendment and West Coast
Power transactions described above. Such amounts are capitalized and amortized
over the terms of the respective financing transactions.
On April 29, 2002, Dynegy closed a $900 million unsecured revolving credit
agreement with a syndicate of commercial banks. This facility, which matures on
April 28, 2003, replaced an expiring $1.2 billion revolving credit agreement.
The new facility provides funding for working capital, capital expenditures and
general corporate purposes. Generally, borrowings under the credit agreement
bear interest at a Eurodollar rate plus a margin that is determined based on
designated unsecured debt ratings. Facility fees are payable on the full amount
of the facility and are determined based on designated unsecured debt ratings.
Dynegy will incur higher interest costs and fees associated with the new
facility as compared to those incurred under the expired facility.
Specifically, assuming that all amounts were outstanding under this facility,
Dynegy would pay approximately $10 million in additional interest expense on
the new facility compared to what it would have paid under the expired
facility. Additionally, as compared to similar fees paid by the Company under
the expired facility, Dynegy expects to pay approximately $2 million in
additional facility fees during the term of the new facility and paid
approximately $3 million in additional upfront fees.
Financial covenants under the new revolver include a debt-to-capitalization
test (which takes into account certain lease and similar commitments of Dynegy
and its subsidiaries) and newly added 3.5 times earnings before interest, taxes
and depreciation and amortization ("EBITDA")-to-interest test. The permissible
threshold for the debt-to-capitalization test was lowered in the new facility
from 65% to 60%. Other newly added covenants in the facility include
subordination of certain intercompany debt owed to Dynegy Inc. and its
subsidiaries (other than Dynegy and its subsidiaries), restrictions on liens
and limitations prohibiting subsidiary debt at Dynegy Marketing & Trade, Dynegy
Power Marketing, Inc. and Dynegy Midstream Services, Limited Partnership.
Default provisions include cross payment default of Dynegy Inc., Dynegy or any
principal subsidiary with respect to debt or other similar obligations that
exceed $100 million, cross acceleration of Dynegy Inc., Dynegy or any principal
subsidiary under any instrument covering debt or similar obligations that
exceed $100 million and bankruptcy or receivership of Dynegy Inc., Dynegy or
any principal subsidiary. The new facility does not contain any defaults
relating to material adverse changes in the condition of Dynegy Inc. or Dynegy
after the closing date or to changes in Dynegy Inc.'s or Dynegy's credit
ratings. The new facility also does not contain a "term-out" provision that
would permit Dynegy to extend the maturity for borrowings under the facility
beyond the facility's April 28, 2003 maturity date. As such, the amounts
outstanding under this facility are classified as current. Management currently
believes Dynegy is in compliance with the covenants contained in this agreement.
On February 21, 2002, Dynegy issued $500 million of 8.75% senior notes due
2012. Interest on the notes is due on February 15 and August 15 of each year,
beginning August 15, 2002. The notes are unsecured and are not
18
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
subject to a sinking fund. Dynegy may redeem the notes prior to maturity, in
whole or in part, at a redemption price equal to the greater of the principal
amount of the notes and the make-whole price specified in the indenture
relating to the notes.
On January 31, 2002, the Company acquired debt with a face value of
approximately $950 million (and a fair value of approximately $890 million)
through the acquisition of Northern Natural. Approximately $500 million of the
Northern Natural debt consists of senior unsecured notes with maturities
ranging from 2005 to 2011. The remaining $450 million consists of a secured
line of credit that matures in November 2002. See Note 6 for discussion of
Dynegy's previously announced sale of Northern Natural. In the event the
Company cannot consummate the sale of Northern Natural, management believes,
based on an internal analysis of Northern Natural's credit capacity, including
a review of other regulated pipelines, that Northern Natural will be able to
refinance the $450 million secured line of credit, and it is Northern Natural's
management's current intention to do so. On April 26, 2002, Dynegy purchased
$90 million of Northern Natural's senior unsecured notes due 2005 pursuant to a
tender offer. The Company is currently considering alternatives relating to the
sale of these notes.
During the six-month period ended June 30, 2002, the Company repaid
commercial paper borrowings and revolving credit facilities of approximately
$255 million. Additionally, during the six months ended June 30, 2002, Dynegy
issued an aggregate of $193 million of letters of credit under its revolving
credit facilities. During the period from June 30, 2002 through August 12,
2002, Dynegy paid at maturity $200 million in senior notes, borrowed $53
million and issued an aggregate $289 million of letters of credit under the
revolving credit facilities.
Note 10--Investments in Unconsolidated Affiliates
Investments in affiliates that are not controlled by the Company but where
the Company has significant influence over operations are accounted for by the
equity method. The Company's share of net income from these affiliates is
reflected in the Condensed Consolidated Statements of Operations as Earnings
from Unconsolidated Investments. The Company's principal equity method
investments consist of entities that operate generation assets and natural gas
liquids assets. These equity investments totaled $778 million and $768 million
at June 30, 2002 and December 31, 2001, respectively. The Company entered into
these ventures principally for the purpose of sharing risk and leveraging
existing commercial relationships. These ventures maintain independent capital
structures and have financed their operations on a non-recourse basis to the
Company.
Generation Assets. These investments primarily include ownership interests
in eight joint ventures that own fossil fuel electric generation facilities in
diverse geographic regions as well as a limited number of international
ventures. The Company's ownership is generally 50 percent in the majority of
these ventures. The Company's aggregate net investment of $644 million at June
30, 2002 represents approximately 2,400 MW of net generating capacity. Dynegy's
most significant investment in generating capacity is its interest in West
Coast Power, representing approximately 1,400 MW of net generating capacity in
California. The net investment in West Coast Power totaled approximately $348
million at June 30, 2002. West Coast Power provided equity earnings of
approximately $37 million and $70 million for the six months ended June 30,
2002 and 2001, respectively.
Midstream Investments. These investments primarily include ownership
interests in three ventures that operate natural gas liquids ("NGL")
processing, extraction, fractionation and storage facilities in the Gulf Coast
region as well as an interstate NGL pipeline. The Company's ownership interest
in these ventures ranges from 23 percent to 39 percent. At June 30, 2002, the
Company's aggregate net investment in these midstream businesses totaled
approximately $134 million.
19
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Summarized aggregate financial information for these generation and
midstream investments and Dynegy's equity share thereof was (in millions):
Six Months Ended June 30,
---------------------------
2002 2001
------------- -------------
Equity Equity
Total Share Total Share
------ ------ ------ ------
Revenues........ $1,594 $662 $2,153 $891
====== ==== ====== ====
Operating margin $ 316 $123 $ 313 $139
====== ==== ====== ====
Net income...... $ 155 $ 57 $ 210 $ 88
====== ==== ====== ====
Other Investments. In addition to these equity investments, the Company
holds interests in non-public companies for which it does not have significant
influence over operations. These investments are generally accounted for by the
cost method. Such investments totaled $28 million and $32 million at June 30,
2002 and December 31, 2001, respectively. The change is primarily attributed to
the impairment of technology investments resulting from unfavorable market
conditions.
The Company also owns equity securities that have a readily determinable
fair market value and are considered available-for-sale. The market value of
these investments at June 30, 2002 and December 31, 2001 was determined to be
$12 million and $9 million, respectively.
Note 11--Commitments and Contingencies
Please see Note 11, "Commitments and Contingencies," in the Form 10-K and
Note 8, "Commitments and Contingencies," in the Company's Form 10-Q for the
quarter ended March 31, 2002 (the "Form 10-Q") for a description of the
Company's material legal proceedings. Set forth below is a description of any
material developments that have occurred with respect to such proceedings since
the Company's filing of the Form 10-Q for the first quarter 2002 and a
description of any new matters that have arisen during the quarter.
Baldwin Station Litigation. Illinois Power ("IP"), an indirect wholly owned
subsidiary of Dynegy Inc., and Dynegy Midwest Generation, Inc. (collectively,
the "Defendants") are currently the subject of a Notice of Violation ("NOV")
from the Environmental Protection Agency (the "EPA") and a complaint filed by
the EPA and the Department of Justice alleging violations of the Clean Air Act
(the "Act") and the regulations promulgated under the Act. Similar notices and
complaints have been filed against a number of other utilities. Both the NOV
and the complaint allege that certain equipment repairs, replacements and
maintenance activities at the Defendants' three Baldwin Station generating
units constituted "major modifications" under the Prevention of Significant
Deterioration and/or the New Source Performance Standards regulations. When
activities that meet the definition of "major modifications" occur and they are
not otherwise exempt, the Act and related regulations generally require that
generating facilities meet more stringent emissions standards, which may entail
the installation of potentially costly pollution control equipment. The
Defendants filed an answer denying all claims and asserting various specific
defenses and a trial date of February 11, 2003 has been set.
The Company believes that it has meritorious defenses to the EPA allegations
and will vigorously defend against these claims. The Company has undertaken
activities to significantly reduce emissions at the Baldwin Station since the
complaint was filed in 1999. In 2000, the Baldwin Station was converted from
high to low sulfur coal. This conversion resulted in sulfur dioxide emission
reductions of over 90% from 1999 levels.
20
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Furthermore, selective catalytic reduction equipment has been installed at two
of the three units at Baldwin Station resulting in significant emission
reductions of nitrogen oxides. However, the EPA may seek to require the
installation of the "best available control technology" (or the equivalent) at
the Baldwin Station. Independent experts hired by Dynegy estimate capital
expenditures of up to $380 million if the installation of best available
control technology is required. The EPA also has the authority to seek
penalties for the alleged violations in question at the rate of up to $27,500
per day for each violation. The Company has filed a motion for summary judgment
based on the five-year statute of limitations, which could affect the EPA's
ability to collect penalties.
None of the Defendants' other facilities are covered in the complaint and
NOV, but the EPA has officially requested information concerning activities at
the Defendants' Vermilion, Wood River, and Hennepin Plants as well as Dynegy
Northeast Generation's Danskammer and Roseton Plants. It is possible that the
EPA will eventually commence enforcement actions based on activities at those
plants as well.
On June 13, 2002, the EPA announced its intention to implement several
reforms to its regulations governing new source review. These reforms, if made,
would clarify the routine maintenance, repair and replacement exclusion,
provide more certainty in evaluating permit requirements and increase
operational flexibility for affected facilities.
California Market Litigation. Six class action lawsuits have been filed
against various Dynegy entities based on the events occurring in the California
power market. The complaints allege violations of California's Business and
Professions Code, Unfair Trade Practices Act and various other statutes. The
plaintiffs allege that the defendants, including the owners of in-state
generation and various power marketers, conspired to manipulate the California
wholesale power market to the detriment of California consumers. Included among
the acts forming the basis of the plaintiffs' claims are the alleged improper
sharing of generation outage data, improper withholding of generation capacity
and the manipulation of power market bid practices. The plaintiffs seek
unspecified treble damages.
All six lawsuits were consolidated before Judge Sammartino, Superior Court
Judge for the County of San Diego. Subsequent to the consolidation two
defendants filed cross complaints against a number of corporations and
governmental agencies that sold power in California's wholesale energy markets.
Four cross defendants removed the six cases to the United States District Court
for the Southern District of California (San Diego). Following removal, certain
cross defendants filed motions to dismiss the cross complaints, which motions
are currently pending. The original plaintiffs in the six consolidated
complaints have filed motions to remand the consolidated cases back to state
court, which motions are currently pending. The defendants in the six
consolidated cases have filed motions to dismiss the complaints based on the
filed rate doctrine and preemption defense, which motions are currently
pending. Federal Judge Whaley has decided that the Court will hear the motion
to remand and the cross defendants' motion to dismiss on September 19, 2002. If
the Court decides that it has jurisdiction over the claims, the defendants'
motion to dismiss will be heard as soon as possible after September 19th.
On March 11, 2002, the California Attorney General filed, on behalf of the
People of the State of California, complaints in San Francisco Superior Court
against several owners of power generation facilities, including subsidiaries
of West Coast Power. The complaints allege that since June 1998, these
generators sold power in the open market that should have been held in
emergency reserve for the State. In the aggregate, the complaints seek more
than $150 million in penalties, restitution and return of profits from the
generators. These lawsuits were subsequently removed to the United States
District Court for the Northern District of California. The California Attorney
General filed motions to remand the cases back to state court. By Order issued
on August 6, 2002,
21
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Judge Walker denied the motions to remand, thus keeping the cases in federal
court. The Company intends to vigorously defend against these claims.
In addition to the six consolidated lawsuits discussed above, eight new
putative class actions were filed on behalf of business and residential
electricity consumers, including consumers residing in the State of Washington.
The lawsuits were filed in various state courts in Northern California, and in
respect to the lawsuit on behalf of consumers in the State of Washington, in
the United States District Court for the Northern District of California. Named
as defendants are various generators and marketers, including Dynegy and
certain affiliates. The complaints allege unfair, unlawful and deceptive
practices in violation of the California Unfair Business Practices Act and seek
to enjoin illegal conduct, restitution and unspecified damages. While some of
the allegations in these lawsuits are similar to the allegations in the other
six lawsuits, these lawsuits include additional allegations based on events
occurring subsequent to the filing of the other six lawsuits. These additional
allegations include allegations similar to those made by the California
Attorney General in the March 11, 2002 lawsuit described above as well as
allegations that contracts between these generators and the California
Department of Water Resources (the "DWR") constitute unfair business practices
resulting from market manipulation. The lawsuits filed in state court have been
removed to federal courts in the Northern and Eastern Districts of California.
Certain defendants have filed a petition with the Judicial Panel For
Multidistrict Litigation seeking to consolidate the new cases with the six
cases consolidated in the United States District Court for the Southern
District of California. The Company intends to vigorously defend against these
claims.
On May 13, 2002, two California law firms filed suit in California State
Court against more than 20 energy generators, including those owned directly by
West Coast Power and indirectly by Dynegy. This suit principally alleges the
defendant generators, in connection with their execution of long-term power
supply contracts with the DWR, took advantage of a manipulated market to
overcharge for electricity. The suit, which was filed on behalf of California
taxpayers, seeks to halt enforcement of the existing DWR contracts to the
extent that the agreed prices are found to be unfair. The suit further seeks
damages in the amount of the alleged excess prices under the contracts. The
Company intends to vigorously defend against these claims.
Enron Litigation. As previously described, Dynegy Inc. and Dynegy were sued
on December 2, 2001 by Enron and Enron Transportation Services Co. in the
United States Bankruptcy Court for the Southern District of New York, Adversary
Proceeding No. 01-03626 (AJG). Enron claims that Dynegy materially breached the
Merger Agreement dated November 9, 2001 between Enron and Dynegy and related
entities by wrongfully terminating that Agreement on November 28, 2001. Enron
also claimed that Dynegy wrongfully exercised its option to take ownership of
Northern Natural under an Option Agreement dated November 9, 2001. Enron sought
damages in excess of $10 billion and declaratory relief against Dynegy for
breach of the Merger Agreement. Enron also sought unspecified damages against
Dynegy Inc. and Dynegy for breach of the Option Agreement. Dynegy filed an
answer on February 4, 2002, denying all material allegations. On April 12,
2002, the Bankruptcy Court granted Dynegy's motion to transfer venue in the
proceeding to the United States District Court for the Southern District of
Texas (Houston Division).
Dynegy also previously described a suit filed against Dynegy and DHI by Ann
C. Pearl and Joel Getzler in the United States District Court for the Southern
District of New York, Cause No. 01 CV 11652. Plaintiffs filed the lawsuit as a
purported class action on behalf of all persons or entities who owned common
stock of Enron Corp. as of November 28, 2001. A similar suit was filed by
Bernard D. Shapiro and Peter Strub in the 129th Judicial District Court for
Harris County, Texas, Cause No. 2002-00080. Plaintiffs in each case allege that
they are intended third party beneficiaries of the Merger Agreement dated
November 9, 2001 between Enron and Dynegy and related entities. Plaintiffs
claim that Dynegy materially breached the Merger Agreement by, inter
22
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
alia, wrongfully terminating that agreement. Plaintiffs also claim that Dynegy
breached the implied covenant of good faith and fair dealing. Plaintiffs seek
an award of damages and other relief. Enron moved for an order of the
Bankruptcy Court in the Southern District of New York, directing that the Pearl
and Shapiro plaintiffs be enjoined from prosecuting their actions and
immediately dismiss those actions. The Bankruptcy Court held that the claims
asserted by the Pearl and Shapiro plaintiffs were the exclusive property of the
Enron bankruptcy estate, and that the plaintiffs lacked standing to sue as
third party beneficiaries of the Merger Agreement. Accordingly, by an order
entered on April 19, 2002, the Bankruptcy Court granted Enron's motion,
enjoined the prosecution of both actions, and directed that they be dismissed.
The Pearl and Shapiro plaintiffs thereafter complied with that order, but filed
an appeal to the United States District Court for the Southern District of New
York, which remains pending.
Dynegy believes the allegations in Enron's claim against Dynegy and the
Pearl and Shapiro matters arising out of the terminated merger are without
merit and will vigorously defend against these claims. An adverse result in any
of these proceedings, however, could have a material adverse effect on the
Company's financial position or results of operations.
As previously described, as a result of Enron's bankruptcy filing, Dynegy
recognized in its fourth quarter 2001 financial results a pre-tax charge
related to the Company's net exposure for commercial transactions with Enron.
