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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
-----------------
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 September 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: 1-15659
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DYNEGY INC.
(Exact name of registrant as specified in its charter)
Illinois 74-2928353
(State or other jurisdiction (I.R.S. Employer 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)
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 [_]
Number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date: Class A Common Stock, no par value
per share, 274,476,836 shares outstanding as of November 12, 2002; Class B
Common Stock, no par value per share, 96,891,014 shares outstanding as of
November 12, 2002.
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DYNEGY INC.
TABLE OF CONTENTS
Page
----
PART I. FINANCIAL INFORMATION
Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS:
Condensed Consolidated Balance Sheets:
September 30, 2002 and December 31, 2001........................... 3
Condensed Consolidated Statements of Operations:
For the three months ended September 30, 2002 and 2001............. 4
Condensed Consolidated Statements of Operations:
For the nine months ended September 30, 2002 and 2001.............. 5
Condensed Consolidated Statements of Cash Flows:
For the nine months ended September 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............................................ 44
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..... 81
Item 4. CONTROLS AND PROCEDURES........................................ 81
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.............................................. 82
Item 6. EXHIBITS AND REPORTS ON FORM 8-K............................... 82
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. The comparative financial
information contained in this report has been revised to reflect the known
effects of the restatement items described in Note 1 to the accompanying
Condensed Consolidated Financial Statements. In this regard, Arthur Andersen
LLP, our former independent public accountant, has advised that its audit
opinion relating to 2001 should no longer be relied upon and such audit opinion
was also withdrawn. Also, concurrent with the filing of this quarterly report,
Dynegy has filed a Current Report on Form 8-K that includes revised financial
statements for each of the years in the three-year period ended December 31,
2001. These revised financial statements have been prepared by management and
reflect all known restatement items to Dynegy's 2001, 2000 and 1999 financial
statements originally filed with its Annual Report on Form 10-K for the year
ended December 31, 2001. However, as a result of the three-year re-audit and
PricewaterhouseCoopers' subsequent review of Dynegy's 2002 quarterly financial
statements, it is possible that additional adjustments to the unaudited revised
financial statements in the Form 8-K and Dynegy's 2002 quarterly reports may
result, some of which could be material. Dynegy expects to file an amended Form
10-K reflecting the unaudited restatements described in the Form 8-K as soon as
practicable after the date of this report. Following completion of the
re-audit, which the Company expects will occur early in the first quarter 2003,
further amendment of the Form 10-K will be necessary in order to include the
audit report of PricewaterhouseCoopers LLP as well as to reflect other changes
resulting from the re-audit, if any.
2
DYNEGY INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in millions, except share data)
December 31,
September 30, 2001
2002 Unaudited
Unaudited Restated
------------- ------------
ASSETS
Current Assets
Cash and cash equivalents......................... $ 881 $ 218
Restricted cash................................... 189 --
Accounts receivable, net of allowance for
doubtful accounts of $114 million and $107
million, respectively............................ 3,108 3,688
Accounts receivable, affiliates................... 69 80
Inventory......................................... 211 258
Assets held for sale (Note 4)..................... 32 --
Assets from risk-management activities............ 4,142 4,399
Prepayments and other assets...................... 792 1,301
------- -------
Total Current Assets......................... 9,424 9,944
------- -------
Property, Plant and Equipment..................... 9,631 9,130
Accumulated depreciation.......................... (1,197) (921)
------- -------
Property, Plant and Equipment, Net........... 8,434 8,209
Other Assets
Unconsolidated investments (Note 7)............... 770 950
Investment in Northern Natural Gas Company (Note
4)............................................... -- 1,501
Assets held for sale (Note 4)..................... 644 --
Assets from risk-management activities............ 4,715 2,680
Goodwill.......................................... 404 1,579
Other assets...................................... 756 852
------- -------
Total Assets................................. $25,147 $25,715
======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable.................................. $ 2,145 $ 2,392
Accounts payable, affiliates...................... 274 40
Accrued liabilities and other..................... 1,323 2,497
Liabilities from risk-management activities....... 4,025 3,805
Notes payable and current portion of long-term
debt............................................. 1,526 458
Liabilities held for sale (Note 4)................ 30 --
------- -------
Total Current Liabilities.................... 9,323 9,192
------- -------
Long-Term Debt.................................... 4,490 3,834
Other Liabilities
Transitional funding trust notes.................. 452 516
Liabilities held for sale (Note 4)................ 211 --
Liabilities from risk-management activities....... 4,141 2,196
Deferred income taxes............................. 1,328 1,768
Other long-term liabilities....................... 724 906
------- -------
Total Liabilities............................ 20,669 18,412
------- -------
Minority Interest................................. 150 1,020
Serial Preferred Securities of a Subsidiary....... 11 46
Company Obligated Preferred Securities of
Subsidiary Trust................................. 200 200
Series B Mandatorily Convertible Redeemable
Preferred Securities............................. 1,527 1,503
Commitments and Contingencies (Note 12)
Stockholders' Equity
Class A Common Stock, no par value, 900,000,000
shares authorized at September 30, 2002 and
December 31, 2001, 272,960,450 and 269,984,456
shares issued and outstanding at September 30,
2002 and December 31, 2001, respectively......... 2,855 2,814
Class B Common Stock, no par value, 360,000,000
shares authorized at September 30, 2002 and
December 31, 2001, 96,891,014 and 86,499,914
shares issued and outstanding at September 30,
2002 and December 31, 2001, respectively......... 1,006 801
Subscriptions receivable (Note 9)................. (13) (38)
Accumulated other comprehensive loss, net of tax.. (3) (21)
Retained earnings (accumulated deficit)........... (1,187) 1,049
Treasury stock, at cost, 1,679,183 shares at
September 30, 2002 and 1,766,800 shares at
December 31, 2001................................ (68) (71)
------- -------
Total Stockholders' Equity........................ 2,590 4,534
------- -------
Total Liabilities and Stockholders' Equity... $25,147 $25,715
======= =======
See the notes to condensed consolidated financial statements.
3
DYNEGY INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions, except per share data)
Three Months Ended
September 30,
------------------
2001
2002 Unaudited
Unaudited Restated
--------- ---------
Revenues (Note 2)........................................................ $ 1,720 $2,329
Cost of sales, exclusive of depreciation shown separately below (Note 2). 1,718 1,657
Depreciation and amortization............................................ 139 113
Goodwill impairment (Note 5)............................................. 908 --
General and administrative expenses...................................... 115 142
-------- ------
Operating income (loss)............................................... (1,160) 417
Earnings (losses) from unconsolidated investments (Note 7)............... (68) 104
Other income............................................................. 24 12
Interest expense......................................................... (100) (63)
Other expenses (Note 5).................................................. (93) (14)
Minority interest expense................................................ (2) (14)
Accumulated distributions associated with trust preferred securities..... (4) (6)
-------- ------
Income (loss) from continuing operations before income taxes............. (1,403) 436
Income tax provision (benefit)........................................... (154) 162
-------- ------
Income (loss) from continuing operations................................. (1,249) 274
Discontinued operations (Note 4):
Loss from discontinued operations (including loss on disposal of Northern
Natural of $586 million)............................................... (569) --
Income tax benefit....................................................... (14) --
-------- ------
Loss on discontinued operations.......................................... (555) --
-------- ------
Net Income (Loss)........................................................ $(1,804) $ 274
======== ======
Net Income (Loss) Per Share:
Net income (loss)........................................................ $(1,804) $ 274
Less: preferred stock dividends.......................................... 8 --
-------- ------
Net income (loss) applicable to common stockholders...................... $(1,812) $ 274
======== ======
Basic earnings (loss) per share:
Income (loss) from continuing operations.............................. $ (3.41) $ 0.84
Loss from discontinued operations..................................... (1.51) --
-------- ------
Basic earnings (loss) per share.......................................... $ (4.92) $ 0.84
======== ======
Diluted earnings (loss) per share (Note 10):
Income (loss) from continuing operations.............................. $ (3.41) $ 0.81
Loss from discontinued operations..................................... (1.51) --
-------- ------
Diluted earnings (loss) per share (Note 10).............................. $ (4.92) $ 0.81
======== ======
Basic shares outstanding................................................. 368 326
======== ======
Diluted shares outstanding............................................... 416 337
======== ======
See the notes to condensed consolidated financial statements.
4
DYNEGY INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS--(Continued)
(in millions, except per share data)
Nine Months Ended
September 30,
------------------
2001
2002 Unaudited
Unaudited Restated
--------- ---------
Revenues (Note 2)....................................................................... $ 4,769 $7,323
Cost of sales, exclusive of depreciation shown separately below (Note 2)................ 4,089 5,863
Depreciation and amortization........................................................... 355 333
Goodwill impairment (Note 5)............................................................ 908 --
Impairment and other charges (Note 5)................................................... 319 --
General and administrative expenses..................................................... 353 383
------- ------
Operating income (loss).............................................................. (1,255) 744
Earnings (losses) from unconsolidated investments (Notes 5 and 7)....................... (86) 214
Other income............................................................................ 75 69
Interest expense........................................................................ (239) (192)
Other expenses (Note 5)................................................................. (128) (44)
Minority interest expense............................................................... (22) (45)
Accumulated distributions associated with trust preferred securities.................... (13) (18)
------- ------
Income (loss) from continuing operations before income taxes and change in accounting
principle............................................................................. (1,668) 728
Income tax provision (benefit).......................................................... (254) 278
------- ------
Income (loss) from continuing operations................................................ (1,414) 450
Discontinued operations (Note 4):
Loss from discontinued operations (including loss on disposal of Northern Natural of
$586 million)...................................................................... (511) --
Income tax provision................................................................. 6 --
------- ------
Loss on discontinued operations......................................................... (517) --
Cumulative effect of change in accounting principle, net (Notes 2 and 5)................ (234) 2
------- ------
Net Income (Loss)....................................................................... $(2,165) $ 452
======= ======
Net Income (Loss) Per Share:
Net income (loss)....................................................................... $(2,165) $ 452
Less: preferred stock dividends......................................................... 24 --
------- ------
Net income (loss) applicable to common stockholders..................................... $(2,189) $ 452
======= ======
Basic earnings (loss) per share:
Income (loss) from continuing operations............................................. $ (3.94) $ 1.38
Loss from discontinued operations.................................................... (1.42) --
Cumulative effect of change in accounting principle, net............................. (0.64) 0.01
------- ------
Basic earnings (loss) per share......................................................... $ (6.00) $ 1.39
======= ======
Diluted earnings (loss) per share (Note 10):
Income (loss) from continuing operations............................................. $ (3.94) $ 1.33
Loss from discontinued operations.................................................... (1.42) --
Cumulative effect of change in accounting principle, net............................. (0.64) 0.01
------- ------
Diluted earnings (loss) per share (Note 10)............................................. $ (6.00) $ 1.34
======= ======
Basic shares outstanding................................................................ 365 325
======= ======
Diluted shares outstanding.............................................................. 416 338
======= ======
See the notes to condensed consolidated financial statements.
5
DYNEGY INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Interim Periods Ended September 30, 2002 and 2001
(in millions)
Nine Months
Ended September 30,
------------------
2001
2002 Unaudited
Unaudited Restated
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)...................................................................... $(2,165) $ 452
Items not affecting cash flows from operating activities:
Depreciation and amortization....................................................... 426 328
Goodwill impairment (Note 5)........................................................ 908 --
Impairment and other charges........................................................ 323 --
(Earnings) losses from unconsolidated investments, net of cash distributions........ 160 (184)
Risk-management activities.......................................................... 444 (76)
Deferred income taxes............................................................... (242) 177
Loss on sale of Northern Natural (Note 4)........................................... 586 --
Cumulative effect of change in accounting principle (Notes 2 and 6)................. 234 (2)
Other............................................................................... 61 (13)
------- -------
Operating cash flows before changes in working capital................................. 735 682
Changes in working capital:
Accounts receivable................................................................. 502 1,414
Inventory........................................................................... (1) 170
Prepayments and other assets (includes $270 million cash collateral postings in the
2002 period)...................................................................... (317) (159)
Accounts payable and accrued liabilities............................................ (543) (1,699)
Other, net.......................................................................... (115) 44
------- -------
Net cash provided by operating activities.............................................. 261 452
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures................................................................... (736) (1,593)
Unconsolidated investments............................................................. (12) (52)
Business acquisitions, net of cash acquired............................................ (20) (21)
Proceeds from asset sales.............................................................. 1,105 1,051
Other investing, net................................................................... 75 (237)
------- -------
Net cash provided by (used in) investing activities.................................... 412 (852)
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from long-term borrowings................................................. 532 855
Repayments of long-term borrowings..................................................... (571) (251)
Net proceeds from short-term borrowings................................................ 437 --
Net cash flow from commercial paper and revolving lines of credit...................... (303) 38
Proceeds from sale of capital stock, options and warrants.............................. 240 57
Purchase of serial preferred securities of a subsidiary................................ (28) --
Purchase of treasury stock............................................................. (1) (59)
Dividends and other distributions, net................................................. (55) (74)
Increase in restricted cash............................................................ (189) --
Other financing, net................................................................... (14) (18)
------- -------
Net cash provided by financing activities.............................................. 48 548
------- -------
Effect of exchange rate changes on cash................................................ (58) 3
Net increase in cash and cash equivalents.............................................. 663 151
Cash and cash equivalents, beginning of period......................................... 218 86
------- -------
Cash and cash equivalents, end of period............................................... $ 881 $ 237
======= =======
See the notes to condensed consolidated financial statements.
6
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the Interim Periods Ended September 30, 2002 and 2001
Note 1--Restatements
This Quarterly Report on Form 10-Q of Dynegy Inc. ("Dynegy" or the
"Company") gives effect to the unaudited restatements of the Company's
consolidated financial statements as of December 31, 2001 and for the three-
and nine-month periods ended September 30, 2002 and 2001, respectively.
Concurrent with the filing of this Form 10-Q, Dynegy has filed a Current Report
on Form 8-K that includes unaudited restated financial statements for each of
the three years in the period ended December 31, 2001. The restatements herein
and therein relate to the Project Alpha structured natural gas transaction, a
balance sheet reconciliation project relating principally to the Company's
natural gas marketing business, adjustments relating to a change in the
accounting for certain contracts from hedge accounting to mark-to-market
accounting under Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities," as amended
("Statement No. 133"), and an overstatement of the valuation used in the
Company's 2000 acquisition of Extant, Inc. Specifically, the restatements are
as follows:
Project Alpha. Dynegy entered into the Project Alpha structured natural gas
transaction in April 2001. As described in a Current Report on Form 8-K dated
April 25, 2002 (the "Alpha Form 8-K"), Dynegy decided 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. The effect of this decision was
to reclassify approximately $180 million of previously disclosed operating cash
flow to financing cash flow for the nine-month period ended September 30, 2001.
Following the disclosure in the Alpha 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 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, the effect of which was a reversal of
the annual tax benefit previously recognized by the Company during the 2001
period. This decision resulted in the reversal of $36 million and $63 million,
respectively, of tax benefit previously reported for the three- and nine-month
periods ended September 30, 2001. Andersen further advised the Company that its
audit opinion relating to 2001 should no longer be relied upon as a result of
the pending restatements relating to Project Alpha and such audit opinion was
also withdrawn. Dynegy subsequently concluded that its restated consolidated
financial statements should include the consolidation of ABG Gas Supply, LLC
("ABG"), one of the entities formed in connection with the transaction. The
consolidation of ABG is included herein based on compilations of financial
information received from an agent of ABG's equity holders. Such compilations
have not been audited and may change upon further assessment by Dynegy. The
most significant impact of consolidating ABG is to increase Dynegy's
consolidated indebtedness by approximately $280 million and $270 million at
December 31, 2001 and September 30, 2002, respectively.
7
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Balance Sheet Reconciliation Project. Dynegy originally reported an
after-tax charge of approximately $80 million ($124 million pre-tax) in the
second quarter 2002 related to a balance sheet reconciliation project
undertaken by the Company at the beginning of 2002. The charge related
principally to the Company's natural gas marketing business. The original $80
million charge has been excluded from net income for the nine-months ended
September 30, 2002. The table below reflects the impact on net income of the
re-allocation of the $80 million charge from the second quarter 2002 back to
the periods in which the transactions giving rise to the charge originally
occurred (in millions).
Three Three Three Three Six Nine Twelve
Months Months Months Months Months Months Months
Ended Ended Ended Ended Ended Ended Ended
March 31, June 30, September 30, December 31, June 30, September 30, December 31,
--------- -------- ------------- ------------ -------- ------------- ------------
1998 and prior..... (34)
1999............... (4)
2000............... 1 5 2 (25) 6 8 (17)
2001............... 11 (69) 22 6 (58) (36) (30)
2002............... 4 1 -- -- 5 5 5
---
Total Re-allocation (80)
===
Changes in Accounting Classification Under Statement No. 133. The Company
adopted Statement No. 133 effective January 1, 2001 and reflected certain
contracts as cash flow hedges upon such adoption. Management has subsequently
determined that following the initial adoption of Statement No. 133, the
documentation of compliance requirements under the standard, particularly as it
relates to the periodic assessment of hedge effectiveness, was inadequate to
support the accounting method previously applied. The resulting restatement
reflects the accounting for these contracts on a mark-to-market basis rather
than on the deferred basis previously employed beginning in the first quarter
2001. The impact of the change in accounting method for these contracts
increased previously reported net income for the three-month period ended
September 30, 2001 by $1 million and reduced previously reported net income
from the nine-month period ended September 30, 2001 by $21 million. The impact
of the change in accounting method for these contracts reduced reported net
income for the nine-month period ended September 30, 2002 by $3 million. The
change in accounting method employed had no impact on previously reported cash
flows from operations in any period.
Valuation of Extant, Inc. Purchase. On September 29, 2000, Dynegy completed
the acquisition of Extant, Inc., a privately held entity engaged in the
communications business. The transaction was accounted for as a purchase. In
2000, the Company incorrectly valued the shares of Class A common stock it
issued as consideration for the acquisition at $49.59 per share, rather than
$36.59 per share, which amount represented the average share price during the
five days surrounding the announcement of the acquisition. As a result, the
purchase price allocated to the assets acquired and liabilities assumed in the
purchase was overstated by $23 million in 2000. This error resulted in an
overstatement of the amortization of goodwill acquired in the transaction
during 2000 and 2001. The resulting restatement reflects an increase in net
income in the three- and nine-month periods ended September 30, 2001 by
approximately $300,000 and $900,000, respectively. Additionally, as a result of
this error, the Company overstated by $22 million the impairment of goodwill
recorded in 2002 associated with the Company's January 1, 2002 adoption of
Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets."
8
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Following is a synopsis of the financial impact of these restatements on the
condensed consolidated financial statements for the periods indicated (in
millions, except per share data):
December 31,
2001
------------
(unaudited)
Balance Sheet:
Current Assets:
As Reported.......... $ 9,730
Restatement Effect... 214
-------
As Restated.......... $ 9,944
=======
Total Assets:
As Reported.......... $25,175
Restatement Effect... 540
-------
As Restated.......... $25,715
=======
Current Liabilities:
As Reported.......... $ 8,869
Restatement Effect... 323
-------
As Restated.......... $ 9,192
=======
Total Liabilities:
As Reported.......... $17,709
Restatement Effect... 703
-------
As Restated.......... $18,412
=======
Stockholders' Equity:
As Reported.......... $ 4,707
Restatement Effect... (173)
-------
As Restated.......... $ 4,534
=======
Three Months Nine Months
Ended Ended
September 30, September 30,
2001 2001
------------- -------------
Statement of Operations:
Net Income (Loss):
As Reported................... $ 286 $ 571
Restatement Effect............ (12) (119)
------ ------
As Restated................... $ 274 $ 452
====== ======
Diluted Earnings (Loss) Per Share:
As Reported................... $ 0.85 $ 1.69
Restatement Effect............ (0.04) (0.35)
------ ------
As Restated................... $ 0.81 $ 1.34
====== ======
Statements of Cash Flows:
Operating Cash Flows:
As Reported................... $ 634
Restatement Effect............ (182)
------
As Restated................... $ 452
======
Investing Cash Flows:
As Reported................... $ (852)
Restatement Effect............ --
------
As Restated................... $ (852)
======
Financing Cash Flows:
As Reported................... $ 366
Restatement Effect............ 182
------
As Restated................... $ 548
======
9
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
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 that they have not been reviewed by
an independent public accountant under Rule 10-01(d) of Regulation S-X. These
interim financial statements should be read in conjunction with the unaudited
restated consolidated financial statements and notes thereto included in the
Company's Current Report on Form 8-K dated November 14, 2002, which includes
unaudited restated financial statements for 1999-2001 reflecting the known
revisions described in Note 1 above (the "Restatement Form 8-K").
The financial statements contained in this quarterly report include all
material adjustments that, in the opinion of management, are necessary for a
fair presentation of the results for the interim periods. Interim period
results are not necessarily indicative of the results for the full year. The
preparation of the 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. The Company reviews significant
estimates affecting its consolidated financial statements on a recurring basis
and records the effect of any necessary adjustments prior to their publication.
Judgments and estimates are based on the Company's beliefs and assumptions
derived from information available at the time such judgments and estimates are
made. Adjustments made with respect to the use of these estimates often relate
to information not previously available. Uncertainties with respect to such
estimates and assumptions are inherent in the preparation of financial
statements. Estimates are primarily used in (1) developing fair value
assumptions, including estimates of future cash flows and discount rates, (2)
analyzing tangible and intangible assets for impairment and (3) determining the
amounts to accrue related to contingencies. Actual results could differ
materially from any such estimates. Certain reclassifications have been made to
prior period amounts in order to conform to current year presentation.
Change in Accounting Principle. EITF Issue 98-10. In October 2002, the
Emerging Issues Task Force ("EITF" or "Task Force") reached a consensus to
rescind EITF Issue 98-10, "Accounting for Contracts Involved in Energy Trading
and Risk Management Activities" ("EITF Issue 98-10"). As such, all new energy
trading contracts entered into after October 25, 2002 that do not qualify as
derivatives under Statement No. 133 will not be accounted for using mark to
market accounting. All derivative contracts will continue to be accounted for
in accordance with Statement No. 133. With the rescission of this standard,
Dynegy will no longer record trading inventories at fair market value. The
effective date for the full rescission of EITF Issue 98-10 will be January 1,
2003. The effect of the rescission of EITF Issue 98-10 will be reported as the
cumulative effect of a change in accounting principle at the time of adoption;
however, the impact is not currently known.
Accounting Principles Adopted. EITF Issue 02-3. In June 2002, the Task
Force 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. Beginning in the
third quarter 2002, Dynegy is presenting all mark-to-market gains and losses on
a net basis to reflect this change in accounting principle. In accordance with
the transition provisions in the consensus, comparative period financial
statements have been conformed to reflect this change in accounting principle.
