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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended June 30, 2002
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 1-15659
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DYNEGY INC.
(Exact name of registrant as specified in its charter)
Illinois 74-2928353
(State or other (I.R.S. Employer
jurisdiction Identification No.)
of incorporation or
organization)
1000 Louisiana, Suite 5800
Houston, Texas 77002
(Address of principal executive offices)
(Zip Code)
(713) 507-6400
(Registrant's telephone number, including area code)
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, 272,427,169 shares outstanding as of August 12, 2002; Class B Common
Stock, no par value per share, 96,891,014 shares outstanding as of August 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:
June 30, 2002 and December 31, 2001.................................. 3
Condensed Consolidated Statements of Operations:
For the three months ended June 30, 2002 and 2001.................... 4
Condensed Consolidated Statements of Operations:
For the six months ended June 30, 2002 and 2001...................... 5
Condensed Consolidated Statements of Cash Flows:
For the six months ended June 30, 2002 and 2001...................... 6
Notes to Condensed Consolidated Financial Statements................... 7
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS............................................ 35
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..... 76
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.............................................. 77
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............ 77
Item 6. EXHIBITS AND REPORTS ON FORM 8-K............................... 78
EXPLANATORY NOTE
This quarterly report includes financial statements which have not been
reviewed by an independent public accountant under Rule 10-01(d) of Regulation
S-X. We expect that our independent public accountant, PricewaterhouseCoopers
LLP, will complete the quarterly review required by Rule 10-01(d) of Regulation
S-X following their re-audit of our historical financial statements for the
three-year period ended December 31, 2001. This three-year re-audit will
address, among other items, the restatements to our historical financial
statements relating to the balance sheet, statement of operations and cash flow
statement impacts resulting from revisions in accounting for a structured
natural gas transaction referred to as Project Alpha and a $124 million pre-tax
charge relating principally to our natural gas marketing business, each as
further described in Note 1 to the accompanying financial statements. In this
regard, Arthur Andersen LLP, our former independent public accountant, has
advised us that its audit opinion relating to 2001 should no longer be relied
upon. As a result of the three-year re-audit, there may be other revisions to
the Company's historical financial statements in addition to those described
above, some of which may be material. Dynegy expects to file amended reports
under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), for
each of the three years in the period ended December 31, 2001, as well as each
quarterly period contained therein. In addition, Dynegy expects to file amended
Exchange Act reports for the quarters ended March 31, 2002 and June 30, 2002.
These amended reports will be filed with the SEC following the completion by
PricewaterhouseCoopers LLP of the three-year re-audit and, for the quarterly
periods during 2002, their subsequent review of the interim financial
statements for these periods.
2
DYNEGY INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited) (in millions, except share data)
June 30, December 31,
2002 2001
-------- ------------
ASSETS
Current Assets
Cash and cash equivalents................................................................................. $ 378 $ 218
Accounts receivable, net of allowance for doubtful accounts of $122 million and $107 million, respectively 3,712 3,641
Accounts receivable, affiliates........................................................................... 22 80
Inventory................................................................................................. 266 391
Assets from risk-management activities.................................................................... 4,759 4,054
Prepayments and other assets.............................................................................. 555 1,370
------- -------
Total Current Assets................................................................................ 9,692 9,754
------- -------
Property, Plant and Equipment............................................................................. 12,039 9,130
Accumulated depreciation.................................................................................. (1,341) (921)
------- -------
Property, Plant and Equipment, Net.................................................................. 10,698 8,209
Other Assets
Investments in unconsolidated affiliates (Note 12)........................................................ 918 950
Investment in Northern Natural Gas Company (Note 6)....................................................... -- 1,501
Assets from risk-management activities.................................................................... 4,493 2,332
Goodwill.................................................................................................. 2,191 1,595
Other assets.............................................................................................. 997 850
------- -------
Total Assets........................................................................................ $28,989 $25,191
======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable.......................................................................................... $ 3,393 $ 3,522
Accounts payable, affiliates.............................................................................. 62 40
Accrued liabilities and other............................................................................. 987 1,346
Liabilities from risk-management activities............................................................... 4,520 3,562
Notes payable and current portion of long-term debt....................................................... 1,871 402
------- -------
Total Current Liabilities........................................................................... 10,833 8,872
------- -------
Long-Term Debt............................................................................................ 4,795 3,608
Other Liabilities
Transitional funding trust notes.......................................................................... 473 516
Liabilities from risk-management activities............................................................... 4,109 2,073
Deferred income taxes..................................................................................... 1,550 1,735
Other long-term liabilities............................................................................... 884 909
------- -------
Total Liabilities................................................................................... 22,644 17,713
------- -------
Minority Interest......................................................................................... 144 1,010
Serial Preferred Securities of a Subsidiary............................................................... 11 46
Company Obligated Preferred Securities of Subsidiary Trust................................................ 200 200
Series B Mandatorily Convertible Redeemable Preferred Securities.......................................... 1,519 1,503
Commitments and Contingencies (Note 13)
Stockholders' Equity
Class A Common Stock, no par value, 900,000,000 shares authorized at June 30, 2002 and December 31, 2001,
272,058,799 and 269,984,456 shares issued and outstanding at June 30, 2002 and December 31, 2001,
respectively............................................................................................. 2,871 2,837
Class B Common Stock, no par value, 360,000,000 shares authorized at June 30, 2002 and December 31, 2001,
96,891,014 and 86,499,914 shares issued and outstanding at June 30, 2002 and December 31, 2001,
respectively............................................................................................. 1,006 801
Subscriptions receivable.................................................................................. (4) (25)
Accumulated other comprehensive loss, net of tax.......................................................... (15) (35)
Retained earnings......................................................................................... 681 1,212
Treasury stock, at cost, 1,679,183 shares at June 30, 2002 and 1,766,800 shares at December 31, 2001...... (68) (71)
------- -------
Total Stockholders' Equity................................................................................ 4,471 4,719
------- -------
Total Liabilities and Stockholders' Equity.......................................................... $28,989 $25,191
======= =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
3
DYNEGY INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited) (in millions, except per share data)
Three Months Ended
June 30,
----------------
2002 2001
------- -------