As of June 30, 2002, the Company's net exposure to Enron, inclusive of certain
liquidated damages and other amounts relating to the termination of the
transactions, was approximately $94 million and was calculated by setting off
approximately $220 million owed from various Dynegy entities to various Enron
entities against approximately $314 million owed from various Enron entities to
various Dynegy entities. The master netting agreement between Dynegy and Enron
as well as the valuation of the commercial transactions covered by the
agreement remain subject to negotiation between the parties and, if any
disputes cannot be resolved by the parties, to arbitration as called for by the
terms of the agreement. If the setoff rights were modified, either by agreement
or otherwise, the amount available for Dynegy entities to set off against sums
that might be due Enron entities could be reduced materially.
Shareholder Litigation. Since April 2002, a number of class action lawsuits
have been filed on behalf of purchasers of publicly traded securities of Dynegy
Inc. generally during the period between April 2001 and April 2002. These
lawsuits principally assert that Dynegy Inc. and certain of its executive
officers violated the federal securities laws in connection with Dynegy Inc.'s
accounting treatment and disclosure of Project Alpha. These lawsuits have been
consolidated in the United States District Court for the Southern District of
Texas. Under the Private Securities Litigation Reform Act of 1995, the court in
which the cases have been consolidated will appoint a lead plaintiff, and the
lead plaintiff will, in turn, select class counsel. Following that process, a
consolidated complaint will be filed which may differ materially from the
complaints presently on file. Dynegy Inc. intends to vigorously defend against
these lawsuits. It is not possible to predict with certainty whether Dynegy
Inc. will incur any liability or to estimate the damages, if any, that might be
incurred in connection with such lawsuits, but an adverse outcome could have a
material adverse effect on the Company's financial condition or results of
operations.
In addition, three derivative lawsuits have been filed in which the Company
is a nominal defendant. Two of these three lawsuits relate to Project Alpha and
the third relates to severance for the Company's former Chief Executive
Officer. All three lawsuits seek recovery on behalf of the Company from various
present and former officers and directors. These actions have only recently
been filed and the Company is currently analyzing them. The Company does not
expect to incur any material liability with respect to these derivative claims.
23
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Farnsworth Litigation. On August 2, 2002, Bradley Farnsworth filed a
lawsuit against Dynegy in Texas state district court claiming that he was
demoted and ultimately fired from the position of Controller for refusing to
participate in alleged accounting irregularities. Specifically, Mr. Farnsworth
alleges that certain present and former executive officers of the Company
requested that he shave forward price curves for natural gas in order to
improve the Company's results of operations for the third quarter 2000. Mr.
Farnsworth, who seeks actual and exemplary damages and other compensation, also
alleges that he is entitled to termination payments under his employment
agreement. Dynegy intends to vigorously defend against these claims. The
Company does not believe that any liability it might incur as a result of this
litigation would have a material adverse effect on its financial condition or
results of operations.
Roundtrip Transactions. On November 15, 2001, Dynegy executed two sets of
simultaneous buy and sale trades with CMS Energy Corp. In the first set of
trades, Dynegy purchased 5 million megawatts of power from CMS Energy for
delivery in December 2001 at $25.50 per megawatt hour; concurrently, CMS Energy
purchased from Dynegy the same amount of power at the same price per megawatt
hour for delivery during the same period. In the second set of trades, Dynegy
purchased 20 million megawatts of power from CMS Energy for delivery in the
period January-December 2002 at $34.00 per megawatt hour; concurrently, CMS
Energy purchased from Dynegy the same amount of power at the same price per
megawatt hour for delivery during the same period. Dynegy and CMS have
terminated the 2002 trades.
During the second quarter of 2002, the Company undertook a comprehensive
review of these CMS Energy trades and its trading operations generally. The
Company's review confirmed that the CMS Energy trades were consummated outside
the view of other trading parties and could not have impacted market prices.
The results of the CMS Energy trades were not included in the Company's
December 31, 2001 Consolidated Statement of Operations, and the volumes from
these trades were not included in the operating statistics for the Wholesale
Energy Network ("WEN") segment in the Form 10-K, nor were such results or
volumes included in the Company's first quarter Form 10-Q. In an April 30, 2002
press release, 2002 first quarter Revenues and 2002 first quarter Costs of
Sales each contained $236 million related to these trades. These amounts netted
to zero in the operating margin line, resulting in no net income effect from
the trades in that press release. The Company eliminated these amounts from
Revenues and Costs of Sales in its Form 10-Q for the first quarter and in this
report.
Based on the Company's review of its trading operations to date, Dynegy
believes that it has not executed any simultaneous buy and sell trades with
counterparties for the purpose of artificially increasing its trading volumes
or revenues.
SEC Investigation. The SEC has commenced an investigation into the facts
and circumstances surrounding Project Alpha and the roundtrip trades described
above. The Company has produced documents and witnesses for interviews in
connection with this investigation. The Company has assured the SEC that it
intends to cooperate fully with this investigation. Dynegy has been informed
that the staff of the SEC Division of Enforcement intends to allege that, among
other things, Dynegy's disclosures and reports relating to both Project Alpha
and the CMS Energy trades violate various antifraud and other provisions of the
federal securities laws. The Company cannot predict the ultimate outcome of
this matter.
CFTC Investigation. The U.S. Commodity Futures Trading Commission ("CFTC")
has commenced an investigation relating to, among other things, trading
activities on Dynegydirect, the Company's on-line trading platform, and any
roundtrip gas or power trades since January 2000, including all trades or
trading activities between Dynegy and CMS Energy in November 2001. The
investigation also relates to the Company's trading
24
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
activities in the California power market. The Company has produced documents
in connection with this investigation. The Company has assured the CFTC that it
intends to cooperate fully with this investigation. The Company cannot predict
the ultimate outcome of this matter.
FERC and Related Regulatory Investigations. On February 13, 2002, the FERC
initiated an investigation of possible manipulation of natural gas and power
prices in the western United States during the period from January 2001 through
the present. On May 8, 2002, in response to three memoranda (authored by
individuals employed by or previously employed by Enron) discovered by the FERC
allegedly containing evidence of market manipulation by Enron in California,
the FERC issued requests for information to all sellers in the California
Independent System Operator (the "ISO") and the California Power Exchange (the
"PX") markets during 2000 and 2001 seeking information with respect to whether
those sellers engaged in trading strategies described in the three Enron
memoranda.
Dynegy responded to these requests on May 22, 2002, and updated its
responses on July 30, 2002 at the conclusion of its due diligence. A California
State Senate committee subsequently issued similar requests, and Dynegy's
responses were consistent with those submitted to the FERC. Based on its
investigation to date, Dynegy believes that its trading practices are
consistent with applicable law and tariffs and will continue to cooperate fully
with these investigations. The California State Senate committee has not issued
its preliminary findings on its investigation, and Dynegy cannot predict with
certainty how such allegations will ultimately be resolved.
On August 13, 2002, the FERC issued a notice requesting comments on a
proposal made by the FERC staff to change the method for determining natural
gas prices for purposes of computing the market mitigation clearing price that
it intends to utilize in calculating refunds for sales of power in California
power markets during the period from October 2, 2000 to June 19, 2001. The
proposed adjustments generally would result in lower gas prices which in turn
would lower the market mitigation clearing price for power, potentially
increasing calculated refunds. However, the FERC staff proposal contains a
provision that provides generators with an "uplift" for gas costs purchased
from unaffiliated suppliers, which would allow generators to fully recover
their gas costs. It is not clear whether the FERC will adopt the staff's
recommendation or, if it does, that a retroactive application of the proposal
would be lawful. Dynegy is evaluating the staff's recommendation and is unable
to assess at this time the impact, if any, that this proposal may have on any
refunds which FERC may order from Dynegy or West Coast Power pursuant to the
FERC's investigation of the California power market for the period from October
2, 2000 to June 19, 2001.
On May 21, 2002, the FERC issued requests for information to all sellers of
wholesale electricity and/or ancillary services in the Western Systems
Coordinating Council ("WSCC") seeking information with respect to whether those
sellers engaged in "wash," "round trip" or "sale/buyback" transactions in the
WSCC during the years 2000-2001. Dynegy responded on May 31, 2002. On May 22,
2002, the FERC issued requests for information to all sellers of natural gas in
the WSCC or Texas seeking information with respect to whether those sellers
engaged in "wash," "round trip" or "sale/buyback" transactions in the WSCC or
Texas during the years 2000-2001. Dynegy responded on June 5, 2002. On August
12, 2002, Dynegy updated its May 31 and June 5 responses at the conclusion of
its due diligence. Requests for similar information with respect to electric
power trading activities in the Electric Reliability Council of Texas were
received from the Texas Public Utility Commission on June 12, 2002. Dynegy
responded to these requests on July 2, 2002.
Based on the investigation conducted in order to make these filings, Dynegy
believes that it has not executed any simultaneous buy and sell trades with
counterparties for the purpose of artificially increasing its trading volumes
or revenues in these markets.
25
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
In addition, on February 25, 2002 the California Public Utilities Commission
and the California Electricity Oversight Board filed complaints with the FERC
asking that it void or reform power supply contracts between the DWR and, among
others, West Coast Power. A rehearing order issued on July 23, 2002 affirmed
the underlying findings and conclusions related to West Coast Power's contract
with the DWR. The complaints allege that prices under the contracts exceed just
and reasonable prices permitted under the Federal Power Act. The FERC recently
set these complaints for evidentiary hearing. The hearing, however, is being
held in abeyance pending completion of settlement talks. While West Coast Power
continues in good faith negotiations with the State of California on reforming
the terms of its DWR contract, settlement ultimately may not be possible. If a
hearing on the contracts entered into by West Coast Power or others is
necessary, the first phase of the hearing will be limited to the question of
whether the California real-time market adversely affected the long-term
bilateral markets. While the Company believes the terms of its contracts are
just and reasonable and do not reflect alleged market manipulation, it cannot
predict the outcome of this matter.
U.S. Attorney Investigation. In May 2002, Dynegy received a subpoena from
the U.S. Attorney's office in Houston requesting documents relating to Project
Alpha, roundtrip trades with CMS Energy and the Catlin/Black Thunder
transaction. The Company is cooperating fully with the U.S. Attorney's office
in its investigation of these matters. The Company cannot predict the ultimate
outcome of this matter.
Note 12--Regulatory Issues
The Company is subject to regulation by various federal, state, local and
foreign agencies, including extensive rules and regulations governing
transportation, transmission and sale of energy commodities as well as the
discharge of materials into the environment or otherwise relating to
environmental protection. Compliance with these regulations requires general
and administrative, capital and operating expenditures including those related
to monitoring, pollution control equipment, emission fees and permitting at
various operating facilities and remediation obligations. In addition, the U.S.
Congress has before it a number of bills that could impact regulations or
impose new regulations applicable to Dynegy and its subsidiaries. The Company
cannot predict the outcome of these bills or other regulatory developments or
the effects that they might have on its business. For a more detailed
description of regulatory issues affecting the Company's business, please refer
to "Item 1. Business--Regulation" in the Form 10-K.
Note 13--Related Party Transactions
ChevronTexaco Commercial Arrangements. In March 2002, Dynegy and
ChevronTexaco executed agreements to expand their commercial relationships to
include substantially all of the natural gas and domestic mixed NGLs and NGL
products produced or controlled by the former Texaco. The expanded term
agreements extend through August 2006. This expanded relationship increased the
volume of natural gas Dynegy purchases from ChevronTexaco from approximately
1.7 Bcf/d to approximately 2.9 Bcf/d. Dynegy also provides supply and service
for in excess of 1.6 Bcf/d of natural gas for the combined ChevronTexaco
facilities and third-party term markets. In addition, the expanded contract
with ChevronTexaco includes substantially all of the U.S. NGL production of the
former Texaco.
Concurrent with the expanded commercial agreements, the two companies
executed a new security agreement designed to improve Dynegy's liquidity
position by reducing its reliance upon the financial markets for surety bonds
and letters of credit and to significantly reduce ChevronTexaco's open credit
exposure. The new security agreement involved the replacement of historic
credit support arrangements with a perfected security interest in a portion of
Dynegy's domestic natural gas receivables. Dynegy has the option to revert back
to historic credit support arrangements, which included the issuance of surety
bonds and/or letters of credit.
26
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
In July 2002, Dynegy and ChevronTexaco executed a 90-day amendment to their
security agreement. This amendment was designed to address the reduction in
activity in Dynegy's gas marketing business and the corresponding reduction in
Dynegy's gas marketing receivables relative to the required coverage ratio
contained in the security agreement. The amendment, which was executed in
conjunction with a six-month netting agreement between the parties that has
since been made permanent, reduced the required coverage ratio contained in the
security agreement.
In August 2002, in partial satisfaction of certain of its obligations to
ChevronTexaco under these agreements, Dynegy transferred to ChevronTexaco its
39.2% ownership interest in West Texas LPG Pipeline Limited Partnership
("WTLPS"), which is the owner of West Texas LPG Pipeline. ChevronTexaco was
already the owner of the largest interest in WTLPS and the operator of the
pipeline. The interest transferred to ChevronTexaco was valued at approximately
$45 million.
Also in August 2002, Dynegy and ChevronTexaco executed an agreement pursuant
to which the parties amended their gas purchase agreement, security agreement,
netting agreement and certain related agreements. Under this new agreement,
Dynegy agreed to accelerate payment to the month of delivery for a portion of
the natural gas it purchases from ChevronTexaco, with the amount of the earlier
payment generally being equal to 75 percent of the value of the prior month's
gas deliveries, after reduction pursuant to the netting agreement described
above. This payment arrangement will be effective upon the closing of the sale
of Northern Natural described in Note 6 above. The initial payment amount, upon
consummation of the Northern Natural sale, will be $187.5 million. The amount
of the payment could change materially as a result of changes in commodity
prices. If the Northern Natural sale does not close on or prior to August 30,
2002, then a special report concerning the security agreement coverage ratios
would be due by September 4, 2002. Dynegy's right to withdraw sums from the
designated account in which the proceeds from the gas receivables covered by
the security agreement in favor of ChevronTexaco are deposited would be
suspended pending receipt of that report, and that report demonstrating
compliance with the required coverage ratios. Management believes that absent
the agreed payment with proceeds from the Northern Natural sale, this special
report likely would require Dynegy to pay additional amounts in order to be in
compliance with the required ratios under the security agreement. The new
agreement also suspends ChevronTexaco's right to request special reports
concerning the security agreement coverage ratios as long as those payments are
made, and makes permanent the netting agreement and reduction in the coverage
ratios referred to above.
The obligation to make payments as described above will be suspended if
Dynegy or a successor to its gas and natural gas liquids customers and
risk-management business carries at least two of the following three credit
ratings: at least BBB+ by Standard & Poor's, at least Baa1 by Moody's and at
least BBB+ by Fitch.
Dan Dienstbier Contract for Services. Dynegy entered into a services
agreement with Daniel L. Dienstbier effective as of May 28, 2002, the date on
which Mr. Dienstbier assumed the position of interim Chief Executive Officer.
Mr. Dienstbier agreed to serve as Dynegy's interim Chief Executive Officer
until either Dynegy or Mr. Dienstbier terminate the arrangement on 30 days'
written notice. Pursuant to the terms of the agreement, Dynegy agreed to pay
Mr. Dienstbier $1 million per year, to be paid ratably once per month, in the
form of cash or Dynegy Class A common stock as the parties shall agree. Upon
termination of the agreement, Mr. Dienstbier is eligible to receive a bonus
payment and a Class A common stock grant, in each case at Dynegy's discretion.
The agreement contains customary indemnification, confidentiality and
non-compete provisions relating to Mr. Dienstbier's provision of services.
Preferred Stock. Dynegy Inc. owns the approximately $1.5 billion in
preferred stock on the accompanying Condensed Consolidated Balance Sheet. This
is preferred stock in Northern Natural. (See Note 6.)
27
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Note 14--Segment Information
Dynegy's operations are divided into three reportable segments: WEN, Dynegy
Midstream Services ("DMS") and Transmission and Distribution ("T&D"). WEN is
engaged in a broad array of businesses, including physical supply of and
risk-management activities around wholesale natural gas, power, coal and other
similar products. This segment is focused on optimizing the Company's and its
customers' global portfolio of energy assets and contracts, as well as direct
commercial and industrial sales and retail marketing alliances. DMS consists of
the Company's North American midstream gas processing and liquids marketing
businesses and worldwide natural gas liquids marketing and transportation
operations. Dynegy's T&D segment includes the operations of Northern Natural.
Northern Natural's 16,600 miles of pipeline extend from the Permian Basin in
Texas to the Upper Midwest, providing extensive access to major utilities and
industrial customers. Northern Natural's storage capacity is 59 billion cubic
feet ("Bcf") and its market area capacity is approximately 4.3 Bcf per day. As
reflected in Note 6, the Company is expecting to close the sale of Northern
Natural in August 2002. Dynegy accounts for intercompany transactions at
prevailing market rates. Unaudited operating segment information for the three-
and six-month periods ended June 30, 2002 and 2001 is presented below.
