Seemingly astute move brings Allegheny pain

THE BALTIMORE SUN

When Allegheny Energy Inc. spent $490 million to buy a power-trading unit from Merrill Lynch & Co. Inc., the purchase was supposed to launch the Hagerstown-based energy company into the ranks of the nation's top 10 power marketers.

Now, more than a year later, owning what was once a lucrative trading business has turned into Allegheny's latest headache, adding to the turmoil resulting from an industry downturn.

This month, Allegheny fired the head of the trading unit on grounds of violating the company's conflict-of-interest policies. Worse, questions of trading improprieties that occurred before it bought Global Energy Markets has Allegheny embroiled in a legal fight with Merrill Lynch.

"At the time, it seemed like the right route to go in order to accelerate earnings," analyst William D. Hyler of CIBC World Markets said of Allegheny's purchase of GEM. "It doesn't look like it made any sense now."

Samir Nangia, energy analyst at Credit Lyonnais Securities, said, "They made a mistake. ... Purchasing GEM has hit them on the negative side in ways that none of us could have perceived."

The GEM debacle punctuates a period during which Allegheny has been forced to drastically change course. It had to dump its plan to split into two businesses. It lowered its expected earnings for the year. It had to cut power plant projects. It trimmed about 600 employees.

The company's stock has plummeted to lows not seen in decades. And investment analysts and ratings agencies have downgraded its credit profile because of a liquidity crunch.

Such a situation was unimaginable in January last year, when it seemed that nothing could go wrong for Allegheny. It had just launched a billion-dollar growth plan, its stock price was at an all-time high, it had announced its plan to buy an energy-trading business, and it had landed in Standard & Poor's 500 index, a closely monitored market benchmark made up of leading U.S. companies.

Allegheny, which supplies electricity to 1.5 million customers in Maryland, Ohio, Pennsylvania, Virginia and West Virginia, was well on its way toward its goal of becoming a nation-wide power producer and marketer.

Then the energy sector collapsed.

Like those of other energy companies, Allegheny's fortunes sank with the fall of wholesale power prices, a reported glut in power plant construction, Enron Corp.'s bankruptcy, California's power crisis and energy-trading scams.

But while others, including Baltimore's Constellation Energy Group Inc. - which changed its top management - have begun recovering, Allegheny is struggling to turn itself around.

"It's not been a very pleasant calendar year for us," said Michael P. Morrell, president of subsidiary Allegheny Energy Supply and the man in charge of the trading unit. Morrell is also Chief Executive Officer Alan J. Noia's No. 2 as they attempt to right the company.

"For the first nine months, 2001 was good for us," Morrell said. "It looked like the moves we made were the right moves. Other companies were making similar decisions.

"But then things that were largely out of our control changed the environment. It made the strategic moves we made not serve us well. ... Now, people say, 'Things would be great if you hadn't bought Global Energy Markets. Things would be great if you hadn't entered into negative cash flow agreements with California.' But at that point, it made eminent good sense to do those things.

"As we all know, life doesn't work out as well as one would hope, and hindsight is 20/20," Morrell said.

Noia and Morrell moved swiftly to cut costs after the economy soured. Besides trimming jobs and canceling two power projects, they refocused on Allegheny's reliable, regulated utility business in five states. Noia also has announced that Allegheny is considering selling some contracts and plants to raise cash.

But that hasn't been enough. The stock is mired in the low double digits, closing Friday at $12.86, down from a 52-week high of $42.86. Its debt-to-equity ratio hovers at more than 60 percent. And it lost $32.3 million in the second quarter.

Morrell concedes that it could be next year before progress is evident.

Not everyone is convinced that it will happen that quickly.

Fitch Ratings, a credit rating agency, lowered its rating on Allegheny's senior unsecured debt to BBB from BBB+, noting key concerns that "poor power markets conditions and trading losses affecting AE Supply will weaken [Allegheny's] 2002 consolidated financial profile considerably, lowering the company's coverage ratios and raising its leverage."

'Stocks to Sell Now'

Zacks Investment Research placed Allegheny on its "Stocks to Sell Now" list. Zacks recommended that customers "save themselves the misery of unrelenting losses" by getting rid of stocks that have done 89.8 percent worse than the S&P; 500.

After Allegheny announced in July that its annual earnings would miss forecasts by as much as 30 percent, Zacks said that Allegheny "is making moves to better itself, but little progress can be made until the industry recovers."

Those reports came out before problems began to surface at GEM, which has been renamed Allegheny Energy Global Markets.

It began with Allegheny's promising $4.5 billion contract to supply electricity to California. Shortly after Allegheny purchased GEM on March 16, 2001, it re-sold an energy supply contract to power hungry California by agreeing to sell electricity at $61 per megawatt to the state for the next 10 years.

"Everything would have been fine if they had managed to spin off or find additional equity," said Nangia of Credit Lyonnais. "No one saw the California Department of Water Resources backtracking on the contract. That's why [Allegheny is] having liquidity problems now."