Dynegy has historically classified net unrealized gains and losses from energy
trading contracts as revenue in its consolidated statement of operations.
Transactions that were realized and settled were previously reflected gross in
revenues and cost of sales. This
10
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
change in accounting classification has no impact on operating income, net
income, earnings per share or cash flow from operations.
The following table reconciles the revenues and costs of sales as previously
reported to the restated amounts herein (in millions):
Three Months Nine Months
Ended Ended
September 30, 2001 September 30, 2001
------------------ ------------------
Revenues as previously reported..... $ 8,519 $ 33,499
Restatements (see Note 1)........... 32 (32)
------- --------
Adjusted revenues................... 8,551 33,467
Change in accounting principle...... (6,222) (26,144)
------- --------
Revenues as reported herein......... $ 2,329 $ 7,323
======= ========
Cost of sales as previously reported $ 7,886 $ 31,952
Restatements (see Note 1)........... (7) 55
------- --------
Adjusted cost of sales.............. 7,879 32,007
Change in accounting principle...... (6,222) (26,144)
------- --------
Cost of sales as reported herein.... $ 1,657 $ 5,863
======= ========
The second consensus reached by the Task Force in June 2002 related to
required disclosures regarding energy trading operations. However, in October
2002, the Task Force rescinded its earlier consensus. With the rescission of
EITF Issue 98-10, as discussed above, the additional disclosures previously
called for under EITF Issue 02-3 are no longer applicable.
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 did
not reach a consensus on this issue in October 2002.
Finally, it is unclear whether the scope of future 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 one or more of
these issues, such guidance may 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 is not expected to be material as a result of the Company's decision
to exit third party risk management aspects of the marketing and trading
business. Please see Note 4 for further discussion.
FASB Statement No. 142. In July 2001, the FASB issued Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets"
("Statement No. 142"). Statement No. 142 discontinued goodwill amortization
over its estimated useful life and provided 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
11
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
estimation of fair value is highly subjective, inherently imprecise and can
change materially from period to period based on, among other things, an
assessment of market conditions, projected cash flows and discount rate.
Accordingly, if conditions change in the future, the Company may record further
impairment losses. On an annual basis, absent any impairment indicators, the
Company expects to perform its annual impairment analysis in the fourth quarter
after the annual budgetary process. The changes in the carrying amount of
goodwill for each of Dynegy's reportable business segments for the nine-month
period ended September 30, 2002 are as follows (in millions):
Wholesale Dynegy Transmission Dynegy
Energy Midstream & Global
Network Services Distribution Communications Total
--------- --------- ------------ -------------- ------
Balances as of January 1, 2002........... $ 940 $16 $ 389 $ 234 $1,579
Cumulative effect of change in accounting
principle (see Note 5)................. -- -- -- (234) (234)
Goodwill acquired during the period (see
Note 4)................................ -- -- 887 -- 887
Purchase price adjustments............... (32) -- (28) -- (60)
Goodwill impaired during the period (see
Note 5)................................ (908) -- -- -- (908)
Sale of Canadian crude business.......... -- (1) -- -- (1)
Sale of Northern Natural Gas Company (see
Note 4)................................ -- -- (859) -- (859)
----- --- ----- ----- ------
Balances as of September 30, 2002........ $ -- $15 $ 389 $ -- $ 404
===== === ===== ===== ======
The purchase price adjustments relate to the United Kingdom natural gas
storage assets purchased in late 2001 and to the acquisition of Northern
Natural Gas Company ("Northern Natural") in early 2002, each of which was sold
within one year. Please see Note 4 for further discussion.
12
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
The following table sets forth what Dynegy's net income and earnings per
share ("EPS") would have been in the three- and nine-month periods ended
September 30, 2001 if goodwill had not been amortized during those periods,
compared to the net loss and loss per share Dynegy recorded for the three- and
nine-month periods ended September 30, 2002 (in millions, except per share
data).
Three Months Nine Months
Ended September 30, Ended September 30,
------------------ ------------------
2002 2001 2002 2001
------- ------- ------- -------
Net income (loss) as previously reported.......... $(1,804) $ 286 $(2,165) $ 571
Restatements (see Note 1)......................... -- (12) -- (119)
------- ------- ------- -------
Restated net income............................... (1,804) 274 (2,165) 452
Add back: Goodwill amortization................... -- 12 -- 36
------- ------- ------- -------
Adjusted net income (loss)........................ $(1,804) $ 286 $(2,165) $ 488
Less: preferred stock dividends................... 8 -- 24 --
------- ------- ------- -------
Net income (loss) available to common stockholders $(1,812) $ 286 $(2,189) $ 488
======= ======= ======= =======
Basic EPS:
Net income (loss) as previously reported.......... $ (4.92) $ 0.88 $ (6.00) $ 1.74
Restatements (see Note 1)......................... -- (0.04) -- (0.37)
------- ------- ------- -------
Restated net income (loss)........................ (4.92) 0.84 (6.00) 1.37
Goodwill amortization............................. -- 0.04 -- 0.11
------- ------- ------- -------
Adjusted net income (loss)........................ $ (4.92) $ 0.88 $ (6.00) $ 1.48
======= ======= ======= =======
Diluted EPS:
Net income (loss) as previously reported.......... $ (4.92) $ 0.85 $ (6.00) $ 1.69
Restatements (see Note 1)......................... -- (0.04) -- (0.35)
------- ------- ------- -------
Restated net income (loss)........................ (4.92) 0.81 (6.00) 1.34
Goodwill amortization............................. -- 0.04 -- 0.11
------- ------- ------- -------
Adjusted net income (loss)........................ $ (4.92) $ 0.85 $ (6.00) $ 1.45
======= ======= ======= =======
FASB Statement No. 144. 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. However, see Note 4 below
regarding the Company's treatment of assets held for sale at September 30,
2002, and see Note 5 below regarding the impairment of the telecommunications
business in the second quarter 2002.
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.
13
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
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 EITF 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
encouraged. The Company is evaluating the impact of this standard on its
current restructuring initiative and will apply provisions of the standard
accordingly.
Note 3--Liquidity and Industry Conditions
Dynegy believes its current liquidity position should be sufficient to
permit the Company to meet its debt maturities and other obligations through
the first quarter 2003. The sufficiency of the Company's liquidity will depend
upon:
. Dynegy's continued compliance with the covenants in its bank credit and
other debt instruments or its ability to negotiate waivers in the event
of a covenant default;
. Dynegy's ability to repay or refinance the Dynegy Holdings Inc. ("DHI")
and Illinois Power Company ("IP") credit facilities that mature in the
second quarter 2003;
. Dynegy's ability to manage its exit from third party risk management
aspects of the marketing and trading business and the timing of the
expected cash flows and reduction in collateral from this exit;
. the level of earnings and cash flow from Dynegy's assets and businesses,
which is subject to the effect of changes in commodity prices,
particularly natural gas and power;
. Dynegy's non-investment grade credit ratings, the effect of these ratings
on Dynegy's ability to access capital markets and to conduct normal
commercial operations and the effect of any further downgrade in these
credit ratings on refinancings;
. ongoing investigations and litigation relating to Project Alpha, Dynegy's
trading practices and its activities in the California power markets;
. confidence in Dynegy's financial reporting in light of the previously
announced restatements and the ongoing re-audit of its 1999-2001
financial statements; and
. Dynegy's ability to eliminate or further reduce net cash outflows
associated with its telecommunications business.
Dynegy's liquidity may be significantly adversely affected if it is unable
to refinance the DHI and IP credit facilities that mature in the second quarter
2003. Dynegy also faces the risk of a covenant default on these facilities or
other debt instruments prior to maturity. The DHI and IP credit facilities and
the Company's telecommunications lease financing contain various covenants,
including EBITDA-to-interest and debt-to-capitalization financial covenants.
The Company was in compliance with the covenants in its credit facilities and
other debt instruments at September 30, 2002. While many of the charges
incurred by the Company during 2002
14
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
are excluded from the compliance calculations, continued weakness in the
Company's operating results compared with results in 2001 will make it more
difficult for the Company to continue to comply with certain of its financial
covenants. Compliance with these financial covenants is measured on a quarterly
basis.
Any failure to satisfy one or more of these financial covenants would
constitute a breach giving rise to a default under the applicable debt
instrument and would permit the lenders under such debt instrument to
accelerate the maturity of Dynegy's outstanding obligations thereunder.
Depending upon the particular debt instrument, such a breach or any action by
the lenders to accelerate the maturity of amounts owing would result in a
default under or trigger cross-acceleration provisions in a significant portion
of the Company's other outstanding debt instruments. In the event of
non-compliance, Dynegy would seek waivers from the lenders under these debt
instruments or attempt to repay or refinance the affected debt instruments. The
Company cannot provide any assurance that it could repay, obtain waivers with
respect to or refinance such debt instruments in the event of any such default.
Dynegy has executed on the principal elements of its capital plan in order
to meet its current obligations as they mature and provide the necessary
collateral to support its commercial operations. Dynegy believes that the
combination of its liquidity initiatives and the roll off of collateral and
cash flow from its exit from third party risk management aspects of the
marketing and trading business should enable the Company to refinance all or a
sufficient portion of its second quarter 2003 maturities. However, the Company
faces significant risks related to its ongoing operations and other matters
discussed above. Dynegy also faces the risk that it may not be able to reach
agreement with its lenders on mutually acceptable terms. If Dynegy fails to
execute the remaining elements of its strategy, it may be forced to consider
other strategic alternatives including a possible reorganization under the
protection of federal 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 subject to the risks and contingencies discussed above.
Management believes that actions presently being taken relative to the
Company's capital plan, its revolving credit facilities and other strategic
alternatives should enable the Company to meet its obligations in a manner
consistent with this accounting treatment.
Note 4--Acquisitions and Dispositions
Northern Natural Gas. In November 2001, Dynegy acquired 1,000 shares of
Series A Preferred Stock ("Series A Preferred Stock") in Northern Natural for
$1.5 billion. DHI, a wholly owned subsidiary of Dynegy, concurrently acquired
an option to purchase all of the equity of Northern Natural's indirect parent
company. DHI exercised its option to acquire the indirect parent of Northern
Natural in November 2001 upon termination of Dynegy's merger agreement with
Enron Corp. ("Enron"), and the closing of the option exercise occurred on
January 31, 2002.
On August 16, 2002, Dynegy sold Northern Natural to MidAmerican for $928
million in cash, subject to adjustment for changes in working capital. Under
the terms of this agreement, MidAmerican acquired all of the common and
preferred stock of Northern Natural and assumed all of Northern Natural's $950
million of debt, which debt had a book value of approximately $890 million.
Dynegy incurred a pre-tax loss of $586 million ($566 million after-tax)
associated with the sale. Subject to resolution of the working capital
adjustments relating to the sale, Dynegy could incur an additional loss in the
fourth quarter 2002.
15
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
On September 30, 2002, DHI sold $90 million in 6.875 percent senior notes of
Northern Natural due May 2005 for approximately $96 million in cash. DHI
acquired the notes at par value in April 2002 pursuant to a tender offer that
it agreed to effect in order to obtain a bondholder consent in connection with
the acquisition of Northern Natural. The gain on sale of approximately $4
million is reflected in Other Income and is net of accrued interest.
As a result of the disposition during the quarter, Northern Natural is
reported as a discontinued operation in the accompanying financial statements
and these notes. Revenues from Northern Natural were $30 million and $201
million, respectively, for the three- and nine-month periods ended September
30, 2002. Income before taxes was zero and $38 million for the three- and
nine-month periods ended September 30, 2002.
Illinois Power Transmission. On October 9, 2002, IP announced that it
agreed to sell its high-voltage electric transmission system to Trans-Elect
Inc., an independent transmission company, for $239 million. The sale is
expected to close in the first half of 2003 and is subject to customary closing
conditions, including required approvals from the SEC, the Federal Trade
Commission, the Illinois Commerce Commission and the FERC. With respect to the
FERC, the sale is conditioned on its approving the levelized rates application
to be filed by Trans-Elect seeking a 13% return on equity. If the FERC does not
approve levelized rates in substantially the form sought by Trans-Elect, then
Trans-Elect is not obligated to close on the sale. The purchase price also is
subject to adjustment with respect to certain items, including a final
determination of the transmission assets to be sold, any variance in the
assumed amount of inventory on hand and the amount of accounts payable at
closing. A change in interest rates from those estimated by Trans-Elect in
contemplating its financing for the sale also could cause an adjustment to the
purchase price or postponement of the closing, at IP's option. The pre-tax gain
on the sale, which will be recorded at closing, is estimated to be
approximately $47 million. In addition, as a result of the sale, IP expects to
accelerate approximately $90 million of regulatory asset amortization.
Marketing & Trading. In October 2002, the Company announced it would exit
third party risk management aspects of the marketing and trading business. The
decision to exit this business is expected to reduce significantly the
Company's collateral requirements and overall corporate expenses. The Company
expects to complete a significant portion of this exit over the next three to
six months. During this period and thereafter, the Company will maintain the
resources and make the necessary arrangements to meet its customer commitments,
including retaining personnel and risk management capabilities. This decision
to exit third party risk management aspects of the marketing and trading
business will not change the commercial activities of Dynegy's midstream or
generation businesses. The midstream business will continue to manage commodity
price risk associated with its operations related to fuel procurement and to
market natural gas and natural gas liquids. Further, the generation business
will continue to manage commodity price risk existing in its physical asset
positions through optimizing fuel procurement and to market power from these
assets.
Canadian Gas Marketing. On October 17, 2002, Dynegy entered into a letter
of intent to sell a portion of its Canadian natural gas marketing business to
The Seminole Group Inc. The sale is expected to close in November 2002, subject
to regulatory approvals and other customary closing conditions. Any loss on the
sale is expected to be less than $10 million and will be recorded upon
consummation of the sale. The remaining Canadian business will consist
primarily of existing power marketing positions and physical gas in storage.
United Kingdom Storage. On September 30, 2002, the Company sold a
subsidiary that owned the Hornsea onshore natural gas storage facility in the
United Kingdom for net cash proceeds of approximately $189 million. No gain or
loss was recognized on the transaction. On November 14, 2002, the Company sold
the subsidiaries that owned the Rough offshore natural gas field in the North
Sea and the Easington natural gas processing
16
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
terminal on the East Yorkshire coast for cash proceeds of approximately $500
million. The Company does not expect to recognize a material gain or loss on
this transaction. The results of operations for the United Kingdom storage
business are included within discontinued operations in the accompanying
Condensed Consolidated Statements of Operations. Revenues from the United
Kingdom storage business were $47 million and $128 million, respectively, for
the three- and nine-month periods ended September 30, 2002. Income before taxes
was $17 million and $37 million, respectively, for the three- and nine-month
periods ended September 30, 2002. Additionally, at September 30, 2002, the
Rough and Easington assets were classified as held for sale in accordance with
Statement No. 144. The major classes of assets and liabilities classified as
"Assets Held for Sale" or "Liabilities Held for Sale" in the accompanying
September 30, 2002 Condensed Consolidated Balance Sheet are as follows (in
millions):
September 30,
2002
-------------
Current Assets:
Accounts receivable............... $ 13
Inventory......................... 15
Other............................. 4
----
Total Current Assets........... 32
====
Other Assets:
Property, plant and equipment, net 638
Other............................. 6
----
Total Other Assets............. 644
----
Total Assets................... $676
====
Current Liabilities............... $ 30
Other Liabilities:
Deferred taxes.................... 133
Other............................. 78
----
Total Other Liabilities........ 211
----
Total Liabilities.............. $241
====
Note 5--Restructuring and Impairment Charges
In the first quarter 2002, the Company recognized a $234 million pre-tax
charge to write-down goodwill in its telecommunications business in connection
with the adoption of Statement No. 142 and reflected such charge as a
cumulative effect of a change in accounting principle. As there was no tax
basis in this goodwill, $234 million represents the pre-tax and after-tax
impact on earnings. The Company also recorded pre-tax charges of $64 million
($42 million after-tax) primarily related to its investment in the
telecommunications business.
During the second quarter 2002, the Company recognized a $375 million
pre-tax ($244 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 the Company's investment in the telecommunications business, the
impairment of investments in securities of entities engaged in
technology-related ventures and a severance charge related to the corporate
restructuring.
During the third quarter 2002, the Company recognized a $1,873 million
pre-tax ($1,752 million after-tax) charge principally related to the impairment
of goodwill associated with the Company's Wholesale Energy Network ("WEN")
segment, a loss on the sale of Northern Natural, the recognition of a liquidity
reserve relating to the Company's marketing and trading portfolio, an
impairment of investments in generating facilities and the write-off of other
obsolete assets.
17
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
The pre-tax charges consisted of the following for the periods ended
September 30, 2002 (in millions):
Three Months Nine Months
Ended Ended
September 30, September 30,
2002 2002
------------- -------------
Impairment of goodwill............................. $ 908 $ 908
Loss on sale of Northern Natural................... 586 586
Cumulative effect of change in accounting principle -- 234
Impairment of telecommunications business.......... -- 305
Liquidity reserve.................................. 223 223
Impairment of generation investments............... 90 90
Impairment of technology investments............... 12 97
Severance charge................................... -- 37
Enron settlement................................... 25 25
Write-off of other obsolete assets................. 29 41
------ ------
$1,873 $2,546
====== ======
Impairment of goodwill. The value of goodwill associated with the WEN
segment was reviewed for impairment at September 30, 2002. Based on this
assessment, an after-tax charge to earnings of $908 million was recorded to
impair substantially all of the goodwill associated with the WEN segment. The
fair value of WEN consists of value associated with marketing and trading as
well as the value associated with power generation. The fair values of the
respective components were estimated utilizing the expected discounted future
cash flows. The primary factors leading to this impairment are: (1) the
reduction in near-term power prices, (2) an increase in the rate of return
required for investors to enter the energy merchant sector and (3) the
Company's decision to exit third party risk management aspects of the marketing
and trading business. The charge was recorded in Goodwill Impairment in the
accompanying Condensed Consolidated Statement of Operations.
Loss on Sale of Northern Natural. On August 16, 2002, Dynegy sold Northern
Natural to MidAmerican for $928 million in cash, subject to adjustment for
changes in working capital. MidAmerican acquired all of the common and
preferred stock of Northern Natural and assumed all of Northern Natural's $950
million of debt, which debt had a book value of approximately $890 million.
Dynegy incurred a pre-tax loss of $586 million ($566 million after-tax)
associated with the sale. This charge is recorded in Discontinued Operations in
the accompanying Condensed Consolidated Statement of Operations.
For federal income tax purposes, the sale resulted in a capital loss, which
may be deducted solely against capital gains, if any, realized by the
enterprise in its consolidated federal tax returns. There is a five-year
carryforward for capital losses under existing federal statutes. For financial
reporting purposes, the Company recorded a valuation allowance against
substantially all of the potential tax benefit as a result of uncertainty of
realization.
Cumulative effect of change in accounting principle. During the first
quarter 2002, the Company recognized a $234 million charge to impair goodwill
related to its Dynegy Global Communications ("DGC") segment in accordance with
Statement No. 142 and reflected such charge as a cumulative effect of a change
in accounting principle. The fair value of that reporting segment was estimated
using the expected present value of future cash flows. The value was negatively
impacted by continued weakness in the telecommunications and broadband markets.
This charge is reflected as a Cumulative Effect of Change in Accounting
Principle in the accompanying Condensed Consolidated Statement of Operations.
18
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Impairment of telecommunications business. During the second quarter 2002,
prospects for the telecommunications sector continued to deteriorate as
evidenced by an increased number of bankruptcies in the sector, continued
devaluation of debt and equity securities, a lack of financing sources and
further pricing pressures resulting from challenges faced by major industry
participants. As a result of this deterioration, a continuing negative outlook
for the industry and Dynegy's desire to improve its own liquidity, management
began to take measures to reduce cash losses in the business, including
reducing capital spending and lowering operating and administrative expenses.
Management is pursuing partnership and sale opportunities for this business
segment, although no formal plans are currently in place.
Dynegy's impairment analysis at June 30, 2002, calculated in accordance with
the guidelines set forth in Statement No. 144, indicated future cash flows from
DGC's operations were insufficient to cover the carrying value of that
segment's long-lived assets. As a result, a pre-tax non-cash impairment charge
totaling $286 million ($186 million after-tax) was recorded in the second
quarter 2002 in Impairment and Other Charges. For the nine-month period ended
September 30, 2002, a cumulative impairment charge totaling $305 million ($200
million after-tax) was recorded in Impairment and Other Charges, Cost of Sales
and Other Expenses in the accompanying Condensed Consolidated Statements of
Operations.
In addition, the impairment analysis indicated that future cash flows were
insufficient to support the lessor's obligation related to a telecommunications
lease, of which Dynegy has guaranteed approximately $306 million. In accordance
with EITF Issue 96-21, "Implementation Issues in Accounting for Leasing
Transactions involving Special-Purpose Entities," the loss under the guarantee
will be accrued under a straight-line method over the remaining term of the
lease. This non-cash pre-tax charge approximates $22 million per quarter and is
included in Depreciation and Amortization in the accompanying Condensed
Consolidated Statement of Operations. The Company began recognizing this loss
in the third quarter 2002 and will continue to accrue for such loss through the
remaining term of the lease, unless the obligation is accelerated or terminated
as a result of a business combination, joint venture or other similar
transaction involving this business.
Liquidity reserve. The Company recognized a pre-tax charge of $223 million
($145 million after-tax) associated with its recognition of a liquidity reserve
in the third quarter 2002 that impairs the mark-to-market value of the
Company's marketing and trading portfolio at September 30, 2002. The
recognition of an incremental liquidity reserve in determining estimated fair
value reflects a substantial reduction during the quarter in market transaction
volumes, principally in the U.S. power marketing and trading business, and
recognizes the negative estimated impact on the realizability of the net asset
value of the portfolio. This charge is included in Revenues in the accompanying
Condensed Consolidated Statement of Operations.
Impairment of generation investments. In conjunction with its review of the
carrying value of goodwill, the Company assessed the carrying value of its
generation portfolio on an asset-by-asset basis. The generation portfolio
includes wholly owned generating facilities, which are reflected in Property,
Plant and Equipment, as well as investments in partnerships and limited
liability companies that own generating facilities, which are reflected in
Unconsolidated Investments. Based on this review, the carrying value associated
with the wholly owned generation facilities was considered realizable. However,
certain investments were considered impaired, resulting in a pre-tax charge of
$90 million, which is reflected in Earnings (Losses) from Unconsolidated
Investments in the accompanying Condensed Consolidated Statement of Operations.