Revenues............................................................ $ 9,906 $10,812
Cost of sales....................................................... 9,604 10,375
Depreciation and amortization....................................... 141 113
Impairment and other charges (Note 5)............................... 323 --
General and administrative expenses................................. 109 126
------- -------
Operating income (loss).......................................... (271) 198
Earnings (losses) from unconsolidated investments (Notes 5 and 12).. (7) 78
Other income (Note 5)............................................... 64 26
Interest expense.................................................... (83) (68)
Other expenses (Note 5)............................................. (194) --
Minority interest expense........................................... (10) (20)
Accumulated distributions associated with trust preferred securities (4) (6)
------- -------
Income (loss) before income taxes................................... (505) 208
Income tax provision (benefit)...................................... (177) 62
------- -------
Net Income (Loss)................................................... $ (328) $ 146
======= =======
Net Income (Loss) Per Share:
Net income (loss)................................................... $ (328) $ 146
Less: preferred stock dividends..................................... 8 --
------- -------
Net income (loss) applicable to common stockholders................. $ (336) $ 146
======= =======
Basic earnings (loss) per share..................................... $ (0.92) $ 0.45
======= =======
Diluted earnings (loss) per share (Note 10)......................... $ (0.92) $ 0.43
======= =======
Basic shares outstanding............................................ 366 326
======= =======
Diluted shares outstanding.......................................... 417 339
======= =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
4
DYNEGY INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS--(Continued)
(unaudited) (in millions, except per share data)
Six Months Ended
June 30,
----------------
2002 2001
------- -------
Revenues................................................................ $18,558 $24,980
Cost of sales........................................................... 17,748 24,066
Depreciation and amortization........................................... 258 220
Impairment and other charges (Note 5)................................... 323 --
General and administrative expenses..................................... 248 241
------- -------
Operating income (loss).............................................. (19) 453
Earnings (losses) from unconsolidated investments (Notes 5 and 12)...... (18) 110
Other income (Note 5)................................................... 100 79
Interest expense........................................................ (162) (130)
Other expenses (Note 5)................................................. (211) (53)
Minority interest expense............................................... (20) (30)
Accumulated distributions associated with trust preferred securities.... (8) (12)
------- -------
Income (loss) before income taxes and change in accounting principle.... (338) 417
Income tax provision (benefit).......................................... (126) 134
------- -------
Income (loss) from operations........................................... (212) 283
Cumulative effect of change in accounting principle, net (Notes 4 and 7) (256) 2
------- -------
Net Income (Loss)....................................................... $ (468) $ 285
======= =======
Net Income (Loss) Per Share:
Net income (loss)....................................................... $ (468) $ 285
Less: preferred stock dividends......................................... 16 --
------- -------
Net income (loss) applicable to common stockholders..................... $ (484) $ 285
======= =======
Basic earnings (loss) per share......................................... $ (1.33) $ 0.88
======= =======
Diluted earnings (loss) per share (Note 10)............................. $ (1.33) $ 0.84
======= =======
Basic shares outstanding................................................ 364 325
======= =======
Diluted shares outstanding.............................................. 416 338
======= =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
5
DYNEGY INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Interim Periods Ended June 30, 2002 and 2001
(unaudited) (in millions)
Six Months
Ended June 30,
--------------
2002 2001
----- -------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)............................................................... $(468) $ 285
Items not affecting cash flows from operating activities:
Depreciation and amortization................................................ 258 216
Impairment and other charges................................................. 286 --
(Earnings) losses from unconsolidated investments, net of cash distributions. 65 (88)
Risk-management activities................................................... 98 244
Deferred income taxes........................................................ (134) 73
Cumulative effect of change in accounting principle.......................... 256 (2)
Gas marketing charge (Note 5)................................................ 124 --
Other........................................................................ 44 (3)
----- -------
Operating cash flows before changes in working capital.......................... 529 725
Change in working capital:
Accounts receivable.......................................................... 19 846
Inventory.................................................................... (20) 13
Prepayments and other assets................................................. (2) (170)
Accounts payable and accrued liabilities..................................... (126) (973)
Other, net................................................................... (25) (70)
----- -------
Net cash provided by operating activities....................................... 375 371
----- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures............................................................ (575) (1,358)
Investments in unconsolidated affiliates........................................ (12) (37)
Business acquisitions, net of cash acquired..................................... (20) (20)
Proceeds from asset sales....................................................... 10 996
Other investing, net............................................................ -- (158)
----- -------
Net cash used in investing activities........................................... (597) (577)
----- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from long-term borrowings.......................................... 496 683
Repayments of long-term borrowings.............................................. (188) (230)
Net proceeds from short-term borrowings......................................... 245 --
Net cash flow from commercial paper and revolving lines of credit............... (233) 4
Proceeds from sale of capital stock, options and warrants....................... 236 63
Purchase of serial preferred securities of a subsidiary......................... (28) --
Purchase of treasury stock...................................................... (1) (13)
Dividends and other distributions, net.......................................... (55) (49)
Other financing, net............................................................ (55) 186
----- -------
Net cash provided by financing activities....................................... 417 644
----- -------
Effect of exchange rate changes on cash......................................... (35) (7)
Net increase in cash and cash equivalents....................................... 160 431
Cash and cash equivalents, beginning of period.................................. 218 86
----- -------
Cash and cash equivalents, end of period........................................ $ 378 $ 517
===== =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
6
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the Interim Periods Ended June 30, 2002 and 2001
Note 1--Restatements
As a result of certain events, which are described below, Dynegy Inc.
("Dynegy" or the "Company") engaged PricewaterhouseCoopers LLP
("PricewaterhouseCoopers") to re-audit its 1999 through 2001 consolidated
financial statements. Following completion of these re-audits, Dynegy intends
to file amended reports under the Securities Exchange Act of 1934, as amended
(the "Exchange Act"), for each of the three years in the period ended December
31, 2001, as well as each quarterly period contained therein. In addition,
Dynegy will file amended Exchange Act reports for the quarters ended March 31,
2002 and June 30, 2002 following completion of PricewaterhouseCoopers'
subsequent review of the interim financial statements for these periods. As a
result of these re-audits and reviews, there may be revisions to the financial
statements contained in the above-referenced reports, including this quarterly
report, which are in addition to the known revisions described below, some of
which could be material. The Company expects that the re-audit of its 1999
through 2001 consolidated financial statements will take at least the remainder
of the year to complete.