California has refused to honor those contracts, claiming that energy companies took advantage of the state's dire straits by manipulating prices and withholding power.

"They believe they shouldn't have to pay what they are supposed to pay," Morrell said. "We vehemently disagree with that. ... We bought power at higher prices and sold it to California at $61. Cash was going out the door in 2001 and 2002. We thought about it very carefully. We were willing to stand the negative cash flow.

"That has been substantially reversed," Morrell said. "But now they want to reduce the price of the contract when we are having substantial problems with cash flow."

The company lost $250 million on that contract last year.

In an attempt to stem the bleeding, Noia said Allegheny cut $700 million from its construction budget over the next two to three years. The company refocused its trading strategy to deal only in power it can produce at its own plants.

To shore up cash flow and its credit standing, it immediately canceled a number of construction projects, including a plant in La Paz County, Ariz., a city barge project in New York and combustion turbines in Indiana and Maryland that had not been announced.

Other energy companies also began cutting costs and scaling back trading operations as the power-trading market crumbled after the California and Enron fiascos.

Then rumblings of so-called round-trip trades - in which power is simultaneously bought and sold - between Merrill Lynch's GEM and Enron in 1999 began to surface at the beginning of August this year.

Through sham option trades, Enron was able to book $60 million of profit from its deal with GEM and Merrill Lynch was able to add to the perceived value of its trading business, according to allegations reported by The New York Times.

Last week, Allegheny filed a $1 billion lawsuit against Merrill Lynch in New York state court for fraud and breach of contract. Allegheny claims that Merrill Lynch used "wash" or "round-trip" trades to artificially inflate the trading unit's revenue and trading volume, which made the business more attractive for sale.

"There are serious issues concerning the adequacy and accuracy of Merrill Lynch's disclosures and representations about the energy trading business it sold to Allegheny Energy - particularly as they pertain to Merrill's dealings with Enron," said Allegheny's counsel, Stanley S. Arkin of Arkin, Kaplan & Cohen.

"These are issues that go to the very validity of the transaction itself, and we intend to get to the bottom of them very soon. Merrill Lynch's lawsuit is nothing more than a gambit to divert Allegheny from its appropriate inquiries."

Merrill Lynch sues

Allegheny sued a day after Merrill Lynch filed a lawsuit in federal court Tuesday claiming that Allegheny failed to buy out the firm's remaining 2 percent stake in the trading unit, worth about $115 million. Merrill Lynch says Allegheny is obligated, under its sales agreement, to buy out the stake if that unit failed to obtain a set level of generating capacity within 18 months of the sale.

The dispute could further hurt investor confidence in the company, said David B. Burks, utilities analyst at J.J.B. Hilliard, W.L. Lyons.

"Any time the specter of potential misdeeds is raised, it increases investor anxieties," Burks said.

The troubles surrounding the trading unit don't stop there.

The termination of Daniel Gordon, the head of the trading unit, on Sept. 5 was another blow to the company's stock price. Shares of Allegheny dropped 8.1 percent the next day.

Morrell would say only that Gordon violated corporate policies, but sources within the company say he was dismissed after it was discovered that he held a financial interest in a company that did business with Allegheny and was part-owner of real estate that Allegheny had agreed to lease.

As the internal investigation continues, Allegheny maintains that Gordon's trades were small and will not affect earnings. But many in the investment community question Gordon's role in the Enron trades and wonder what new revelations could surface.

"This development bears negatively on Allegheny's credit profile because of the potential for additional discoveries of improprieties as the internal investigation continues," according to a recent statement from Standard & Poor's.

Nangia said, "I can only assume that there will be nothing else that will come out wrong about the financials. If not, I would say that would be 'game over.'"

Some analysts wonder whether the continuing struggles could leave the company vulnerable. Its low stock price could make Allegheny a take-over target, said analysts, who added that recent rumors about possible mergers with other companies are premature.

"Clearly, the company must be frustrated and concerned," Burks said. "I think it is certainly well within their right to ask Merrill Lynch for more information on what may or may not have occurred before [Allegheny] purchased the trading business. It raises questions. ... They still have some hurdles to jump before the end of the year is through."

In the meantime, Allegheny leadership has been meeting with investment analysts and its largest shareholders to reassure them about the future. Allegheny is also planning to issue $400 million to $600 million of equity in the fourth quarter of this year to improve liquidity.

Analysts say the equity infusion will be vital to bolster the balance sheet, but they warn that it could depress its stock price further as shares are diluted.

Recently, Morrell met with Chicago-based Duff & Phelps Investment Management, which holds 1.3 million shares of Allegheny.

"If you buy the company at $30 and it's now at $15, you worry," Morrell said. "You worry that it'll go down to $1. I told them that's not the case here."

"Some days, I sit in my office and think, 'Will somebody please walk in the door and deliver a piece of good news to me?'" Morrell said. "It's a tough world at the moment. You've got two choices: You can mope or you can put one foot in front of the other every morning and move on. I believe that's what I and the rest of the company will do. We'll move along."

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