This diminution in the fair value of these investments is a result of depressed
energy prices and an increase in the rate of return required by investors to
enter into the power generating business.
Impairment of technology investments. At June 30, 2002, the valuations of
technology investments were assessed in light of the Company's decision to
pursue partnership and sale opportunities for its
19
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
telecommunications business. 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 its telecommunications strategy. Accordingly, Dynegy
expected to hold these investments for the long term and viewed trends in the
sector as cyclical. These investments include ownership in public and private
companies and investment funds focused in the technology sector. The continued
downturn in the technology sector during the second quarter 2002 combined with
the Company's change in strategy resulted in an impairment charge relative to
these investments. In the second quarter 2002, the Company recorded a $40
million pre-tax ($26 million after-tax) charge in Earnings (Losses) From
Unconsolidated Investments in the accompanying Condensed Consolidated
Statements of Operations. This is in addition to the first quarter pre-tax
charge of $45 million ($30 million after-tax) resulting from unfavorable market
conditions.
These investments were reevaluated at September 30, 2002 based on the
Company's inability to sell certain investments for their adjusted carrying
values and the continued depressed conditions in the technology sector. Based
on this assessment, the remaining carrying values of such investments were
written off, resulting in a pre-tax charge of $12 million ($8 million
after-tax). The cumulative pre-tax charge related to technology investments for
the nine months ended September 30, 2002 was $97 million ($64 million
after-tax).
Severance charge. The Company recognized a pre-tax charge of approximately
$37 million ($24 million after-tax) in the second quarter 2002 for severance
benefits for approximately 325 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. The following is a schedule of the reduction in the liability
related to this charge (in millions):
Original Cash Balance at
Charge Amount Utilization September 30, 2002
------------- ----------- ------------------
$37 $(15) $22
A substantial amount of the balance at September 30, 2002 relates to
severance that has not been paid to the Company's former Chief Executive
Officer and Chief Financial Officer.
Enron settlement. In August 2002, Dynegy agreed to pay Enron $25 million to
settle the lawsuit Enron had filed alleging wrongful termination of the
parties' November 2001 merger agreement, $10 million of which was paid to Enron
upon approval of the settlement agreement by the Bankruptcy Court, with the
remaining $15 million escrowed until the settlement becomes final. This pre-tax
$25 million ($16 million after-tax) charge was recorded in Other Expenses in
the accompanying Condensed Consolidated Statements of Operations for the nine
months ended September 30, 2002. Please see Note 12 for further discussion.
Write-off of other obsolete assets. The Company recognized a pre-tax charge
of $12 million ($8 million after-tax) in the second quarter 2002 related 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.
As a result of the Company's decision to exit third party risk management
aspects of the marketing and trading business, its investment in Dynegydirect
was written-off in the third quarter 2002, resulting in a pre-tax charge of $29
million ($19 million after-tax). The charge was recorded in Other Expenses in
the accompanying Condensed Consolidated Statements of Operations.
20
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Corporate Restructuring. In October 2002, the Company announced that it is
implementing a restructuring plan designed to improve operational efficiencies
and performance across its lines of business. The Company will adopt a
decentralized business structure consisting of a streamlined corporate center
and operating units in power generation, natural gas liquids, regulated energy
delivery and communications. As a result of this restructuring, the Company
will recognize pre-tax charges of approximately $50 million ($33 million
after-tax) and $6 million ($4 million after-tax) in the fourth quarter 2002 and
first quarter 2003, respectively, for severance benefits for approximately 780
employees who were from various segments and included all staff levels.
The Company is currently assessing other potential fourth quarter charges,
which may include, but are not limited to, charges associated with the recently
announced reduction in workforce and organizational restructuring and charges
associated with exiting third party risk management aspects of the marketing
and trading business.
Note 6--Commercial Operations, Risk Management Activities and Financial
Instruments
Provisions in Statement No. 133 affect the accounting and disclosure of
certain contractual arrangements and operations of the Company. Under Statement
No. 133, 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 or 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 nine-month
period ended September 30, 2002 were as follows, net of tax (in millions):
Balance at December 31, 2001............. $ 26
Current period changes in fair value, net (22)
Reclassifications to earnings, net....... (17)
----
Balance at September 30, 2002............ $(13)
====
Accumulated other comprehensive loss, net of tax, is included in
Stockholders' Equity on the Condensed Consolidated Balance Sheets as follows
(in millions):
Statement No. 133, net................................................. $(13)
Currency translation adjustment........................................ 10
----
Accumulated other comprehensive loss, net of tax, at September 30, 2002 $ (3)
====
21
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Other comprehensive income (loss) is as follows (in millions):
Nine Months
Ended
September 30,
-------------
2002 2001
---- ----
Net income (loss)................ $(2,165) $452
Other comprehensive income (loss) 18 6
------- ----
Total comprehensive income (loss) $(2,147) $458
======= ====
The Company adopted Statement No. 133, effective January 1, 2001, resulting
in an after-tax cumulative effect gain of approximately $2 million.
From time to time 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 nine months ended September 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 September 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 and payments of interest as applicable to each type of hedge. Of this
amount, an approximate $16 million loss, net of taxes, is estimated to be
reclassed into earnings over the 12-month period ending September 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.
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 nine months ended September 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, the net assets of which
are exposed to currency exchange-rate volatility. The Company uses derivative
financial instruments 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. Any ineffective portion of a hedge is reported in earnings
immediately. For the nine months ended September 30, 2002, approximately $31
million of
22
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
net losses related to these contracts were included in the cumulative
translation adjustment. During the nine months ended September 30, 2002,
ineffectiveness from changes in fair value of net investment hedge positions
was a loss of approximately $7 million. There were no net investment hedges
during the nine months ended September 30, 2001.
Note 7--Unconsolidated Investments
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
(Losses) 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 $738 million and $843 million
at September 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. Generation investments primarily include ownership
interests in eight joint ventures that own fossil fuel electric generation
facilities as well as a limited number of international ventures. The Company's
ownership is 50 percent in the majority of these ventures. The Company's
aggregate net investment of $622 million at September 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 $355 million and
$330 million at September 30, 2002 and December 31, 2001, respectively. West
Coast Power provided equity earnings of approximately $49 million and $157
million in the nine months ended September 30, 2002 and 2001, respectively. NRG
Energy Inc., the parent company of Dynegy's partner in two joint ventures,
including West Coast Power, recently announced that it has presented a
restructuring proposal to representatives of its bank lenders and bondholders.
NRG Energy also indicated that a Chapter 11 filing may ultimately be the means
for it to implement any restructuring proposal with its creditors. Dynegy
cannot predict with any degree of certainty the effects of these or similar
actions by NRG Energy on the operations or collateral obligations of these two
joint ventures.
Midstream Investments. Midstream investments include a 23 percent ownership
interest in a venture that operates a natural gas liquids ("NGL") processing,
extraction, fractionation and storage facility in the Gulf Coast region as well
as a 39 percent ownership interest in a venture that fractionates NGLs on the
Gulf Coast. At September 30, 2002 and December 31, 2001, the Company's
aggregate net investment in these midstream businesses totaled approximately
$116 million and $146 million, respectively. The $146 million of investments at
December 31, 2001 included Dynegy's investment in West Texas LPG Pipeline
Limited Partnership ("WTLPS"), which was transferred to ChevronTexaco
Corporation in August 2002. Please see Note 9 for further discussion of this
transaction.
23
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Summarized aggregate financial information for these generation and
midstream investments and Dynegy's equity share thereof was (in millions):
Nine Months Ended
September 30,
---------------------------
2002 2001
------------- -------------
Equity Equity
Total Share Total Share
------ ------ ------ ------
Revenues........ $2,786 $1,075 $3,444 $1,333
====== ====== ====== ======
Operating margin $ 572 $ 204 $ 764 $ 299
====== ====== ====== ======
Net income...... $ 281 $ 108 $ 461 $ 193
====== ====== ====== ======
In addition to its equity share of net income from these investments, the
Company recognized an impairment charge of $90 million, which is also included
in Earnings (Losses) from Unconsolidated Investments. See Note 5 for further
discussion regarding the impairment of certain of these assets in the third
quarter 2002.
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 $32 million and $84 million at September
30, 2002 and December 31, 2001, respectively. The change is primarily
attributed to the impairment of technology investments resulting from
unfavorable market conditions. See Note 5 for further discussion regarding
these impairments.
The Company also owned equity securities that had readily determinable fair
market values and were considered available-for-sale. During the nine months
ended September 30, 2002, the Company impaired the carrying value of these
investments, consistent with a continuing decline in market values, and
eventually sold substantially all of these investments realizing a loss of $2
million. At September 30, 2002, there is no remaining carrying value associated
with these investments.
24
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Note 8--Debt
As of the date of this report, the Company's debt maturities and related
obligations through December 31, 2003 were approximately as follows:
Date Type Amount Outstanding/Owed
---- ---- -----------------------
Fourth Quarter 2002 Canadian Credit Facility $40 million
IP Transitional Funding Trust Notes/(1)/ $21.6 million
ABG Gas Supply/(2)/ $11.7 million
First Quarter 2003. Renaissance/Rolling Hills Interim Financing $200 million
IP Transitional Funding Trust Notes/(1)/ $21.6 million
Black Thunder Financing/ (3)/ $18.9 million
ABG Gas Supply/(2)/ $17.8 million
Second Quarter 2003 DHI $900 million Revolving Credit Facility $789 million/(4)/
DHI $400 million Revolving Credit Facility $382 million/(5)/
IP Bank Credit Facility $300 million
IP Transitional Funding Trust Notes/(1)/ $21.6 million
Black Thunder Financing/(3)/ $21.6 million
ABG Gas Supply/(2)/ $18.1 million
Third Quarter 2003. IP Maturing Mortgage Bonds $190 million
IP Transitional Funding Trust Notes/(1)/ $21.6 million
Black Thunder Financing/(3)/ $21.6 million
ABG Gas Supply/(2)/ $18.4 million
Fourth Quarter 2003 IP Transitional Funding Trust Notes/(1)/ $21.6 million
Black Thunder Financing/(3)/ $21.6 million
ABG Gas Supply/(2)/ $18.7 million
- --------
(1) Reflects required quarterly payments which are made with cash set aside
from IP customer billings.
(2) Reflects required payments associated with Project Alpha as further
described in Note 1.
(3) Reflects required quarterly payments under Dynegy's Black Thunder financing.
(4) Reflects amounts currently outstanding under the DHI $900 million revolving
credit facility, including $661 million in outstanding letters of credit.
(5) Reflects amounts currently outstanding under the DHI $400 million revolving
credit facility, including $382 million in outstanding letters of credit.
The Company's decision to exit third party risk management aspects of the
marketing and trading business is expected to reduce significantly its future
requirements to post collateral in the form of cash or letters of credit.
Accordingly, upon successful execution of the Company's exit from this
business, a corresponding reduction in the Company's second quarter 2003
maturities is anticipated. 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 liquidity and capital plan.
During the nine-month period ended September 30, 2002, the Company repaid
commercial paper borrowings and revolving credit facilities for Dynegy, DHI and
IP of approximately $500 million in the aggregate and borrowed an aggregate of
approximately $137 million under the Dynegy and DHI revolving credit facilities
and $60 million under IP's revolving credit facility. Additionally, during the
nine months ended
25
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
September 30, 2002, Dynegy and DHI issued an aggregate of $651 million of
letters of credit under their revolving credit facilities. During the period
from September 30, 2002 through the date of this report, Dynegy repaid $84
million under the Dynegy revolving credit facility that expired on November 2,
2002 and repaid $75 million under the DHI revolving credit facility in order to
allow for capacity to issue additional letters of credit. Additionally, as
described below, Dynegy used $250 million in proceeds from sales of its United
Kingdom natural gas storage facilities to repay an interim financing that
represented an advance on a portion of the proceeds from such sales.
Interim Financings. 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 sale of the
Company's United Kingdom natural gas storage facilities. In September 2002,
Dynegy sold the entity that owned the Hornsea storage facility and in October
2002 repaid approximately $189 million of this interim financing with the net
proceeds. On November 14, 2002, Dynegy sold the entities that owned the Rough
facilities and repaid the remaining balance of this financing with a portion of
the proceeds therefrom.
Illinois Power. On May 17, 2002, IP exercised the "term-out" provision
contained in its $300 million 364-day revolving credit facility, which was
scheduled to mature on May 20, 2002. In connection with this conversion, IP
borrowed the remaining $60 million available under this facility. The exercise
of the "term-out" provision converted the facility to a one-year term loan that
matures in May 2003. As such, the amounts outstanding under this loan are
classified as current. Borrowings of $300 million were outstanding under this
loan at September 30, 2002.
DHI Revolvers. On April 29, 2002, DHI closed a $900 million unsecured
revolving credit agreement with a syndicate of commercial banks. This facility
matures on April 28, 2003. Generally, borrowings under the credit agreement
bear interest at a Eurodollar rate plus a margin that is determined based on
designated unsecured debt ratings of Dynegy. Facility fees are payable on the
full amount of the facility and are determined based on designated unsecured
debt ratings. As of September 30, 2002, amounts outstanding under this facility
included $203 million of borrowings and $517 million in letters of credit.
During October 2002, Dynegy repaid $75 million of outstanding borrowings under
this facility in order to allow for capacity to issue additional letters of
credit. As of November 13, 2002, amounts outstanding under this facility
included $128 million of borrowings and $661 million in letters of credit.
Financial covenants under the DHI $900 million revolver include a
debt-to-capitalization test (which takes into account certain lease and similar
commitments of DHI and its subsidiaries) and a 3.5 times EBITDA-to-interest
test. The permissible threshold for the debt-to-capitalization is 60%. Other
covenants in the facility include subordination of certain intercompany debt
owed to Dynegy and its subsidiaries (other than DHI 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, DHI or any principal subsidiary with respect to debt or other similar
obligations that exceed $100 million, cross acceleration of Dynegy, DHI or any
principal subsidiary under any instrument covering debt or similar obligations
that exceed $100 million and bankruptcy or receivership of Dynegy, DHI or any
principal subsidiary. The facility does not contain any defaults relating to
material adverse changes in the condition of Dynegy or DHI after the closing
date or to changes in Dynegy's or DHI's credit
26
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
ratings. The 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.
Dynegy was in compliance with the covenants contained in its revolving
credit agreements and other debt instruments at September 30, 2002. Dynegy's
recent operating losses and any further operating losses will make it more
difficult for Dynegy to continue to satisfy the financial covenants in its
revolving credit agreements, particularly the EBITDA-to-interest covenants.
Management will continue to analyze these covenants relative to its results of
operations. The Company is required to deliver a certificate to the lenders
under its revolving credit facilities attesting to its compliance with the
financial covenants under these facilities on a quarterly basis. Any failure to
satisfy one or more of these covenants would constitute a breach giving rise to
a default under the applicable debt instrument and would permit the lenders
under such debt instrument to accelerate the maturity of Dynegy's outstanding
obligations thereunder. Depending upon the particular debt instrument, such a
breach or any action by the lenders to accelerate the maturity of amounts owing
would result in a default under or trigger cross-acceleration provisions in a
significant portion of the Company's other outstanding debt instruments. In the
event of non-compliance, Dynegy would seek waivers from the lenders under these
debt instruments or attempt to repay or refinance the affected debt
instruments. The Company cannot provide any assurance that it could repay,
obtain waivers with respect to or refinance such debt instruments in the event
of any such default.
ABG Gas Supply Credit Agreement. On April 10, 2001, ABG entered into a
credit agreement with a consortium of lenders in order to provide financing
associated with Project Alpha (the "ABG Credit Agreement"). Advances under the
agreement allowed ABG to purchase NYMEX natural gas contracts with the
underlying physical gas supply to be sold to Dynegy Marketing and Trade under
an existing natural gas purchases and sales agreement. The ABG Credit Agreement
requires ABG to repay the advances in monthly installments commencing February
2002 through December 2004 from funds received from Dynegy Marketing and Trade
under the natural gas purchases and sales agreement. The advances bear interest
at a Eurodollar rate plus a margin as defined in the agreement. Advances of
$272 million were outstanding under this agreement at September 30, 2002.
DHI Senior Notes. On February 21, 2002, DHI 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
subject to a sinking fund.
Capital Leases. In response to the initiatives currently underway at the
FASB, on June 28, 2002 the Company unilaterally undertook certain 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
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 Annual Report on Form 10-K for the year ended
December 31, 2001 (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 Condensed Consolidated
27
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Balance Sheet. Property under capital leases of $525 million at September 30,
2002 is included in Property, Plant and Equipment and is amortized over the
useful life of the asset, which approximates 40 years.
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
September 30, 2002 (in millions):
Three months ending December 31, 2002...... $ 3
Year ending December 31:
2003.................................... 13
2004.................................... 13
2005.................................... 176
2006.................................... 186
2007.................................... 185
----
Total minimum lease payments............... 576
Less: Amount representing interest......... (51)
----
Present value of net minimum lease payments $525
====
Other. 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 make periodic payments totaling $275 million over the
remaining three years of the transaction. The subsidiary has already paid
approximately $73 million of this total. 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 Sheet.
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
which could have been 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. Please see "Note 7--Unconsolidated Investments" for a discussion
of recent developments involving NRG Energy.
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 term of the respective financing transactions.
Note 9--Related Party Transactions
ChevronTexaco Commercial Arrangements. In March 2002, Dynegy and
ChevronTexaco agreed 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.
28
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
In August 2002, Dynegy and ChevronTexaco executed an agreement pursuant to
which the parties amended the existing 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 accelerated payment generally being equal to 75 percent of the value of the
prior month's gas deliveries, after reduction pursuant to a netting agreement
between Dynegy and ChevronTexaco. This payment arrangement was effective upon
the closing of the sale of Northern Natural described in Note 4 above. The
accelerated payment totaled $152 million at September 30, 2002.
In connection with Dynegy's announced exit from third party risk management
aspects of the marketing and trading business, Dynegy and ChevronTexaco have
been negotiating to terminate the natural gas purchase agreement between the
parties and to provide for an orderly transition of responsibility for
marketing ChevronTexaco's domestic natural gas production. These discussions
will not affect Dynegy's current contractual agreements with ChevronTexaco
relative to ChevronTexaco's U.S. natural gas processing and the marketing of
ChevronTexaco's domestic NGLs.
Also in August 2002, in partial satisfaction of certain of its obligations
to ChevronTexaco under these agreements, Dynegy sold to ChevronTexaco its 39.2%
ownership interest in 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 sold to ChevronTexaco was valued at $45
million. This non-cash transaction reduced Accounts Payable to Affiliates and
Unconsolidated Investments by $45 million.
Dan Dienstbier Contract. 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 served as Dynegy's interim Chief Executive Officer from such
date until October 23, 2002. Mr. Dienstbier continues to serve as non-executive
Chairman of the Board of Directors. 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 common stock as the parties shall agree.
Upon termination of the agreement, Mr. Dienstbier is eligible to receive a
bonus payment and 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. Mr.
Dienstbier is continuing to be compensated under this agreement.
Short-Term Executive Stock Purchase Loan Program. In July 2001, Dynegy
established the Dynegy Inc. Short-Term Executive Stock Purchase Loan Program
pursuant to which eligible employees were loaned funds to acquire Class A
common stock through market purchases. Dynegy ceased making new loans under the
program at June 30, 2002. Outstanding loans bear interest at the greater of
five percent or the applicable federal rate as of the loan date, are full
recourse to the participants and mature on December 19, 2004. At September 30,
2002 and December 31, 2001, approximately $12 million and $13 million,
respectively, which included accrued and unpaid interest, was owed to the
Company under this program. The loans are accounted for as Subscriptions
Receivable within Stockholders' Equity on the Condensed Consolidated Balance
Sheet.
In connection with the Company's organizational restructuring, the Company
offered to immediately forgive 50 percent of the outstanding balance under each
loan established through this program to non-executive officers. In order to
provide incentives to those employees with outstanding loans under this program
to remain with the Company post-restructuring, the Company has agreed to
forgive one-half of the remaining balance of each of their loans on October 1,
2003 and to forgive the then remaining balance under each such loan on October
1, 2004, subject to achievement of specified employment objectives. For
employees terminated as part of the restructuring, the remaining balance
outstanding under each loan matures and is due and payable on
29
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
December 19, 2004. Interest rates charged under these loans remain unchanged.
An accounting charge of approximately $3 million is expected to be recognized
in the fourth quarter 2002 related to the forgiveness of these loans.
December 2001 Equity Purchases. In December 2001, certain executive
officers purchased Class A common stock from Dynegy in a private placement
pursuant to Section 4(2) of the Securities Act of 1933. These executives
received loans from Dynegy to purchase the common stock at a price of $19.75
per share. The purchase price equaled the net proceeds per share to Dynegy from
a concurrent public offering (after a $1.00 per share underwriting discount).
The loans bear interest at 3.25 percent per annum.
During the quarter ended September 30, 2002, three executive officers with
loans then outstanding for December 2001 equity purchases and under the
Short-Term Executive Stock Purchase Loan Program resigned from their positions
with the Company. Two of these former executive officers paid an aggregate of
approximately $1.5 million to retire their outstanding December 2001 loans as
part of their severance arrangements. These former executive officers'
outstanding loans under the Short-Term Executive Stock Purchase Loan Program,
which aggregated approximately $2 million, were then extended to September
2007. The severance arrangement with the third former executive officer
included a similar pay down of 50 percent of an outstanding December 2001 loan
and an extension of the maturity date for the $512,000 remaining outstanding
under that loan, from September 15, 2002 to September 30, 2007. The extended
loans bear interest at the same interest rate as the initial loans.
Two other executive officers with loans outstanding under each program
repaid an aggregate of $1 million to retire their December 2001 Equity Purchase
loans during the third quarter. These executive officers used proceeds from a
special bonus payment paid by the Company as part of their re-negotiated
employment contracts to make these loan payments. These executive officers'
outstanding loans under the Short-Term Executive Stock Purchase Loan Program,
which aggregate approximately $855,000 as of September 30, 2002, remain
outstanding and mature on December 19, 2004.
Other. At September 30, 2002, the Company had several financing
arrangements under which it was owed approximately $12 million from one of its
equity investees, Nicor Energy. The interest rate varies from zero to prime
plus two percent. The repayment terms for $4 million are over the next fifteen
months, while the remaining $8 million is due when Nicor Energy is sold.
Note 10--Earnings Per Share
Basic earnings (loss) per share represents the amount of earnings (loss) for
the period available to each share of common stock outstanding during the
period. Diluted earnings (loss) per share represents the amount of earnings
(loss) for the period available to each share of common stock outstanding
during the period plus each share that would have been outstanding assuming the
issuance of common shares for all dilutive potential common shares outstanding
during the period. In-the-money outstanding options contribute to the
differences between basic and diluted shares outstanding in all periods.