Dynegy's Segment Data for the Quarter Ended June 30, 2002
($ in millions)
WEN DMS T&D Eliminations Total
------- ------ ------ ------------ -------
Unaffiliated revenues:
Domestic........................................... $ 6,204 $ 778 $ 74 $ -- $ 7,056
Canadian........................................... 725 361 -- -- 1,086
European and other................................. 1,429 -- -- -- 1,429
------- ------ ------ ---- -------
8,358 1,139 74 -- 9,571
Affiliated Revenues................................... 124 -- -- -- 124
Intersegment revenues:
Domestic........................................... 50 41 5 (96) --
------- ------ ------ ---- -------
Total revenues................................. 8,532 1,180 79 (96) 9,695
Depreciation and amortization......................... (59) (24) (17) -- (100)
Impairment and other charges.......................... (25) (3) (4) -- (32)
Operating income (loss)............................... (19) 11 10 -- 2
Interest expense...................................... (27) (13) (16) -- (56)
Other expense, net.................................... (122) (13) (1) -- (136)
Earnings (losses) from unconsolidated investments..... (6) 6 -- -- --
Income tax benefit.................................... (50) (2) (3) -- (55)
Net loss.............................................. $ (124) $ (7) $ (4) $ -- $ (135)
Identifiable assets:..................................
Domestic........................................... $17,543 $1,971 $2,764 $ -- $22,278
Canadian........................................... 605 139 -- -- 744
European and other................................. 2,653 -- -- -- 2,653
Investments in unconsolidated affiliates.............. 672 146 -- -- 818
Capital expenditures and investments in unconsolidated
affiliates.......................................... (322) (22) (5) -- (349)
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
28
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Dynegy's Segment Data for the Quarter Ended June 30, 2001
($ in millions)
WEN DMS Eliminations Total
------- ------ ------------ -------
Unaffiliated revenues:
Domestic...................................................... $ 7,742 $ 580 $ -- $ 8,322
Canadian...................................................... 1,188 327 -- 1,515
European and other............................................ 715 -- -- 715
------- ------ ----- -------
9,645 907 -- 10,552
Affiliate Revenues............................................... 118 -- -- 118
Intersegment revenues:
Domestic...................................................... 38 68 (106) --
------- ------ ----- -------
Total revenues............................................ 9,801 975 (106) 10,670
------- ------ ----- -------
Depreciation and amortization.................................... (48) (20) -- (68)
Interest expense................................................. (20) (14) -- (34)
Other income (expense)........................................... 20 (6) -- 14
Earnings from unconsolidated investments......................... 56 5 -- 61
Income tax provision............................................. 65 7 -- 72
Net income....................................................... $ 149 $ 10 $ -- $ 159
Identifiable assets:
Domestic...................................................... $16,721 $1,898 $ -- $18,619
Canadian...................................................... 714 227 -- 941
European and other............................................ 506 -- -- 506
Investment in unconsolidated affiliates.......................... 620 161 -- 781
Capital expenditures and investments in unconsolidated affiliates (159) (25) -- (184)
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
29
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Dynegy's Segment Data for the Six Months Ended June 30, 2002
($ in millions)
WEN DMS T&D Eliminations Total
------- ------ ------ ------------ -------
Unaffiliated revenues:
Domestic........................................... $11,017 $1,674 $ 172 $ -- $12,863
Canadian........................................... 1,430 592 -- -- 2,022
European and other................................. 2,947 -- -- -- 2,947
------- ------ ------ ----- -------
15,394 2,266 172 -- 17,832
Affiliated revenues................................... 237 -- -- -- 237
Intersegment revenues:
Domestic........................................... 79 74 5 (158) --
------- ------ ------ ----- -------
Total revenues................................. 15,710 2,340 177 (158) 18,069
Depreciation and amortization......................... (108) (43) (28) -- (179)
Impairment and other charges.......................... (25) (3) (4) -- (32)
Operating income...................................... 149 42 66 -- 257
Interest expense...................................... (54) (23) (29) -- (106)
Other income (expense)................................ (130) (11) 1 -- (140)
Earnings from unconsolidated investments.............. 21 10 -- -- 31
Income tax provision.................................. (7) 7 15 -- 15
Net income (loss)..................................... $ (7) $ 11 $ 23 $ -- $ 27
Identifiable assets:
Domestic........................................... $17,543 $1,971 $2,764 $ -- $22,278
Canadian........................................... 605 139 -- -- 744
European and other................................. 2,653 -- -- -- 2,653
Investments in unconsolidated affiliates.............. 672 146 -- -- 818
Capital expenditures and investments in unconsolidated
affiliates.......................................... (415) (53) (9) -- (477)
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
30
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Dynegy's Segment Data for the Six Months Ended June 30, 2001
($ in millions)
WEN DMS Eliminations Total
------- ------ ------------ -------
Unaffiliated revenues:
Domestic...................................................... $14,651 $2,720 $ -- $17,371
Canadian...................................................... 3,275 681 -- 3,956
European and other............................................ 1,720 -- -- 1,720
------- ------ ----- -------
19,646 3,401 -- 23,047
Affiliate Revenues............................................... 231 -- -- 231
Intersegment revenues:
Domestic...................................................... 74 159 (233) --
------- ------ ----- -------
Total revenues............................................ 19,951 3,560 (233) 23,278
------- ------ ----- -------
Depreciation and amortization.................................... (92) (40) -- (132)
Operating income................................................. 329 84 -- 413
Interest expense................................................. (36) (27) -- (63)
Other expense.................................................... (11) (12) -- (23)
Earnings from unconsolidated investments......................... 84 6 -- 90
Income tax provision............................................. 115 19 -- 134
Income from operations........................................... 250 33 -- 283
Cumulative effect of change in accounting principle.............. 2 -- -- 2
Net income....................................................... $ 252 $ 33 $ -- $ 285
Identifiable assets:
Domestic...................................................... $16,721 $1,898 $ -- $18,619
Canadian...................................................... 714 227 -- 941
European and other............................................ 506 -- -- 506
Investments in unconsolidated affiliates......................... 620 161 -- 781
Capital expenditures and investments in unconsolidated affiliates (1,224) (58) -- (1,282)
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
31
DYNEGY HOLDINGS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended June 30, 2002 and 2001
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction with the
unaudited condensed consolidated financial statements of Dynegy Holdings Inc.
("Dynegy" or the "Company") included elsewhere herein and with the Company's
Annual Report on Form 10-K for the year ended December 31, 2001 (the "Form
10-K"), as filed with the SEC. As discussed in the Explanatory Note on the
Table of Contents, Dynegy intends to file amended reports under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), for each of the three
years in the period ended December 31, 2001, as well as each quarterly period
contained therein. In addition, Dynegy intends to file amended Exchange Act
reports for the quarters ended March 31, 2002 and June 30, 2002. Dynegy expects
to file these amended reports with the SEC following completion of
PricewaterhouseCoopers LLP's previously announced re-audit of Dynegy's
1999-2001 financial statements and, for the quarterly periods during 2002,
PricewaterhouseCoopers' subsequent review of the interim financial statements
for those periods. As a result of the three-year re-audit, there may be
revisions to the Company's historical financial statements in addition to those
described in the Explanatory Note on the Table of Contents and in Note 1 to the
accompanying financial statements, some of which could be material.
Dynegy is a global energy merchant. Through its owned and contractually
controlled network of physical assets and its marketing, logistics and
risk-management capabilities, the Company provides services to customers in
North America, the United Kingdom and Continental Europe. Dynegy's operations
are reported in three segments: Wholesale Energy Network ("WEN"), Dynegy
Midstream Services ("DMS") and Transmission and Distribution ("T&D").
Like many companies in the merchant energy industry, Dynegy has faced a
number of challenges since the end of 2001. These challenges include, among
others, the effects of contraction in the trading markets and downgrades in the
Company's credit ratings on its ability to conduct its customer and
risk-management business, a weak commodity price environment for natural gas
and power, the impact of various legal proceedings and investigations involving
Project Alpha, roundtrip trades and the Company's failed merger with Enron,
increased collateralization requirements for the Company's commercial
obligations resulting from downgrades in its credit ratings and the effect of
these and other issues on public confidence in Dynegy's long-term business
strategy and its ability to generate sustainable cash flows.
Since the Company filed its first quarter 2002 Form 10-Q on May 15, 2002,
Dynegy has announced a number of significant developments. On May 24, 2002,
Dynegy announced that it received a subpoena from the U.S. Attorney's office in
Houston requesting documents relating to the Company's transactions, including
Project Alpha and the roundtrip trades with CMS Energy. On May 28, 2002, Dynegy
announced that Charles L. Watson had resigned as its Chairman of the Board and
Chief Executive Officer and that two of Dynegy Inc.'s Board members, Glenn F.
Tilton and Daniel L. Dienstbier, respectively, had been appointed to fill those
positions on an interim basis. On June 19, 2002, Dynegy announced that Robert
D. Doty, Jr. had resigned as its Chief Financial Officer and that Louis J.
Dorey had been appointed to fill that position. Also on June 19/th/, Dynegy
announced a workforce reduction that affected approximately 309 employees.
On June 24, 2002, Dynegy Inc. announced a $2 billion capital plan designed
to enhance liquidity and reduce debt. Dynegy also announced that
PricewaterhouseCoopers would re-audit Dynegy's 2001 financial statements as
part of the previously announced 2001 restatement process. Dynegy Inc. further
announced that its second quarter results were expected to include certain
non-recurring pre-tax charges of up to $450 million related to the
32
telecommunications business, severance expenses, consulting fees and other
charges. On July 15, 2002, Dynegy Inc. announced that it would adjust upward
its previously disclosed estimated second quarter pre-tax charge from $450
million to $500 million as the result of an increase in an expected non-cash
charge in the Company's natural gas marketing business. Dynegy also announced
that it had requested PricewaterhouseCoopers to expand its re-audit to include
the Company's 1999 and 2000 financial statements. On July 23, 2002, Dynegy Inc.
announced that it was lowering its earlier fiscal year 2002 guidance for cash
flow from operations to a range of $600 million to $700 million from its
previous estimate of up to $1 billion. The Company's parent attributed the
reduction to a downturn in its customer and risk-management activities,
partially the result of industry conditions, and lower-than-expected prices for
power, natural gas and natural gas liquids.
These and other issues facing the Company have resulted in downgrades to the
Company's credit ratings by all three major credit rating agencies to below
investment grade. The Company's trading and commercial counterparties have also
required additional postings of collateral or ceased conducting business with
the Company. These actions, together with the general contraction in the
trading markets, contributed to lower than anticipated operating results and
cash flows during the second quarter 2002 and have materially adversely
affected the Company's business and operating capabilities. Dynegy remains
committed to addressing these issues. However, the Company's future financial
condition will depend upon its ability to successfully execute its $2 billion
capital plan. Important factors impacting Dynegy's ability to execute this plan
and to otherwise continue its operations and achieve its business strategy
include the following:
. Dynegy's ability to address its significant financial obligations given
its non-investment grade status and lack of borrowing capacity;
. Dynegy's ability to rationalize its customer and risk-management
business, either through the formation of a joint venture or the
execution of an alternative strategy;
. Dynegy's ability to generate sustainable cash flows from its assets and
businesses;
. Ongoing investigations and litigation relating to Project Alpha, Black
Thunder, the California power markets and roundtrip transactions; and
. Confidence in Dynegy's financial reporting in light of the previously
announced restatements and the ongoing re-audit of its 1999-2001
financial statements.
Please read "Liquidity and Capital Resources" for additional details with
respect to these factors and "Uncertainty of Forward-Looking Statements and
Information" for additional factors that could impact future operating results.
33
LIQUIDITY AND CAPITAL RESOURCES
Capital Plan
On June 24, 2002 Dynegy Inc. announced a $2 billion capital plan designed to
enhance liquidity and reduce debt. These measures are in addition to the equity
sales and capital expenditure reductions totaling approximately $1.25 billion
previously achieved by Dynegy Inc. through its December 2001 capital plan. The
new plan proposed removing $301 million in obligations triggered by declines in
Dynegy's credit ratings, a $100 million reduction in Dynegy Inc. capital
expenditures, a sale or joint venture of a portion of Dynegy's ownership
interest in Northern Natural and in its United Kingdom natural gas storage
facilities, a proposed initial public offering of Dynegy Energy Partners L.P.,
a proposed $300-$400 million mortgage bond offering by Illinois Power ("IP,")
an indirect wholly owned subsidiary of Dynegy Inc., workforce reductions and
certain other measures.
As part of the capital plan, on June 27, 2002, Dynegy completed an
amendment to the Catlin Associates, LLC minority interest transaction (also
referred to as "Black Thunder"), which permanently removed a $270 million
obligation which could have been triggered by declines in Dynegy's credit
ratings. The amended agreement requires a subsidiary of Dynegy to amortize $275
million over the remaining three years of the transaction. The subsidiary has
already paid approximately $73 million of the amortization. Quarterly
maturities are approximately $20 million through the first quarter 2005. In
addition, Dynegy agreed to grant mortgages on the midwest power generation
assets covered by the transaction, post a letter of credit to secure a
contingent obligation expiring on December 31, 2002 and make certain structural
changes to enhance the security of the third-party lenders involved in the
transaction. As a result of this amendment, $796 million related to Catlin
Associates, LLC was reclassified from Minority Interest to Debt on Dynegy's
Condensed Consolidated Balance Sheets at June 30, 2002.
On June 28, 2002, Dynegy completed a $250 million interim financing, which
bears interest at LIBOR plus 1.75 percent. This loan matures in June 2003 and
represents an advance on a portion of the proceeds from the expected sale of
certain of the Company's United Kingdom natural gas storage facilities. Dynegy
also completed a restructuring of the financing arrangements for West Coast
Power, LLC ("West Coast Power"), a joint venture owned equally by Dynegy and
NRG Energy, that resulted in the release of approximately $100 million in
letters of credit that Dynegy had posted on behalf of West Coast Power. In
connection with this restructuring, West Coast Power repaid bank borrowings
that resulted in the permanent elimination of a $31 million net obligation
which could have been triggered by declines in Dynegy's credit ratings.
On July 15, 2002, Dynegy completed a $200 million interim financing, bearing
interest at LIBOR plus 1.38 percent. This loan matures in January 2003 and is
secured by interests in Dynegy's Renaissance and Rolling Hills merchant power
generation facilities.
Dynegy incurred upfront fees aggregating approximately $19 million in
connection with the interim financings, Black Thunder amendment and West Coast
Power transaction described above.
In addition, on July 28, 2002 Dynegy entered into an agreement to sell
Northern Natural Gas Company ("Northern Natural") to MidAmerican Energy
Holdings Company ("MidAmerican") for $928 million in cash, subject to
adjustment for working capital changes. Under the terms of this agreement,
MidAmerican is expected to acquire all of the common and preferred stock of
Northern Natural and to assume $950 million in outstanding Northern Natural
debt. The transaction is expected to close in August 2002 and is subject to
customary closing conditions, including expiration of the Hart-Scott-Rodino
waiting period, and the continuation of certain transition services to Northern
Natural. The sale will eliminate approximately $800 million of Northern Natural
debt on Dynegy's consolidated balance sheet.
34
Following is a list of items that remain to be completed under Dynegy Inc.'s
original $2 billion capital plan:
. Closing of the pending sale of Northern Natural;
. Sale or joint venture transaction of Dynegy's natural gas storage and gas
processing facilities in the United Kingdom;
. Sale of additional Dynegy Inc. assets totaling $200 million;
. Issuance of $300-$400 million of IP mortgage bonds to repay or refinance
existing obligations;
. Initial public offering of Dynegy Energy Partners L.P., a newly formed
master limited partnership expected to own and operate a portion of the
Company's downstream natural gas liquids business; and
. Consideration of an equity-like offering based on market conditions and
the results of capital-enhancing transactions.
The closing of the Northern Natural sale and the execution of the remaining
elements of the Company's capital plan is expected to provide sufficient
near-term liquidity for the Company. The remaining elements of the capital plan
are subject to a number of risks including factors beyond the Company's
control. These factors include, among others, market conditions for asset
sales, the timeliness and ability to obtain required regulatory approvals,
ongoing investigations and litigation, and the effect of commodity prices and
continued contraction in the markets in which the Company operates, which may
negatively impact its operating cash flow. Current conditions have caused the
termination of a previously announced $325 million mortgage bond offering by
Illinois Power ("IP") and delayed the proposed initial public offering of
Dynegy Energy Partners L.P. These conditions will also impact any potential
capital-raising activities of Dynegy in the near future. In addition, Dynegy
has previously announced its intention to rationalize its customer and
risk-management business through a joint venture or another strategic
alternative. Dynegy cannot guarantee that any of these planned transactions
will be successfully completed or that if completed they will occur on terms
that the Company currently anticipates.
Available Credit Capacity, Liquidity and Debt Maturities
Dynegy is currently satisfying its capital requirements primarily with cash
from operations, cash on hand and limited borrowings available under its
revolving credit facilities. Dynegy currently does not have access to the
commercial paper market and has only limited access to the capital markets due
to its non-investment grade credit ratings, the ongoing re-audit of the
Company's historical financial statements and other factors. Given these facts,
Dynegy expects to continue to rely primarily on cash from operations, cash on
hand and proceeds from its capital plan initiatives to fund its near-term
obligations.
The following table summarizes Dynegy's credit capacity and liquidity
position at June 30, 2002:
Dynegy
Holdings Northern
Total Inc. Natural
------- -------- --------
($ in millions)
Total Credit Capacity........ $ 2,040 $1,590 $ 450
Outstanding Loans............ (1,090) (640) (450)
Outstanding Letters of Credit (570) (570) --
------- ------ -----
Unused Borrowing Capacity.... $ 380 $ 380 $ --
Cash......................... 322 322 --
Highly Liquid Inventory(1)... 214 214 --
------- ------ -----
Total Available Liquidity.... $ 916 $ 916 $ --
======= ====== =====
- --------
(1) Consists principally of natural gas inventories that the Company believes
could be monetized within 60 days based on current spot market prices.