Dynegy entered into a structured natural gas transaction known as Project
Alpha in April 2001. As described in a Current Report on Form 8-K dated April
25, 2002 (the "Form 8-K") Dynegy decided, after consultation with the Staff of
the SEC, to present the cash flow associated with the related gas supply
contract as a financing activity in its Consolidated Statements of Cash Flows
for 2001. Following the disclosure in the Form 8-K and in connection with a
further review of Project Alpha, Arthur Andersen ("Andersen") informed the
Company that it could no longer support its tax opinion relating to the
transaction. Andersen's change in position was based in part on its conclusion
that the reclassification of $300 million in cash flow from operations to cash
flow from financing lessened the factual basis for the opinion. Dynegy's
financial statement recognition of the tax benefit in 2001 was based
principally on the Company's assessment of the relevant issues, as corroborated
by Andersen's tax opinion. After the withdrawal of Andersen's tax opinion,
management concluded that sufficient support to include the income tax benefit
for financial statement presentation purposes no longer existed. Additionally,
as a result of further discussions with representatives of the SEC Division of
Enforcement, Dynegy will include in its restatement of its 2001 and 2002
financial statements the consolidation of ABG Gas Supply LLC, one of the
special purpose entities sponsored by Dynegy in the transaction.
The impact of Project Alpha restatement items on Dynegy's financial
statements are expected to be as follows:
. Previously reported operating cash flow for the year ended December 31,
2001 will be reduced by approximately $300 million with a corresponding
increase to financing cash flow;
. Previously reported operating cash flow for the six-month period ended
June 30, 2001 will be reduced from $371 million reported herein to
approximately $263 million, with a corresponding increase in financing
cash flow from the $644 million reported herein to approximately $752
million;
. Retained earnings at December 31, 2001 will be reduced by approximately
$79 million in relation to the balances previously reported by the
Company;
. Previously reported net income for the three-month period ended June 30,
2001 of $146 million, or $0.43 per diluted share, will be reduced to
approximately $119 million and $0.35 per diluted share, respectively;
. Previously reported net income for the six-month period ended June 30,
2001 of $285 million, or $0.84 per diluted share, will be reduced to
approximately $258 million and $0.76 per diluted share, respectively;
7
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
. Reported balance sheets for each Exchange Act reporting period in 2001
(beginning with June 30, 2001) will reflect a reclassification of
approximately $300 million from either Minority Interest or Liabilities
from Risk-Management Activities (or a combination of the two) to debt,
depending on the specific reporting period; and
. Reported balance sheets for each Exchange Act reporting period in 2002
will reflect a reclassification of approximately $300 million from
Liabilities from Risk-Management Activities to debt.
The Company's Condensed Consolidated Statements of Cash Flows for 2002 reflect
(and in all future Exchange Act filings will reflect) the cash flow associated
with the related gas supply contract as financing cash flow rather than
operating cash flow.
Andersen, Dynegy's former independent public accountant, has advised that
its audit opinion relating to 2001 should no longer be relied upon as a result
of the pending restatements relating to Project Alpha. The balance sheets,
statements of operations and cash flow statements for periods ended in 2001 and
2002 to date contained in Dynegy's Exchange Act reports have not been adjusted
to reflect the impacts of the restatements relating to Project Alpha. These
changes will be reflected in the amended Exchange Act reports once the
re-audits and reviews are completed by PricewaterhouseCoopers.
Please see Note 13 below for a description of the ongoing investigations by
the SEC and U.S. Attorney relating to Project Alpha. Note 13 also includes a
description of related shareholder litigation.
In addition to financial statement activities relating to Project Alpha,
Dynegy recognized a pre-tax charge in Other Income and Other Expenses of
approximately $124 million ($80 million after-tax) in the second quarter 2002
related principally to a balance sheet reconciliation project undertaken by the
Company at the beginning of 2002. The charge largely relates to the Company's
natural gas marketing business and is believed to have accumulated over a
number of years. As a result of the charge and the current inability of the
Company to allocate this charge to specific accounting periods, the Company
decided to extend the re-audits of its financial statements to each of the
three years in the period ended December 31, 2001, as described in the first
paragraph above. If necessary, the Company will correct prior period financial
statements based on the results of these re-audits.
Dynegy expects that one of the issues to be addressed in the re-audits is
hedge accounting under Financial Accounting Standards Board ("FASB") Statement
of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended ("Statement No. 133"). Please
see Note 7 for further discussion.
Note 2--Accounting Policies
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with the instructions to interim financial
reporting as prescribed by the SEC, except as provided in the Explanatory Note
on the Table of Contents. These interim financial statements should be read in
conjunction with the consolidated financial statements and notes thereto
included in the Company's Annual Report on Form 10-K for the year ended
December 31, 2001 (the "Form 10-K"), as filed with the SEC.
The financial statements include all material adjustments, which, in the
opinion of management, are necessary for a fair presentation of the results for
the interim periods, except for the specific items described in Note 1. Interim
period results are not necessarily indicative of the results for the full year.
The preparation of the
8
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
condensed consolidated financial statements in conformity with generally
accepted accounting principles requires management to develop estimates and
make assumptions that affect reported financial position and results of
operations and that impact the nature and extent of disclosure, if any, of
contingent assets and liabilities. Actual results could differ materially from
those estimates. Certain reclassifications have been made to prior period
amounts in order to conform to current year presentation.
Note 3--Liquidity and Industry Conditions
During 2002, a number of events negatively impacted Dynegy as well as the
merchant energy industry in general. These events have resulted in downgrades
in the Company's credit ratings to non-investment grade by each of the major
rating agencies and a reduction in available liquidity resulting from a
combination of lower than expected cash flow from operations, reduced access to
sources of capital and increased collateralization of its trading and
commercial obligations. The credit ratings downgrades have limited and will
likely continue to limit significantly the Company's ability to refinance its
debt obligations and to access the capital markets and will likely increase the
borrowing costs incurred by the Company in connection with any refinancing
activities. The Company's financial and operating flexibility is likely to be
similarly reduced as a result of restrictive covenants and other terms that are
typically imposed on non-investment grade borrowers. The Company has
significant debt maturities over the next 12 months, which are further
described in Note 9 below. Additionally, the increased collateralization of the
Company's trading and commercial obligations has decreased capital otherwise
available to satisfy the Company's debt service, debt maturities and other
obligations.
In response to these events, on June 24, 2002 Dynegy announced a $2 billion
capital plan designed to enhance liquidity and reduce debt. Pursuant to this
capital plan, Dynegy negotiated the elimination of $301 million in credit
ratings triggers relating to its financings and completed several interim
financings. On July 28, 2002, Dynegy entered into an agreement to sell Northern
Natural Gas Company ("Northern Natural") to MidAmerican Energy Holdings Company
("MidAmerican") for $928 million in cash, subject to adjustment for working
capital changes.