Additionally, the diluted shares in the 2002 periods include the effect of the
assumed conversion to Class A common stock of the Series B Mandatorily
Convertible Redeemable Preferred Securities held by ChevronTexaco.
When an entity has a net loss from continuing operations, Statement of
Financial Accounting Standards No. 128, "Earnings per Share," prohibits the
inclusion of potential common shares in the computation of diluted per-share
amounts. Accordingly, the Company has utilized the basic shares outstanding
amount to calculate both basic and diluted loss per share for the three and
nine months ended September 30, 2002.
30
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Note 11--Capital Stock
Chevron U.S.A. Inc., a ChevronTexaco subsidiary, purchased approximately
10.4 million shares of Class B common stock in January 2002 pursuant to its
preemptive right under its shareholder agreement with Dynegy. Proceeds from
this sale totaled approximately $205 million and were invested in cash to
enhance short-term liquidity.
Dynegy's Board of Directors elected not to pay a dividend on Dynegy's Class
A or Class B common stock for the third quarter 2002.
Note 12--Commitments and Contingencies
Please see Note 11, "Commitments and Contingencies," in the Form 10-K and
Notes 10 and 13, "Commitments and Contingencies," in the Company's Forms 10-Q
for the quarters ended March 31, 2002 and June 30, 2002 (the "Forms 10-Q"),
respectively, 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 second quarter 2002 and a description of any new matters that
have arisen during the quarter. Except as otherwise indicated, the Company
cannot currently predict with any degree of certainty the outcome of the
proceedings or the amount of any potential liabilities.
In addition to the matters described below, the Company is party to legal
proceedings arising in the ordinary course of business. In the opinion of
management, the disposition of any such matters will not have a material
adverse effect on the Company's financial condition, results of operations or
cash flows. The Company recognizes estimated losses from contingencies when
information available indicates that a loss is probable and the amount of the
loss is reasonably estimable in accordance with SFAS No. 5, "Accounting for
Contingencies."
Baldwin Station Litigation. IP 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 June 3, 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. 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 originally estimated capital expenditures of up to $380
million if the installation of best
31
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
available control technology is required. Current estimates suggest that such
capital expenditures could be as much as $410 million. 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. The Company has recorded a
reserve for potential penalties that could be imposed if the EPA were to
successfully prosecute its claims.
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 the
Danskammer and Roseton Plants operated by other Dynegy subsidiaries. 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 were filed in
2000-2001 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. The motion to remand and the cross
defendants' motion to dismiss were heard by the Court and taken under
submission by Federal Judge Whaley 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 thereafter.
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, Judge Walker denied the motions to remand, thus keeping the
cases in federal court. The defendants have filed motions to dismiss, which
were argued and taken under submission by Judge Walker.
32
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
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. By order dated October 11, 2002, the Judicial Panel for
Multidistrict Litigation ordered the new cases consolidated with the original
six cases in the United States District Court for the Southern District of
California.
Dynegy intends to vigorously defend against the claims made with respect to
its activities in the California power markets. However, an adverse result in
any of these proceedings could have a material adverse effect on the Company's
financial condition and results of operations.
Enron Litigation. Dynegy and DHI 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
claimed 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 DHI 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 and DHI 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).
On August 15, 2002, Dynegy and Enron entered into an agreement to settle
this lawsuit. Under the terms of the settlement agreement, Dynegy agreed to pay
Enron $25 million, $10 million of which was paid to Enron upon approval of the
settlement agreement by the Bankruptcy Court, with the remaining $15 million
escrowed until approval of the settlement becomes final. In addition, Dynegy
and Enron agreed to exchange mutual releases of any and all claims related to
the terminated merger and to dismiss such litigation. Dynegy also agreed not to
pursue any claims for working capital adjustments relating to its acquisition
of Northern Natural. The terms of the settlement were approved by the
Bankruptcy Court on August 29, 2002. On September 6, 2002, an appeal of the
Bankruptcy Court's approval was filed by the plaintiffs who had filed the class
action lawsuits described below, and such appeal remains pending. The effect of
the appeal is to delay the effective date of the settlement, the release of the
remaining $15 million to Enron and the dismissal of the pending Enron lawsuit.
Dynegy 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
33
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
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
alleged that they are intended third party beneficiaries of the Merger
Agreement dated November 9, 2001 between Enron and Dynegy and related entities.
Plaintiffs claimed that Dynegy materially breached the Merger Agreement by,
inter alia, wrongfully terminating that agreement. Plaintiffs also claimed that
Dynegy breached the implied covenant of good faith and fair dealing. Plaintiffs
sought 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. On October 22, 2002, the District Court reversed the Bankruptcy Court's
determination, holding that the Pearl and Shapiro plaintiffs do have standing
to sue as third party beneficiaries, and that their claims are not the
exclusive property of the estate. That ruling is subject to further review by
the United States Court of Appeals for the Second Circuit, should Enron elect
to file an appeal. Shortly after this ruling, certain Enron shareholders filed
an action against Dynegy for wrongful termination of the Merger Agreement in
the United States District Court for the Southern District of New York.
On October 28, 2002, Dynegy and DHI filed a declaratory action in Harris
County Judicial District Court relating to the Shapiro action. The action seeks
to reinstate the Shapiro action in the 129/th/ Judicial District Court that is
no longer stayed. The action also seeks affirmative declarations to the effect
that Dynegy did not wrongfully terminate the Merger Agreement, that the
termination did not breach any duty owed to the Shapiro plaintiffs or to
Enron's shareholders generally and that neither the Shapiro plaintiffs nor
Enron's shareholders generally have a right to enforce or to make claims under
the Merger Agreement.
Should the settlement with Enron fail to be consummated, and/or should the
Pearl and Shapiro lawsuits proceed, Dynegy nevertheless believes that all such
claims 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 a result of Enron's bankruptcy filing, Dynegy recognized in its fourth
quarter 2001 financial statements a pre-tax charge related to the Company's net
exposure for commercial transactions with Enron. As of September 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 and the
valuation of the commercial transactions covered by the agreement, which
valuation is based principally on the parties' assessment of market prices for
such period, remain subject to dispute by Enron with respect to which there
have been negotiations between the parties. These negotiations have focused on
the scope of the transactions covered by the master netting agreement and the
parties' valuations of those transactions. If any disputes cannot be resolved
by the parties, the agreements call for arbitration. Dynegy has instituted
arbitration proceedings against those Enron parties not in bankruptcy, and has
filed a motion with the Bankruptcy Court requesting that it be allowed to
proceed to arbitration against those Enron parties that are in bankruptcy. If
the setoff rights were modified or disallowed, either by agreement or
34
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
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
generally during the period between April 2001 and April 2002. These lawsuits
principally assert that Dynegy and certain of its executive officers violated
the federal securities laws in connection with Dynegy'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. On October 28,
2002, the court in which the cases have been consolidated appointed the Regents
of the University of California as lead plaintiff and the Milberg Weiss firm
class counsel. Plaintiffs were given 60 days to file a consolidated amended
complaint, which may differ materially from the complaints presently on file.
Dynegy intends to vigorously defend against these lawsuits. It is not possible
to predict with certainty whether Dynegy 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, five derivative lawsuits have been filed in which the Company
is a nominal defendant. Three of these lawsuits relate to Project Alpha,
round-trip trades and alleged manipulation of the California power market. The
fourth lawsuit relates solely to Project Alpha and the fifth lawsuit relates to
severance for the Company's former Chief Executive Officer. All five lawsuits
seek recovery on behalf of the Company from various present and former officers
and directors. The Company continues to analyze these claims and does not
expect to incur any material liability with respect to these derivative claims.
On August 15, 2002, a purported class action complaint was filed against
Dynegy in the United States District Court for the Southern District of Texas
(Houston Division) alleging violations of the Employee Retirement Income
Securities Act. The lawsuit concerns the Dynegy Inc. 401(k) Savings Plan and
claims that the Company's Board of Directors and certain former and current
officers involved in the administration of the 401(k) Plan breached their
fiduciary duties to the Plan's participants and beneficiaries in connection
with the Plan's holdings of Dynegy Class A common stock. The lawsuit seeks
damages for the losses to the Plan resulting from the alleged breaches of
fiduciary duties, as well as attorney's fees and certain other costs. Dynegy is
analyzing these claims and intends to vigorously defend against them. As with
the shareholder class action lawsuits described above, it is not possible to
predict with certainty whether Dynegy will incur any liability or to estimate
the damages, if any, that might be incurred in connection with this lawsuit.
However, an adverse outcome could have a material adverse effect on the
Company's financial condition or results of operations.
Farnsworth Litigation. On August 2, 2002, Bradley Farnsworth filed a
lawsuit against Dynegy in Texas state district court claiming breach of
contract and that he was demoted and ultimately fired from the position of
Controller for refusing to participate in illegal activities. Specifically, Mr.
Farnsworth alleges, in the words of his complaint, that certain former
executive officers of the Company requested that he "shave or reduce for
accounting purposes" the forward price curves associated with the natural gas
business in the United Kingdom for the period of October 1, 2000 through
March 31, 2001, in order to indicate a reduction in the Company's
mark-to-market losses. Mr. Farnsworth, who seeks unspecified actual and
exemplary damages and other compensation, also alleges that he is entitled to a
termination payment under his employment agreement equal to 2.99 times the
greater of his average base salary and incentive compensation for the highest
three calendar years preceding termination or his base salary and target bonus
amount for the year of termination. The parties have commenced discovery in
this lawsuit. 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.
35
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
SEC Settlement. On September 24, 2002, Dynegy announced that it had
concluded a settlement with the SEC of allegations made against the Company in
connection with the previously disclosed investigation relating to Project
Alpha and round-trip electricity trades with CMS Energy. In the settlement, the
SEC found that Dynegy engaged in securities fraud in connection with its
disclosures and accounting for Project Alpha, and negligently included
materially misleading information about the round-trip energy trades with CMS
Energy in two press releases it issued in early 2002. In settlement of the
SEC's enforcement action, Dynegy, without admitting or denying the SEC's
findings, agreed to the entry of a cease-and-desist order and to pay a $3
million penalty in a related civil suit filed in the United States District
Court in Houston, Texas. Dynegy is continuing to cooperate with the SEC's
ongoing investigation of other parties related to Project Alpha.
CFTC Investigation. The U.S. Commodity Futures Trading Commission ("CFTC")
commenced an investigation in June 2002 relating to the Company's trading
activities. The investigation covers Dynegydirect and round-trip trading and
was recently expanded to cover Dynegy's practices with respect to furnishing
information regarding natural gas trades to various energy industry
publications that compile and report index prices. The Company previously
announced that, during an internal review of its trading activities that is
being conducted in connection with the CFTC investigation, it discovered that
certain employees in its trading business had furnished inaccurate information
to various industry publications. The Company is one of many energy industry
participants who routinely provide trade data to the publications;
consequently, the Company cannot determine whether the inaccurate data had any
impact on the published indices. In response to these findings, Dynegy now
requires that all price information provided to industry publications be
verified by the office of Dynegy's Chief Risk Officer. In addition, in October
2002 Dynegy dismissed six employees and disciplined seven others in its natural
gas trading business as a result of an investigation conducted by Dynegy's
Audit and Compliance Committee and in collaboration with independent counsel.
Dynegy also relieved a corporate compliance officer of his responsibilities in
connection with its investigation into this matter. The Company has produced
documents in connection with the CFTC's investigation. The Company has assured
the Staff of the CFTC that it intends to cooperate with this investigation. The
Company cannot predict the ultimate outcome of this matter.
U.S. Attorney Investigations. The U.S. Attorney's office in Houston has
commenced an investigation of the Company relating to Project Alpha, roundtrip
trades with CMS Energy and Dynegy's gas trade reporting practices. The Company
has produced documents and witnesses for interviews in connection with this
investigation. 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.
Additionally, the U.S. Attorney's office in the Northern District of
California has issued a subpoena to the Company requesting information related
to the California energy markets. The Company intends to cooperate fully with
the U.S. Attorney's office in its investigation of these matters. The Company
cannot predict the ultimate outcome of this matter.
FERC and Related Regulatory Investigations.
Requests for Refunds. On July 25, 2002, the FERC initiated a hearing to
establish refunds to electricity customers, or offsets against amounts owed to
electricity suppliers, during the period of October 2, 2000 through June 19,
2001. In particular, the FERC established a methodology to calculate mitigated
market clearing prices in the California Independent System Operator (the
"ISO") and the California Power Exchange (the "PX") markets. During March 2002
and August 2002, hearings on this matter were held before an administrative law
judge. The administrative law judge has stated that his findings of fact will
be issued before the end of 2002. Such findings will then be forwarded to the
FERC Commissioners for final determination.
36
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
In August 2002, the FERC requested comments on a proposal made by the FERC
staff to change the method for determining natural gas prices for purposes of
computing the mitigated market-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. As drafted, the proposal would
replace the gas prices used in the computation, thus reducing the mitigated
market clearing price for power and increasing calculated refunds, subject to a
provision that generally would provide full recoverability of gas costs paid by
the generators to unaffiliated third parties. If adopted, this methodology
could have a material effect on any refunds or offsets that the FERC might
order from Dynegy or West Coast Power pursuant to its investigation of the
California power markets.
Alleged California Market Manipulation and Round-Trip Trades. 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 ISO and 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 has responded to these requests, indicating that
it did not engage in any of the trading strategies described in the three Enron
memoranda. In August 2002, the FERC staff issued its preliminary report on its
investigation into trading practices in the three Enron memoranda.
On May 21, 2002, the FERC issued requests for information to all sellers of
wholesale electricity or ancillary services in the Western Systems Coordinating
Council (the "WSCC"), and 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 during 2000-2001. 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 in June 2002.
Dynegy responded to each of these requests. Based on its investigation to
date, Dynegy believes that its trading practices are consistent with applicable
law and tariffs. In addition, Dynegy's investigations concluded that it did not
engage in "wash," "round-trip" or "sale/buyback" transactions in the WSCC, for
electricity or ancillary services, and the WSCC or Texas for natural gas
transactions. Neither the California State Senate committee nor the Texas
Public Utility Commission has issued its preliminary findings on its
investigation, and Dynegy cannot predict with certainty how such allegations
will ultimately be resolved. Dynegy will continue to cooperate fully with these
investigations.
On August 13, 2002, the FERC staff issued its preliminary report on its
investigation into the Enron memoranda and "wash," "round-trip" or
"sale/buyback" transactions. The FERC has stated that a final staff report will
not be issued before March 2003.
On September 17, 2002, California Public Utilities Commission President
Loretta Lynch released a report indicating that Dynegy and five other energy
firms did not produce all available power on days in which the State of
California experienced power service interruptions between November 1, 2000 and
May 31, 2001. No mention is made of prosecuting the named firms in the report.
However, the SEC and FERC have requested additional information and comment
with respect to the report. Dynegy disputes the report's findings and is
cooperating with the SEC and the FERC in connection with their requests.
Trade Press. In September 2002, the FERC staff issued requests for
information on issues related to reporting of information on natural gas trades
to energy industry publications that compile and report index
37
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
prices. Dynegy has responded to many of these requests and is cooperating with
the FERC staff in connection with this matter.
Western Long-Term Contract Complaints. 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. The complaints
allege that prices under the contracts exceed just and reasonable prices
permitted under the Federal Power Act. The FERC set these complaints for
evidentiary hearing. 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. An administrative law
judge has been directed to issue an order by February 14, 2003 as to whether
West Coast Power's or other contacts with the DWR must be reformed. 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.
In a related complaint, The Kroger Co. filed a complaint with the FERC in
August 2002 asking that the four wholesale contracts between Dynegy Power
Marketing, Inc. and AES New Energy, Inc., which provides retail
service to The Kroger Co., be declared void for their remaining terms, and that
the FERC set just and reasonable rates for prior periods. Alternatively, The
Kroger Co. asks that the FERC allow for an annual review procedure to reset the
contract prices. The complaint alleges that but for the dysfunctional
California electricity markets, it would not have entered into the contracts
for delivery of energy through December 2006. Dynegy intends to vigorously
defend against these claims.
West Coast Power. 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 a long-term sales agreement.
Please see "Western Long-Term Contracts Complaints" above for discussion of the
actions taken by various parties with respect to this agreement.
As a result of West Coast Power's long-term sales arrangement with the DWR,
management believes that Dynegy's primary exposure in the California market
relates to the realization of its share of West Coast Power's receivables from
the ISO and PX and potential refunds or offsets associated with related
transactions. The DWR is current under the terms of its arrangements with West
Coast Power. At September 30, 2002, Dynegy's portion of the receivables owed to
West Coast Power by the ISO and PX approximated $205 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.
Telstra Litigation. On January 25, 2002, Telstra Corporation, Ltd. and
Telstra Wholesale Inc. filed suit in Delaware Chancery Court against
DynegyConnect, L.P. ("DynegyConnect"), a limited partnership in which Dynegy
holds a combined 80% interest, as well as certain other Dynegy affiliates.
DynegyConnect is a vehicle through which the Company participates in the U.S.
telecommunications business. Telstra Wholesale holds the remaining 20% interest
in DynegyConnect pursuant to a limited partnership agreement that was executed
in October 2000 and details the partners' rights and obligations. Under the
agreement, Telstra Wholesale was granted a put option permitting it to require
Dynegy or its designee, at any time on or before September 20, 2002, to
purchase its 20% partnership interest for a purchase price equal to the value
of Telstra Wholesale's capital account in DynegyConnect, subject to certain
adjustments. The plaintiffs brought this action in connection with Telstra
Wholesale's attempted exercise of this put option. The plaintiffs allege breach
of contract and bad faith, among other things, in connection with the valuation
of Telstra Wholesale's capital account and, as a result, the
38
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
put option purchase price, as well as the administration of the partnership.
The plaintiffs seek approximately $50 million plus interest in damages together
with fees and other litigation expenses. Minority Interest on Dynegy's
Condensed Consolidated Balance Sheet includes amounts relating to Telstra
Wholesale's investment in DynegyConnect. A March 2003 trial date has been set
for this lawsuit. Dynegy intends to vigorously defend against these claims.
Note 13--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 14--Pension Plan Assets
As a result of general declines in financial markets, the actual return on
pension plan assets was a negative 14 percent for the nine months ended
September 30, 2002. These negative returns have reduced plan assets during 2002
to levels that will likely fall below projected plan obligations at year end.
If any of Dynegy's pension plans are underfunded at year end, the Company has
two alternatives. The first alternative is to contribute cash to the plan in an
amount equal to the underfunded amount. The second alternative is to establish
a liability equal to the underfunded amount with the offset being an after-tax
reduction in shareholders' equity. Determination of any underfunded amount will
be made at year end 2002 and will be dependent on the actual return on pension
plan assets for 2002, the discount rate assumptions, which depend on year-end
interest rates, and actual participant numbers.
Note 15--Segment Information
Dynegy's operations are divided into four reportable segments: WEN, Dynegy
Midstream Services ("DMS"), Transmission and Distribution ("T&D") and Dynegy
Global Communications ("DGC"). 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
gathering and processing, NGL fractionation and NGL marketing businesses and
worldwide NGL marketing and transportation operations. Dynegy's T&D segment
includes the operations of IP and Northern Natural. IP is an energy-delivery
company engaged in the transmission, distribution and sale of electricity and
natural gas to customers across a 15,000-square-mile area of Illinois. As
described in Note 4, the Company sold Northern Natural in August 2002. Northern
Natural's results are included within the Company's consolidated results in the
Discontinued Operation section of the Statements of Operations. DGC is engaged
in the telecommunications business through its global long-haul fiber optic and
metropolitan network located in the United States and Europe. Dynegy accounts
for intercompany transactions at prevailing market rates. Unaudited operating
segment information for the three- and nine-month periods ended September 30,
2002 and 2001 is presented below. See Note 4 for an explanation of anticipated
changes impacting segment disclosures in the third quarter 2002 and beyond. See
Note 1 for a discussion of the restatements made to the financial information
included herein.