35
During July and August 2002, Dynegy repaid approximately $200 million in
debt maturities and posted substantial additional collateral to support its
business resulting in a reduction in total liquidity from June 30, 2002. The
Company's total available liquidity as of August 12, 2002 was approximately
$558 million, including an aggregate of approximately $309 million in cash,
$211 million in highly liquid inventory and $38 million in available borrowing
capacity. Completion of the Northern Natural sale should enable Dynegy to have
sufficient time and financial resources to rationalize its customer and
risk-management business through a joint venture or another strategic
alternative, thereby reducing its capital requirements and enhancing its
liquidity position.
Dynegy's current liquidity levels and its dependence on the sale of Northern
Natural and other elements of its capital plan for financing expose the Company
to substantial risk. In the event that the Northern Natural sale is not
completed or is significantly delayed or if other adverse developments impact
cash liquidity, Dynegy may not be able to meet its near-term obligations. Over
the longer term, particularly in the second quarter 2003 when Dynegy expects to
have approximately $1.5 billion in debt maturities, Dynegy's ability to meet
its obligations will require the successful execution of remaining elements of
the capital plan and the rationalization of its customer and risk-management
business. Dynegy faces execution risk with respect to its capital plan and
other strategies both in the near and longer term. If Dynegy is unable to
complete the Northern Natural sale in the near term or other elements of its
strategy prior to the second quarter 2003, it may be forced to consider other
strategic alternatives or a possible reorganization under the protection of
bankruptcy laws.
As of August 12, 2002, the Company's debt maturities through December 31,
2003, inclusive of letters of credit issued under revolving credit facilities,
were as follows: remainder of third quarter 2002--zero; fourth quarter
2002--$59 million (not including a $450 million secured line of credit at
Northern Natural that will be assumed by MidAmerican in the sale of Northern
Natural as further described above); first quarter 2003--$219 million; second
quarter 2003--$1,534 million; third quarter 2003--$22 million; and fourth
quarter 2003--$22 million.
Trade Credit and Other Collateral Obligations
During the second quarter 2002, Dynegy continued to experience increased
demands to provide collateral in both its trading and other commercial
operations. Counterparties have increased their collateral demands and, in some
cases, have refused to transact little more than spot gas trades with Dynegy.
Most commercial agreements typically include "adequate assurance" provisions or
specific ratings triggers. Specific ratings triggers give counterparties the
right to suspend or terminate credit if the Company's credit ratings fall below
investment grade; "adequate assurance" provisions permit a counterparty to
request adequate assurance (which is generally not specified in the agreement)
of continued performance. Parties engaged in the customer and risk-management
business, including Dynegy, are attempting to implement standardized agreements
that allow for the netting of positive and negative exposures associated with a
single counterparty. Dynegy has executed or is in the process of negotiating
such agreements with a number of its trading partners.
Dynegy's counterparties have historically relied upon the Company's
investment grade credit rating to satisfy their credit support requirements.
Prior to April 25, 2002, Dynegy had approximately $350 million in letters of
credit posted in connection with its commercial operations. Since that date,
Dynegy has posted approximately $710 million in additional cash and letters of
credit to collateralize its commercial obligations. Outstanding letters of
credit and cash collateral totaled approximately $1.06 billion as of August 12,
2002.
As further described in Note 15 to the accompanying financial statements,
following the closing of the Northern Natural sale, Dynegy has agreed to
accelerate payment to the month of delivery for a portion of the natural gas
sold to Dynegy by ChevronTexaco under the parties' gas purchase agreement, with
the amount of the accelerated payment generally being equal to 75 percent of
the value of the prior month's gas deliveries, after reduction pursuant to the
parties' netting agreement. Upon consummation of the Northern Natural sale, the
initial payment amount will be $187.5 million. The amount of the payment could
change materially as a result of changes in commodity prices.
36
As a result of downgrades to Dynegy's credit ratings, the Company recently
received a request from Sithe/Independence Funding to provide adequate
assurance in the form of substitute guarantees for its obligations under a
long-term tolling agreement, and three other related contracts, with the
Sithe/Independence Power Project. The Company's annual payments under these
arrangements approximate $66 million and the contracts extend through 2014. The
Company has not provided the requested substitute guarantees and can provide no
assurance as to the ultimate resolution of its obligations under these
arrangements.
Dynegy intends to continue to manage its customer and risk-management
business in a manner consistent with its liquidity position. In response to the
decreasing liquidity in the trading markets and the actions of counterparties
either requiring additional collateral or refusing to trade with the Company,
Dynegy has reduced the level of its customer and risk-management business
activities. The impact of this reduction in activities has adversely impacted
earnings and cash flow. Accordingly, Dynegy is assessing alternative strategies
for its customer and risk-management business. These alternatives include,
among others, an independently rated joint venture comprising this business and
potentially other complimentary assets or businesses. Dynegy's ability to
execute a joint venture or other alternative transaction with respect to its
customer and risk-management business will significantly affect its liquidity
position and future results of operations. For example, if Dynegy were to
contribute its customer and risk-management business to a joint venture with an
investment grade credit rating and independently established trade credit,
Dynegy's capital commitments with respect to that business would be
significantly reduced. Similarly, a reduction in the size of this business
would reduce Dynegy's capital commitments. However, the amount of this
reduction will depend upon the Company's ability to execute such a transaction
and the structure of any such transaction.
Credit Rating Discussion
Credit ratings impact the Company's ability to obtain short- and long-term
financing, the cost of such financing and the execution of its commercial
strategies, including counterparty confidence and the Company's ability to
conduct its customer and risk-management business. In determining the Company's
credit ratings, the rating agencies consider a number of factors. Quantitative
factors that management believes are given significant weight include, among
other things, EBITDA; operating cash flow; total debt outstanding; off balance
sheet obligations and other commitments; fixed charges such as interest
expense, rent or lease payments; payments to preferred stockholders; liquidity
needs and availability; and various ratios calculated from these factors.
Qualitative factors include, among other things, predictability of cash flows,
business strategy, industry position, regulatory investigations and other
contingencies. Although these factors are among those considered by the rating
agencies, each agency may calculate and weigh each factor differently.
Since the Company filed its first quarter 2002 Form 10-Q on May 15, 2002,
all three major credit rating agencies have downgraded Dynegy's credit ratings.
On June 24, 2002, following the announcement of Dynegy Inc.'s new capital plan,
Fitch, Inc. lowered its credit ratings for, and maintained its Ratings Watch
Negative status on Dynegy. The senior unsecured debt was downgraded to "BB+,"
which is below investment grade. Fitch subsequently downgraded the senior
unsecured debt ratings to "BB-" and then to "B," which is five notches below
investment grade. Fitch stated that these ratings actions were based on a
continued weakening in Dynegy's credit profile and concerns over Dynegy's
ability to generate sustainable cash flows and to execute Dynegy Inc.'s $2
billion capital plan.
On June 25, 2002, Standard & Poor's Rating Services lowered its ratings on
Dynegy and stated that these ratings would remain on CreditWatch with negative
implications. Standard & Poor's lowered its long-term corporate credit ratings
to "BBB-," its lowest investment grade credit rating. Standard & Poor's
subsequently lowered its long-term corporate credit ratings of Dynegy to "BB"
and then to "B+," which is four notches below investment grade. Standard &
Poor's stated that these ratings actions reflected pronounced erosion in
Dynegy's core merchant energy business, including the unwillingness of
counterparties to transact in little more than spot gas trades with Dynegy, and
Dynegy's failure to provide sustainable cash flow necessary for investment
grade status.
37
On June 28, 2002, Moody's Investors Service lowered its ratings on Dynegy
and stated that the ratings outlook remained negative. The senior unsecured
debt was downgraded from "Baa3" to "Ba1," which is below investment grade.
Moody's subsequently lowered its senior unsecured debt ratings to "B1," which
is four notches below investment grade. Moody's stated that these ratings
actions were based on continuing concerns over Dynegy's liquidity and operating
cash flow, increased amounts of secured debt and the expectation that future
renewals of existing bank debt will likely be done on a secured basis,
effectively subordinating the Company's senior unsecured lenders.
As of August 12, 2002, Dynegy's credit ratings, as assessed by the three
major credit rating agencies, were as follows:
Rated Enterprises Standard & Poor's Moody's Fitch
----------------- ----------------- ------- -----
Senior Unsecured Debt Rating:
Dynegy Holdings Inc....... B- B1 B
Northern Natural.......... B+ B3 B
The recent downgrades in Dynegy's credit ratings have caused further
reductions in the amount of trade credit extended by Dynegy's counterparties.
Counterparties have generally increased their collateral demands relating to
Dynegy's trading and commercial obligations. Counterparties in Dynegy's
customer and risk-management business have refused to trade or are unwilling to
transact little more than spot gas trades with the Company. See "Trade Credit
and Other Collateral Obligations" discussion above. Additionally, Dynegy's
non-investment grade status has limited and will likely continue to limit
significantly its ability to refinance its debt obligations and to access the
capital markets and will likely increase the borrowing costs incurred in
connection with any refinancing activities. The Company's financial flexibility
is likely to be reduced as a result of, among other things, restrictive
covenants and other terms typically imposed on non-investment grade borrowers.
Financing Trigger Events
Dynegy's debt instruments and other financial obligations include routine
provisions, which, if not met, could require early payment, additional
collateral support or similar actions. For Dynegy, these trigger events include
leverage ratios, insolvency events, defaults on scheduled principal or interest
payments, acceleration of other financial obligations and change of control
provisions. Dynegy does not currently have any trigger events tied to specified
credit ratings or Dynegy Inc. stock price in its debt instruments and has not
executed any transactions that require it to issue equity based on credit
rating or other trigger events.
Capital Leases
In response to the initiatives currently underway at the FASB, on June 28,
2002 the Company unilaterally undertook actions, the effect of which altered
the accounting for some of its existing lease obligations and anticipated lease
obligations relating to assets under construction. These actions included the
delivery of guarantees of lessor debt in certain existing leases of power
generation facilities. In addition, the Company notified certain lenders of its
intent to purchase power generation facilities that are currently under
construction and that were expected to be placed in synthetic leases upon
completion of their construction. As a result of these actions, approximately
$528 million of obligations due in 2005 to 2007 were brought on-balance sheet.
This non-cash action resulted in an increase to Property, Plant and Equipment
and a corresponding increase in Long-Term Debt on the Company's June 30, 2002
Condensed Consolidated Balance Sheet. These obligations were previously
reported as lease obligations in the footnotes to the Company's financial
statements and in the Commercial Financial Obligations and Contingent Financial
Commitments tables in the Form 10-K. In addition, actions taken by the Company
relating to assets under construction required the reclassification of
approximately $673 million from Prepayments and Other Assets to Property, Plant
and Equipment on the Company's June 30, 2002 Condensed Consolidated Balance
Sheet. Property under capital leases of $528 million is included in Property,
Plant and Equipment and is amortized over the useful life of the asset, which
approximates 40 years.
38
OTHER MATTERS
California Market/West Coast Power Dynegy and NRG Energy each own 50 percent
of West Coast Power, a joint venture owning power generation plants in southern
California. Dynegy's net interest in West Coast Power represents approximately
1,400 MW of generating capacity. Dynegy also participates in the California
markets independently, as a wholesale marketer of gas and power. Substantially
all of Dynegy's direct sales made in California represent bilateral sales made
to creditworthy counterparties. Through its interest in West Coast Power,
Dynegy has credit exposure for past transactions to certain state agencies
("ISO" and "PX"), which primarily relied on receipts from California utilities
to pay their bills. West Coast Power currently sells directly to the California
Department of Water Resources ("DWR") pursuant to other bilateral agreements.
As described in Note 11 to the accompanying financial statements, on
February 25, 2002, the California Public Utilities Commission and the
California Electricity Oversight Board filed complaints with the FERC asking
that it void or reform power supply contracts between DWR and, among others,
West Coast Power. The complaints allege that prices under the contracts exceed
just and reasonable prices permitted under the Federal Power Act. The FERC
recently set these complaints for evidentiary hearing. The hearing, however, is
being held in abeyance pending completion of settlement talks. While West Coast
Power continues in good faith negotiations with the State of California on
reforming the terms of its DWR contract, settlement ultimately may not be
possible. If a hearing on the contracts entered into by West Coast Power or
others is necessary, the first phase of the hearing will be limited to the
question of whether the California real-time market adversely affected the
long-term bilateral markets. Please read Note 11, "Commitments and
Contingencies," to the Form 10-K and Note 11 to the accompanying financial
statements for additional discussion of the Company's activities in the
California power market.
As a result of West Coast Power's previously announced long-term sales
arrangement with the DWR, ongoing management of credit risk associated with
direct sales to customers in California and other factors, management believes
that Dynegy's primary exposure relates to the realization of its share of West
Coast
39
Power's receivables from the ISO and PX and potential refunds or offsets
associated with related transactions. Transactions with the aforementioned
counterparties, other than the ISO and PX, are current under the terms of each
individual arrangement. At June 30, 2002, Dynegy's portion of the receivables
owed to West Coast Power by the ISO and PX approximated $208 million.
Management is continually assessing Dynegy's exposure, as well as its exposure
through West Coast Power, relative to its California receivables and
establishes and maintains reserves as necessary.
New Power Plants
In the second quarter 2002, Dynegy started commercial operation at three new
merchant power plants in Kentucky and Michigan. The combined generating
capacity of the facilities is 1,510 MW. These three peaking facilities will
sell the power generated through the East Central Area Reliability Council and
other regions of the country.
Recent Accounting Pronouncements
See Note 4 to the accompanying financial statements for a discussion of
recently issued accounting pronouncements that could affect the Company.
Additionally, the following further describes proposed rules that are likely to
affect the Company if they are issued.
EITF Issue 02-3. In June 2002, the EITF reached consensus on two of three
issues presented in EITF Issue 02-3 "Accounting for Contracts Involved in
Energy Trading and Risk Management Activities." First, the Task Force concluded
that all mark-to-market gains and losses on energy trading contracts (whether
realized or unrealized) should be shown net in the income statement,
irrespective of whether the contract is physically or financially settled. In
addition, the Task Force concluded that an entity should disclose the gross
transaction volumes for those energy trading contracts that are physically
settled. Beginning in the third quarter of 2002, Dynegy will present all
mark-to-market gains and losses on a net basis and will expand its volumetric
disclosures to comply with the consensus. Additionally, in accordance with the
transition provisions in the consensus, comparative financial statements will
be conformed to meet the requirements mandated by the Task Force. It is
estimated that this accounting change will reduce Dynegy's reported revenues
and cost of sales by as much as 90 percent in any given period. The change in
accounting classification will have no impact on operating income, net income,
earnings per share or cash flow from operations.
The second consensus reached by the Task Force related to required
disclosures regarding energy trading operations. The Task Force agreed to
clarify the application of APB Opinion No. 22, "Disclosure of Accounting
Policies" and SOP 94-6, "Disclosure of Significant Risks and Uncertainties" to
an entity's energy trading operations by requiring that entities disclose the
applicability of EITF Issue 98-10, "Accounting for Contracts Involved in Energy
Trading and Risk Management Activities," the types of contracts that are
accounted for as energy trading contracts, a description of the methods and
significant assumptions used to estimate the fair value of various classes of
energy trading contracts and the sensitivity of its estimates to changes in the
near term. The Task Force indicated that additional disclosure regarding the
fair value of contracts, aggregated by source or method of estimating fair
value and by maturity date, would also be meaningful. The Company will assess
its disclosures with respect to these matters.
The third issue addressed by the Task Force in EITF Issue 02-3 deals with
the recognition of unrealized gains and losses at inception (commonly referred
to as dealer profit) of an energy trading contract. The Task Force reached no
consensus on this issue and the issue was assigned to a working group for
resolution by no later than the end of the calendar year. Inherent in these
discussions is the fundamental conclusion of whether and when an enterprise
should use valuation models for the purpose of valuing energy contracts that
are transacted in regions or in periods which lack significant trading activity
(i.e., market liquidity).
40
Consistent with SFAS No. 107, SFAS No. 125, and SFAS No. 133, EITF Issue No.
98-10 footnote 2, stated that quoted market prices in active markets are the
best evidence of fair value and shall be used as the basis for measuring
transactions, if available. The footnote further states that if a quoted market
price is unavailable, the estimate of fair value shall be based on the best
information available in the circumstances. The estimate of fair value shall
consider prices for similar energy contracts and the results of valuation
techniques to the extent available. Those techniques shall incorporate
assumptions that market participants would use in their estimates of values,
future revenues, future expenses, interest rates, default risk, prepayment
risk, and volatility. The guidance goes on to explain that examples of
valuation techniques include the present value of expected future cash flows
using discount rates commensurate with the risks involved, option-pricing
models, matrix pricing, option-adjusted spread models, and fundamental analysis.
In EITF Issue No. 00-17, the Task Force reiterated its consensus that energy
contracts, including energy-related contracts, that are within the scope of
EITF Issue No. 98-10 should be reported at fair value on a stand-alone, or
individual contract, basis. In Issue No. 00-17, the Task Force declined to
specify whether any specific measurement techniques for estimating fair value
of individual contracts should be considered unacceptable or to proscribe any
specific valuation methodologies. Rather, the Task Force reiterated that the
estimate of fair value should be based on the best information available in the
circumstances. The Task Force stated in Issue No. 00-17 that:
. The price at which an energy contract is exchanged normally is its
initial fair value;
. Current market transactions also may provide evidence for recognition of
dealer profit;
. When available, current market transactions provide the basis for
estimating subsequent changes in fair value;
. Valuation models, including option pricing models, should be used only
when market transactions are not available to evidence fair values; and
. When valuation models are used, the best information available would
consider, but is not limited to, recent spot prices and forward prices,
and for option pricing models, the volatility implied by recent
transactions, when available, or the historical volatility of the
commodities and/or services underlying the contract.