The closing of the Northern Natural sale and the execution of the remaining
elements of the Company's capital plan are expected to provide sufficient
near-term liquidity for the Company. The Northern Natural sale is expected to
close in August 2002 and is subject to customary closing conditions, including
expiration of the Hart-Scott-Rodino waiting period, and the continuation of
certain transition services to Northern Natural. The remaining elements of the
capital plan are subject to a number of risks including factors beyond the
Company's control. These factors include, among others, market conditions for
asset sales, the timeliness and ability to obtain required regulatory
approvals, ongoing investigations and litigation, and the effect of commodity
prices and continued contraction in the markets in which the Company operates,
which may negatively impact its operating cash flow. The Company also must seek
to rationalize its customer and risk-management business either through the
formation of a joint venture or an alternative strategy that would reduce
Dynegy's capital commitments to this business.
As is discussed in greater detail in "Management's Discussion and Analysis
of Financial Condition and Results of Operations," the Company's liquidity will
be improved by the closing of the Northern Natural sale. Dynegy has no
significant maturities prior to November 2002 and believes that its current
liquidity will be sufficient to meet the collateral requirements of its
business through the expected closing of the Northern Natural sale. However, a
delay in the closing of the Northern Natural sale or other adverse developments
affecting the Company's liquidity could materially adversely affect Dynegy's
financial condition. If Dynegy is unable to
9
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
complete the Northern Natural sale in the near term or other elements of its
strategy prior to the second quarter 2003, it may be forced to consider other
strategic alternatives or a possible reorganization under the protection of
bankruptcy laws.
The accompanying unaudited condensed consolidated financial statements have
been prepared assuming that the Company will continue as a going concern. This
basis of accounting contemplates the recovery of the Company's assets and the
satisfaction of its liabilities in the normal course of conducting business,
which in turn is dependent upon the Company's ability to consummate the
Northern Natural sale and successfully execute its capital plan as well as the
performance of the Company's operations for the foreseeable future. Management
believes that actions presently being taken relative to the Company's capital
plan and other strategic alternatives should enable the Company to meet its
obligations in a manner consistent with this accounting treatment.
Note 4--Changes in Accounting Principles
In July 2001, the FASB issued Statement of Financial Accounting Standards
No. 142, "Goodwill and Other Intangible Assets" ("Statement No. 142").
Statement No. 142 discontinues goodwill amortization over its estimated useful
life and provides that goodwill is subject to at least an annual fair-value
based impairment test. The Company adopted Statement No. 142 effective January
1, 2002. The changes in the carrying amount of goodwill for each of Dynegy's
reportable business segments for the six-month period ended June 30, 2002 are
as follows (in millions):
Wholesale Dynegy Transmission Dynegy
Energy Midstream & Global
Network Services Distribution Communications Total
--------- --------- ------------ -------------- ------
Balances as of January 1, 2002........... $935 $16 $ 388 $ 256 $1,595
Cumulative effect of change in accounting
principle.............................. -- -- -- (256) (256)
Goodwill acquired during the period...... -- -- 887 -- 887
Purchase price adjustments............... (7) -- (28) -- (35)
---- --- ------ ----- ------
Balances as of June 30, 2002............. $928 $16 $1,247 $ -- $2,191
==== === ====== ===== ======
The Company recognized a $256 million charge in the first quarter 2002
related to its Dynegy Global Communications ("DGC") segment in accordance with
Statement No. 142 and reflected such charge as a cumulative effect of 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.
Goodwill acquired during the period relates to the acquisition of Northern
Natural, the previously announced sale of which is further described in Note 6
below. The purchase price adjustments relate to the United Kingdom natural gas
storage assets purchased in late 2001 and to the acquisition of Northern
Natural in early 2002.
10
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 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 six-month periods ended June
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 six-month
periods ended June 30, 2002 (in millions, except per share data).
Three Months Six Months
Ended Ended
June 30, June 30,
------------- -------------
2002 2001 2002 2001
------ ----- ------ -----
Reported net income (loss)........................ $ (328) $ 146 $ (468) $ 285
Add back: Goodwill amortization................... -- 12 -- 24
------ ----- ------ -----
Adjusted net income (loss)........................ $ (328) $ 158 $ (468) $ 309
Less: preferred stock dividends................... 8 -- 16 --
------ ----- ------ -----
Net income (loss) available to common stockholders $ (336) $ 158 $ (484) $ 309
====== ===== ====== =====
Basic EPS:
Reported net income (loss)........................ $(0.92) $0.45 $(1.33) $0.88
Goodwill amortization............................. -- 0.03 -- 0.07
------ ----- ------ -----
Adjusted net income (loss)........................ $(0.92) $0.48 $(1.33) $0.95
====== ===== ====== =====
Diluted EPS:
Reported net income (loss)........................ $(0.92) $0.43 $(1.33) $0.84
Goodwill amortization............................. -- 0.04 -- 0.07
------ ----- ------ -----
Adjusted net income (loss)........................ $(0.92) $0.47 $(1.33) $0.91
====== ===== ====== =====
In August 2001, the FASB issued Statement of Financial Accounting Standards
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
("Statement No. 144"). Statement No. 144 addresses the accounting and reporting
for the impairment or disposal of long-lived assets and supersedes FASB
Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of" and APB Opinion No. 30, "Reporting the
Results of Operations--Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions." The Company's adoption of Statement No. 144 on January 1, 2002
did not have any impact on its financial position, results of operations or
cash flows.
Accounting Principles Not Yet Adopted. FASB Statement No. 143. Also during
2001, the FASB issued Statement of Financial Accounting Standards No. 143,
"Accounting for Asset Retirement Obligations" ("Statement No. 143"). Statement
No. 143 requires that the fair value of a liability for an asset retirement
obligation be recognized in the period in which it is incurred with the
associated asset retirement costs being capitalized as a part of the carrying
amount of the long-lived asset. The Company is evaluating the future financial
effects of adopting Statement No. 143 and will adopt the standard effective
January 1, 2003.
FASB Statement No. 145. In April 2002, the FASB issued Statement of
Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4,
44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections"
("Statement No. 145"). The adoption of Statement No. 145 effective January 1,
2003 is not expected to impact the Company.