39
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Dynegy's Segment Data for the Quarter Ended September 30, 2002
($ in millions)
WEN DMS T&D DGC Eliminations Total
------- ------ ------ ---- ------------ -------
Unaffiliated revenues:
Domestic.......................................... $ 437 $ 574 $ 396 $ 6 $ -- $ 1,413
Canadian.......................................... -- 130 -- -- -- 130
European and other................................ -- 175 -- 2 -- 177
------- ------ ------ ---- ----- -------
437 879 396 8 -- 1,720
Intersegment revenues:
Domestic.......................................... 186 33 11 -- (230) --
------- ------ ------ ---- ----- -------
Total revenues................................ 623 912 407 8 (230) 1,720
------- ------ ------ ---- ----- -------
Depreciation and amortization........................ (56) (22) (39) (22) -- (139)
Goodwill impairment.................................. (908) -- -- -- -- (908)
Operating income (loss).............................. (1,210) 23 71 (44) -- (1,160)
Interest expense..................................... (61) (13) (25) (1) -- (100)
Other income (expense)............................... (51) (6) (2) (16) -- (75)
Earnings (losses) from unconsolidated
investments........................................ (71) 4 -- (1) -- (68)
Income tax provision (benefit)....................... (134) 4 8 (32) -- (154)
Income (loss) from continuing operations............. (1,259) 4 36 (30) -- (1,249)
Discontinued operations (Note 4):
Income (loss) from discontinued operations
(including loss on disposal of Northern Natural
of $586 million)................................ 17 -- (586) -- -- (569)
Income tax provision (benefit).................... 6 -- (20) -- -- (14)
------- ------ ------ ---- ----- -------
Income (loss) on discontinued operations............. 11 -- (566) -- -- (555)
Net income (loss).................................... $(1,248) $ 4 $ (530) $(30) $ -- $(1,804)
Identifiable assets:
Domestic.......................................... $16,311 $1,966 $3,611 $ 66 $ -- $21,954
Canadian.......................................... 468 25 -- -- -- 493
European and other................................ 2,668 -- -- 32 -- 2,700
Unconsolidated investments........................... 654 116 -- -- -- 770
Capital expenditures and unconsolidated
investments........................................ (71) (31) (52) (7) -- (161)
40
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Dynegy's Segment Data for the Quarter Ended September 30, 2001 (Restated)
($ in millions)
WEN DMS T&D DGC Eliminations Total
------- ------ ------ ---- ------------ -------
Unaffiliated revenues:
Domestic............................. $ 509 $ 793 $ 395 $ 4 $ -- $ 1,701
Canadian............................. 12 447 -- -- -- 459
European and other................... -- 165 -- 4 -- 169
------- ------ ------ ---- ----- -------
521 1,405 395 8 -- 2,329
Intersegment revenues:
Domestic............................. 149 43 6 -- (198) --
------- ------ ------ ---- ----- -------
Total revenues................... 670 1,448 401 8 (198) 2,329
------- ------ ------ ---- ----- -------
Depreciation and amortization........... (46) (21) (41) (5) -- (113)
Operating income (loss)................. 351 27 68 (29) -- 417
Interest expense........................ (22) (12) (27) (2) -- (63)
Other income (expense).................. (25) 1 (1) 3 -- (22)
Earnings from unconsolidated investments 96 3 -- 5 -- 104
Income tax provision (benefit).......... 149 7 14 (8) -- 162
Net income (loss)....................... $ 251 $ 12 $ 26 $(15) $ -- $ 274
Identifiable assets:
Domestic............................. $15,739 $1,889 $3,562 $349 $ -- $21,539
Canadian............................. 441 342 -- -- -- 783
European and other................... 1,447 -- -- 210 -- 1,657
Unconsolidated investments.............. 804 160 -- 25 -- 989
Capital expenditures and unconsolidated
investments........................... (108) (25) (30) (87) -- (250)
41
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Dynegy's Segment Data for the Nine Months Ended September 30, 2002
($ in millions)
WEN DMS T&D DGC Eliminations Total
------- ------ ------ ----- ------------ -------
Unaffiliated revenues:
Domestic................................... $ 462 $1,855 $1,119 $ 12 $ -- $ 3,448
Canadian................................... 25 722 -- -- -- 747
European and other......................... -- 568 -- 6 -- 574
------- ------ ------ ----- ----- -------
487 3,145 1,119 18 -- 4,769
Intersegment revenues:
Domestic................................... 500 107 26 -- (633) --
------- ------ ------ ----- ----- -------
Total revenues......................... 987 3,252 1,145 18 (633) 4,769
------- ------ ------ ----- ----- -------
Depreciation and amortization................. (141) (65) (115) (34) -- (355)
Goodwill impairment........................... (908) -- -- -- -- (908)
Impairment and other charges.................. (26) (3) (3) (287) -- (319)
Operating income (loss)....................... (1,065) 65 157 (412) -- (1,255)
Interest expense.............................. (122) (36) (77) (4) -- (239)
Other income (expense)........................ (47) (17) 2 (26) -- (88)
Earnings (losses) from unconsolidated
investments................................. (47) 12 (2) (49) -- (86)
Income tax provision (benefit)................ (110) 11 22 (177) -- (254)
Income (loss) from continuing operations...... (1,171) 13 58 (314) -- (1,414)
Discontinued operations (Note 4):
Income (loss) from discontinued operations
(including loss on disposal of Northern
Natural of $586 million)................. 37 -- (548) -- -- (511)
Income tax provision (benefit)............. 11 -- (5) -- -- 6
------- ------ ------ ----- ----- -------
Income (loss) on discontinued operations...... 26 -- (543) -- -- (517)
Cumulative effect of change in accounting
principle................................... -- -- -- (234) -- (234)
Net income (loss)............................. $(1,145) $ 13 $ (485) $(548) $ -- $(2,165)
Identifiable assets:
Domestic................................... $16,311 $1,966 $3,611 $ 66 $ -- $21,954
Canadian................................... 468 25 -- -- -- 493
European and other......................... 2,668 -- -- 32 -- 2,700
Unconsolidated investments.................... 654 116 -- -- -- 770
Capital expenditures and unconsolidated
investments................................. (492) (84) (124) (48) -- (748)
42
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended September 30, 2002 and 2001
Dynegy's Segment Data for the Nine Months Ended September 30, 2001 (Restated)
($ in millions)
WEN DMS T&D DGC Eliminations Total
------- ------ ------ ----- ------------ -------
Unaffiliated revenues:
Domestic.............................. $ 1,170 $3,164 $1,255 $ 8 $ -- $ 5,597
Canadian.............................. 56 1,128 -- -- -- 1,184
European and other.................... 20 514 -- 8 -- 542
------- ------ ------ ----- ----- -------
1,246 4,806 1,255 16 -- 7,323
Intersegment revenues:
Domestic.............................. 449 202 20 -- (671) --
------- ------ ------ ----- ----- -------
Total revenues.................... 1,695 5,008 1,275 16 (671) 7,323
------- ------ ------ ----- ----- -------
Depreciation and amortization............ (132) (61) (124) (16) -- (333)
Operating income (loss).................. 563 111 160 (90) -- 744
Interest expense......................... (61) (39) (87) (5) -- (192)
Other income (expense)................... (49) (10) 18 3 -- (38)
Earnings from unconsolidated investments. 186 9 -- 19 -- 214
Income tax provision (benefit)........... 246 26 34 (28) -- 278
Income (loss) from operations............ 393 45 57 (45) -- 450
Cumulative effect of change in accounting
principle.............................. 2 -- -- -- -- 2
Net income (loss)........................ $ 395 $ 45 $ 57 $ (45) $ -- $ 452
Identifiable assets:
Domestic.............................. $15,739 $1,889 $3,562 $ 349 $ -- $21,539
Canadian.............................. 441 342 -- -- -- 783
European and other.................... 1,447 -- -- 210 -- 1,657
Unconsolidated investments............... 804 160 -- 25 -- 989
Capital expenditures and unconsolidated
investments............................ (1,351) (83) (95) (116) -- (1,645)
Note 16--Subsequent Event
On October 23, 2002, Dynegy announced that Bruce A. Williamson had been
elected as its President and Chief Executive Officer. Effective as of such
date, Dynegy executed an agreement with Mr. Williamson pursuant to which Mr.
Williamson agreed to serve in such positions for an initial term of three
years, subject to extension. Under the terms of the agreement, Mr. Williamson
received a signing bonus of $2.25 million and a grant of options to purchase 2
million shares of common stock at an exercise price of $0.88. Mr. Williamson's
employment agreement entitles him to an annual base salary of $1 million,
subject to increase at the discretion of the Board of Directors, and the annual
opportunity to earn additional bonus amounts, dependent upon certain financial
or performance objectives, as a participant in Dynegy's Incentive Compensation
Plan. The agreement also provides that Mr. Williamson is entitled to receive
stock option grants each year during the term of the agreement. The agreement
contains non-compete and severance provisions relating to the termination of
Mr. Williamson's employment.
43
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 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 Inc. ("Dynegy"
or the "Company") included herein and with the Company's Current Report on Form
8-K dated November 14, 2002, which includes unaudited restated financial
statements for 1999-2001 reflecting the known revisions described elsewhere in
this quarterly report (the "Restatement Form 8-K"). As discussed in the
Explanatory Note on the Table of Contents, the comparative financial
information contained in this report has been revised to reflect the known
effects of the restatement items described in Note 1 to the accompanying
Condensed Consolidated Financial Statements. Concurrent with the filing of this
quarterly report, Dynegy has filed the Restatement Form 8-K, which includes
revised financial statements for each of the years in the three-year period
ended December 31, 2001. These revised financial statements have been prepared
by management and reflect all known restatement items as of the date hereof.
However, as a result of the three-year re-audit and PricewaterhouseCoopers'
subsequent review of Dynegy's 2002 quarterly financial statements, it is
possible that additional adjustments to the unaudited financial statements in
the Restatement Form 8-K and Dynegy's 2002 quarterly reports may result, some
of which could be material. Dynegy expects to file an amended Form 10-K
reflecting the unaudited restatements described in the Restatement Form 8-K as
soon as practicable after the date of this report. Following completion of the
re-audit, which the Company expects will occur early in the first quarter 2003,
further amendment of the Form 10-K will be necessary in order to include the
audit report of PricewaterhouseCoopers LLP as well as to reflect other changes
resulting from the re-audit, if any.
RECENT DEVELOPMENTS
A number of significant developments have occurred with respect to Dynegy
since the filing of its second quarter 2002 Form 10-Q. On October 16, 2002,
Dynegy announced an organizational restructuring plan designed to improve
operational efficiencies and performance across its asset-based lines of
business. The plan provides for the adoption of a decentralized business
structure consisting of a streamlined corporate center and operating units in
power generation, natural gas liquids, regulated energy delivery and
communications.
Also on October 16th, Dynegy announced that it would exit third party risk
management aspects of the marketing and trading business. As a result of its
organizational restructuring and exit from third party risk management aspects
of the marketing and trading business, Dynegy announced a workforce reduction
affecting approximately 780 employees and the resignation of President and
Chief Operating Officer Steve Bergstrom.
Several events affecting Dynegy precipitated the above actions. These events
include, among others, contraction in the trading markets, downgrades in the
Company's credit ratings, increased collateralization requirements and a weak
commodity price environment for power, as well as various legal proceedings and
investigations involving Project Alpha, Dynegy's trading practices and its
failed merger with Enron Corp. These events have had a severely negative effect
on Dynegy's operating results, liquidity, confidence in Dynegy's ability to
meet its debt and other obligations and its long-term business strategy, all of
which is reflected in continued declines in the market price for Dynegy's debt
and equity securities. These events, affecting Dynegy and the industry in
general, contributed to lower operating results in the third quarter 2002 and
have significantly affected the Company's business and operating capabilities.
Dynegy has been and remains committed to addressing these issues. Since the
filing of its second quarter 2002 Form 10-Q, Dynegy continued to execute on the
elements of its capital and liquidity plan. In particular, the sale of Northern
Natural Gas Company ("Northern Natural") to MidAmerican Energy Holdings Company
("MidAmerican") in August enabled the Company to meet the sharp increase in
collateral obligations and to improve its liquidity position. This liquidity
position also was improved by the sale of the Company's United
44
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
Kingdom natural gas storage assets. The Company's decision to exit third party
risk management aspects of the marketing and trading business is intended to
add to the capital plan by freeing up material amounts of letters of credit and
cash collateral otherwise committed to customers in this business.
On October 23, 2002, Dynegy announced the selection of Bruce Williamson as
the Company's new President and Chief Executive Officer. Under Mr. Williamson's
leadership, the Company intends to continue to execute the remaining elements
of the capital plan now enhanced by the exit from third party risk management
aspects of the marketing and trading business and additional general and
administrative expense reductions. On November 14, 2002, Dynegy completed the
sale of the Rough storage facility and certain related assets in the United
Kingdom as described below.
The goal of Dynegy's enhanced capital plan is to enable the Company to meet
its debt obligations as they mature through 2003 and thereafter. Dynegy's
success and its future financial condition will depend on the management of its
exit from third party risk management aspects of the marketing and trading
business and execution of the remaining elements of its capital plan, each of
which is subject to the risks described in this quarterly report. Please read
"Liquidity and Capital Resources" for further details with respect to these
risks and "Uncertainty of Forward-Looking Statements and Information" for
additional factors that could impact Dynegy's future operating results and
financial condition.
LIQUIDITY AND CAPITAL RESOURCES
Capital Plan
In June 2002, Dynegy announced a $2 billion capital plan designed to improve
liquidity and reduce debt. 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 that could have been triggered by declines in Dynegy's
credit ratings. Dynegy subsequently completed a $250 million interim financing
as an advance on a portion of the proceeds from the expected sale of certain of
its United Kingdom natural gas storage facilities and a $200 million interim
financing secured by interests in its Renaissance and Rolling Hills merchant
power generation facilities.
During the third quarter, Dynegy continued to execute on elements of its
capital plan. On August 16, 2002, Dynegy completed the sale of Northern Natural
to MidAmerican for $928 million in cash, subject to adjustment for changes in
working capital. The sale eliminated approximately $890 million of Northern
Natural debt. In September 2002, DHI sold $90 million in 6.875 percent Northern
Natural senior notes due May 2005 for approximately $96 million in cash. DHI
had acquired the notes at par value in April 2002 in order to obtain a
bondholder consent in connection with the acquisition of Northern Natural.
In September 2002, Dynegy sold all of the shares of Dynegy Hornsea Limited,
a subsidiary that owned and operated a portion of its natural gas storage
facilities in the United Kingdom, to SSE Energy Supply Limited, a subsidiary of
Scottish and Southern Energy plc. SSE paid approximately $200 million (130
million (Pounds)). The net proceeds from the sale of approximately $189 million
were used to pay down a portion of the related $250 million interim financing
during October 2002.
In October 2002, Dynegy's Illinois Power subsidiary ("IP") announced that it
agreed to sell its high-voltage electric transmission system to Trans-Elect,
Inc., an independent transmission company, for $239 million. The sale
represents the culmination of IP's long-term strategic initiatives relative to
its transmission assets and
45
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
affirms the strategic direction established by IP over two years ago. The sale
is expected to close in the first half of 2003 and is subject to customary
closing conditions, including required approvals from the SEC, the Federal
Trade Commission, the Illinois Commerce Commission and the FERC. With respect
to the FERC, the sale is conditioned on its approving the levelized rates
application to be filed by Trans-Elect seeking a 13% return on equity. If the
FERC does not approve levelized rates in substantially the form sought by
Trans-Elect, then Trans- Elect is not obligated to close on the sale. The
purchase price also is subject to adjustment with respect to certain items,
including a final determination of the transmission assets to be sold, any
variance in the assumed amount of inventory on hand and the amount of accounts
payable at closing. A change in interest rates from those estimated by
Trans-Elect in contemplating its financing for the sale also could cause an
adjustment to the purchase price or postponement of the closing, at IP's option.
During the second and third quarters of 2002, Dynegy took a number of steps
to reduce general and administrative expenses to more appropriately align the
Company's corporate structure with industry conditions and the decline in
commercial activity. Included among these measures are the June 2002 and
October 2002 workforce reductions affecting approximately 325 employees and 780
employees, respectively.
On November 14, 2002, Dynegy sold all of the shares of two subsidiaries that
own and operate the Rough storage facility and certain related assets in the
United Kingdom to a subsidiary of Centrica plc for approximately $500 million.
The Company repaid the approximately $60 million remaining balance of the
related $250 million interim financing with proceeds from the sale.
At the end of the third quarter, the following items in Dynegy's capital
plan remain to be completed:
. Closing of the pending sale of IP's transmission assets; and
. Issuance of IP mortgage bonds to repay or refinance IP obligations
maturing in 2003.
Additionally, the capital plan has been enhanced by the Company's decision to
exit third party risk management aspects of the marketing and trading business
and certain other actions that are expected to result in reduced collateral
requirements, which actions are further described below.
The remaining elements of the capital plan are subject to a number of risks,
including market conditions for asset sales, the timeliness and ability to
obtain required regulatory approvals for asset sales and the negative effects
of Dynegy's current financial condition, weak operating results and ongoing
investigations and litigation. Dynegy currently does not expect to pursue the
initial public offering of Dynegy Energy Partners L.P. Dynegy cannot guarantee
that any of the remaining 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
Sources of Liquidity. Dynegy's liquidity position has improved since the
filing of its second quarter 2002 Form 10-Q, primarily from the cash proceeds
received from the sale of Northern Natural in August 2002 and the sale of its
United Kingdom natural gas storage assets in September 2002 and November 2002.
Dynegy has relied on these cash proceeds, together with cash proceeds from the
other capital plan initiatives described above, cash from operations and
limited borrowings available under its revolving credit facilities, to satisfy
its capital requirements. Given its current non-investment grade credit
ratings, the ongoing re-audit of its 1999-2001 financial statements and its
limited access to the capital markets, Dynegy expects to continue to rely
primarily on cash on hand, cash from operations and proceeds from its capital
plan initiatives to fund its near-term obligations.
46
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
The following table summarizes Dynegy's consolidated credit capacity and
liquidity position at September 30, 2002 ($ in millions):
Total Credit Capacity........ $ 1,940
Outstanding Loans............ (626)
Outstanding Letters of Credit (1,028)
-------
Unused Borrowing Capacity.... 286
Cash(1)...................... 1,070
Liquid Inventory(2).......... 332
-------
Total Available Liquidity.... $ 1,688
=======
- --------
(1) Includes $189 million in net cash proceeds from the sale of the Hornsea
storage facility, which is included in Restricted cash on the Condensed
Consolidated Balance Sheet. These proceeds were used to pay down the
principal on the related interim financing in early October 2002.
(2) Consists principally of natural gas inventories that the Company expects to
monetize over the next six months in connection with the exit of third
party risk management aspects of the marketing and trading business. The
value presented is based on spot market prices at September 30, 2002.
Uses of Liquidity and Current Liquidity Position. During the third quarter
2002, significant uses of liquidity included the following:
. Retirement of $96 million in IP mortgage bonds which matured on July 15,
2002.
. Retirement of $200 million in DHI senior notes which matured on July 15,
2002.
. Funding of a $19 million quarterly payment under the Black Thunder
financing.
. Funding of a $22 million quarterly payment on IP's transitional funding
trust notes.
. Funding of a $17 million payment under the ABG Gas Supply financing.
. Issuance of approximately $455 million of cash collateral and letters of
credit relating to the Company's marketing and trading business and other
commercial obligations.
On November 1, 2002, in connection with the expiration of the Dynegy Inc.
$300 million revolving credit facility, the Company repaid all of the $84
million of borrowings outstanding under the facility. Additionally, since
September 30, 2002, Dynegy has repaid the $250 million interim financing
relating to the sale of the UK storage facilities, $20 million in maturing
Illinova Corporation senior notes and the $19 million fourth quarter payment
under the Black Thunder financing.
After giving effect to the Rough sale and expiration of the Dynegy Inc. $300
million revolving credit facility and repayment on the $250 million interim
financing, together with the above-described uses of liquidity, the Company's
total available liquidity as of the date of this report was approximately
$1,497 million, including approximately $974 million in cash, $129 million in
available borrowing capacity and $394 million in highly liquid inventory.
47
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
Debt Maturities. As of the date of this report, the Company's debt
maturities and related obligations through December 31, 2003 were approximately
as follows:
Date Type Amount Outstanding/Owed
---- ---- -----------------------
Fourth Quarter 2002 Canadian Credit Facility $40 million
IP Transitional Funding Trust Notes (1) $21.6 million
ABG Gas Supply (2) $11.7 million
First Quarter 2003. Renaissance/Rolling Hills Interim Financing $200 million
IP Transitional Funding Trust Notes (1) $21.6 million
Black Thunder Financing (3) $18.9 million
ABG Gas Supply (2) $17.8 million
Second Quarter 2003 DHI $900 Million Revolving Credit Facility $789 million (4)
DHI $400 Million Revolving Credit Facility $382 million (5)
IP Bank Credit Facility $300 million
IP Transitional Funding Trust Notes (1) $21.6 million
Black Thunder Financing (3) $21.6 million
ABG Gas Supply (2) $18.1 million
Third Quarter 2003. IP Mortgage Bonds $190 million
IP Transitional Funding Trust Notes (1) $21.6 million
Black Thunder Financing (3) $21.6 million
ABG Gas Supply (2) $18.4 million
Fourth Quarter 2003 IP Transitional Funding Trust Notes (1) $21.6 million
Black Thunder Financing (3) $21.6 million
ABG Gas Supply (2) $18.7 million
- --------
(1) Reflects required quarterly payments which are made with cash set aside
from IP customer billings.
(2) Reflects required payments associated with Project Alpha as further
described in Note 1 to the accompanying financial statements.
(3) Reflects required quarterly payments under Dynegy's Black Thunder financing
as further described in Note 8 to the accompanying financial statements.
(4) Reflects amounts currently outstanding under the DHI $900 million revolving
credit facility, including $661 million in outstanding letters of credit.
(5) Reflects amounts currently outstanding under the DHI $400 million revolving
credit facility, including $382 million in outstanding letters of credit.
As indicated above, Dynegy has significant revolver maturities in the second
quarter 2003. Dynegy has begun discussions with its lenders with respect to the
refinancing of all or a portion of these revolving credit facilities. If Dynegy
is successful in entering into one or more new revolving credit facilities, it
expects such facilities would likely be smaller and would have higher pricing
and more restrictive terms than the current facilities. However, the Company
and its lenders may be unable to reach mutually agreeable terms for one or more
new revolving credit facilities. Dynegy faces significant risks relating to the
satisfaction or refinancing of the obligations under these facilities. Please
read "Conclusion" below for discussion of Dynegy's plans with respect to these
obligations and the covenant compliance and other execution risks inherent
therein.
48
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
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 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. Please read "Conclusion" for a discussion of the Company's
compliance with other covenants contained in its debt instruments.
Collateral Obligations
As a result of Dynegy's non-investment grade credit ratings and
counterparties' reduced confidence in its ability to satisfy its obligations,
the Company has received numerous requests from counterparties to provide
collateral support for its marketing and trading and other commercial
obligations, including obligations to support DMS and IP. These requests
generally are made under the Uniform Commercial Code, which allows for demands
of adequate assurance of performance when reasonable grounds for insecurity
exist, or contracts containing "adequate assurance" provisions or specific
ratings triggers that address collateral posting requirements. Specific ratings
triggers generally give counterparties the right to request collateral or, if
collateral is not provided, 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. In most instances Dynegy has responded
by posting cash or letters of credit to collateralize substantially all of its
marketing and trading obligations and a large portion of its other commercial
obligations. Outstanding letters of credit and cash collateral totaled
approximately $1.36 billion as of November 13, 2002.
The obligations against which Dynegy has posted collateral include those
relating to certain of its long-term tolling agreements and other related
contracts. The Company is working with various counterparties to determine and
provide mutually acceptable collateral or other adequate assurance under these
contracts. The Company has yet to reach agreement with Sithe/Independence
Funding and Quachita Power LLC regarding a mutually acceptable amount of
collateral. Although the Company is current on all payments, it has received a
notice of default from each of these counterparties with regard to collateral
assurance and is continuing to negotiate these issues. The Company's annual net
payments under the Sithe/Independence and Quachita Power arrangements
approximate $66 million and $55 million, respectively, and the contracts extend
through 2014 and 2012, respectively.
In response to the ongoing reductions in the liquidity of the trading
markets and the actions of counterparties either requiring additional
collateral or refusing to trade with the Company, Dynegy continued to scale
back the level of its customer and risk-management business activities during
the third quarter 2002. On October 16, 2002, Dynegy announced its decision to
exit third party risk management aspects of the marketing and trading business.
This announcement has no impact on the commercial activities of Dynegy's power
generation or midstream businesses. The power generation business will continue
to manage commodity price risk existing in its physical asset positions through
optimizing fuel procurement and the marketing of power from these assets.
Further, the midstream business will continue to manage commodity price risk
associated with its operations related to fuel procurement and the marketing of
natural gas and natural gas liquids in the markets where it operates.