As stated previously, a working group of the Task Force was assigned the
task of definitively resolving this issue by the end of the calendar year.
However, upon issuing the EITF minutes of the June 19 - 20 EITF meeting (which
meeting included a discussion of Issue No. 02-3), the FASB staff stated that it
will continue to hold the view that EITF 98-10 and 00-17 do not allow for
recognition of dealer profit (i.e., unrealized gain or loss at inception of a
transaction) unless evidenced by quoted market prices or other current market
transactions for energy trading contracts with similar terms and counterparties.
Dynegy has consistently employed modeling valuation techniques consistent
with those described in Issues 98-10 and 00-17 as a means of adhering to the
fair value accounting model prescribed by authoritative literature for certain
parts of its business operations. The businesses affected, the models employed
and the assumptions underlying these models are disclosed in Dynegy's annual
report on Form 10-K for the year ended December 31, 2001.
Management is uncertain as to how the working group will resolve issues
related to true recognition of dealer profit. Further, it is unclear how the
working group will address dealer profit and the accounting transition
resulting from adoption of new guidance. Three transition alternatives exist in
practice. These transition alternatives include: (a) a retroactive restatement
to eliminate dealer profit recognized in previous periods; (b) a cumulative
effect adjustment for a change in accounting principle, which eliminates the
recognition of previous periods' dealer profit in the current period; or, (c)
as a prospective change, eliminating the recognition of dealer profit on future
transactions but leaving past transactions unaffected. Finally, it is unclear
whether the scope of
41
the working group's activities will include a comprehensive conclusion
regarding the appropriateness of the use of models as a fundamental method for
valuing transactions when market quotations are unavailable. Should the Task
Force issue definitive guidance on any one or all of these issues, it will
impact Dynegy. However, the extent of the financial impact to Dynegy, if any,
cannot be predicted with any degree of certainty until the scope of the Task
Force's conclusion is known and the transition alternative is mandated. If the
Task Force prefers a retroactive or a cumulative effect transition alternative,
then Dynegy's historical financial position and results of operations will be
impacted negatively. If the Task Force prefers a prospective transition
alternative, then Dynegy's current financial position will be unaffected and
the impact to future operations in the near term is not expected to be material
(largely as a result of a reduction in these types of transactions in the
marketplace). As an order of magnitude, approximately $419 million of assets
valued using models are included in Dynegy's net risk management asset at June
30, 2002.
EITF Issue 01-08. The EITF is deliberating the issue of when an
energy-related contract under EITF Issue No. 98-10, "Accounting for Contracts
Involved in Energy Trading and Risk Management Activities," is a lease. This
issue impacts the accounting for tolling arrangements that are considered
energy-related contracts. A working group has been formed to assess the
implications of this issue and their work is continuing. The working group
agreed that the evaluation of whether an arrangement conveys the right to use
property, plant, or equipment should be based on the substance of an
arrangement and that the property that is the subject of a lease must be
specified (explicitly or implicitly) either at inception of the arrangement or
at the beginning of the lease term. The working group generally agreed that
when property, plant, or equipment is explicitly identified and the benefits of
the property, plant, or equipment are conveyed based on the passage of time,
the arrangement is likely a lease. The difficulty in determining whether an
arrangement is a lease arises when the property, plant, or equipment is not
explicitly identified and/or the benefits of property, plant, or equipment are
conveyed based on the output of the property, plant, or equipment. Management
is uncertain as to how the working group will conclude on this issue but will
continue to assess the potential impact to the Company as more definitive
guidance from the working group is made public.
42
ACCOUNTING METHODOLOGY
The Company has identified three critical accounting policies that require a
significant amount of judgment and are considered to be the most important to
the portrayal of Dynegy's financial position and results of operations. These
policies include the accounting for long-lived assets, the evaluation of
counterparty credit and other similar risks and revenue recognition. See Note 3
to the financial statements included in the Form 10-K for a discussion of the
process surrounding the evaluation of counterparty credit and other similar
risks. For disclosure on the Company's accounting for long-lived assets and
revenue recognition, refer to Note 2 to the financial statements included in
the Form 10-K. Accounting methodology and application of accounting
methodologies are more fully described in the Form 10-K.
ENTERPRISE RISK MANAGEMENT, VALUATION AND MONITORING
Market Risk. The Company is exposed to commodity price variability related
to its natural gas, NGLs, crude oil, electricity and coal businesses. In
addition, fuel requirements at its power generation, gas processing and
fractionation facilities represent additional commodity price risks to the
Company. In order to manage these commodity price risks, Dynegy routinely
utilizes certain types of fixed-price forward purchase and sales contracts,
futures and option contracts traded on the New York Mercantile Exchange and
swaps and options traded in the over-the-counter financial markets to:
. Manage and hedge its fixed-price purchase and sales commitments;
. Provide fixed-price commitments as a service to its customers and
suppliers;
. Reduce its exposure to the volatility of cash market prices;
. Protect its investment in storage inventories; and
. Hedge fuel requirements.
The potential for changes in the market value of Dynegy's commodity,
interest rate and currency portfolios is referred to as "market risk." A
description of each market risk category is set forth below:
. Commodity price risks result from exposures to changes in spot rates,
forward prices and volatilities in commodities, such as electricity,
natural gas, coal, NGLs, crude oil and other similar products;
. Interest rate risks primarily result from exposures to changes in the
level, slope and curvature of the yield curve and the volatility of
interest rates; and
. Currency rate risks result from exposures to changes in spot rates,
forward rates and volatilities in currency rates.
Dynegy seeks to manage these market risks through diversification,
controlling position sizes and executing hedging strategies. The ability to
manage an exposure may, however, be limited by adverse changes in market
liquidity or other factors.
Valuation Criteria and Management Estimates. As more fully described in the
Form 10-K, Dynegy utilizes a fair value accounting model for certain aspects of
its operations as required by generally accepted accounting principles. The net
gains or losses resulting from the revaluation of these contracts during the
period are recognized currently in the Company's results of operations. For
financial reporting purposes, assets and liabilities associated with these
transactions are reflected on the Company's balance sheet as risk management
assets and liabilities, classified as short- or long-term pursuant to each
contract's individual tenor. Net unrealized gains and losses from these
contracts are classified as revenue in the accompanying statement of
operations. Transactions that have been realized and settled are currently
reflected gross in revenues and cost of sales. Upon adoption of EITF 02-3,
effective for the third quarter 2002, realized and settled amounts will be
reflected net in the income statement.
Dynegy estimates the fair value of its marketing portfolio using a
liquidation value approach assuming normal liquidity. The estimated fair value
of the portfolio is computed by multiplying all existing positions in the
43
portfolio by estimated mid-market prices, reduced by a LIBOR-based time value
of money adjustment and deduction of reserves for credit, price and market
risks.
Dynegy's forward power price curves are derived by modeling a combined cycle
gas facility as a "spark spread" in the calculation of required cost of capital
returns. This assumption is based on the premise that a portfolio manager would
be indifferent to holding these two assets and is reflective of how Dynegy
manages its own portfolio of physical and financial positions. Dynegy's
modeling methodology has been consistently applied during the quarters ended
June 30, 2002 and March 31, 2002 and the three years in the period ended
December 31, 2001.
Market Information Generating Facility
Information
Natural Gas Location
Prices Inflation Rates
Natural Gas Location Capital and Operational
Market Volatility Costs
Natural Gas Volatility
Forecast Economic Growth Rates
Power Volatility Factors Impact of Temperature and
Altitude
Monthly On and Off Peak Local Taxes and
Curve Shapes Environmental Restriction
Regional Correlation
Assessments Industry Cost of Capital
Supply/Demand Balance
Dynegy's cost-based pricing models depend on extensive, region specific
studies regarding the cost of new generation, as well as detailed proprietary
competitive intelligence on new generation additions, retirements and estimates
of regional power demand growth. Dynegy believes its pricing models are based
on reasonable and sound assumptions. Risks associated with these assumptions
include actual versus estimated regional supply/demand balance, the accuracy of
cost and cost of capital estimates and assumptions regarding the preferred
future technologies and regulatory factors that could impact the continued
formation of competitive markets. As with pricing curves derived from quoted
market prices, the application of forecasted pricing curves to contractual
commitments may result in realized cash returns on these commitments that vary
significantly, either positively or negatively, from the estimated values.
Dynegy's enterprise-wide risk department, led by Dynegy's Chief Risk
Officer, independently verifies the outputs from the Company's proprietary
pricing models. This department routinely applies a mathematical model approach
to independently assess forward price curves. This methodology derives forward
energy prices from assumptions about the random factors driving energy prices
and other key variables such as the long-term price and mean reversion rate.
This method is consistent with market observable forward prices and
volatilities. The method models the evolution of the entire forward curve
conditioned on the initial forward curve. Material differences, if any, between
the forward curves developed from Dynegy's proprietary systems and the
mathematical model are reviewed, assessed and, if deemed necessary by the Chief
Risk Officer and Controller, adjusted in determining the reported fair value of
the marketing portfolio.
44
Risk-Management Asset and Liability Disclosures. The following tables
depict the mark-to-market value and cash flow components of the Company's net
risk-management assets and liabilities at June 30, 2002 and December 31, 2001:
Net Risk-Management Asset and Liability Disclosures
Total 2002(3) 2003 2004 2005 2006 Thereafter
----- ------- ---- ---- ---- ---- ----------
($ in millions)
Mark-to-Market Value of Risk-Management Assets and
Liabilities (1):
June 30, 2002(2).................................. $642 $ 6 $93 $38 $ (1) $58 $448
December 31, 2001................................. 683 465 33 20 (18) 29 154
---- ----- --- --- ---- --- ----
Increase (Decrease)............................... $(41) $(459) $60 $18 $ 17 $29 $294
==== ===== === === ==== === ====
- --------
(1) The table reflects the fair value of Dynegy's risk-management asset
position after deduction of time value, credit, price and other reserves
necessary to determine fair value. These amounts exclude the fair value
associated with certain derivative instruments designated as hedges, which
are included in other comprehensive income (a component of Stockholders'
Equity). The net risk-management assets of $623 million on the Condensed
Consolidated Balance Sheet include the $639 million herein as well as
emission allowance credits, other comprehensive income balances and other
non-trading amounts.
(2) Excluding the impact of Project Alpha, net risk-management assets and
liabilities would have been as follows: Total--$961 million, 2002--$51
million, 2003--$182 million, 2004--$123 million, 2005--$80 million,
2006--$77 million and Thereafter--$448 million. See Note 1 to the
accompanying financial statements.
(3) Amounts represent July 1 to December 31, 2002 values in the June 30, 2002
row and January 1 to December 31, 2002 values in the December 31, 2001 row.
The increases (decreases) in the Net Risk Management Asset and Liabilities
were impacted by the following:
. A net deferral of the anticipated timing of cash inflows totaling $95
million from the 2002 through 2004 time periods to beyond 2006 related to
long-term natural gas storage transactions. The change in the timing of
cash inflows on these transactions results from the decision to extend
the term of the contract through 2007;
. The realization of approximately $338 million of cash related to
contracts settled during the first and second quarters of 2002;
. The execution in the first quarter of 2002 of a large power origination
transaction, which increased anticipated cash inflows beyond 2006 by $114
million; and
. The impact of the recognition of other net mark-to-market gains, change
in reserves, changes in interest rates and changes in foreign exchange
rates and their related impact on the discounted value of the portfolio
and related annual cash flow amounts.
45
Net Risk-Management Asset and Liability Disclosures
Six Months Six Months
Ended Ended
June 30, December 31, Total
2002 2002 2002 2003 2004 2005 2006 Thereafter
---------- ------------ ----- ---- ---- ---- ---- ----------
($ in millions)
Cash Flow of Risk-Management
Assets and Liabilities (1):
June 30, 2002(2)............. $338 $26 $ 364 $115 $51 $ 5 $75 $1,079
December 31, 2001............ 496 55 40 (2) 53 330
----- ---- --- --- --- ------
Increase (Decrease).......... $(132) $ 60 $11 $ 7 $22 $ 749
===== ==== === === === ======
- --------
(1) The cash flow value reflects realized cash flows for the six months ended
June 30, 2002 and anticipated undiscounted cash inflows and outflows for
the remaining periods by contract based on tenor of individual contract
position and have not been adjusted for counterparty credit or other
reserves. These amounts exclude the cash flows associated with certain
derivative instruments designated as hedges, which are included in other
comprehensive income (a component of Stockholders' Equity) as well as
emission allowance credits and other non-trading amounts.
(2) Excluding the impact of Project Alpha, the cash flows would have been as
follows: six months ended December 31, 2002--$71 million; 2003--$206
million; 2004--$142 million; 2005--$97 million; 2006--$105 million and
Thereafter--$1,079 million. See Note 1 to the accompanying financial
statements.
The following table provides a reconciliation of the risk-management data on
the balance sheet, statement of operations and statement of cash flows ($ in
millions):
As of and for
the Six
Months
Ended
June 30, 2002
-------------
Balance Sheet Risk-Management Accounts
Fair value of portfolio at January 1, 2002........................................... $ 751
Risk-management gains recognized through the income statement in the period, net (1). 208
Cash received related to contracts settled in the period, net........................ (338)
Changes in fair value as a result of a change in valuation technique (2)............. --
Non-cash adjustments and other....................................................... 5
-----
Fair value of portfolio June 30, 2002................................................ $ 626
=====
Income Statement Reconciliation
Risk-management gains recognized through the income statement in the period, net..... $ 208
Physical business recognized through the income statement in the period, net......... (30)
Non-cash adjustments and other....................................................... (3)
-----
Net recognized operating margin (3).................................................. $ 175
=====
Cash Flow Statement
Cash received related to risk-management contracts settled in the period, net........ $ 338
Estimated cash paid related to physical business settled in the period, net.......... (30)
Timing and other, net (4)............................................................ (34)
-----
Cash received (paid) during the period............................................... $ 274
=====
Risk Management cash flow adjustment for the six-month period ended June 30, 2002 (5) $ 99
=====
- --------
(1) This amount includes approximately $140 million which represents
management's estimate of the initial value of new contracts entered into in
the six months ended June 30, 2002.
(2) Dynegy's modeling methodology has been consistently applied period over
period.
46
(3) This amount consists primarily of the customer and risk-management portion
of WEN's operating income before the deduction of Depreciation and
Amortization, Impairment and Other Charges and General and Administrative
Expenses.
(4) Primarily represents cash paid for emission credits and physical inventory
utilized in customer and risk-management business.
(5) This amount is calculated as "Cash received (paid) during the period" less
"Net recognized operating margin."
The following table provides an assessment of net contract values by year
based on the Company's valuation methodology described above. Approximately 35
percent of Dynegy's net risk-management asset value at June 30, 2002 was
determined by market quotations or validation against industry posted prices.
This is a significant reduction from the December 31, 2001 amount of 83 percent
and March 31, 2002 amount of 55 percent. The percentage reduction resulted from
a significant realization of cash during the six-month period, a significant
power origination transaction during the first quarter, the impact of reduced
industry liquidity on the portfolio and a transfer of $105 million of cash
flows from Other External Sources to Prices Based on Models. At June 30, 2002,
the Company was unable to validate the pricing of certain transactions against
external sources, as the merchant energy industry is currently experiencing
reduced energy trading and wholesale origination activity associated with low
market liquidity. The Company will continue to assess the liquidity of the
market as a prolonged downturn in transaction volumes in the industry as a
whole or within specific regions could result in further reduction in the
availability of market quotations.
Net Fair Value of Marketing Portfolio
Total 2002(1) 2003 2004 2005 2006 Thereafter
----- ------- ---- ---- ---- ---- ----------
($ in millions)
Market Quotations (2)....................... $113 $ 6 $51 $(1) $(85) $(20) $162
Other External Sources (3).................. 110 -- 42 39 25 (1) 5
---- --- --- --- ---- ---- ----
Market Quotations and Other External Sources 223 6 93 38 (60) (21) 167
Prices Based on Models (4).................. 419 -- -- -- 59 79 281
- --------
(1) Amount represents July 1 to December 31, 2002 values.
(2) Prices obtained from actively traded, liquid markets for commodities other
than natural gas positions. All natural gas positions for all periods are
contained in this line based on available market quotations.
(3) Mid-term prices validated against industry posted prices.
(4) See discussion of the Company's use of long-term models in the
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" section in the Form 10-K.
The Company is evaluating the possibility of presenting the Net Fair Value of
the Marketing Portfolio in two categories, "Market Quotations and Other
External Sources" and "Prices Based on Models" beginning in the third quarter
2002.
Value at Risk ("VaR"). In addition to applying business judgment, senior
management uses a number of quantitative tools to manage the Company's exposure
to market risk. These tools include:
. Risk limits based on a summary measure of market risk exposure, referred
to as VaR; and
. Stress and scenario analyses performed daily that measure the potential
effects of various market events, including substantial swings in
volatility factors, absolute commodity price changes and the impact of
interest rate and foreign exchange rate movements.