11
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 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 Emerging Issues Task
Force ("EITF" or the "Task Force") has set forth in EITF Issue No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)." The scope of Statement No. 146 also includes (1) costs related
to terminating a contract that is not a capital lease and (2) termination
benefits that employees who are involuntarily terminated receive under the
terms of a one-time benefit arrangement that is not an ongoing benefit
arrangement or an individual deferred compensation contract. Statement No. 146
will be effective for exit or disposal activities that are initiated after
December 31, 2002, although early adoption of the standard is allowed. If the
Company had adopted Statement No. 146 early, it would not have affected the
Company's accounting for restructuring activities which occurred in the second
quarter 2002.
EITF Issue 02-3. In June 2002, the EITF reached consensus on two of three
issues presented in EITF Issue 02-3, "Accounting for Contracts Involved in
Energy Trading and Risk Management Activities" ("EITF Issue 02-3"). First, the
Task Force concluded that all mark-to-market gains and losses on energy trading
contracts (whether realized or unrealized) should be shown net in the income
statement, irrespective of whether the contract is physically or financially
settled. In addition, the Task Force concluded that an entity should disclose
the gross transaction volumes for those energy trading contracts that are
physically settled. Beginning in the third quarter 2002, Dynegy will present
all mark-to-market gains and losses on a net basis and will expand its
volumetric disclosures to comply with the consensus. Additionally, in
accordance with the transition provisions in the consensus, comparative
financial statements will be conformed to meet the requirements mandated by the
Task Force. This change in accounting classification will have no impact on
operating income, net income, earnings per share or cash flow from operations.
The second consensus reached by the Task Force related to required
disclosures regarding energy trading operations. The Task Force agreed to
clarify the application of APB Opinion No. 22, "Disclosure of Accounting
Policies" and SOP 94-6, "Disclosure of Significant Risks and Uncertainties" to
an entity's energy trading operations by requiring that entities disclose the
applicability of EITF Issue 98-10, "Accounting for Contracts Involved in Energy
Trading and Risk Management Activities," the types of contracts that are
accounted for as energy trading contracts, a description of the methods and
significant assumptions used to estimate the fair value of various classes of
energy trading contracts and the sensitivity of its estimates to changes in the
near term. The Task Force indicated that additional disclosure regarding the
fair value of contracts, aggregated by source or method of estimating fair
value and by maturity date, would also be meaningful. The Company will assess
its disclosures with respect to these matters.
The third issue addressed by the Task Force in EITF Issue 02-3 deals with
the recognition of unrealized gains and losses at inception of an energy
trading contract (commonly referred to as dealer profit). The Task Force
reached no consensus on this issue, and the issue was assigned to a working
group for resolution by the end of 2002. It is not possible to predict how the
working group will resolve issues related to the recognition of dealer profit.
Further, it is unclear how the working group will address the accounting
transition resulting from adoption of new guidance. Three transition
alternatives exist in practice. These transition alternatives include: (a) a
retroactive restatement to eliminate dealer profit recognized in previous
periods; (b) a cumulative effect adjustment for a change in accounting
principle, which eliminates the recognition of previous periods' dealer profit
in the current period; or, (c) as a prospective change, eliminating the
recognition of dealer profit on future transactions but leaving past
transactions unaffected.
12
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Finally, it is unclear whether the scope of the working group's activities
will include a comprehensive conclusion regarding the appropriateness of the
use of models as a fundamental method for valuing transactions when market
quotations are unavailable. Should the Task Force issue definitive guidance on
any one or all of these issues, it will impact Dynegy. However, the extent of
the financial impact to Dynegy, if any, cannot be predicted with any degree of
certainty until the scope of the Task Force's conclusion is known and the
transition alternative is determined. If the Task Force prefers a retroactive
or a cumulative effect transition alternative, then Dynegy's historical
financial position and results of operations will be impacted negatively. If
the Task Force prefers a prospective transition alternative, then Dynegy's
current financial position will be unaffected and the impact to future
operations in the near term is not expected to be material (largely as a result
of a reduction in these types of transactions in the marketplace).
Note 5--Restructuring and Impairment Charges
During the second quarter 2002, the Company recognized a $499 million
pre-tax ($324 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 certain investments in securities of entities engaged in
technology-related ventures, a write-off of net assets related principally to
the Company's gas marketing business and a severance charge related to a plan
of restructuring of the Company's operations. The pre-tax charge, which was
substantially non-cash in nature, consisted of the following (in millions):
Impairment of telecommunications business $286
Impairment of technology investments..... 40
Gas marketing charge..................... 124
Severance charge......................... 37
Write-off of other obsolete assets....... 12
----
$499
====
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 and 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 aggressively pursuing alternatives for
exiting this business segment, although no formal plans are currently in place
and no assurance can be provided as to the timing or structure of any such
transaction.
Statement No. 144 requires long-lived assets to be tested for impairment
whenever events or changes in circumstances indicate that their carrying amount
may not be recoverable from future cash-flows of the segment or there is an
expectation that it is more likely than not that a long-lived asset group will
be sold or otherwise disposed of before the end of its previously estimated
useful life. Dynegy's impairment analysis at June 30, 2002, calculated in
accordance with the guidelines set forth in Statement No. 144, indicates future
cash flows from DGC's operations are insufficient to cover the carrying value
of that segment's long-lived assets. As a result, a pre-tax impairment charge
totaling $286 million ($186 million after-tax) was recorded in Impairment and
Other Charges in the accompanying Condensed Consolidated Statements of
Operations for the three- and six-month periods ended June 30, 2002.
13
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
In addition, the impairment analysis indicates that future cash flows are
insufficient to support the lessor's obligation of $367 million related to
telecommunications leases, of which Dynegy has guaranteed approximately $303
million. In accordance with EITF Issue 96-21, "Implementation Issues in
Accounting for Leasing Transactions involving Special-Purpose Entities", the
loss under the guarantees will be accrued under a straight-line method over the
remaining terms of the leases. This non-cash pre-tax charge is expected to
approximate $23 million per quarter beginning in the third quarter 2002 through
the remaining terms of the leases, unless the obligation is accelerated or
terminated as a result of a business combination, joint venture or other
similar transaction resulting from Dynegy's managed exit from its
telecommunications business.
At June 30, 2002, the valuations of certain technology investments were
assessed in light of the Company's decision to pursue a managed exit strategy
from its 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 a decision to recognize an
impairment charge relative to these investments. After recognition of the
impairment, values for these investments represent expected realizable value at
June 30, 2002. The $40 million pre-tax ($26 million after-tax) charge was
recorded in Earnings of Unconsolidated Affiliates in the accompanying Condensed
Consolidated Statements of Operations for the three and six months ended June
30, 2002.