49
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
In connection with the Company's decision to exit third party risk
management aspects of the marketing and trading business, it subsequently
announced that it entered into a letter of intent to sell a significant portion
of its Canadian natural gas business to The Seminole Group, Inc. Dynegy also
agreed to sell to Seminole its 50 percent ownership in Tidal Energy Marketing,
Inc., a wholesale crude oil marketing company. The transactions, which are
subject to the negotiation and execution of definitive documentation,
regulatory approval and other customary conditions, are expected to close in
November 2002.
The Company's decision to exit third party risk management aspects of the
marketing and trading business is expected to reduce significantly its
collateral requirements and overall corporate expenses.
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. 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, litigation, 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 second quarter 2002 Form 10-Q on August 14,
2002, Moody's Investors Service again lowered its ratings on Dynegy and its
subsidiaries. The senior unsecured debt ratings of Dynegy and DHI were lowered
from "Ba3" to "B2" and "B1" to "B3," respectively. Moody's also downgraded IP's
mortgage bonds from "Ba2" to "B1," stating that the ratings outlook for all of
Dynegy's ratings remained negative. Moody's stated that these ratings actions
were based on continuing concerns due to, among other things, 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 DHI's senior
unsecured lenders.
As of November 13, 2002, Dynegy's credit ratings were as set forth in the
table below. All three major credit rating agencies maintained a negative
outlook with respect to their ratings.
Rated Enterprises Standard & Poor's Moody's Fitch
----------------- ----------------- ------- -----
Senior Unsecured Debt Rating:
Dynegy Inc.(1)............ B- B2 B
Dynegy Holdings Inc.(2)... B- B3 B
Illinois Power(3)......... * B2 B
Illinova Corporation(4)... B- B3 B
Senior Secured Debt Rating:
Illinois Power............ B+ B1 BB-
- --------
* Not rated.
(1) Dynegy Inc. is the parent holding company. This entity generally provides
financing to the enterprise through issuance of capital stock.
50
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
(2) Dynegy Holdings Inc. is the primary debt financing entity for the
enterprise. This entity is a subsidiary of Dynegy Inc. and is a holding
company that includes substantially all of the operations of the WEN and
DMS business segments.
(3) This entity includes the Company's regulated transmission and distribution
business in Illinois.
(4) Illinova Corporation is the holding company for Illinois Power.
IP Liquidity
As described above in "Available Credit Capacity, Liquidity and Debt
Maturities," IP has significant debt maturities through December 31, 2003.
These maturities include the May 2003 maturity of its $300 million bank credit
facility, the August 2003 and September 2003 mortgage bond maturities of $100
million and $90 million, respectively, and quarterly payments of approximately
$22 million on IP's transitional funding trust notes. IP is required to make
these same quarterly payments of approximately $22 million on its transitional
funding trust notes into 2008, and has a payment of up to $81 million due on
its Tilton lease financing in the third quarter of 2004. IP's plans to satisfy
its significant near-term debt maturities and to improve its liquidity position
include the successful execution of capital-raising transactions, including its
previously terminated mortgage bond offering, and the closing of the previously
announced sale of its transmission assets. IP also plans to seek to refinance
its $300 million bank credit facility with another facility of equal or lesser
size. Such a facility would provide IP with additional liquidity to support its
ongoing capital requirements.
IP's ability to successfully execute these initiatives is subject to a
number of risks including factors beyond its control. These factors include,
among others, the timeliness and ability to obtain required regulatory
approvals, further credit rating downgrades, the receptiveness of the capital
markets to the IP bond offering and the continued negative effects of its
relationship with Dynegy. If IP is unable to successfully execute these
initiatives, it could require additional liquidity support from Dynegy, to the
extent available and subject to receipt of any required regulatory approvals,
in order to satisfy its debt maturities and other obligations as they become
due.
On October 23, 2002, the Illinois Commerce Commission (the "ICC") issued an
order approving a petition submitted by IP to enter into an agreement with
Dynegy and its affiliates that would allow for the netting of certain payments
due to Dynegy under the services and facilities agreement pursuant to which
Dynegy affiliates exchange certain corporate services and share facility space
with IP. Under the ICC's order, payments due to Dynegy from IP under this
agreement can be netted against certain intercompany payments due to IP from
Dynegy should Dynegy or its affiliates fail to make those payments on or before
their due dates. The agreement also allows Dynegy to net payments in the event
IP fails to make its required payments to Dynegy. Additionally, IP will not be
permitted to pay any common dividend to Dynegy or its affiliates until IP's
mortgage bonds are rated investment grade by Moody's and S&P and specific
approval is obtained from the ICC. The ICC also made certain provisions for the
advancement of funds necessary to fund payments on Illinova Corporation's
outstanding senior notes.
ChevronTexaco Preferred Stock
In November 2001 in connection with entering into its merger agreement with
Enron, Dynegy issued $1.5 billion of Series B preferred stock to ChevronTexaco.
Dynegy used the proceeds from this preferred stock issuance to purchase $1.5
billion of preferred stock in Northern Natural. The resolutions establishing
the Series B preferred stock provide that all of the outstanding shares of the
series will be redeemed on November 9, 2003.
51
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
The Company believes that there are restrictions under applicable state law
that prevent the Company from redeeming the preferred stock if it would render
the Company insolvent. If such redemption is restricted under applicable law,
the Company believes that the redemption obligation will remain outstanding
until such time as the law would permit such redemption and such redemption
obligation is satisfied. The failure to redeem the Series B preferred stock on
the redemption date as described above is not an event of default under any of
the Company's bank borrowings, secured debt, senior notes or other debt
obligations. The shares of Series B preferred stock are not entitled to a
dividend in cash or in kind or Board representation either before or after the
redemption date.
Capital Leases
In response to the initiatives currently underway at the FASB, on June 28,
2002 the Company unilaterally undertook certain 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 Dynegy 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 $525 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 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 Annual Report on Form 10-K for the period
ended December 31, 2001 (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 Condensed Consolidated Balance Sheet.
Capital Expenditures
Capital spending for the three- and nine-month periods ended September 30,
2002 totaled $161 million and $736 million, respectively, and related primarily
to the WEN and T&D operating segments. For the anticipated future, the Company
intends to limit its capital expenditures primarily to required maintenance
capital expenditures. The Company expects that its required maintenance capital
expenditures will total approximately $75 million for the fourth quarter 2002
and approximately $285 million for 2003.
Dividend Policy
In further support of the Company's capital and liquidity plan, Dynegy's
Board of Directors elected not to pay a dividend on Dynegy's Class A or Class B
common stock for the third quarter 2002. Dynegy does not anticipate reinstating
the dividend for the foreseeable future. During the nine-month periods ended
September 30, 2002 and 2001, the Company paid approximately $55 million and $74
million in cash dividends, respectively, on its common stock.
Conclusion
Dynegy believes its current liquidity position should be sufficient to
permit the Company to meet its debt maturities and other obligations through
the first quarter 2003. The sufficiency of the Company's liquidity will depend
upon:
. Dynegy's continued compliance with the covenants in its bank credit and
other debt instruments or its ability to negotiate waivers in the event
of a covenant default;
52
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
. Dynegy's ability to repay or refinance the DHI and IP credit facilities
that mature in the second quarter 2003;
. Dynegy's ability to manage its exit from third party risk management
aspects of the marketing and trading business and the timing of the
expected cash flows and reduction in collateral from this exit;
. the level of earnings and cash flow from Dynegy's assets and businesses,
which is subject to the effect of changes in commodity prices,
particularly natural gas and power;
. Dynegy's non-investment grade credit ratings, the effect of these ratings
on Dynegy's ability to access capital markets and to conduct normal
commercial operations and the effect of any further downgrade in these
credit ratings on refinancings;
. ongoing investigations and litigation relating to Project Alpha, Dynegy's
trading practices and its activities in the California power markets;
. confidence in Dynegy's financial reporting in light of the previously
announced restatements and the ongoing re-audit of its 1999-2001
financial statements; and
. Dynegy's ability to eliminate or further reduce net cash outflows
associated with its telecommunications business.
Dynegy's liquidity may be significantly adversely affected if it is unable
to refinance the DHI and IP credit facilities that mature in the second quarter
2003. Dynegy also faces the risk of a covenant default on these facilities or
other debt instruments prior to maturity. The DHI and IP credit facilities and
the Company's telecommunications lease financing contain various covenants,
including EBITDA-to-interest and debt-to-capitalization financial covenants.
The Company was in compliance with the covenants in its credit facilities and
other debt instruments at September 30, 2002. While many of the charges
incurred by the Company during 2002 are excluded from the compliance
calculations, continued weakness in the Company's operating results compared
with results in 2001 will make it more difficult for the Company to continue to
comply with certain of its financial covenants. Compliance with these financial
covenants is measured on a quarterly basis.
Any failure to satisfy one or more of these covenants would constitute a
breach giving rise to a default under the applicable debt instrument and would
permit the lenders under such debt instrument to accelerate the maturity of
Dynegy's outstanding obligations thereunder. Depending upon the particular debt
instrument, such a breach or any action by the lenders to accelerate the
maturity of amounts owing would result in a default under or trigger
cross-acceleration provisions in a significant portion of the Company's other
outstanding debt instruments. In the event of non-compliance, Dynegy would seek
waivers from the lenders under these debt instruments or attempt to repay or
refinance the affected debt instruments. The Company cannot provide any
assurance that it could repay, obtain waivers with respect to or refinance such
debt instruments in the event of any such default.
Dynegy has executed on the principal elements of its capital plan in order
to meet its current obligations as they mature and provide the necessary
collateral to support its commercial operations. Dynegy believes that the
combination of its liquidity initiatives and the roll off of collateral and
cash flow from its exit from third party risk management aspects of the
marketing and trading business should enable the Company to refinance all or a
sufficient portion of its second quarter 2003 maturities. However, the Company
faces significant risks related to its ongoing operations and other matters
discussed above. Dynegy also faces the risk that it may not be able to reach
agreement with its lenders on mutually acceptable terms. If Dynegy fails to
execute the remaining elements of its strategy, it may be forced to consider
other strategic alternatives including a possible reorganization under the
protection of federal bankruptcy laws.
53
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 2 to the accompanying financial statements for a discussion of
recently issued accounting pronouncements affecting the Company. Specifically,
Dynegy adopted the net presentation provisions of Emerging Issues Task Force
Issue No. 02-3 in the third quarter 2002. Please see Note 2 for the impact such
adoption had on the Company's Condensed Consolidated Statements of Operations.
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: 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 risk related to its
natural gas, NGLs, 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 has routinely utilized 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, 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.
54
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
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.
In October 2002, the Company announced it would exit aspects of the
marketing and trading business relating to third party or customer risk
management for natural gas and power. The Company expects to complete a
significant portion of the exit from this business over the next three to six
months. The Company will maintain the resources and make the necessary
arrangements to meet its customer commitments, including retaining personnel
and risk management capabilities.
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. As a result of EITF 02-3, the Company recorded realized and settled
amounts net in the income statement and has restated prior periods herein for
comparative purposes.
Dynegy has historically estimated 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 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. The assumptions used in evaluating the realizability of the
Company's portfolio have been changed to reflect current market conditions and
Dynegy's decision to exit aspects of the marketing and trading business
relating to third party or customer risk management for natural gas and power
changes the assumptions used by the Company in extracting the realizability of
its portfolio. (See discussion in Results of Operations below.)
Dynegy's forward power price curves are derived by modeling a combined cycle
gas facility as a "spark spread option" in the calculation of required cost of
capital returns. A spark spread option represents the implied value
relationship between natural gas as a fuel for the combined cycle gas facility
and the conversion value of the power generated by the facility. This price
curve assumption is based on the premise that a portfolio manager would be
indifferent to holding these two assets (the spark spread option or the
generation facility) and is reflective of how Dynegy manages its own portfolio
of physical and financial positions. Dynegy's modeling methodology has been
consistently applied during 2002 and the three years ended December 31, 2001.
Dynegy's proprietary models compute forward prices over a time horizon based on
the following set of inputs:
Market Information Generating Facility Information
Natural Gas Location Prices Inflation Rates
Natural Gas Location Market Volatility Capital and Operational Costs
Natural Gas Volatility Forecast Economic Growth Rates
Power Volatility Factors Impact of Temperature and Altitude
Monthly On and Off Peak Curve Shapes Local Taxes and Environmental Restriction
Regional Correlation Assessments Industry Cost of Capital
Supply/Demand Balance
55
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
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.
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 September 30, 2002 and December 31,
2001:
Mark-to-Market Value of Net Risk-Management Asset(1)
Total 2002(2) 2003 2004 2005 2006 Thereafter
------ ------- ---- ---- ---- ---- ----------
(in millions)
September 30, 2002. $ 658 $ (31) $177 $90 $68 $63 $291
December 31, 2001.. 1,038 576 114 97 52 45 154
------ ----- ---- --- --- --- ----
Increase (Decrease) $ (380) $(607) $ 63 $(7) $16 $18 $137
====== ===== ==== === === === ====
- --------
(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. The
net risk-management assets at September 30 of $691 million on the Condensed
Consolidated Balance Sheet include the $658 million herein as well as
emission allowance credits, hedging instruments and other non-trading
amounts.
(2) Amounts represent October 1 to December 31, 2002 values in the September
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:
. The recognition of a $223 million liquidity reserve in the third quarter
2002 that impairs the mark-to-market value of the Company's marketing and
trading portfolio at September 30, 2002. The recognition of an
incremental liquidity reserve in determining estimated fair value
reflects a substantial reduction during the quarter in market transaction
volumes, principally in the U.S. power marketing and trading business and
recognizes the negative estimated impact on the realizability of the net
asset value of the portfolio;
56
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
. The realization of approximately $442 million of cash related to
contracts settled during the first three quarters of 2002;
. 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 resulted from the decision to extend
the term of the contract through 2007;
. 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 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.
Cash Flow Components of Net Risk-Management Asset
Nine Months Three Months
Ended Ended
September 30, December 31, Total
2002 2002 2002 2003 2004 2005 2006 Thereafter
------------- ------------ ----- ---- ---- ---- ---- ----------
(in millions)
September 30, 2002(1) $442 $(19) $ 423 $206 $115 $96 $89 $1,046
December 31, 2001.... 611 137 119 73 71 330
----- ---- ---- --- --- ------
Increase (Decrease).. $(188) $ 69 $ (4) $23 $18 $ 716
===== ==== ==== === === ======
- --------
(1) The cash flow values at September 30, 2002 reflect realized cash flows for
the nine months ended September 30, 2002 and anticipated undiscounted cash
inflows and outflows by contract based on tenor of individual contract
position for the remaining periods. These anticipated undiscounted cash
flows have not been adjusted for counterparty credit or other reserves.
These amounts exclude the cash flows associated with certain derivative
instruments designated as hedges as well as emission allowance credits and
other non-trading amounts.
57
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
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
Nine Months
Ended
September 30,
2002
-----------------
Balance Sheet Risk-Management Accounts
Fair value of portfolio at January 1, 2002............................................ $1,078
Risk-management gains recognized through the income statement in the period, net(1)(2) 9
Cash received related to contracts settled in the period, net(3)...................... (354)
Changes in fair value as a result of a change in valuation technique(4)............... --
Non-cash adjustments and other(5)..................................................... (42)
------
Fair value of portfolio at September 30, 2002......................................... $ 691
======
Income Statement Reconciliation
Risk-management gains recognized through the income statement in the period, net(1)(2) $ 9
Physical business recognized through the income statement in the period, net.......... 23
Non-cash adjustments and other(6)..................................................... (34)
------
Net recognized operating loss(7)...................................................... $ (2)
======
Cash Flow Statement
Cash received related to risk-management contracts settled in the period, net(3)...... $ 354
Estimated cash paid related to physical business settled in the period, net........... 23
Timing and other, net(8).............................................................. 65
------
Cash received during the period....................................................... $ 442
======
Risk Management cash flow adjustment for the nine-month period ended September 30,
2002(9)............................................................................. $ 444
======
- --------
(1) This amount includes approximately $140 million which represents
management's estimate of the initial value of new contracts entered into in
the nine months ended September 30, 2002.
(2) This amount includes a $223 million liquidity reserve discussed more fully
in Note 5 to the accompanying Condensed Consolidated Financial Statements.
(3) This amount includes cash settlements of hedging instruments, emission
allowances and other non-trading amounts in addition to the cash settlement
of trading contracts.
(4) Dynegy's modeling methodology has been consistently applied period over
period.
(5) This amount consists primarily of changes in value and cash settlements
associated with foreign currency and interest rate hedges.
(6) This amount consists primarily of changes in value of interest rate hedges.
(7) 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.
(8) This amount represents cash received for sales of emission credits, cash
received associated with the settlement of fuel hedges and cash payments
associated with foreign currency hedges.
(9) This amount is calculated as "Cash received during the period" less "Net
recognized operating loss."
58
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
The following table provides an assessment of net contract values by year
based on the Company's valuation methodology described above. Approximately 62
percent of Dynegy's net risk-management asset value at September 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 92
percent. The percentage reduction resulted from a significant realization of
cash during the nine-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 during the second quarter 2002. As a result
of reduced industry liquidity, the Company recognized a pre-tax charge of $223
million to impair the mark-to-market value of the marketing and trading
portfolio. 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
September 30, 2002
Total 2002(1) 2003 2004 2005 2006 Thereafter
----- ------- ---- ---- ---- ---- ----------
(in millions)
Market Quotations(2)........................ $300 $(32) $142 $49 $(4) $ (6) $151
Other External Sources(3)................... 107 -- 37 41 28 -- 1
---- ---- ---- --- --- ---- ----
Market Quotations and Other External Sources 407 (32) 179 90 24 (6) 152
Prices Based on Models(4)................... 251 -- (1) -- 45 68 139
- --------
(1) Amount represents October 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.
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 a
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.
59
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
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 100 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 nine-month period ended September 30, 2002 and the year
ended 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
September 30, December 31,
2002 2001
------------- ------------
(in millions)
One Day VaR--95% Confidence Level............................... $11 $18
=== ===
One Day VaR--99% Confidence Level............................... $16 $26
=== ===
Average VaR for the Year-to-Date Period--95% Confidence Level(1) $17 $12
=== ===
- --------
(1) Amounts have not been updated for restatement items discussed in Note 1 to
the accompanying Condensed Consolidated Financial Statements as such
amounts cannot be retroactively recalculated.
The decrease in One Day VaR from December 31, 2001 is due primarily to the
reduction in exposure in the domestic power portfolio. The reduced exposure is
a result of less price volatility and less trading caused by the current market
conditions and the downgrades to Dynegy's credit ratings. 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.
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 payment netting
agreements with counterparties that permit Dynegy to offset receivables and
payables with such
60
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
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. 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 represents Dynegy's credit exposure at September 30,
2002 associated with its forward positions within the Company's risk-management
portfolio, netted by counterparty (in millions):
Credit Exposure Summary
September 30, 2002
Non-
Investment Investment
Grade Quality Grade Quality Total
------------- ------------- ------
Type of Business:
Financial Institutions......... $ 95 $ -- $ 95
Commercial/Industrial/End Users 720 83 803
Utility and Power Generators... 62 5 67
Oil and Gas Producers.......... 28 1 29
Other.......................... 236 57 293
------ ---- ------
Total....................... $1,141 $146 $1,287
====== ==== ======
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.
61
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
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 September 30, 2002 and
December 31, 2001 and are reflected in the table below.
Daily and Average VaR on Interest Component of Marketing Portfolio
September 30, December 31,
2002 2001
------------- ------------
(in millions)
One Day VaR--95% Confidence Level............................ $0.3 $1.6
==== ====
Average VaR for the Year-to-Date Period--95% Confidence Level $0.4 $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 nine 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 September 30, 2002, it is
estimated that a one percentage point interest rate movement in the average
market interest rates (either higher or (lower)) over the twelve months ended
September 30, 2003 would (decrease) increase income before taxes by
approximately $21 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 September 30, 2002, the Company's primary foreign currency
exchange rate exposures were the United Kingdom Pound, Canadian Dollar and
European Euro.
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 September 30, 2002 and December
31, 2001 reflected in the table below.
Daily and Average Foreign Currency Exchange VaR
September 30, December 31,
2002 2001
------------- ------------
(in millions)
One Day VaR--95% Confidence Level............................ $4.6 $0.6
==== ====
Average VaR for the Year-to-Date Period--95% Confidence Level $2.9 $1.1
==== ====
The increase in One Day and Average VaR is due to the removal of a United
Kingdom Pound currency hedge associated with the Company's net investment in
the United Kingdom natural gas storage business.
62
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
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 September 30, 2002 and
December 31, 2001, respectively:
Absolute Notional Contract Amounts
September 30, December 31,
2002 2001
------------- ------------
Natural Gas (Trillion Cubic Feet).......................................... 10.920 11.894
Electricity (Million Megawatt Hours)....................................... 85.553 77.997
Natural Gas Liquids (Million Barrels)...................................... 1.705 5.655
Crude Oil (Million Barrels)................................................ 11.665 --
Weather Derivatives (In thousands of $/Degree Day)......................... $ -- $ 190
Coal (Millions of Tons).................................................... 9.5 18.5
Variable Rate Financial Obligation Interest Rate Swaps (In Millions of U.S.
Dollars)................................................................. $ 1,696 $ --
Weighted Average Fixed Interest Rate Paid (Percent)........................ 2.796 --
Fair Value Hedge Interest Rate Swaps (In Millions of U.S. Dollars)......... $ 601 $ 206
Fixed Interest Rate Received on Swaps (Percent)............................ 5.616 5.284
Interest Rate Risk-Management Contract (In Millions of U.S. Dollars)....... $ 601 $ 206
Fixed Interest Rate Paid (Percent)......................................... 5.640 5.310
U.K. Pound Sterling (In Millions of U.S. Dollars).......................... $ 207 $ 906
Average U.K. Pound Sterling Contract Rate (In U.S. Dollars)................ $ 1.547 $ 1.423
Euro (In Millions of U.S. Dollars)......................................... $ 10 $ 18
Average Euro Contract Rate (In U.S. Dollars)............................... $ 0.978 $ 0.886
Canadian Dollar (In Millions of U.S. Dollars).............................. $ 617 $ 1,395
Average Canadian Dollar Contract Rate (In U.S. Dollars).................... $ 0.637 $ 0.644
63
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
RESULTS OF OPERATIONS
On October 16, 2002, Dynegy announced a restructuring plan designed to
improve operational efficiencies and performance across its lines of business.
The plan provides for the adoption of a decentralized business structure
consisting of a streamlined corporate center and operating units in power
generation, natural gas liquids, regulated energy delivery and communications.
Dynegy's operations are reported in four segments: Wholesale Energy Network
("WEN"), Dynegy Midstream Services ("DMS"), Transmission and Distribution
("T&D") and Dynegy Global Communications ("DGC").