The modeling of the risk characteristics of Dynegy's marketing portfolio
involves a number of assumptions and approximations. Dynegy estimates VaR using
a JP Morgan RiskMetrics(TM) approach assuming a one-day holding period. Inputs
for the VaR calculation are prices, positions, instrument valuations and the
variance-covariance matrix. While management believes that these assumptions
and approximations are reasonable, there is no uniform industry methodology for
estimating VaR, and different assumptions and/or approximations could produce
materially different VaR estimates.
47
Dynegy uses historical data to estimate the Company's VaR and, to better
reflect current asset and liability volatilities, these historical data are
weighted to give greater importance to more recent observations. Given its
reliance on historical data, VaR is effective in estimating risk exposures in
markets in which there are not sudden fundamental changes or shifts in market
conditions. An inherent limitation of VaR is that past changes in market risk
factors, even when weighted toward more recent observations, may not produce
accurate predictions of future market risk. VaR should be evaluated in light of
this and the methodology's other limitations.
VaR represents the potential loss in value of Dynegy's enterprise-wide
marketing portfolio due to adverse market movements over a defined time horizon
within a specified confidence level. For the VaR numbers reported below, a
one-day time horizon and a 95% confidence level were used. This means that
there is a one in 20 statistical chance that the daily portfolio value will
fall below the expected maximum potential reduction in portfolio value at least
as large as the reported VaR. Thus, a change in portfolio value greater than
the expected change in portfolio value on a single trading day would be
anticipated to occur, on average, about once a month. Gains or losses on a
single day can exceed reported VaR by significant amounts. Gains or losses can
also accumulate over a longer time horizon such as a number of consecutive
trading days.
In addition, Dynegy has provided its VaR using a one-day time horizon and a
99% confidence level. The purpose of this disclosure is to provide an
indication of earnings volatility using a higher confidence level. Under this
presentation, there is one in one hundred statistical chance that the daily
portfolio value will fall below the expected maximum potential reduction in
portfolio value at least as large as the reported VaR. The Company has also
disclosed an average VaR for the quarters ended June 30, 2002 and December 31,
2001 in order to provide context around the one-day amounts.
The following table sets forth the aggregate daily VaR of Dynegy's marketing
portfolio:
Daily and Average VaR for Marketing Portfolio
June 30, December 31,
2002 2001
-------- ------------
($ in millions)
One Day VaR--95% Confidence Level............................ $16 $18
=== ===
One Day VaR--99% Confidence Level............................ $23 $26
=== ===
Average VaR for the Year-to-Date Period--95% Confidence Level $19 $12
=== ===
The increase in Average VAR from December 31, 2001 is due primarily to the
long-term power origination transactions executed in the first quarter 2002 and
to increased volatility in the second quarter 2002 due to volatility of power
prices in the summer months as compared to the entire year of 2001.
Credit Risk. Credit risk represents the loss that the Company would incur
if a counterparty fails to perform under its contractual obligations. To reduce
the Company's credit exposure, the Company seeks to enter into netting
agreements with counterparties that permit Dynegy to offset receivables and
payables with such counterparties. Dynegy attempts to further reduce credit
risk with certain counterparties by entering into agreements that enable the
Company to obtain collateral or to terminate or reset the terms of transactions
after specified time periods or upon the occurrence of credit-related events.
The Company may, at times, use credit derivatives or other structures and
techniques to provide for third-party guarantees of the Company's
counterparties' obligations.
Dynegy's industry has historically operated under negotiated credit lines
for physical delivery contracts. Dynegy's Credit Department, based on
guidelines set by Dynegy's Credit Policy Committee, establishes Dynegy's
counterparty credit limits. For collateralized transactions, the Company also
evaluates potential exposure over a shorter collection period and gives effect
to the value of collateral received. The Company further seeks to measure
credit exposure through the use of scenario analyses and other quantitative
tools.
48
Dynegy's credit management systems monitor current and potential credit
exposure to individual counterparties and on an aggregate basis to
counterparties and their affiliates. Recent events in the merchant energy
industry have affected historical credit activities in the industry. Please
read "Trade Credit and Other Collateral Obligations" above.
The following table displays the value of Dynegy's marketing portfolio,
inclusive of hedging activities, at June 30, 2002 (in millions):
Investment Grade Credit Quality.......... $ 660
Below Investment Grade Quality or Unrated 174
-----
Value of portfolio before reserves....... 834
Credit and market reserves............... (192)
-----
642
Other (1)................................ (16)
-----
Net risk-management assets (2)........... $ 626
=====
- --------
(1) Amount represents emission allowance credits, other comprehensive income
balances and other non-trading amounts.
(2) Represents amounts included in "Current Assets-Assets from Risk Management
Activities," "Other Assets--Assets from Risk-Management Activities,"
"Current Liabilities--Liabilities from Risk-Management Activities," and
"Other Liabilities--Liabilities from Risk-Management Activities" on the
Condensed Consolidated Balance Sheet.
Interest Rate Risk. Interest rate risk results from variable rate financial
obligations and from providing risk-management services to customers, since
changing interest rates impact the discounted value of future cash flows used
to value risk-management assets and liabilities. Management continually
monitors its exposure to fluctuations in interest rates and may execute swaps
or other financial instruments to hedge and mitigate this exposure.
The following table sets forth the daily and average VaR associated with the
interest rate component of the marketing portfolio. Dynegy seeks to manage its
interest rate exposure through application of various hedging strategies.
Hedging instruments executed to mitigate such interest rate exposure in the
marketing portfolio are included in the VaR as of June 30, 2002 and December
31, 2001 and are reflected in the table below.
Daily and Average VaR on Interest Component of Marketing Portfolio
June 30, December 31,
2002 2001
-------- ------------
($ in millions)
One Day VaR--95% Confidence Level............................ $0.2 $1.6
==== ====
Average VaR for the Year-to-Date Period--95% Confidence Level $0.5 $1.6
==== ====
The decrease in One Day VaR is due to the timing of removing positions with
Enron from the Company's portfolio at the end of December 2001 and not changing
the hedge positions until early January 2002. The decrease in Average VaR is
due to the impact of the Company's hedging program since the entire six months
of 2002 were under this program that was initiated in November 2001.
In addition to the marketing portfolio, the Company is exposed to
fluctuating interest rates as it relates to other variable rate financial
obligations. Based on sensitivity analysis as of June 30, 2002, it is estimated
that a one percentage point interest rate movement in the average market
interest rates (either higher or (lower)) over
49
the twelve months ended June 30, 2003 would (decrease) increase income before
taxes by approximately $13 million. Hedging instruments executed to mitigate
such interest rate exposure are included in the sensitivity analysis.
Foreign Currency Exchange Rate Risk. Foreign currency risk arises from the
Company's investments in affiliates and subsidiaries owned and operated in
foreign countries. Such risk is also a result of risk management transactions
with customers in countries outside the U.S. Management continually monitors
its exposure to fluctuations in foreign currency exchange rates. When possible,
contracts are denominated in or indexed to the U.S. dollar, or such risk may be
hedged through debt denominated in the foreign currency or through financial
contracts. At June 30, 2002, the Company's primary foreign currency exchange
rate exposures were the United Kingdom Pound, Canadian Dollar, European Euro
and Norwegian Kroner.
The following table sets forth the daily and average foreign currency
exchange VaR. Hedging instruments executed to mitigate such foreign currency
exchange exposure are included in the VaR as of June 30, 2002 and December 31,
2001 reflected in the table below.
Daily and Average Foreign Currency Exchange VaR
June 30, December 31,
2002 2001
-------- ------------
($ in millions)
One Day VaR--95% Confidence Level............................ $0.7 $0.6
==== ====
Average VaR for the Year-to-Date Period--95% Confidence Level $0.4 $1.1
==== ====
Derivative Contracts. The absolute notional financial contract amounts
associated with the Company's commodity risk-management, interest rate and
foreign currency exchange contracts were as follows at June 30, 2002 and
December 31, 2001, respectively:
Absolute Notional Contract Amounts
June 30, December 31,
2002 2001
-------- ------------
Natural Gas (Trillion Cubic Feet).......................................... 17.087 11.936
Electricity (Million Megawatt Hours)....................................... 149.830 77.997
Natural Gas Liquids (Million Barrels)...................................... 2.920 5.655
Weather Derivatives (In Thousands of $/Degree Day)......................... $ 224 $ 190
Crude Oil (Million Barrels)................................................ $ 37.250 $ --
Coal (Millions of Tons).................................................... 9.8 18.5
Variable Rate Financial Obligation Interest Rate Swaps (In Millions of U.S.
Dollars)................................................................. $ 2,000 $ --
Weighted Average Fixed Interest Rate Paid (Percent)........................ 2.755 --
Fair Value Hedge Interest Rate Swaps (In Millions of U.S. Dollars)......... $ 626 $ 206
Fixed Interest Rate Received on Swaps (Percent)............................ 5.619 5.284
Interest Rate Risk-Management Contract (In Millions of U.S. Dollars)....... $ 626 $ 206
Fixed Interest Rate Paid (Percent)......................................... 5.643 5.310
U.K. Pound Sterling (In Millions of U.S. Dollars).......................... $ 595 $ --
Average U.K. Pound Sterling Contract Rate (In U.S. Dollars)................ $ 1.413 $ --
Canadian Dollar (In Millions of U.S. Dollars).............................. $ 1,141 $ 1.395
Average Canadian Dollar Contract Rate (In U.S. Dollars).................... $ 0.640 $ 0.644
50
RESULTS OF OPERATIONS
Provided below are a narrative and tabular presentation of certain operating
and financial data and statistics for the Company's businesses for the three-
and six- month periods ended June 30, 2002 and 2001. For segment reporting
purposes, all general and administrative expenses incurred by Dynegy on behalf
of its subsidiaries are charged to the applicable subsidiary as incurred.
Dynegy allocates indirect general and administrative expenses to its
subsidiaries using a two-step formula that considers both payroll expense and
the net book value of property, plant and equipment. Interest expense incurred
by Dynegy on behalf of its subsidiaries is allocated based on the subsidiaries'
debt to equity relationship. Other income (expense) items incurred by Dynegy on
behalf of its subsidiaries are allocated equally among sub-components of the
three segments.
The reconciliation from reported net income (loss) to recurring net income
(loss), adjusted for the impact of non-recurring special charges, is as follows:
Three Months Six Months
Ended June 30, Ended June 30,
------------- ------------
2002 2001 2002 2001
------ ------ ------ ------
Income Income
(Loss) Income (Loss) Income
------ ------ ------ ------
(in millions)
Net Income (Loss), as reported (1)..................... $(135) $159 $ 27 $285
Impairment of communications assets (2)................ 17 -- 17 --
Severance (3).......................................... 21 -- 21 --
Natural gas marketing charge (4)....................... 80 -- 80 --
Loss of gas delivery commitment (5).................... -- -- 13 --
Cumulative effect of change in accounting principle (6) -- -- -- (2)
Other (7).............................................. 8 -- 8 --
----- ---- ---- ----
Recurring Net Income (Loss)............................ $ (9) $159 $166 $283
===== ==== ==== ====
- --------
(1) Dynegy will restate its June 30, 2001 Condensed Consolidated Financial
Statements to increase the income tax provision for the three- and
six-month period ended June 30, 2001 by approximately $27 million relating
to the elimination of the tax benefit associated with Project Alpha. This
will reduce net income and recurring net income by $27 million in the
three- and six-month periods ended June 30, 2001. See the related
disclosure in Note 1 to the accompanying Condensed Consolidated Financial
Statements.
(2) The Company recognized an after-tax charge of $17 million ($26 million
pre-tax) associated with the write-down of certain technology investments
for the three- and six-month periods ended June 30, 2002. The pre-tax
charge is included in Earnings of Unconsolidated Affiliates in the
accompanying Condensed Consolidated Statements of Operations.
(3) The Company recognized an after-tax charge of approximately $21 million
($32 million pre-tax) for severance benefits for approximately 309
employees including the Company's former Chief Executive Officer and Chief
Financial Officer. The charge is included in Impairment and Other Charges
in the accompanying Condensed Consolidated Statements of Operations.
(4) Dynegy recognized an after-tax charge of $80 million ($124 million pre-tax)
related principally to its natural gas marketing business. As a result of
this charge and the current inability of the Company to allocate this
charge to specific accounting periods, the Company has decided to undergo
re-audits of its financial statements for each of the three years in the
period ended December 31, 2001. If necessary, the Company will restate
prior period financial statements based on its continuing review process to
determine the periods affected. Dynegy has engaged PricewaterhouseCoopers
to re-audit its 1999-2001 consolidated financial statements. The Company
expects that this re-audit will take at least the remainder of the year to
complete. Following the completion of this re-audit, the Company expects
that PricewaterhouseCoopers will perform its required quarterly reviews of
the financial statements for each of the quarterly periods in 2002.
51
(5) The Company incurred a $13 million ($18 million pre-tax) charge in the
first quarter 2002 associated with a commitment to deliver gas assumed in
the acquisition of Northern Natural. The pre-tax charge is included in
Revenues in the accompanying Condensed Consolidated Statements of
Operations.
(6) Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 133, "Accounting for Derivative Instruments and
Hedging Activities," as amended, realizing an after-tax cumulative effect
gain of approximately $2 million.
(7) The amount represents $4 million ($6 million pre-tax) fees related to a
voluntary action that the Company took that altered the accounting for
certain lease obligations. Additionally, the Company had $4 million ($6
million pre-tax) of write-offs related to information technology equipment.
These amounts are included in Other Income and Expense, Net.
Three-Month Periods Ended June 30, 2002 and 2001
For the quarter ended June 30, 2002, Dynegy recorded a net loss of $135
million, compared with second quarter 2001 net income of $159 million.
Recurring net loss, excluding non-recurring after-tax charges of $126 million,
was a net loss of $9 million for the quarter ended June 30, 2002, compared with
second quarter 2001 recurring net income of $159 million. The second quarter
2002 recurring net income excludes non-recurring after-tax charges of $17
million related to the impairment of certain technology investments, $80
million related to the Company's natural gas marketing business and $29 million
primarily for severance and related exit costs and other write-offs. On a
recurring basis, the $168 million decrease in net income is due primarily to
reduced energy trading and customer origination and lower sales prices received
by the Company's generation and natural gas liquids businesses. Second quarter
2002 results benefited from inclusion of the BG Storage Limited ("BGSL")
natural gas storage assets in the United Kingdom, which were acquired in the
fourth quarter 2001.
As described in Note 4 to the accompanying financial statements, the Company
adopted Statement of Financial Accounting Standards No. 142, "Goodwill and
Other Intangible Assets" ("Statement No. 142"), effective January 1, 2002. The
Company's net income for the three months ended June 30, 2001, had goodwill not
been amortized during that period, would have been $162 million.
Operating income decreased $188 million quarter-to-quarter due primarily to
less price volatility for gas marketing in certain areas of the country, lower
sales prices received by the Company's generation and natural gas liquids
businesses, a $32 million pre-tax charge related to severance and increased
depreciation and amortization expense. Increased depreciation and amortization
expense is associated with the expansion of Dynegy's depreciable asset base,
primarily due to the acquisitions of Northern Natural and the BGSL natural gas
storage assets.
General and Administrative expenses decreased $30 million period over period
primarily as a result of lower variable compensation offset by costs associated
with Northern Natural.
Impacting Dynegy's consolidated results was the Company's earnings from
investments in unconsolidated affiliates, which was a net of zero in 2002
compared to $61 million in 2001, respectively. Variances period-to-period in
these results primarily reflect the impact of the impairment of $26 million of
certain technology investments resulting from unfavorable market conditions, a
$36 million decrease in earnings related to West Coast Power and an approximate
$10 million charge recognized in the second quarter 2002 related to a 2001
earnings restatement at NICOR Energy.
Interest expense totaled $56 million for the three-month period ended June
30, 2002, compared to $34 million for the equivalent 2001 period. The variance
is primarily attributable to higher average principal balances in the 2002
period compared to the 2001 period, partially offset by lower average interest
rates on borrowings.
Other income and expenses, net (including minority interest expense and
accumulated distributions associated with trust preferred securities) totaled
$136 million in expense in the quarter ended June 30, 2002. Combined other
income and other expenses totaled $14 million in income in 2001. Variances
period-to-period in these results primarily reflect the impact of the natural
gas marketing charge described above. Additional items impacting the variance
include increased litigation expense during 2002, losses associated with the
retirement of existing IT systems during the second quarter 2002 as a result of
implementing new systems.
52
The Company reported an income tax benefit of $55 million for the quarter
ended June 30, 2002, compared to an income tax provision of $72 million for the
2001 period. The effective tax rates approximated 29 percent and 31 percent in
2002 and 2001, respectively. The difference in the 2001 period from the
effective tax rates and the statutory tax rate of 35 percent results
principally from permanent differences arising from the amortization of certain
intangibles, book-tax basis differences and the effect of certain foreign
equity investments and state income taxes.
Six-Month Periods Ended June 30, 2002 and 2001
For the six months ended June 30, 2002, Dynegy recorded net income of $27
million, compared with net income of $285 million in the same 2001 period.