The non-cash gas marketing charge is the result of a balance sheet review
and reconciliation process started early in 2002. Management believes the
charge is largely associated with the process of reconciling accrued to actual
results principally in its natural gas marketing business and that it
accumulated over a number of years. Accrual accounting for natural gas
marketing involves the estimation of gas volumes bought, sold, transported and
stored, as well as the subsequent reconciliation from estimated to actual
volumes. The $124 million pre-tax ($80 million after-tax) charge was recorded
in Other Income and Other Expenses in the accompanying Condensed Consolidated
Statements of Operations for the three and six months ended June 30, 2002.
Please read Note 1 above for additional information regarding the previously
announced re-audit of Dynegy's 1999-2001 financial statements.
The Company recognized a pre-tax charge of approximately $37 million ($24
million after-tax) 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. No severance amounts were paid
as of June 30, 2002, thus the entire amount is included within Accrued
Liabilities and Other in the accompanying June 30, 2002 Condensed Consolidated
Balance Sheet.
The remaining pre-tax non-cash charge of $12 million ($8 million after-tax)
relates to the retirement of partially depreciated information technology
equipment and software replaced during the quarter with new system applications
and arrangements as well as miscellaneous deposits that are not expected to
provide future value. The charge was recorded in Other Expenses in the
accompanying Condensed Consolidated Statements of Operations for the three and
six months ended June 30, 2002.
During the three months ended March 31, 2002, the Company incurred an $18
million pre-tax ($13 million after-tax) charge associated with a commitment to
deliver gas assumed in the acquisition of Northern Natural. The pre-tax charge
is included in the accompanying Condensed Consolidated Statement of Operations
for the six months ended June 30, 2002.
14
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Note 6--Business Combinations and Other Acquisitions
In November 2001, Dynegy acquired 1,000 shares of Series A Preferred Stock
("Series A Preferred Stock") in Northern Natural for $1.5 billion. In
connection with the investment, Dynegy Holdings Inc. ("DHI"), a wholly owned
subsidiary of Dynegy, 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. Enron retained an option to
reacquire Northern Natural, which expired unexercised on July 1, 2002.
On July 28, 2002, Dynegy executed an agreement to sell Northern Natural to
MidAmerican for $928 million in cash, subject to adjustment for working capital
changes. Under the terms of this agreement, MidAmerican is expected to acquire
all of the common and preferred stock of Northern Natural and to assume all of
Northern Natural's $950 million of debt with a fair value of approximately $890
million. The transaction is expected to close in August 2002 and is subject to
customary closing conditions, including expiration of the Hart-Scott-Rodino
waiting period. No assurance can be given as to the timing of such approval or
the consummation, if at all, of the transaction. Because Dynegy paid
approximately $1.5 billion for Northern Natural, Dynegy expects to incur a
significant loss associated with the sale.
Northern Natural was consolidated with Dynegy's operations beginning
February 1, 2002. The following table reflects certain unaudited pro forma
information for Dynegy for the periods presented as if Dynegy's acquisition of
Northern Natural had taken place on January 1, 2001 (in millions, except per
share data).
Three Months Six Months
Ended Ended
June 30, June 30,
--------------- ----------------
2002 2001 2002 2001
------ ------- ------- -------
Pro forma revenues................................................. $9,906 $10,920 $18,616 $25,263
Pro forma income (loss) from operations before change in accounting
principle (Notes 4 and 7)........................................ (328) 163 (189) 348
Pro forma income (loss) from operations before change in accounting
principle per share (diluted).................................... (0.92) 0.48 (0.52) 1.03
Pro forma net income (loss) before preferred stock dividends....... (328) 163 (445) 350
Pro forma net income (loss) available to common shareholders....... (336) 163 (461) 350
Pro forma earnings (loss) per share (diluted)...................... (0.92) 0.48 (1.27) 1.04
Note 7--Commercial Operations, Risk Management Activities and Financial
Instruments
Provisions in Statement No. 133, as amended, affect the accounting and
disclosure of certain contractual arrangements and operations of the Company.
Under Statement No. 133, as amended, all derivative instruments are recognized
in the balance sheet at their fair values and changes in fair value are
recognized immediately in earnings, unless the derivatives (which are not a
part of the Company's marketing activities) qualify and are designated as
hedges of future cash flows, fair values or net investments or qualify, and are
designated, as normal purchases and sales. Derivatives treated as normal
purchases or sales are recorded and recognized in income using accrual
accounting.
The nature of the Company's business necessarily involves certain market and
financial risks. The Company routinely enters into financial instrument
contracts in an attempt to mitigate or eliminate these various risks. These
risks and the Company's strategy for mitigating these risks are more fully
described in Note 3 to the Form 10-K.
15
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Changes in stockholders' equity related to derivatives for the six-month
period ended June 30, 2002 were as follows, net of tax (in millions):
Balance at December 31, 2001............. $ 12
Current period changes in fair value, net (3)
Reclassifications to earnings, net....... (27)
----
Balance at June 30, 2002................. $(18)
====
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............................................ $(18)
Currency translation adjustment................................... 3
Unrealized loss on available-for-sale securities, net............. --
----
Accumulated other comprehensive loss, net of tax, at June 30, 2002 $(15)
====
Other comprehensive income (loss) is as follows (in millions):
Six Months
Ended June 30,
--------------
2002 2001
----- ----
Net income (loss)................ $(468) $285
Other comprehensive income....... 20 27
----- ----
Total comprehensive income (loss) $(448) $312
===== ====
Additional disclosures required by Statement No. 133, as amended, are
provided in the following paragraphs.
Effective January 1, 2001, the Company adopted Statement of Financial
Accounting Standards No. 133, "Accounting for Derivative Instruments and
Hedging Activities," as amended, realizing an after-tax cumulative effect gain
of approximately $2 million.
The Company enters into various financial derivative instruments which
qualify as cash flow hedges. For derivatives treated as hedges of future cash
flows, the effective portion of changes in fair value is recorded in other
comprehensive income until the related hedged items impact earnings. Any
ineffective portion of a hedge is reported in earnings immediately. Instruments
related to the Company's customer and risk-management and midstream liquids
businesses are entered into for purposes of hedging forward fuel requirements
for certain power generation facilities, locking in future margin in the
domestic midstream liquids business and hedging price risk in the global
liquids business. Interest rate swaps are used to convert the floating interest
rate component of certain obligations to fixed rates.