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 nine-month periods ended September 30, 2002 and 2001. The comparative
financial information contained herein has been revised to reflect the known
effects of the restatement items described in Note 1 to the accompanying
Condensed Consolidated Financial Statements. Please read Note 1 for further
discussion of these restatement items. 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 four
segments.
Net income (loss) and EPS include the following charges (in millions, except
per share data):
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- ------------------------------
2002 2001 2002 2001
----------------- -------------- -------------- ---------------
Charge EPS Charge EPS Charge EPS Income EPS
------ ----- ------ --- ------ ----- ------ ------
Impairment of goodwill (1)............... $908 $2.47 $-- $-- $908 $2.49 $-- $ --
Loss on sale of Northern Natural (2)..... 566 1.54 -- -- 566 1.55 -- --
Cumulative effect of change in accounting
principle (3).......................... -- -- -- -- 234 0.64 (2) (0.01)
Impairment of communications assets (4).. -- -- -- -- 200 0.54 -- --
Liquidity reserve (5).................... 145 0.39 -- -- 145 0.40 -- --
Impairment of generation investments (6). 90 0.25 -- -- 90 0.25 -- --
Impairment of technology investments (7). 8 0.02 -- -- 64 0.18 -- --
Severance (8)............................ -- -- -- -- 21 0.06 -- --
Enron settlement (9)..................... 16 0.04 -- -- 16 0.04 -- --
Other (10)............................... 19 0.05 -- -- 27 0.07 -- --
- --------
(1) The Company recognized an after-tax charge of $908 million associated with
the impairment of goodwill in the WEN segment. There was no tax basis in
this intangible asset resulting in a pre-tax charge equal to the after-tax
amount. This third quarter charge is included in Goodwill impairment in
the accompanying Condensed Consolidated Statement of Operations.
(2) Dynegy incurred an after-tax loss of $566 million ($586 million pre-tax)
on the sale of Northern Natural to MidAmerican during the third quarter
2002. (See Note 4 to the accompanying financial statements.) This loss is
included in Discontinued Operations in the accompanying Condensed
Consolidated Statement of Operations.
(3) Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 142, "Goodwill and Other Intangible Assets,"
realizing an after-tax cumulative effect loss of approximately
64
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
$234 million relating to its telecommunications business. 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.
(4) The Company recognized an after-tax charge of $200 million ($305 million
pre-tax) associated with the write-down of certain telecommunications
assets in the second quarter 2002. The pre-tax charge is included in Cost
of Sales, Impairment and Other Charges and Other Expenses in the
accompanying Condensed Consolidated Statement of Operations.
(5) The Company recognized an after-tax charge of $145 million ($223 million
pre-tax) associated with recognition of a liquidity reserve in the third
quarter 2002 that impairs the mark-to-market value of the Company's
marketing and trading portfolio at September 30, 2002. The recognition of
an incremental liquidity reserve in determining estimated fair value
reflects a substantial reduction during the quarter in market transaction
volumes, principally in the U.S. power marketing and trading business, and
recognizes the negative estimated impact on the realizability of the net
asset value of the portfolio. This charge is included in Revenues in the
accompanying Condensed Consolidated Statement of Operations.
(6) The Company recognized an after-tax charge of approximately $90 million
for the impairment of investments in generation assets in the third
quarter 2002. The charge is included in Earnings (Losses) From
Unconsolidated Investments in the accompanying Condensed Consolidated
Statement of Operations.
(7) The Company recognized an after-tax charge of approximately $8 million
($12 million pre-tax) for the impairment of technology investments in the
third quarter 2002. For the nine-month period ended September 30, 2002,
the Company recognized a cumulative after-tax charge of approximately $64
million ($97 million pre-tax) for the impairment of technology
investments. These charges are included in Earnings (Losses) from
Investments in Unconsolidated Investments in the accompanying Condensed
Consolidated Statement of Operations.
(8) The Company recognized an after-tax charge of approximately $21 million
($33 million pre-tax) for severance benefits for approximately 325
employees, including the Company's former Chief Executive Officer and
Chief Financial Officer in the second quarter. The charge is included in
Impairment and Other Charges in the accompanying Condensed Consolidated
Statement of Operations. The additional severance charge of $3 million
after-tax ($4 million pre-tax) was allocated to Northern Natural, which is
included in Discontinued Operations.
(9) The Company recognized an after-tax charge of approximately $16 million
($25 million pre-tax) in the third quarter 2002 associated with the
settlement of the Enron litigation. The charge is included in Other
Expenses in the accompanying Condensed Consolidated Statement of
Operations.
(10) The amount represents $4 million after-tax ($6 million pre-tax) of fees
related to a voluntary action that the Company took in the second quarter
2002 that altered the accounting for certain lease obligations.
Additionally, the Company had $4 million after-tax ($6 million pre-tax) of
write-offs in the second quarter 2002 related to information technology
equipment. In the third quarter 2002, in conjunction with the Company's
decision to exit certain aspects of the marketing and trading business
relating to third party or customer risk management for natural gas and
power, the Company's investment in Dynegydirect was written off. This
resulted in an after-tax charge of $19 million ($29 million pre-tax).
These amounts are included in Other Expenses in the accompanying Condensed
Consolidated Statement of Operations.
Three-Month Periods Ended September 30, 2002 and 2001
For the quarter ended September 30, 2002, Dynegy recorded a net loss of
$1,804 million or $4.92 per share, compared with third quarter 2001 net income
of $274 million or $0.81 per diluted share. Charges recognized in the third
quarter 2002, as more fully described in the footnotes to the table above,
included after-
65
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
tax charges for a $908 million goodwill impairment, a $566 million loss on the
sale of Northern Natural, a $145 million liquidity reserve, a $90 million
impairment of generation investments, a $19 million after-tax charge related to
the write-off of Dynegydirect, a $16 million after-tax charge related to the
Enron litigation settlement and an $8 million after-tax impairment of
technology investments.
Dynegy announced in early October 2002 an organizational restructuring and
its intent to exit third party risk management aspects of the marketing and
trading business. The Company also announced a work force reduction affecting
approximately 780 employees. The Company estimates that it will recognize
pre-tax charges associated with severance of $50 million ($33 million
after-tax) in the fourth quarter 2002 and $6 million ($4 million after-tax) in
the first quarter 2003.
Operating income decreased approximately $1,577 million quarter-to-quarter
due primarily to the negative impact of the goodwill impairment and the
liquidity reserve, as well as reduced margins from operating units. Operating
income also reflects increased depreciation and amortization expense associated
with the expansion of Dynegy's depreciable asset base. General and
administrative expenses were lower period-to-period principally as a result of
significantly lower variable compensation costs in the 2002 period, which were
partially offset by higher legal and audit fees.
Dynegy's losses from unconsolidated investments were approximately $68
million in the 2002 period compared to earnings of $104 million in 2001.
Variances period-to-period in these results primarily reflect the impact of the
$90 million impairment of generation investments, the $12 million impairment of
technology investments and a $75 million decrease in earnings related to West
Coast Power due to lower delivered power volumes.
Interest expense totaled $100 million for the three-month period ended
September 30, 2002, compared to $63 million for the 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
$75 million in expense in the quarter ended September 30, 2002. Combined other
income and other expenses totaled $22 million in expense in 2001. The 2002
quarter includes the $25 million pre-tax charge related to the Enron litigation
settlement and the $29 million pre-tax write-down of Dynegydirect.
The Company reported an income tax benefit of $154 million for the quarter
ended September 30, 2002, compared to an income tax provision of $162 million
for the 2001 period. The effective tax rates approximated 11 percent and 37
percent in 2002 and 2001, respectively. The 2002 tax benefit was reduced from
statutory rates as a result of book-tax basis differences (principally
impacting the goodwill impairment), the effect of foreign equity investments,
the amortization of intangibles, state income taxes and valuation allowances
recognized in the period relative to the realizability of certain capital loss
carryforwards arising from the sale of Northern Natural and foreign tax credit
carryforwards. The tax provision in the 2001 period varied from the statutory
tax rate of 35 percent principally as a result of book-tax basis differentials
related to the amortization of certain intangibles, other book-tax basis
differences and the effect of foreign equity investments and state income taxes.
Nine-Month Periods Ended September 30, 2002 and 2001
For the nine months ended September 30, 2002, Dynegy recorded a net loss of
$2,165 million or $6.00 per share, compared with net income of $452 million or
$1.34 per diluted share in the same 2001 period. The nine- month period ended
September 30, 2002 included charges related to the items described above for
the three-
66
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
month period plus the impairment of communications assets and technology
investments, a severance charge and the cumulative effect of a change in
accounting principle related to goodwill.
In addition to these charges, 2002 net income decreased period-to-period due
primarily to market events that negatively affected the gas and power marketing
and trading industry in 2002 and the resulting negative impact these events had
on Dynegy's liquidity and creditworthiness, which in turn reduced the
effectiveness and profitability of the Company's marketing and trading,
generation and NGL businesses. Further, principally as a result of continued
depressed values in the telecommunications sector, the Company has to date been
unable to execute a managed exit from its telecommunications business thus
increasing financial losses period over period as well as reducing available
cash flow.
Operating income decreased $1,999 million period over period primarily due
to the reasons described in the previous paragraph as well as the
aforementioned goodwill charge and liquidity reserve recorded in the third
quarter 2002 and the impairment and other charges taken during the previous two
quarters in 2002 that are more fully described in Note 5 to the accompanying
financial statements.
Dynegy's earnings (losses) from unconsolidated investments were
approximately $86 million of losses and $214 million of earnings in the 2002
and 2001 periods, respectively. Variances period-to-period in these results
primarily reflect the impact of the impairment of $90 million of generation
investments, the impairment of $97 million of technology investments resulting
from unfavorable market conditions and a $108 million decrease in earnings
related to West Coast Power due to a decrease in realized prices as well as an
overall decline in demand.
Interest expense totaled $239 million for the nine-month period ended
September 30, 2002, compared to $192 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
$88 million in expense in the nine-month period ended September 30, 2002
compared with $38 million in expense in the same 2001 period. Variances
period-to-period in these results primarily reflect losses associated with the
impairment of IT systems in 2002 as well as the settlement of the Enron
litigation.
The Company reported an income tax benefit of $254 million for the
nine-month period ended September 30, 2002, compared to an income tax provision
of $278 million for the 2001 period. The effective tax rates approximated 15
percent and 38 percent in 2002 and 2001, respectively. The difference from the
effective tax rates and the statutory tax rate of 35 percent result from the
same factors impacting the third quarter periods.
Effect of Accounting for Goodwill. As described in Note 2 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. Had Statement No. 142 been in
effect in 2001, the Company's net income and earnings per share for the three
months ended September 30, 2001 would have been $286 million or $0.85 per
diluted share compared to actual net income reported of $274 million or $0.81
per diluted share. For the nine-months ended September 30, 2001, net income
would have been $488 million or $1.45 per diluted share compared to actual net
income reported of $452 million or $1.34 per diluted share.
67
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
Segment Disclosures
WHOLESALE ENERGY NETWORK
Restated
--------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
----------------- -------------------
2002 2001 2002 2001
------- ------ ------- ------
(in millions, except operating statistics)
Operating Income (loss):
Customer and Risk-Management Activities................. $ (350) $ 161 $ (288) $ 264
Asset Businesses........................................ 48 190 131 299
Goodwill Impairment..................................... (908) -- (908) --
------- ------ ------- ------
Total Operating Income (Loss).................... (1,210) 351 (1,065) 563
Earnings (Losses) from Unconsolidated Investments.......... (71) 96 (47) 186
Other Items................................................ (51) (25) (47) (49)
------- ------ ------- ------
Earnings (Loss) Before Interest and Taxes........ (1,332) 422 (1,159) 700
Interest Expense........................................... (61) (22) (122) (61)
------- ------ ------- ------
Pre-tax Earnings (Loss).......................... (1,393) 400 (1,281) 639
Income Tax Provision (Benefit)............................. (134) 149 (110) 246
------- ------ ------- ------
Income (Loss) From Continuing Operations......... (1,259) 251 (1,171) 393
Discontinued operations (1):
Income from discontinued operations..................... 17 -- 37 --
Income tax provision.................................... 6 -- 11 --
------- ------ ------- ------
Income on discontinued operations....................... 11 -- 26 --
Cumulative Effect of Change in Accounting Principle........ -- -- -- 2
------- ------ ------- ------
Net Income (Loss)................................ $(1,248) $ 251 $(1,145) $ 395
======= ====== ======= ======
Operating Statistics:
Natural Gas Marketing (Bcf/d)--
Domestic Marketing Volumes.......................... 6.4 8.1 8.2 8.2
Canadian Marketing Volumes.......................... 2.1 2.9 2.7 2.6
European Marketing Volumes.......................... 2.5 1.0 2.3 1.4
------- ------ ------- ------
Total Marketing Volumes.......................... 11.0 12.0 13.2 12.2
======= ====== ======= ======
Million Megawatt Hours Generated--Gross.................... 13.0 11.5 32.5 31.7
Million Megawatt Hours Generated--Net...................... 11.8 10.1 29.4 26.9
North American Physical Million Megawatt Hours Sold........ 31.1 90.5 263.0 212.6
European Physical Million Megawatt Hours Sold.............. 21.2 34.6 116.7 69.4
------- ------ ------- ------
Total Physical Million Megawatt Hours Sold.............. 52.3 125.1 379.7 282.0
======= ====== ======= ======
68
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ ------------------
2002 2001 2002 2001
------ ------ ------ -------
($ in millions, except operating statistics)
Coal Marketing Volumes (Millions of Tons)...... 10.5 11.2 27.8 29.7
Average Natural Gas Price--Henry Hub ($/MMbtu). $ 3.16 $ 2.92 $ 2.96 $ 4.87
Average On-Peak Market Power Prices
Cinergy.................................... $33.47 $37.02 $27.48 $ 39.24
TVA........................................ 32.69 35.72 27.67 38.99
PJM........................................ 46.04 48.82 35.77 45.23
New York--Zone G........................... 55.57 57.04 44.90 58.05
Platts SP 15............................... 35.73 45.02 32.25 147.26
- --------
(1) See Note 4 to the accompanying financial statements.
Three-Month Periods Ended September 30, 2002 and 2001
WEN reported a net loss of $1,248 million for the three-month period ended
September 30, 2002, compared with net income of $251 million in the 2001
quarter. The results reflect an overall decline in market liquidity principally
caused by increasing credit concerns in the merchant energy sector,
counterparty concerns over Dynegy's non investment grade credit ratings and a
reduction in the spread between natural gas and power prices. The segment
results generally reflect lower returns from its generation portfolio as a
result of lower power prices and excess generation capacity in the market. As
previously discussed, the segment's operating results include a liquidity
reserve charge in response to current market conditions. The recognition of an
incremental liquidity reserve in determining estimated fair value reflects a
substantial reduction during the quarter in market transaction volumes,
principally in the U.S. power marketing and trading business, and recognizes
the negative estimated impact on the realizability of the net asset value of
the portfolio. Additionally, the Company recognized an after-tax charge of $908
million associated with the impairment of goodwill. There was no tax basis in
this intangible asset resulting in a pre-tax charge equal to the after-tax
amount. The reported earnings were also negatively impacted by the third
quarter 2002 impairment of equity investments, the write-down of Dynegydirect
and an allocation of the Enron litigation settlement. Additionally, there was a
$75 million decline in earnings from the equity investment in West Coast Power
due to a decrease in delivered volumes period-over-period. Interest expense was
higher in the third quarter 2002 due to higher average borrowings, partially
offset by lower average interest rates.
Total physical MW hours sold in the third quarter 2002 decreased to 52.3
million MW hours as compared to 125.1 million MW hours in the third quarter
2001. Total natural gas volumes sold in the third quarter 2002 decreased to
11.0 billion cubic feet per day as compared to 12.0 billion cubic feet per day
during last year's third quarter. The decrease in power and gas volumes is due
primarily to the decline in market liquidity resulting from increasing credit
concerns related to Dynegy and in the merchant energy sector generally.
Nine-Month Periods Ended September 30, 2002 and 2001
WEN reported a net loss of $1,145 million for the nine-month period ended
September 30, 2002, compared with net income of $395 million in the same 2001
period. Absent the charges discussed above, the decrease in operating results
generally reflect the significant downturn in profitability in the marketing
and trading business period-over-period resulting from credit, liquidity and
market concerns as well as significantly lower price realization in the
generation business in 2002. In addition to the items described above for the
third
69
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
quarter comparisons, Dynegy's customer and risk-management business' operating
income for the nine-month period included significant customer origination
during the first quarter 2002 in both the wholesale and commercial and
industrial businesses. The increased origination resulted from new contracts
for the acquisition of long-term power supply at competitive prices and
incremental natural gas storage contracts. The segment's 2002 results include a
$109 million decline in earnings from the equity investment in West Coast Power
due to a decrease in realized power prices period-over-period as well as an
overall decline in demand and impairment of technology investments. The results
also include an allocated charge of $19 million associated with severance and
related costs recorded in the second quarter 2002.
Total physical MW hours sold in the nine-month period ended September 30,
2002 increased to 379.7 million MW hours compared to 282.0 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 nine months ended September 30, 2002 increased
to 13.2 billion cubic feet per day as compared to 12.2 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.
WEN Outlook
The weak power price environment has continued into the fourth quarter 2002.
Increased collateralization requirements resulting from credit concerns have
also continued, resulting in higher interest expense and other capital costs in
order to satisfy counterparties' credit concerns. Going forward, Dynegy expects
that its managed exit from third party risk management aspects of the marketing
and trading business will significantly reduce this segment's collateral
requirements and general and administrative expenses. During this period, which
the Company expects will take up to six months, Dynegy will make appropriate
arrangements regarding its long-term contractual obligations, including
retaining personnel and risk-management capabilities and continuing capacity to
support its customers. The Company's ability to successfully manage this exit,
which is dependent on a number of factors, some of which are outside of the
Company's control, will effect the amount of cash that is ultimately realized
from its marketing and trading portfolio.
Following the exit from third party risk management aspects of the marketing
and trading business, Dynegy's WEN segment will consist primarily of its
generation assets (as well as any remaining risk management positions that
remain pending a roll off over the contract term). The results of operations
for Dynegy's generation assets will reflect a sensitivity to natural gas and
power prices as well as terms of contracts for contracted generation. The
Company expects that this business will continue its efforts to manage this
price risk through the optimization of fuel procurement and the marketing of
power generated from its owned and controlled assets. Dynegy's sensitivity to
prices and its ability to manage this sensitivity, however, is subject to a
number of factors, including general market liquidity, Dynegy's liquidity
position and the willingness of counterparties to transact business with Dynegy
given its non-investment grade credit ratings. Other factors that could affect
the prices at which transactions can be consummated and this segment's results
of operations include governmental actions or excess generation capacity in the
markets it serves.
70
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
DYNEGY MIDSTREAM SERVICES
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ ------------------
2002 2001 2002 2001
------ ------ ------ ------
($ in millions, except operating statistics)
Operating Income:
Upstream......................................... $ 10 $ 16 $ 21 $ 73
Downstream....................................... 13 11 44 38
------ ------ ------ ------
Total Operating Income.................... 23 27 65 111
Earnings from Unconsolidated Investments............ 4 3 12 9
Other Items......................................... (6) 1 (17) (10)
------ ------ ------ ------
Earnings Before Interest and Taxes 21 31 60 110
Interest Expense.................................... (13) (12) (36) (39)
------ ------ ------ ------
Pre-tax Earnings.......................... 8 19 24 71
Income Tax Provision................................ 4 7 11 26
------ ------ ------ ------
Net Income................................ $ 4 $ 12 $ 13 $ 45
====== ====== ====== ======
Operating Statistics:
Natural Gas Processing Volumes (MBbls/d):
Field Plants................................. 56.3 56.3 55.0 56.0
Straddle Plants.............................. 35.3 26.1 36.5 25.5
------ ------ ------ ------
Total Natural Gas Processing Volumes......... 91.6 82.4 91.5 81.5
====== ====== ====== ======
Fractionation Volumes (MBbls/d).................. 224.8 241.6 223.7 230.4
Natural Gas Liquids Sold (MBbls/d)............... 481.9 550.4 519.6 562.0
Average Commodity Prices:
Natural Gas--Henry Hub ($/MMBtu)............. $ 3.16 $ 2.92 $ 2.96 $ 4.87
Crude Oil--Cushing ($/Bbl)................... 28.40 26.64 24.78 27.85
Natural Gas Liquids ($/Gal).................. 0.41 0.39 0.37 0.50
Fractionation Spread ($/MMBtu)............... 1.40 1.51 1.24 0.80
Three-Month Periods Ended September 30, 2002 and 2001
DMS reported net income of $4 million in the third quarter 2002 compared
with net income of $12 million in the third quarter 2001. The segment's results
of operations during the third quarter 2002 were impacted by lower
fractionation spreads and lower realized prices as compared to higher
fractionation spreads and higher realized prices during the third quarter 2001
as a result of the Company's hedging program and forward selling products at a
higher price than the prevailing market price during such quarter. 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.
DMS' quarterly results were negatively impacted by $4 million, net of tax, due
to allocated charges related to the Enron settlement and the impairment of
technology investments as more fully discussed in Note 5 to the Condensed
Consolidated Financial Statements. There were no such charges recorded in the
third quarter 2001.
Aggregate domestic NGL processing volumes totaled 91.6 thousand gross
barrels per day in the third quarter 2002 compared to 82.4 thousand gross
barrels per day during the same period in 2001. A small
71
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
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 meet third party pipeline dew point specification limits.
The average fractionation spread was $1.40 for the three months ended
September 30, 2002, compared to $1.51 for the comparable 2001 period.
Traditional keep-whole processing is only marginally economical at this level.
Historically, the Louisiana straddle plants would not have operated in this
pricing environment.
Nine-Month Periods Ended September 30, 2002 and 2001
DMS reported net income of $13 million in the nine months ended September
30, 2002 compared with net income of $45 million in the nine months ended
September 30, 2001. In addition to the items described above for the second
quarter comparisons, warmer winter temperatures influenced results of
operations period-to-period. DMS' results for the nine-months ended September
30, 2002 were negatively impacted by $8 million, net of tax, due to allocated
charges related to the Enron settlement, severance costs and the impairment of
technology investments as more fully discussed in Note 5 to the Condensed
Consolidated Financial Statements. There were no such charges recorded in the
nine-month period in 2001.
Aggregate domestic NGL volumes from processing totaled 91.5 thousand gross
barrels per day in the nine months ended September 30, 2002 compared to 81.5
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.