Recurring net income, excluding non-recurring after tax charges of $139
million, was $166 million for the six months ended June 30, 2002, compared with
recurring net income of $283 million in the same 2001 period. The six-month
period ended June 30, 2002 recurring net income excludes non-recurring charges
related to impairment of technology investments, severance and related exit
costs and other write-offs, a charge related principally to natural gas
marketing and a loss on a gas delivery commitment. On a recurring basis, the
$117 million decrease in net income is due primarily to the aforementioned
reduced energy trading and origination, decline in price volatility and lower
sales prices received by the Company's generation and natural gas liquids
businesses in the second quarter, partially offset by increased origination in
the first quarter. In addition, the 2002 period results benefited from the
inclusion of Northern Natural, which the Company acquired effective February 1,
2002, and the BGSL natural gas storage assets. The recurring net income for the
six-month period ended June 30, 2001 excludes the $2 million cumulative effect
of change in accounting principle recorded in connection with the Company's
adoption of Statement No. 133.
As described in Note 4 to the accompanying financial statements, the Company
adopted Statement of Financial Accounting Standards No. 142, "Goodwill and
Other Intangible Assets" ("Statement No. 142"), effective January 1, 2002. The
Company's net income and earnings per share for the six months ended June 30,
2001, had goodwill not been amortized during the period, would have been $291
million.
Operating income decreased $156 million period over period primarily due to
less price volatility for gas marketing in certain areas of the country, lower
sales prices received by the generation business, a $32 million pre-tax charge
related to severance and increased depreciation and amortization expense.
Increased depreciation and amortization expense is associated with the
expansion of Dynegy's depreciable asset base, primarily due to the acquisitions
of Northern Natural and the BGSL natural gas storage assets.
Impacting Dynegy's consolidated results was the Company's earnings from
investments in unconsolidated affiliates, which was approximately $31 million
and $90 million in the 2002 and 2001 periods, respectively. Variances
period-to-period in these results primarily reflect the impact of the
impairment of $26 million of certain technology investments resulting from
unfavorable market conditions, a $33 million decrease in earnings related to
West Coast Power and an approximate $10 million charge recognized in the second
quarter 2002 related to a 2001 earnings restatement at NICOR Energy.
Interest expense totaled $106 million for the six-month period ended June
30, 2002, compared to $63 million for the equivalent 2001 period. The variance
is primarily attributed to higher average principal balances in the 2002 period
compared to the 2001 period, partially offset by lower average interest rates
on borrowings.
Other income and expenses, net (including minority interest expense and
accumulated distributions associated with trust preferred securities) totaled
$140 million in expense in the six-month period ended June 30, 2002 compared
with $23 million in expense in the same 2001 period. Variances period-to-period
in these results primarily reflect the impact of the natural gas marketing
charge described above. Additional items impacting the variance include
increased litigation expense during 2002, losses associated with the retirement
of existing IT systems during the second quarter of 2002 as a result of
implementing new systems.
53
The Company reported an income tax provision of $15 million for the
six-month period ended June 30, 2002, compared to an income tax provision of
$134 million for the 2001 period. The effective tax rates approximated 36
percent and 32 percent in 2002 and 2001, respectively. The difference from the
effective tax rates and the statutory tax rate of 35 percent results
principally from permanent differences arising from the amortization of certain
intangibles, book-tax basis differences and the effect of certain foreign
equity investments and state income taxes.
The following table provides recurring financial contribution by contract
type and segment. Financial contribution is defined as Revenues less Cost of
Sales plus Earnings from Unconsolidated Investments. Management believes this
disclosure provides insight into the dependability and sustainability of
earnings and cash flows by business segment. However, financial contribution is
a non-GAAP measure and should not be considered as an alternative to net income
as an indicator of the Company's operating performance or as an alternative to
cash flows as a better measure of liquidity. Additionally, other companies may
calculate similarly titled measures in a different manner so as to make these
measures difficult to compare. A reconciliation to recurring and reported
operating income has been provided for further clarification of how this
non-GAAP measure compares to a GAAP measure.
For the Three Months Ended
June 30, 2002
- - ------------------------------
($ in millions)
WEN DMS T&D Consolidated
----- ---- ---- ------------
Regulated............................................ $ -- $ -- $ 32 $ 32
Contract............................................. 131 55 -- 186
Other Asset Businesses............................... 16 -- -- 16
Trading and Other.................................... (8) 3 -- (5)
----- ---- ---- -----
Total Recurring Financial Contribution............... 139 58 32 229
Less Earnings from Unconsolidated Investments........ (19) (7) -- (26)
Less Depreciation and Amortization................... (59) (24) (17) (100)
Less General and Administrative Expenses............. (55) (13) (1) (69)
----- ---- ---- -----
Total Recurring Operating Income..................... 6 14 14 34
Non-Recurring Items Impacting Operating Income (Loss) (25) (3) (4) (32)
----- ---- ---- -----
Total Operating Income (Loss)........................ $ (19) $ 11 $ 10 $ 2
===== ==== ==== =====
For the Six Months Ended
June 30, 2002
------------------------------
($ in millions)
WEN DMS T&D Consolidated
----- ---- ---- ------------
Regulated............................................ $ -- $ -- $124 $ 124
Contract............................................. 256 105 -- 361
Other Asset Businesses............................... 45 -- -- 45
Trading and Other (1)................................ 162 20 -- 182
----- ---- ---- -----
Total Recurring Financial Contribution............... 463 125 124 712
Less Earnings from Unconsolidated Investments........ (46) (11) -- (57)
Less Depreciation and Amortization................... (108) (43) (28) (179)
Less General and Administrative Expenses............. (135) (26) (8) (169)
----- ---- ---- -----
Total Recurring Operating Income..................... 174 45 88 307
Non-Recurring Items Impacting Operating Income....... (25) (3) (22) (50)
----- ---- ---- -----
Total Operating Income............................... $ 149 $ 42 $ 66 $ 257
===== ==== ==== =====
- --------
(1) WEN's Trading and Other for the six months ended June 30, 2002 included
$114 million related to a large power origination transaction executed in
the first quarter 2002.
54
Segment Disclosures
WHOLESALE ENERGY NETWORK
Three Months Six Months Ended
Ended June 30, June 30,
--------------------- --------------------
2002 2001 2002 2001
------ ------- ------ -------
($ in millions, except operating statistics)
Operating Income:
Customer and Risk-Management Activities........... $ (67) $ 96 $ 40 $ 193
Asset Businesses.................................. 48 62 109 136
------ ------- ------ -------
Total Operating Income........................ (19) 158 149 329
Earnings (Losses) from Unconsolidated Investments.... (6) 56 21 84
Other Items.......................................... (122) 20 (130) (12)
------ ------- ------ -------
Earnings (Loss) Before Interest and Taxes..... (147) 234 40 401
Interest Expense..................................... (27) (20) (54) (36)
------ ------- ------ -------
Pre-tax Earnings (Loss)....................... (174) 214 (14) 365
Income Tax Provision (Benefit)....................... (50) 65 (7) 115
------ ------- ------ -------
Income (Loss) From Operations................. (124) 149 (7) 250
Cumulative Effect of Change in Accounting Principle.. -- -- -- 2
------ ------- ------ -------
Net Income (Loss)............................. $ (124) $ 149 $ (7) $ 252
====== ======= ====== =======
Recurring Net Income (Loss)(1)................ $ (4) $ 149 $ 113 $ 250
====== ======= ====== =======
Operating Statistics:
Natural Gas Marketing (Bcf/d)--
Domestic Marketing Volumes........................ 8.5 8.2 9.1 8.3
Canadian Marketing Volumes........................ 2.7 2.7 3.0 2.5
European Marketing Volumes........................ 2.2 0.7 2.2 0.7
------ ------- ------ -------
Total Marketing Volumes....................... 13.4 11.6 14.3 11.5
====== ======= ====== =======
Million Megawatt Hours Generated--Gross.............. 10.0 9.9 19.5 20.2
Million Megawatt Hours Generated--Net................ 9.1 7.9 17.6 16.9
North American Physical Million Megawatt Hours Sold.. 82.0 70.1 232.0 122.1
European Physical Million Megawatt Hours Sold........ 36.2 -- 96.2 --
------ ------- ------ -------
Total Physical Million Megawatt Hours Sold........ 118.2 70.1 328.2 122.1
====== ======= ====== =======
Coal Marketing Volumes (Millions of Tons)............ 9.0 9.3 17.3 18.5
Average Natural Gas Price--Henry Hub ($/MMbtu)....... $ 3.38 $ 4.65 $ 2.86 $ 5.85
Average On-Peak Market Power Prices
Cinergy........................................... $26.89 $ 39.71 $24.43 $ 41.01
TVA............................................... 28.06 51.71 25.11 47.25
PJM............................................... 35.84 44.09 30.54 44.19
New York--Zone G.................................. 46.52 57.97 39.48 58.57
Platts SP 15...................................... 32.14 188.92 30.49 206.58
- --------
(1) The recurring net income consists of segment reported net income adjusted
for identified non-recurring items more fully described above.
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
Three-Month Periods Ended June 30, 2002 and 2001
WEN reported recurring segment net loss of $4 million for the three-month
period ended June 30, 2002, compared with recurring segment net income of $149
million in the 2001 quarter. The segment's customer and risk-management
business incurred an operating loss of $67 million during the second quarter
2002. The results reflect reduced energy trading and customer origination due
to an overall decline in market liquidity because of
55
increasing credit concerns in the merchant energy sector, counterparty concerns
over Dynegy's lower credit ratings, a reduction in the spread between natural
gas and power prices and an allocated charge of $19 million associated with
severance and related costs. The segment's asset businesses recorded operating
income of $48 million in the second quarter 2002. The results reflect lower
generation earnings due to an overall decrease in commodity prices compared to
the second quarter 2001 and an allocated charge of $6 million associated with
severance and related costs. The lower earnings from generation were partially
offset by margins associated with the BGSL natural gas storage and processing
facilities in the United Kingdom not included in 2001 results. The loss from
unconsolidated subsidiaries in the second quarter 2002 resulted primarily from
charges related to a 2001 earnings restatement at NICOR Energy, a joint venture
in which Dynegy maintains an equity investment, and impairment of certain
technology equity investments. Additionally, there was a $36 million decline in
earnings from the equity investment in West Coast Power due to a decrease in
power prices and an overall decline in demand. The $122 million loss in Other
Items results primarily from a non-recurring charge in the natural gas
marketing business. Management believes the charge is largely associated with
the process of reconciling accrued to actual results in its natural gas
marketing business and that it accumulated over a number of years. Interest
expense was higher in the second quarter 2002 due to higher average borrowings,
partially offset by lower average interest rates.
Total physical MW hours sold in the second quarter 2002 increased to 118.2
million MW hours as compared to 70.1 million MW hours in the second quarter
2001 due primarily to increased physical MW hours sold in Europe. Total natural
gas volumes sold in the second quarter 2002 increased to 13.4 billion cubic
feet per day as compared to 11.6 billion cubic feet per day during last year's
second quarter due primarily to increases in gas volumes sold in Europe.
Six-Month Periods Ended June 30, 2002 and 2001
WEN reported recurring segment net income of $113 million for the six-month
period ended June 30, 2002, compared with recurring net income of $250 million
in the same 2001 period. In addition to the items described above for the
second quarter comparisons, Dynegy's customer and risk-management business'
operating income for the six-month period included increased customer
origination during the first quarter 2002 in both the wholesale and commercial
and industrial businesses. The increased origination resulted from the absence
of Enron in the market, new contracts for the acquisition of long-term power
supply at competitive prices and incremental natural gas storage contracts.
Earnings from the long-term power origination contracts were significant to the
results for the first quarter 2002, accounting for approximately 20 percent of
the Company's consolidated financial contribution in that quarter. Offsetting
the increased origination were unfavorable variances in marketing activities
due to a continual decline in price volatility throughout the first quarter
2002 as well as reduced margins associated with power generation as a result of
lower market prices.
Total physical MW hours sold in the six-month period ended June 30, 2002
increased to 328.2 million MW hours compared to 122.1 million MW hours in the
same period in 2001 due primarily to increased physical MW hours sold in Europe
and greater customer origination in the first quarter of 2002. Total natural
gas volumes sold in the six months ended June 30, 2002 increased to 14.3
billion cubic feet per day as compared to 11.5 billion cubic feet per day
during the same period last year due to the inclusion of incremental
ChevronTexaco volumes associated with former Texaco equity production and
increases in gas volumes sold in Europe.
Outlook for Remainder of 2002
The weak commodity price environment for natural gas and power has continued
into the third quarter 2002. In addition, the above-described reduction in
market liquidity has become more pronounced, as has the inability of the
customer and risk-management business to hedge its positions. These and other
factors, including counterparty concerns relating to Dynegy's non-investment
grade credit ratings and Dynegy's ability to rationalize its customer and
risk-management business through a joint venture or another strategic
alternative can be expected to negatively impact this segment's results of
operations for the third quarter 2002 and beyond.
56
DYNEGY MIDSTREAM SERVICES
Three Months Six Months Ended
Ended June 30, June 30,
-------------- --------------
2002 2001 2002 2001
------ ------ ------ ------
Operating Income:
Upstream..................................... $ 6 $ 21 $ 11 $ 56
Downstream................................... 5 11 31 28
------ ------ ------ ------
Total Operating Income................... 11 32 42 84
Earnings from Unconsolidated Investments........ 6 5 10 6
Other Items..................................... (13) (6) (11) (11)
------ ------ ------ ------
Earnings Before Interest and Taxes....... 4 31 41 79
Interest Expense................................ (13) (14) (23) (27)
------ ------ ------ ------
Pre-tax Earnings (Loss).................. (9) 17 18 52
Income Tax Provision (Benefit).................. (2) 7 7 19
------ ------ ------ ------
Net Income (Loss)........................ $ (7) $ 10 $ 11 $ 33
====== ====== ====== ======
Recurring Net Income (Loss)(1)........... $ (4) $ 10 $ 14 $ 33
====== ====== ====== ======
Operating Statistics:
Natural Gas Processing Volumes (MBbls/d):
Field Plants................................. 52.7 56.0 54.3 55.8
Straddle Plants.............................. 37.9 27.9 37.1 25.2
------ ------ ------ ------
Total Natural Gas Processing Volumes..... 90.6 83.9 91.4 81.0
====== ====== ====== ======
Fractionation Volumes (MBbls/d)................. 241.6 250.6 223.2 224.9
Natural Gas Liquids Sold (MBbls/d)............. 468.8 493.8 538.7 567.9
Average Commodity Prices:
Average Natural Gas Price-Henry Hub ($/Mmbtu).. $ 3.38 $ 4.65 $ 2.86 $ 5.85
Crude Oil--Cushing ($/Bbl)................... 25.32 27.90 22.95 28.46
Natural Gas Liquids ($/Gal).................. 0.39 0.49 0.36 0.55
Fractionation Spread ($/MMBtu)............... 1.02 0.92 1.16 0.45
- --------
(1) The recurring net income (loss) consists of segment reported net income
adjusted for identified non-recurring items more fully describe above.
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
Three-Month Periods Ended June 30, 2002 and 2001
DMS reported recurring net loss of $4 million in the second quarter 2002
compared with recurring net income of $10 million in the second quarter 2001.
The segment's recurring results of operations were impacted by lower natural
gas and NGL prices, the residual volume effect of low rig counts in the second
half of 2001 and a temporary shutdown of a major third-party natural gas
pipeline in North Texas, which resulted in a decline in volumes processed. In
addition, as a result of slow economic recovery, high industry-wide inventory
levels, reduced NGL liquidity and Dynegy specific credit limitations, the
segment experienced a decline in domestic and foreign marketing volumes and
margins.
Aggregate domestic NGL processing volumes totaled 90.6 thousand gross
barrels per day in the second quarter 2002 compared to 83.9 thousand gross
barrels per day during the same period in 2001. A small percentage of this
volume increase resulted from the inclusion of incremental ChevronTexaco
volumes associated with former Texaco equity production. The majority of the
volume growth is related to the Louisiana straddle plants and is the direct
result of an increasing need to process Gulf of Mexico natural gas production to
57
meet third party pipeline dew point specification limits. This pipeline
specification-driven need for processing has moved fractionation spread risk to
the producer by shifting processing contract terms to a fee based arrangement
when keep-whole processing is not economical. This trend is expected to
continue as the volume of gas produced in the deep-water Gulf of Mexico
increases.
The average fractionation spread was $1.02 for the three months ended June
30, 2002, compared to $0.92 for the comparable 2001 period. Despite the
year-over-year increase in this spread, traditional keep-whole processing is
still not economical at this level. Historically, the Louisiana straddle plants
would not have operated in this pricing environment.
Gas processing volumes for the field plants were slightly lower for the
second quarter 2002 as compared to prior period volumes as the result of low
drilling rig counts during the latter half of 2001 and second quarter 2002.
DMS' business is dependent on producer drilling activity in the producing
regions that its gathering systems serve. At current natural gas price levels,
producers are actively drilling new wells and DMS' new connect gas volumes for
processing are currently growing enough to more than offset natural decline in
production. The producers supplying DMS' facilities are primarily independent
producers who, as a group, react quickly to changes in gas prices. As natural
gas prices decline significantly from current levels, these producers have
historically reduced their drilling investment. If this occurs going forward,
DMS could experience difficulty in acquiring enough volumes to offset natural
declines. Conversely, as gas prices strengthen from current levels, producers
have historically invested more heavily in drilling and development.
Six-Month Periods Ended June 30, 2002 and 2001
DMS reported recurring net income of $14 million in the six months ended
June 30, 2002 compared with recurring net income of $33 million in the six
months ended June 30, 2001. In addition to the items described above for the
second quarter comparisons, warmer winter temperatures influenced recurring
results of operations period-to-period.