Dynegy recognized a charge of less than $1 million relating to hedge
ineffectiveness during the six months ended June 30, 2002, and no amounts were
excluded from the assessment of hedge effectiveness related to the hedge of
future cash flows. Additionally, no amounts were reclassified to earnings in
connection with forecasted transactions that were no longer considered probable
of occurring.
The balance in other comprehensive income at June 30, 2002 associated with
these cash flow hedges is expected to be reclassified to future earnings,
contemporaneously with the related purchases of fuel, sales of
16
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
electricity or liquids, payments of interest and recognition of operating lease
expense, as applicable to each type of hedge. Of this amount, approximately $13
million loss, net of taxes, is estimated to be reclassed into earnings over the
12-month period ending June 30, 2003. Actual amounts ultimately reclassed to
earnings over the next 12 months could vary materially from this estimated
amount as a result of changes in market conditions.
The Company also enters into derivative instruments which qualify as fair
value hedges. For derivatives treated as fair value hedges, changes in the fair
value of the derivative and changes in the fair value of the related asset or
liability are recorded in current period earnings. The Company uses interest
rate swaps to convert a portion of its fixed-rate debt into variable-rate debt.
During the six months ended June 30, 2002 and 2001, there was no
ineffectiveness from changes in fair value of hedge positions, and no amounts
were excluded from the assessment of hedge effectiveness. Additionally, no
amounts were recognized in relation to firm commitments that no longer
qualified as fair value hedge items.
The Company has investments in foreign subsidiaries, and the net assets of
these subsidiaries are exposed to currency exchange-rate volatility. The
Company uses derivative financial instruments, including foreign exchange
forward contracts and cross currency interest rate swaps, to hedge this
exposure. For derivatives treated as hedges of net investments in foreign
operations, the effective portion of changes in the fair value of the
derivative is recorded in the cumulative translation adjustment. For the six
months ended June 30, 2002, approximately $34 million of net losses related to
these contracts were included in the cumulative translation adjustment. During
the six months ended June 30, 2002, ineffectiveness from changes in fair value
of net investment hedge positions was a loss of approximately $5 million. There
were no net investment hedges for the six months ended June 30, 2001.
As part of the re-audit process (see Note 1), Dynegy expects the criteria
for and interpretation of hedge accounting under Statement No. 133 to be one of
the issues addressed. During the six-quarter period ended June 30, 2002, Dynegy
accounted for certain derivative transactions as hedges of its generation
facilities. If Dynegy's accounting treatment relating to Statement No. 133 were
to change as a result of the re-audit, the income recognized over the six
quarters may be re-allocated within the period. Cash flow for the six-quarter
period would remain unaffected by any change in the timing of income statement
recognition.
Note 8--Capital Leases
In response to the initiatives currently underway at the FASB, on June 28,
2002 the Company unilaterally undertook actions, the effect of which altered
the accounting for some of its existing lease obligations and anticipated lease
obligations relating to assets under construction. These actions included the
delivery of guarantees of lessor debt in certain existing leases of power
generation facilities. In addition, the Company notified certain lenders of its
intent to purchase power generation facilities that are currently under
construction and that were expected to be placed in synthetic leases upon
completion of their construction. As a result of these actions, approximately
$528 million of obligations due in 2005 to 2007 were brought on-balance sheet.
This non-cash action resulted in an increase to Property, Plant and Equipment
and a corresponding increase in Long-Term Debt on the Company's June 30, 2002
Condensed Consolidated Balance Sheet. These obligations were previously
reported as lease obligations in the footnotes to the Company's financial
statements and in the Commercial Financial Obligations and Contingent Financial
Commitments tables in the Form 10-K. In addition, actions taken by the Company
relating to assets under construction required the reclassification of
approximately $673 million from Prepayments and Other Assets to Property, Plant
and Equipment on the Company's June 30, 2002 Condensed Consolidated Balance
Sheet. Property under capital leases of $528 million is included in Property,
Plant and Equipment and is amortized over the useful life of the asset, which
approximates 40 years.
17
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
The following is a schedule of future minimum lease payments under capital
leases together with the present value of the net minimum lease payments as of
June 30, 2002 (in millions):
Six months ending December 31, 2002........ $ 6
Year ending December 31:
2003.................................... 13
2004.................................... 13
2005.................................... 176
2006.................................... 186
2007.................................... 185
----
Total minimum lease payments............... 579
Less: Amount representing interest......... (51)
----
Present value of net minimum lease payments $528
====
Note 9--Debt
As of August 12, 2002, the Company's debt and preferred stock maturities
through December 31, 2003, inclusive of letters of credit issued under
revolving credit facilities, were as follows: remainder of third quarter
2002--$14 million; fourth quarter 2002--$386 million (not including a $450
million secured line of credit at Northern Natural that will be assumed by
MidAmerican in the sale of Northern Natural, as further described in Note 6
above); first quarter 2003--$241 million; second quarter 2003--$1,856 million;
third quarter 2003--$233 million; and fourth quarter 2003--$1,543 million
(including $1.5 billion in Series B Mandatorily Convertible Redeemable
Preferred Stock held by ChevronTexaco Corporation). Please read "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources" for a discussion of the Company's
current liquidity and capital plans.
In July 2002, the Company completed a $200 million interim financing,
bearing interest at LIBOR plus 1.38 percent. This loan matures in January 2003
and is secured by interests in Dynegy's Renaissance and Rolling Hills merchant
power generation facilities.
In June 2002, the Company completed a $250 million interim financing,
bearing interest at LIBOR plus 1.75 percent. This loan matures in June 2003 and
represents an advance on a portion of the proceeds from the expected sale of
certain of the Company's United Kingdom natural gas storage facilities.
Dynegy completed an amendment to the Catlin Associates, LLC minority
interest transaction (also referred to as "Black Thunder") in June 2002, which
permanently removed a $270 million obligation which could have been triggered
by declines in Dynegy's credit ratings. The amended agreement requires a
subsidiary of Dynegy to amortize $275 million over the remaining three years of
the transaction. The subsidiary has already paid approximately $73 million of
the amortization. Quarterly maturities are approximately $20 million through
the first quarter 2005. In addition, Dynegy agreed to grant mortgages on the
midwest generation assets covered by the transaction, post a letter of credit
to secure a contingent obligation expiring December 31, 2002 and make certain
structural changes to enhance the security of the third-party lenders involved
in the transaction. As a result of this amendment, $796 million related to
Catlin Associates, LLC was reclassified from Minority Interest to debt on
Dynegy's Condensed Consolidated Balance Sheets at June 30, 2002.