The average fractionation spread was $1.24 for the nine months ended
September 30, 2002, compared to $0.80 for the comparable 2001 period. Despite
the year-over-year increase in this spread, traditional keep-whole processing
is only marginally economical at this level. Historically, the Louisiana
straddle plants would not have operated in this pricing environment.
DMS Outlook
The weak fractionation spread environment has continued into the fourth
quarter 2002. Increased collateralization requirements resulting from credit
concerns have also continued, particularly with respect to the global liquids
business. The Company is exploring alternatives for the global liquids business
to reduce its collateral commitments or to otherwise align it with Dynegy's
current liquidity position, which may include a sale. Going forward, Dynegy
expects that its DMS segment will incur higher interest expenses and other
capital costs in order to satisfy counterparties' credit concerns. Credit
concerns have also made it more difficult for DMS to execute new long-term
commercial agreements or to renew expiring commercial agreements in the
ordinary course of business, potentially resulting in reduced results of
operation.
DMS' sensitivity to commodity prices can be expected to continue and is
impacted by a number of factors, including:
. The correlation between the price of crude oil and NGLs;
. The absolute price of natural gas;
72
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
. The spread between the price of natural gas and the price of NGLs;
. The relative impact of all of these factors based on DMS' mix of
processing contracts; and
. The resulting volumes of NGLs available for DMS' fee-driven downstream
business.
Sensitivity to commodity prices varies at any point in time based on the
relative combination of the above factors. DMS intends to manage its commodity
price exposure by hedging its natural gas and NGL production within the limits
of market liquidity and credit availability. Typically, this hedging strategy
primarily focuses on the forward twelve months.
In addition, 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 offset the 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.
73
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
TRANSMISSION AND DISTRIBUTION
Three Months Ended Nine Months Ended
September 30, September 30,
----------------- ----------------
2002 2001 2002 2001
------ ------ ------- -------
($ in millions)
Operating Income................................................. $ 71 $ 68 $ 157 $ 160
Losses from Unconsolidated Investments.............................. -- -- (2) --
Other Items......................................................... (2) (1) 2 18
------ ------ ------- -------
Earnings Before Interest and Taxes............................... 69 67 157 178
Interest Expense.................................................... (25) (27) (77) (87)
------ ------ ------- -------
Pre-tax Earnings................................................. 44 40 80 91
Income Tax Provision................................................ 8 14 22 34
------ ------ ------- -------
Income from continuing operations................................... 36 26 58 57
Discontinued operation (1):
Loss from discontinued operations (including loss on disposal of
$586 million).................................................. (586) -- (548) --
Income tax benefit............................................... (20) -- (5) --
------ ------ ------- -------
Loss on discontinued operations.................................. (566) -- (543) --
------ ------ ------- -------
Net Income (Loss)................................................ $ (530) $ 26 $ (485) $ 57
====== ====== ======= =======
Illinois Power:
Electric Sales in kWh (Millions)
Residential...................................................... 1,832 1,681 4,342 4,160
Commercial....................................................... 1,231 1,194 3,334 3,308
Commercial distribution.......................................... 1 5 2 39
Industrial....................................................... 1,667 1,645 4,719 4,754
Industrial distribution.......................................... 621 677 1,921 1,937
Other............................................................ 98 97 283 287
------ ------ ------- -------
Total Electric Sales......................................... 5,450 5,299 14,601 14,485
====== ====== ======= =======
Gas Sales in Therms (Millions)
Residential...................................................... 18 20 214 225
Commercial....................................................... 11 12 90 99
Industrial....................................................... 24 24 61 69
Transportation of Customer-Owned Gas............................. 47 49 180 185
------ ------ ------- -------
Total Gas Delivered.......................................... 100 105 545 578
====== ====== ======= =======
Heating Degree Days.............................................. 29 89 3,024 3,146
====== ====== ======= =======
Cooling Degree Days.............................................. 1,006 847 1,432 1,291
====== ====== ======= =======
- --------
(1) See Note 4 to the accompanying financial statements.
Three-Month Periods Ended September 30, 2002 and 2001
The T&D segment reported a net loss of $530 million in the third quarter
2002 compared to $26 million net income in the third quarter 2001. Net income
for the three months ended September 30, 2002 includes a $566 million after-tax
($586 million pre-tax) loss on the sale of Northern Natural. (See Note 4 for
further details.)
74
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
Illinois Power ("IP") experienced favorable results from operations
period-to-period that were influenced by increased electricity usage from
commercial and residential customers due to favorable weather conditions. These
results were partially offset by a mandated five percent residential rate
reduction effective May 1, 2002, the election of some commercial and industrial
customers to pay for power at market-based prices, rather than under bundled
tariffs, and a decrease in industrial customer demand due to a weakened economy
in IP's principal market areas.
Nine-Month Periods Ended September 30, 2002 and 2001
The T&D segment reported a net loss of $485 million in the nine months ended
September 30, 2002 compared to $57 million in the same 2001 period. Net income
for the nine months ended September 30, 2002 includes the loss on the sale of
Northern Natural. IP experienced slightly favorable results period-to-period.
In addition to the items described above for the third quarter comparisons, the
nine-month results were influenced by decreased demand from commercial and
residential customers due to unfavorable weather conditions experienced during
the first quarter 2002.
IP Outlook
Future results of operations for IP may be affected, either positively or
negatively, by regulatory actions, general economic conditions, overall
economic growth, the demand for power and natural gas in IP's service area and
interest rates. In addition, Dynegy's financial condition may impact IP's
business, as well as its capitalization structure and ability to access the
capital markets. The transmission sale, if approved, is expected to decrease
annual operating margin by approximately $42 million, offset by a $28 million
reduction in regulatory asset amortization. The change in annual free cash flow
is expected to be relatively neutral.
Please read "IP Liquidity" above for further discussion regarding IP's
significant near-term debt maturities and IP's plans to satisfy these
maturities.
DYNEGY GLOBAL COMMUNICATIONS
Restated
-----------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
----------------- ----------------
2002 2001 2002 2001
---- ---- ----- ----
($ in millions)
Operating Loss..................................... $(44) $(29) $(412) $(90)
Earnings (Losses) from Unconsolidated Investments.. (1) 5 (49) 19
Other Items........................................ (16) 3 (26) 3
---- ---- ----- ----
Loss Before Interest and Taxes..................... (61) (21) (487) (68)
Interest Expense................................... (1) (2) (4) (5)
---- ---- ----- ----
Pre-tax Loss....................................... (62) (23) (491) (73)
Income Tax Benefit................................. (32) (8) (177) (28)
---- ---- ----- ----
Net Loss from Operations........................... (30) (15) (314) (45)
Cumulative Effect of Change in Accounting Principle -- -- (234) --
---- ---- ----- ----
Net Loss........................................... $(30) $(15) (548) $(45)
==== ==== ===== ====
75
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
Three-Month Periods Ended September 30, 2002 and 2001
The telecommunications segment continues to experience severely depressed
industry conditions as evidenced by an increased number of bankruptcies,
continued devaluation of equity securities, lack of financing sources in the
sector and further pricing pressures resulting from challenges faced by major
industry players. During the period, management continued to take measures to
reduce losses in the business by limiting capital spending and reducing
operating and administrative expenses. Capital expenditures for the third
quarter 2002 were $7 million compared to $87 million in the third quarter 2001,
$28 million in the first quarter 2002 and $13 million in the second quarter
2002. Based on ongoing analysis pursuant to Statement No. 144, the Company is
expensing capital investment in the segment as incurred (see Note 5 of the
accompanying financial statements).
DGC reported a net loss of $30 million for the third quarter 2002 compared
to a net loss of $15 million in the third quarter 2001. Results for 2002
include non-cash expenses to cover DGC's accrual of costs for the lease
obligation on its domestic network assets and the cost to purchase a lease
obligation associated with the European network. (See Note 5 of the
accompanying financial statements for further discussion.) Period-to-period
operating results were negatively impacted by higher operating costs
attributable to the domestic fiber optic network becoming operational in the
fourth quarter 2001, partially offset by efforts to reduce operating and
administrative expenses in 2002.
Nine-Month Periods Ended September 30, 2002 and 2001
DGC reported a $548 million net loss in the nine-month period ended
September 30, 2002. This compares to a $45 million net loss in the nine-month
period ended September 30, 2001. Segment results for 2002 include a $234
million charge for the impairment of goodwill upon adoption of Statement No.
142 and a pre-tax charge of $305 million ($200 million after tax) associated
with the impairment of assets pursuant to the application of Statement No. 144
(see Note 5 of the accompanying financial statements for further discussion of
these two charges). These results were adversely impacted by higher operating
costs associated with a fully operational domestic network, non-cash expenses
to cover DGC's anticipated loss for a lease obligation on the domestic network,
the purchase of a lease obligation associated with the European network and a
decrease in equity earnings related to technology investments. These results
were partially offset by lower depreciation expense resulting from the 2002
impairment of assets and aggressive efforts this year to lower administrative
expenses.
DGC Outlook
The outlook for telecommunications services remains depressed in the near
term. Management anticipates the segment will continue to negatively impact the
Company's cash flows and earnings for the remainder of 2002. Thus, management
is pursuing efforts to reduce costs, limit capital spending, and obtain new
revenue while seeking mutually beneficial resolution of longer-term
commitments. Dynegy is also pursuing partnership and sale opportunities for
this business, although no formal plans are currently in place and no assurance
can be provided as to the timing or structure of any such transaction. If
Dynegy is unable to eliminate these losses or is unsuccessful in attracting a
partner or buyer and decides to shut down or otherwise dispose of its
telecommunications business, Dynegy could incur up to $360 million in lease
obligations relating to its US telecommunications network upon expiration of
the lease term. In addition, as of September 30, 2002, Dynegy has approximately
$185 million, or approximately $100 million on a discounted basis, in long-term
operating commitments relating to its global telecommunications business.
76
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
Cash Flow Disclosures
The following table is a condensed version of the operating section of the
Condensed Consolidated Statements of Cash Flows (in millions):
For the Nine Months Ended September 30, 2002
-----------------------------------------------------
Corporate
&
WEN DMS T&D DGC Eliminations Consolidated
------- ---- ----- ----- ------------ ------------
Net Income (Loss)........................ $(1,145) $ 13 $(485) $(548) $ -- $(2,165)
Net Non-Cash Items Included in Net Income 1,606 55 784 450 5 2,900
------- ---- ----- ----- ---- -------
Operating Cash Flows Before Changes in
Working Capital........................ 461 68 299 (98) 5 735
Changes in Working Capital............... (393) (6) (41) (3) (31) (474)
------- ---- ----- ----- ---- -------
Net Cash Provided by (Used in) Operating
Activities............................. $ 68 $ 62 $ 258 $(101) $(26) $ 261
======= ==== ===== ===== ==== =======
For the Nine Months Ended September 30, 2001 Restated
-----------------------------------------------------
Corporate
&
WEN DMS T&D DGC Eliminations Consolidated
------- ---- ----- ----- ------------ ------------
Net Income (Loss)........................ $ 395 $ 45 $ 57 $ (45) $ $ 452
Net Non-Cash Items Included in Net Income 3 82 153 (8) 230
------- ---- ----- ----- ---- -------
Operating Cash Flows Before Changes in
Working Capital........................ 398 127 210 (53) -- 682
Changes in Working Capital............... (120) 21 (130) (20) 19 (230)
------- ---- ----- ----- ---- -------
Net Cash Provided by (Used in) Operating
Activities............................. $ 278 $148 $ 80 $ (73) $ 19 $ 452
======= ==== ===== ===== ==== =======
Operating Cash Flow. Cash flow from operating activities totaled $261
million for the nine-month period ended September 30, 2002 compared to $452
million reported in the same 2001 period. Non-cash add-backs were greater in
the 2002 period, primarily due to the following charges, which are further
described in Notes 4 and 5 to the accompanying financial statements:
. The $908 million goodwill impairment associated with the WEN segment;
. The $586 million loss on the sale of Northern Natural;
. The $234 million impairment of goodwill for DGC related to the adoption
of Statement No. 142 as previously disclosed in the first quarter 2002
and $286 million of additional pre-tax impairment charges for DGC during
the second quarter 2002;
. Write-offs within Earnings (Losses) from Unconsolidated Investments in
the first three quarters of 2002 of $97 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,
$43 million related to WEN and $50 million related to DGC, with the
remaining amounts allocated to DMS and T&D. Additionally, the Company
wrote off $90 million of generation investments in the third quarter
2002, all of which was associated with the WEN segment.
77
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
Other changes in non-cash items include the following:
. Depreciation and amortization expense increased by $98 million primarily
due to the inclusion of Northern Natural from February through July 2002
and the United Kingdom natural gas storage facilities beginning in
November 2001 and the accrual for the telecommunication lease guarantee
in the third quarter 2002, offset by the discontinued amortization of
goodwill in 2002;
. A reduction in Earnings (Losses) from Unconsolidated Investments of
approximately $108 million related to West Coast Power;
. Deferred income taxes are a $242 million benefit position for the nine
months ended September 30, 2002, compared to an expense of $177 million
in the same 2001 period, producing a $419 million decreased add-back; and
. Risk Management activity produced a $444 million add-back, compared to a
deduction of $76 million in the 2001 period. The add-backs represent cash
realized for settled contracts in excess of gains recognized combined
with non-cash losses realized in the period in excess of cash
settlements, including the $223 million liquidity reserve recorded in the
third quarter 2002.
Changes in working capital had a negative impact on cash flow from
operations for the nine-month period ended September 30, 2002 primarily due to
the following:
. Increased cash collateral requirements resulting from the Company's below
investment grade credit rating;
. Settlement of foreign exchange swaps; and
. Amortization of liabilities associated with previous acquisitions.
Capital Expenditures and Investing Activities. Cash provided by investing
activities during the nine-month period ended September 30, 2002 totaled $412
million. Capital spending and investments in unconsolidated investments totaled
$748 million and relate 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
$1,105 million in proceeds primarily from the sales of Northern Natural and the
Hornsea UK storage facility. Other Investing activities include proceeds from
the sale of the Northern Natural bonds.
Financing Activities. Cash provided by financing activities during the
nine-month period ended September 30, 2002 totaled $237 million. The Company
received $205 million in cash proceeds relative to ChevronTexaco's purchase of
approximately 10.4 million shares of Class B common stock in January 2002.
Additional capital stock proceeds include $24 million in cash from members of
senior management associated with the December 2001 private equity placement.
Dividends declared and paid to holders of Class A and Class B common stock
totaled $40 million and $15 million, respectively, for the nine-month period
ended September 30, 2002.
In March 2002, Illinova Corporation, a wholly owned subsidiary of Dynegy and
the parent company of IP, paid $28 million in cash for shares of IP's preferred
stock through a tender offer.
Long-term debt proceeds, net of issuance costs, for the nine-months ended
September 30, 2002 consisted of $496 million from the issuance of 8.75 percent
senior notes due February 2012 and $36 million from ABG.
78
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
Repayments of long-term debt totaled $571 million for the nine-months ended
September 30, 2002 and consisted of the following:
. $66 million in quarterly payments of IP Transitional Funding Trust Notes;
. $90 million relating to the April 2002 purchase of Northern Natural's
senior unsecured notes due 2005;
. $73 million in principle payments related to the Black Thunder financing;
. $200 million relating to the July 2002 DHI 6.785% senior note repayment;
and
. $96 million relating to the July 2002 IP mortgage bond repayment; and
. $46 million relating to ABG.
Net proceeds from short-term financing consisted of a $245 million net cash
advance for the anticipated sale of United Kingdom gas storage assets as well
as $192 million in financings secured by interests in two of the Company's
generating facilities. Additionally, during the nine months ended September 30,
2002, Dynegy repaid $500 million in commercial paper and borrowings under
revolving credit lines for DHI and IP in the aggregate and borrowed $60 million
under IP's term loan and drew upon $137 million under the Company's revolvers.
Also, as more fully described in Note 1 in the accompanying financial
statements, the consolidation of ABG Gas Supply increased cash flows from
financing activities in 2001 by approximately $282 million.
Finally, other financing cash payments totaled $14 million for the
nine-months ended September 30, 2002, which primarily consisted of $13 million
in minority interest associated with Black Thunder prior to the September 2002
restructuring (see Note 8 to the accompanying financial statements for more
information).
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;
. Expectations regarding capital expenditures and other payments;
. Expectations regarding transaction volume and liquidity in wholesale
energy markets in North America and Europe;
. The Company's beliefs and assumptions relating to its liquidity position,
including its ability to satisfy or refinance its obligations as they
come due;
. The Company's ability to execute additional capital-raising transactions
or refinancings to enhance its liquidity position;
. 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 and environmental matters as well as
the investigations primarily relating to Project Alpha and the Company's
trading practices;
79
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
. The Company's ability to manage its exit from third party risk management
aspects of the marketing and trading business and the timing of the
expected cash flow and collateral rolloff related to this exit; and
. The Company's strategic plans in communications, including the Company's
ability to eliminate or further reduce net cash outflows associated with
this segment.
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 asset sales or refinancings;
. The timing and extent of changes in commodity prices for energy,
particularly natural gas, electricity and NGLs;
. The extent and timing of the entry of additional competition in the
Company's lines of business;
. 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
refinance or repay its significant debt maturities and to maintain its
credit ratings;
. Developments in the California power markets, including, but not limited
to, governmental intervention, deterioration in the financial condition
of Dynegy's counterparties, default on receivables due and adverse
results in current or future investigations or litigation;
. The effectiveness of Dynegy's risk-management policies and procedures and
the ability of Dynegy's counterparties to satisfy their financial
commitments;
. The liquidity and competitiveness of wholesale trading markets for energy
commodities, particularly natural gas, electricity and NGLs;
. 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, regulatory
approval of permit issues, 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's ability to successfully execute the remaining elements of its
capital plan and to generate sustainable earnings and cash flow from its
assets and businesses;
. The direct or indirect effects on Dynegy's business of further downgrades
in its credit ratings (or actions Dynegy may take in response to changing
credit ratings criteria), including refusal by counterparties to enter
into transactions with the Company and its inability to obtain credit or
capital in amounts or on terms that are considered favorable;
. 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 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 the
Company's trading practices;
80
DYNEGY INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For the Interim Periods Ended September 30, 2002 and 2001
. Other North American regulatory or legislative developments that affect
the regulation of the electric utility industry, 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 and developments in the United States and in
foreign countries whose affairs affect Dynegy's lines of business,
including any extended period of war or conflict.
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.
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.
ITEM 4--CONTROLS AND PROCEDURES
Within the 90-day period immediately preceding the filing of this report, an
evaluation was carried out under the supervision and with the participation of
Dynegy's management, including its Chief Executive Officer and its Chief
Accounting Officer (as Dynegy's responsible financial officer), of the
effectiveness of the design and operation of its disclosure controls and
procedures (as defined in Rule 13a-14(c) under the Exchange Act). Based upon
that evaluation, the Chief Executive Officer and Chief Accounting Officer
concluded that the design and operation of these disclosure controls and
procedures were effective. No significant changes were made to Dynegy's
internal controls or in other factors that could significantly affect these
controls subsequent to the date of this evaluation.
81
DYNEGY INC.
PART II. OTHER INFORMATION
ITEM 1--LEGAL PROCEEDINGS
See Note 12 to the accompanying financial statements for discussion of
material recent developments in the Company's material legal proceedings.
ITEM 5--OTHER
Accompanying the filing of this Form 10-Q for the quarterly period ended
September 30, 2002, we have provided to the Securities and Exchange Commission
the Certifications of the chief executive officer and the chief accounting
officer (as Dynegy's responsible financial officer) required pursuant to 18
U.S.C. Section 1359, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
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 Employment Agreement, effective as of September 16, 2002, between R. Blake Young and
Dynegy Inc.
10.2 Employment Agreement, effective as of September 16, 2002, between Hugh A. Tarpley and
Dynegy Inc.
10.3 Employment Agreement, effective as of October 1, 2002, between Michael R. Mott and Dynegy
Inc.
10.4 Employment Agreement, effective as of October 23, 2002, between Bruce A. Williamson and
Dynegy Inc.
(b) Reports on Form 8-K of Dynegy Inc. for the third quarter 2002.
1. During the quarter ended September 30, 2002, the Company filed a
Current Report on Form 8-K dated July 15, 2002. Items 5 and 7 were
reported and no financial statements were filed.
2. During the quarter ended September 30, 2002, the Company filed a
Current Report on Form 8-K dated July 23, 2002. Items 7 and 9 were
reported and no financial statements were filed.
3. During the quarter ended September 30, 2002, the Company filed a
Current Report on Form 8-K dated July 30, 2002. Items 5 and 7 were
reported and no financial statements were filed.
4. During the quarter ended September 30, 2002, the Company filed a
Current Report on Form 8-K dated August 9, 2002. Items 5 and 7 were
reported and no financial statements were filed.
5. During the quarter ended September 30, 2002, the Company filed a
Current Report on Form 8-K dated August 14, 2002. Items 7 and 9 were
reported and no financial statements were filed.
6. During the quarter ended September 30, 2002, the Company filed a
Current Report on Form 8-K dated August 16, 2002. Items 5, 7 and 9
were reported and no financial statements were filed.
7. During the quarter ended September 30, 2002, the Company filed a
Current Report on Form 8-K dated August 30, 2002. Items 5, 7 and 9
were reported and no financial statements were filed.
8. During the quarter ended September 30, 2002, the Company filed a
Current Report on Form 8-K dated September 6, 2002. Items 5 and 7
were reported and no financial statements were filed.
9. During the quarter ended September 30, 2002, the Company filed a
Current Report on Form 8-K dated September 23, 2002. Items 5 and 7
were reported and no financial statements were filed.
10. During the quarter ended September 30, 2002, the Company filed a
Current Report on Form 8-K dated September 25, 2002. Items 5 and 7
were reported and no financial statements were filed.
82
DYNEGY 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 INC.
Date: November 14, 2002 By: /S/ MICHAEL R. MOTT
----------------------------------
Michael R. Mott
Chief Accounting Officer, Senior
Vice President and
Controller (Duly Authorized
Officer and Principal Accounting
Officer)
83
Section 302 Certification
I, Bruce A. Williamson, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Dynegy Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
(a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
(b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of the registrant's board of directors (or persons performing the equivalent
functions):
(a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal
controls; and
(b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 14, 2002
/S/ BRUCE A. WILLIAMSON
--------------------------------------
Bruce A. Williamson
Chief Executive Officer
84
Section 302 Certification
I, Michael R. Mott, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Dynegy Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
(a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
(b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of the registrant's board of directors (or persons performing the equivalent
functions):
(a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal
controls; and
(b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 14, 2002
/S/ MICHAEL R. MOTT
______________________________________
Michael R. Mott
Chief Accounting Officer
85