Aggregate domestic NGL processing volumes totaled 91.4 thousand gross
barrels per day in the six months ended June 30, 2002 compared to 81.0 thousand
gross barrels per day during the same period in 2001. A small percentage of
this volume resulted from the inclusion of incremental ChevronTexaco volumes
associated with former Texaco equity production. The majority of the volume
growth related to the Company's Louisiana straddle plants and is the direct
result of an increasing need to process Gulf of Mexico natural gas production
to meet third party pipeline dew point specification limits. This pipeline
specification-driven need for processing has moved fractionation spread risk to
the producer by shifting processing contract terms to a fee based arrangement
when keep-whole processing is not economical. This trend is expected to
continue as the volume of gas produced in the deep-water Gulf of Mexico
increases.
The average fractionation spread was $1.16 for the six months ended June 30,
2002, compared to $0.45 for the comparable 2001 period. Despite the
year-over-year increase in this spread, traditional keep-whole processing is
still not economical at this level. Historically, the Louisiana straddle plants
would not have operated in this pricing environment.
Outlook for Remainder of 2002
The weak fractionation spread environment has continued into the third
quarter 2002. The correlation of prices for propane relative to prices for oil
is lower than historical levels, yielding lower than expected revenues for DMS
in the current pricing environment. As described above, drilling activity,
which is substantially dependent upon the commodity pricing environment,
significantly impacts DMS' results of operations.
In addition, counterparty credit concerns and the resulting industry-wide
contraction in trade credit have limited DMS' ability to purchase incremental
volumes of natural gas liquids at historical levels. DMS cannot predict with
any degree of certainty the effect that this contraction in credit will have on
its result of operations in the future.
58
TRANSMISSION AND DISTRIBUTION
Three Months Six Months
Ended Ended
June 30, June 30,
------------ ------------
2002 2001 2002 2001
---- ---- ------ ----
($ in millions)
Operating Income................... $ 10 $ -- $ 66 $ --
Losses from Unconsolidated Investments -- -- -- --
Other Items........................... (1) -- 1 --
---- ---- ------ ----
Earnings Before Interest and Taxes. 9 -- 67 --
Interest Expense...................... (16) -- (29) --
---- ---- ------ ----
Pre-tax Earnings................... (7) -- 38 --
Income Tax Provision (Benefit)........ (3) -- 15 --
---- ---- ------ ----
Net Income......................... $ (4) $ -- $ 23 $ --
==== ==== ====== ====
Recurring Net Income (1)........... $ (1) $ -- $ 39 $ --
==== ==== ====== ====
Operating Statistics:
Heating Degree Days................ 976 N/A 4,465 N/A
Throughput (Bcf/d)................. 3.2 N/A 12.8 N/A
- --------
(1) The 2002 recurring net income consists of segment reported net income
adjusted for identified non-recurring items more fully described above.
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
Three-Month Periods Ended June 30, 2002 and 2001
Northern Natural was acquired February 1, 2002, therefore there were not
results for this segment in the prior year. The T&D segment reported recurring
net loss of $1 million in the second quarter 2002. Northern Natural had a net
loss of $4 million. The non-recurring item relates to severance expense
discussed above.
Six Month Periods Ended June 30, 2002 and 2001
Northern Natural was acquired February 1, 2002, therefore there were not
results for this segment in the prior year. The T&D segment reported recurring
net income of $39 million in the six months ended June 30, 2002. In addition to
the non-recurring item in the three-month period, the recurring net income for
the six months ended June 30, 2002 excludes an $18 million pre-tax ($13 million
after-tax) charge associated with a gas delivery commitment that was assumed
with the acquisition of Northern Natural.
Outlook for Remainder of 2002
The T&D Segment's results of operations for the third quarter 2002 and
beyond will exclude the operating results of Northern Natural upon consummation
of the sale of Northern Natural as described in Note 6 to the accompanying
financial statements.
59
Cash Flow Disclosures
The following table is a condensed version of the operating section of the
Condensed Consolidated Statements of Cash Flows:
For the Six Months Ended June 30, 2002
-----------------------------------------
Corporate &
WEN DMS T&D Eliminations Consolidated
----- ---- ---- ------------ ------------
Net Income (Loss)..................................... $ (8) $ 11 $ 24 $-- $ 27
Net Non-Cash Items Included in Net Income............. 332 42 61 3 438
----- ---- ---- --- -----
Operating Cash Flows Before Changes in Working Capital 324 53 85 3 465
Changes in Working Capital............................ (175) 8 31 30 (106)
----- ---- ---- --- -----
Net Cash Provided by Operating Activities............. $ 149 $ 61 $116 $33 $ 359
===== ==== ==== === =====
For the Six Months Ended June 30, 2001(1)
-----------------------------------------
Corporate &
WEN DMS T&D Eliminations Consolidated
----- ---- ---- ------------ ------------
Net Income............................................ $ 252 $ 33 $ -- $-- $ 285
Net Non-Cash Items Included in Net Income............. 307 50 -- 2 359
----- ---- ---- --- -----
Operating Cash Flows Before Changes in Working Capital 559 83 -- 2 644
Changes in Working Capital............................ (321) 64 -- (2) (259)
----- ---- ---- --- -----
Net Cash Provided by Operating Activities............. $ 238 $147 $ -- $-- $ 385
===== ==== ==== === =====
- --------
(1) Dynegy intends to restate the 2001 operating cash flow amounts from $385
million to approximately $277 million related to Project Alpha. This
reduction to operating cash flow will impact the risk management line on
the statement of cash flow for the six months ended June 30, 2001 by
changing the current $236 million add-back to an approximate $128 million
add-back. (See Note 1 to the accompanying financial statements.)
Operating Cash Flow. Cash flow from operating activities totaled $359
million for the six-month period ended June 30, 2002 compared to $385 million
reported in the same 2001 period. Non-cash add-backs were greater in the 2002
period, primarily due to the following non-recurring charges, which are further
described in Note 5 to the accompanying financial statements:
. Reconciliation of estimated accrued to actual charges in the natural gas
marketing business following a balance sheet review, which produced a
$124 million pre-tax charge in the WEN segment;
. Pre-tax write-offs within Earnings (Losses) from Unconsolidated
Investments of $26 million representing technology investment impairments
based on the Company's change in business strategy and continued downturn
in the technology sector. Of the total write-offs, $25 million related to
or was allocated to WEN and $1 million was allocated to DMS.
Other changes in non-cash items include the following:
. Depreciation and amortization expense increased by $52 million primarily
due to the addition of Northern Natural in January 2002 and the United
Kingdom natural gas storage facilities in November 2001;
. A reduction in Earnings from Unconsolidated Investments of approximately
$33 million related to West Coast Power;
. Deferred income taxes decreased by $72 million as compared to the 2001
period; and
60
. Risk Management activity produced a $99 million add-back, compared to an
add-back of $128 million in the 2001 period (after taking into account
the Project Alpha adjustment the Company intends to make). The add-backs
represent cash realized for settled contracts in excess of gains
recognized.
Changes in working capital had a negative impact on cash flow from
operations for the six-month period ended June 30, 2002 primarily due to the
following:
. Timing of customer receivable and vendor payable trade accounts,
primarily for WEN's natural gas and power accruals for seasonal trends
beginning in the summer months;
. Parts, supplies and natural gas inventory builds for the power generation
business in anticipation of plants becoming commercial and increased
summer generation demand;
. Fuel oil and coal inventory builds to replenish supply for the Northeast
generation plants in anticipation of seasonal summer generation demand;
. Amortization of liabilities associated with previous acquisitions; and
. Increased natural gas future positions or contracts at June 30, 2002
versus December 31, 2001, representing cash remitted to brokers held on
account for the WEN segment.
Capital Expenditures and Investing Activities. Cash used for investing
activities during the six-month period ended June 30, 2002 totaled $431
million. Capital spending and investments in unconsolidated investments totaled
$477 million and relates primarily to generation asset additions and
improvements, environmental compliance and first quarter investments in
technology infrastructure. Cash spent for the acquisition of Northern Natural
totaled $20 million, net of cash acquired. These cash outflows were offset by
$5 million in proceeds from asset sales.
Financing Activities. Cash provided by financing activities during the
six-month period ended June 30, 2002 totaled $287 million.
Long-term debt proceeds, net of issuance costs, for the six-months ended
June 30, 2002 consisted of $496 million from the issuance of 8.75 percent
senior notes due February 2012. Repayments of long-term debt totaled $144
million for the six-months ended June 30, 2002 and consisted of $90 million
relating to the April 2002 purchase of Northern Natural's senior unsecured
notes due 2005 and $54 million in June 2002 principal payments related to the
restructuring of Black Thunder from Minority Interest to Long-Term Debt. Net
proceeds from short-term financing consisted of $245 million of cash advanced
for the anticipated sale of certain United Kingdom gas storage assets.
Additionally, during the six months ended June 30, 2002, Dynegy repaid $255
million in commercial paper and borrowings under revolving credit lines for the
six-months ended June 30, 2002.
Finally, other financing cash payments totaled $55 million for the
six-months ended June 30, 2002. These payments primarily consisted of $13
million in interest associated with the Black Thunder transaction prior to the
June 2002 restructuring and $39 million associated with Project Alpha. (See
Note 1 to the accompanying financial statements for more information on Project
Alpha.) Additionally, Dynegy intends to restate the statement of cash flows for
the six months ended June 30, 2001 to increase cash from financing activities
from $624 million to approximately $732 million.
61
UNCERTAINTY OF FORWARD-LOOKING STATEMENTS AND INFORMATION
This Quarterly Report on Form 10-Q includes statements reflecting
assumptions, expectations, projections, intentions or beliefs about future
events that are intended as "forward-looking statements" under the Private
Securities Litigation Reform Act of 1995. You can identify these statements by
the fact that they do not relate strictly to historical or current facts. They
use words such as "anticipate," "estimate," "project," "forecast," "may,"
"will," "should," "expect" and other words of similar meaning. In particular,
these include, but are not limited to, statements relating to the following:
. Projected operating or financial results, including the application of
forecasted pricing curves to contractual commitments that may result in
realized cash returns on these commitments which may vary significantly,
either positively or negatively, from estimated values;
. Expectations regarding capital expenditures and other payments;
. The pending sale of Northern Natural, including the anticipated closing
date and the financial impact of the sale on Dynegy's balance sheet and
liquidity position;
. Expectations regarding transaction volume and liquidity in wholesale
energy markets in North America and Europe;
. The Company's beliefs and assumptions relating to trade credit in the
wholesale energy market and its liquidity position, including its ability
to meet its obligations;
. The Company's ability to execute additional capital-raising transactions
such as asset sales, joint ventures or financings to enhance its
liquidity position;
. Beliefs or assumptions about the outlook for deregulation of retail and
wholesale energy markets in North America and Europe and anticipated
business developments in such markets;
. The Company's ability to effectively compete for market share with
industry participants;
. Beliefs about the outcome of legal and administrative proceedings,
including matters involving Enron, the California power market,
shareholder class action lawsuits related to Dynegy Inc. and
environmental matters as well as the investigations primarily relating to
Project Alpha, roundtrip trades and Black Thunder;
. The Company's ability to rationalize its customer and risk-management
business, either through the formation of a joint venture or the
execution of an alternative strategy; and
. The expected commencement date for commercial operations for new power
plants.
Any or all of Dynegy's forward-looking statements may turn out to be wrong.
They can be affected by inaccurate assumptions or by known or unknown risks and
uncertainties, including the following:
. The timing and consummation of the Northern Natural sale;
. The timing and extent of changes in commodity prices for energy,
particularly natural gas, electricity and NGLs;
. The timing and extent of deregulation of energy markets in North America
and Europe and the rules and regulations adopted on a transitional basis
in such markets;
. The condition of the capital markets generally, which will be affected by
interest rates, foreign currency fluctuations and general economic
conditions, and Dynegy's financial condition, including its ability to
improve its credit ratings;
. Developments in the California power markets, including, but not limited
to, governmental intervention, deterioration in the financial condition
of our counterparties, default on receivables due and adverse results in
current or future litigation;
. The effectiveness of Dynegy's risk-management policies and procedures and
the ability of Dynegy's counterparties to satisfy their financial
commitments;
62
. The liquidity and competitiveness of wholesale trading markets for energy
commodities, including the impact of electronic or online trading in
these markets;
. The direct or indirect effects on Dynegy's business resulting from the
financial difficulties of Enron, or other competitors of Dynegy,
including, but not limited to, their effects on liquidity in the trading
and power industry, and its effects on the capital markets views of the
energy or trading industry and our ability to access the capital markets;
. Operational factors affecting the start up or ongoing commercial
operations of Dynegy's power generation or midstream natural gas
facilities, including catastrophic weather related damage, unscheduled
outages or repairs, unanticipated changes in fuel costs or availability
of fuel emission credits, the unavailability of gas transportation, the
unavailability of electric transmission service or workforce issues;
. The cost of borrowing, availability of trade credit and other factor's
affecting Dynegy's financing activities, including the effect of Dynegy's
publicly announced re-audit of its 1999-2001 financial statements and the
other issues described in this Form 10-Q;
. Dynegy Inc. ability to successfully execute its $2 billion capital plan
and to otherwise satisfy its obligations as they become due;
. The direct or indirect effects on Dynegy's business of downgrades in
credit ratings (or actions we may take in response to changing credit
ratings criteria), including increased collateral requirements to execute
our business plan, demands for increased collateral by our current
counterparties, refusal by our current or potential counterparties to
enter into transactions with us and our inability to obtain credit or
capital in amounts or on terms favorable to us; and
. Cost and other effects of legal and administrative proceedings,
settlements, investigations and claims, including legal proceedings
related to the terminated merger with Enron, the California power market,
shareholder claims related to Dynegy and environmental liabilities that
may not be covered by indemnity or insurance, as well as the SEC, FERC,
CFTC and other similar investigations primarily surrounding Project Alpha
and roundtrip trades;
. Other North American or European regulatory or legislative developments
that affect the demand for energy generally, increase the environmental
compliance cost for Dynegy's power generation or midstream gas facilities
or impose liabilities on the owners of such facilities; and
. General political conditions, including any extended period of war or
conflict involving North America or Europe.
Many of these factors will be important in determining Dynegy's actual
future results. Consequently, no forward-looking statement can be guaranteed.
Dynegy's actual future results may vary materially from those expressed or
implied in any forward-looking statements.
All of Dynegy's forward-looking statements, whether written or oral, are
expressly qualified by these cautionary statements and any other cautionary
statements that may accompany such forward-looking statements. In addition,
Dynegy disclaims any obligation to update any forward-looking statements to
reflect events or circumstances after the date of this report.
63
DYNEGY HOLDINGS, INC.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For the Interim Periods Ended June 30, 2002 and 2001
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Quantitative and Qualitative Disclosures About Market Risk are set forth
in "Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations" herein.
64
DYNEGY HOLDINGS INC.
PART II. OTHER INFORMATION
For the Interim Periods Ended June 30, 2002 and 2001
ITEM 1--LEGAL PROCEEDINGS
See Note 11 to the accompanying financial statements for discussion of
material recent developments in the Company's material legal proceedings.
ITEM 6--EXHIBITS AND REPORTS ON FORM 8-K
(a) The following instruments and documents are included as exhibits to this
Form 10-Q:
10.1 Purchase and Sale Agreement dated July 28, 2002 among Dynegy Inc., NNGC Holding Company,
Inc. and MidAmerican Energy Holdings Company (incorporated by reference to Exhibit 99.2 to
the Company's Current Report on Form 8-K dated July 29, 2002).
10.2 Agreement dated as of July 31, 2002 among Chevron U.S.A. Inc., Dynegy Marketing and Trade,
Dynegy Holdings Inc., Dynegy Inc. and the other parties thereto (incorporated by reference to
Exhibit 10.2 to Dynegy Inc.'s Quarterly Report on Form 10-Q for the quarterly period ended
June 30, 2002).
10.3 Contract for Services between Daniel L. Dienstbier and Dynegy Inc. effective as of May 28, 2002
(incorporated by reference to Exhibit 10.3 to Dynegy Inc.'s Quarterly Report on Form 10-Q for the
quarterly period ended June 30, 2002).
(b) Reports on Form 8-K of Dynegy Inc. for the second quarter of 2002.
1. During the quarter ended June 30, 2002, the Company filed a Current
Report on Form 8-K dated April 25, 2002. Items 5, 7 and 9 were
reported and no financial statements were filed.
2. During the quarter ended June 30, 2002, the Company filed a Current
Report on Form 8-K dated April 29, 2002. Items 5 and 7 were reported
and no financial statements were filed.
3. During the quarter ended June 30, 2002, the Company filed a Current
Report on Form 8-K dated May 8, 2002. Items 5 and 7 were reported and
no financial statements were filed.
4. During the quarter ended June 30, 2002, the Company filed a Current
Report on Form 8-K dated May 28, 2002. Items 5 and 7 were reported
and no financial statements were filed.
5. During the quarter ended June 30, 2002, the Company filed a Current
Report on Form 8-K dated June 24, 2002. Items 5 and 7 were reported
and no financial statements were filed.
65
DYNEGY HOLDINGS INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DYNEGY HOLDINGS INC.
Date: August 14, 2002
BY: /s/ Michael R. Mott
---------------------------------------
Michael R. Mott
Senior Vice President and Controller
(Duly Authorized Officer and Principal Accounting Officer)
66