El Paso's Long Battle Isn't Over


By Brian Hindo When Ronald Kuehn Jr., the embattled interim chief executive of El Paso Corp. (EP), paused to survey his situation on June 17, chances are he felt like a soldier on the beach the day after the Normandy invasion: He had survived D-Day, but he still faced a long, hard war.

D-Day in Kuehn's case has been all of 2003, right up until now. The once high-flying natural-gas producer and energy trader's revenues are running 80% below what they were two years ago. El Paso's stock has plummeted almost 90% since then. And its board has just spent upwards of $9 million to win a vicious proxy battle over dissident shareholders who wanted to throw out Kuehn and his management team.

The results of the June 17 vote won't be officially known for a couple of weeks, the company says, but after the meeting, both El Paso and the dissident slate agreed that the incumbents most likely prevailed by a narrow margin.

TRADING IN TOMORROWS. Whichever side ultimately wins, it won't have much time to enjoy the victory. Cash-strapped El Paso has been racked by losses from energy trading and is choking on a huge slug of debt, a hangover from the days when it emulated such Enron strategies as moving borrowings off its balance sheet and building a big trading operation.

That left it staggering under $25 billion in debt and further burdened by a junk credit rating of B+, according to Standard & Poor's. And that's a warning to investors that even though El Paso's stock price is in the single digits and its forward price-earnings ratio of 11 looks cheap compared with that of competitors, its multiple challenges make it a dicey choice for the faint of heart.

El Paso has several options to boost cash flow and pay down debt, but none are terribly appealing. One step, says management, is to continue selling what it calls "noncore" assets. Morgan Stanley estimates that El Paso could generate as much as $3.4 billion on sales of everything from pipelines to refineries to gas reserves -- assets it really doesn't need to sustain itself right now. The problem, of course, is that such a move would be trading in El Paso's tomorrows for today. "If you sell good assets [now]," notes Credit Lyonnais analyst Gordon Howald, "you're selling future cash-flow streams."

LOCATION PROBLEMS. Indeed, the dissident slate -- led by El Paso's largest individual shareholder, Selim Zilkha, CEO of privately held Zilkha Renewable Energy -- downplayed asset sales as a fix, instead focusing on cutting costs. A cornerstone of Zilkha's plan was to streamline operations in the exploration and production business, which brings in steady profits but costs more than $1 billion a year to run -- though the dissidents offered few details on how they would do that.

The exploration business is suffering from its location in the Gulf of Mexico, which has been so exploited that expensive deep-sea exploration is now necessary. Also complicating matters, says analyst Howald: El Paso, like other production companies, routinely hedges its selling prices with futures, swaps, and other instruments, to ensure earnings stability as natural-gas prices fluctuate. And over the past year or so, unexpectedly high spikes in gas prices have resulted in losses on the hedges.

Another way to raise cash on the run would be to issue more equity. That would seem to make sense, given El Paso's debt burden: Fellow power companies AES (AES) and Reliant Resources (RRI) have recently issued stock and convertibles, respectively, to raise money. But the pitfall is that the dilutive effect of issuing shares typically drives down a stock.

STOCK SWINGS. With El Paso's shares hovering around $9, down from their peak of $75 during the boom, that option may not sit well with investors, many of whom voiced their displeasure by voting the Zilkha proxy slate. One ray of hope: "If the shares rally 20% to 30% from here, [an equity offering] may happen in the next six to nine months," says S&P equity analyst Craig Shere. Morgan Stanley says El Paso needs $2 billion in equity to right its ship.

The stock price has risen an impressive 170% off its mid-February low of $3.33, aided by the resignation of former CEO William Wise in March. Yet many analysts are betting that the improvement won't continue, even with the proxy dispute over. S&P's Shere and Credit Lyonnais' Howald both have hold ratings on El Paso, while A.G. Edwards and Morgan Stanley have sell ratings. The stock price rose slightly heading into the proxy meeting, but fell afterward, closing at $8.86 on June 19.

Houston-based RBC Capital Markets analysts Mark Easterbrook and Kevin Gallagher predict that in 2003, El Paso will swing to a modest profit of $5 million, vs. a loss of $1.29 billion in 2002. They expect revenues to total $11.7 billion, down 4% from 2002's $12.2 billion. Easterbrook and Gallagher have a "sector perform," or hold, rating on the stock, with 12-month price target of $8.

"GIANT BLACK BOX." Then there's the small matter of energy trading -- an industry that cratered after Enron's fall. El Paso began unwinding its trading operations later than most of its scorched peers, such as Dynegy (DYN) and Williams (WMB) -- and it is paying the price. It still has 33,000 contracts left on its books, although El Paso expects to bring the number down to 12,000 by yearend by selling its positions or by pursuing "early termination" -- that is, negotiating its way out of contracts at a loss.

It's possible that further write-downs from energy-trading losses -- El Paso's trading outfit lost about $1.5 billion in 2002 -- could dog the company later this year, but analysts can't tell how likely that is: El Paso's trading operation "has been a giant black box," says Credit Lyonnais' Howald. "There's not a lot of visibility." The 10-K filing warns of possible "future losses of up to $200 million" in 2003 from the trading book.

If the Zilkha-led proxy battle did nothing else, it held a magnifying glass to El Paso's recent management follies. That prompted Kuehn, whose permanent successor is expected to be named in the next few weeks, to strike a conciliatory tone at the shareholders' meeting: "We have to work very hard to get the support of the people who supported Mr. Zilkha's slate, and we will," he said. That's just one more skirmish El Paso has to put behind it as it girds for the tougher fight ahead. Hindo reports for BusinessWeek Online from New York


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