18
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Also in June 2002, West Coast Power, LLC ("West Coast Power"), a joint
venture owned equally by Dynegy and NRG Energy with generation assets in
California, repaid a non-recourse project financing with cash on hand within
the joint venture entity. This payment eliminated a $31 million obligation
triggered by declines in Dynegy's credit ratings. Concurrent with the
retirement of the project financing, West Coast Power entered into an amended
$120 million bank facility consisting of a $100 million letter of credit
facility that will be used to collateralize West Coast Power's obligations, a
$10 million term loan and a $10 million working capital facility. The facility
has resulted in the release of approximately $100 million in letters of credit
previously posted by Dynegy on behalf of West Coast Power.
Dynegy incurred upfront fees aggregating approximately $19 million in
connection with the interim financings, Black Thunder amendment and West Coast
Power transactions described above. Such amounts are capitalized and amortized
over the term of the respective financing transaction.
On May 17, 2002, Illinois Power Company ("IP"), an indirect wholly owned
Dynegy subsidiary, 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 June 30, 2002.
On April 29, 2002, DHI closed a $900 million unsecured revolving credit
agreement with a syndicate of commercial banks. This facility, which matures on
April 28, 2003, replaced an expiring $1.2 billion revolving credit agreement.
The new facility provides funding for working capital, capital expenditures and
general corporate purposes. Generally, borrowings under the credit agreement
bear interest at a Eurodollar rate plus a margin that is determined based on
designated unsecured debt ratings. Facility fees are payable on the full amount
of the facility and are determined based on designated unsecured debt ratings.
Dynegy will incur higher interest costs and fees associated with the new
facility as compared to those incurred under the expired facility.
Specifically, assuming that all amounts were outstanding under this facility,
DHI would pay approximately $10 million in additional interest expense on the
new facility compared to what it would have paid under the expired facility.
Additionally, as compared to similar fees paid by DHI under the expired
facility, DHI expects to pay approximately $2 million in additional facility
fees during the term of the new facility and paid approximately $3 million in
additional upfront fees.
Financial covenants under the new DHI revolver include a
debt-to-capitalization test (which takes into account certain lease and similar
commitments of DHI and its subsidiaries) and a newly added 3.5 times earnings
before interest, taxes and depreciation and amortization ("EBITDA")-to-interest
test. The permissible threshold for the debt-to-capitalization test was lowered
in the new facility from 65% to 60%. Other newly added covenants in the
facility include subordination of certain intercompany debt owed to Dynegy 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 new facility does not contain any defaults relating
19
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
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 ratings. The new facility also
does not contain a "term-out" provision that would permit Dynegy to extend the
maturity for borrowings under the facility beyond the facility's April 28, 2003
maturity date. As such, the amounts outstanding under this facility are
classified as current. Management currently believes DHI is in compliance with
the covenants contained in this agreement.
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. DHI may redeem the notes prior to maturity, in whole or in part,
at a redemption price equal to the greater of the principal amount of the notes
and the make-whole price specified in the indenture relating to the notes.
On January 31, 2002, the Company acquired debt with a face value of
approximately $950 million (and a fair value of approximately $890 million)
through the acquisition of Northern Natural. Approximately $500 million of the
Northern Natural debt consists of senior unsecured notes with maturities
ranging from 2005 to 2011. The remaining $450 million consists of a secured
line of credit that matures in November 2002. See Note 6 for discussion of
Dynegy's previously announced sale of Northern Natural. In the event the
Company cannot consummate the sale of Northern Natural, management believes,
based on an internal analysis of Northern Natural's credit capacity, including
a review of other regulated pipelines, that Northern Natural will be able to
refinance the $450 million secured line of credit, and it is Northern Natural's
management's current intention to do so. On April 26, 2002, DHI purchased $90
million of Northern Natural's senior unsecured notes due 2005 pursuant to a
tender offer. The Company is currently considering alternatives relating to the
sale of these notes.
During the six-month period ended June 30, 2002, the Company repaid
commercial paper borrowings and revolving credit facilities for DHI and IP of
approximately $293 million in the aggregate and borrowed approximately $60
million under IP's revolving credit facility. Additionally, during the six
months ended June 30, 2002, Dynegy and DHI issued an aggregate of $433 million
of letters of credit under their revolving credit facilities. During the period
from June 30, 2002 through August 12, 2002, Dynegy paid at maturity $200
million in senior notes of DHI and $96 million in IP mortgage bonds, borrowed
an aggregate of $137 million and issued an aggregate of $251 million of letters
of credit under the Dynegy and DHI revolving credit facilities.
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 six
months ended June 30, 2002.
20
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 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 has elected not to pay a dividend on Dynegy's
Class A or Class B common stock for the third quarter 2002. Payments of
dividends for subsequent periods will be at the discretion of the Board of
Directors.
Note 12--Investments in Unconsolidated Affiliates
Investments in affiliates that are not controlled by the Company but where
the Company has significant influence over operations are accounted for by the
equity method. The Company's share of net income from these affiliates is
reflected in the Condensed Consolidated Statements of Operations as Earnings
from Unconsolidated Investments. The Company's principal equity method
investments consist of entities that operate generation assets and natural gas
liquids assets. These equity investments totaled $854 million and $843 million
at June 30, 2002 and December 31, 2001, respectively. The Company entered into
these ventures principally for the purpose of sharing risk and leveraging
existing commercial relationships. These ventures maintain independent capital
structures and have financed their operations on a non-recourse basis to the
Company.
Generation Assets. These investments primarily include ownership interests
in eight joint ventures that own fossil fuel electric generation facilities in
diverse geographic regions as well as a limited number of international
ventures. The Company's ownership is generally 50 percent in the majority of
these ventures. The Company's aggregate net investment of $720 million at June
30, 2002 represents approximately 2,400 MW of net generating capacity. Dynegy's
most significant investment in generating capacity is its interest in West
Coast Power, representing approximately 1,400 MW of net generating capacity in
California. The net investment in West Coast Power totaled approximately $348
million at June 30, 2002. West Coast Power provided equity earnings of
approximately $37 million and $70 million in the six months ended June 30, 2002
and 2001, respectively.
Midstream Investments. These investments primarily include ownership
interests in three ventures that operate natural gas liquids ("NGL")
processing, extraction, fractionation and storage facilities in the Gulf Coast
region as well as an interstate NGL pipeline. The Company's ownership interest
in these ventures ranges from 23 percent to 39 percent. At June 30, 2002, the
Company's aggregate net investment in these midstream businesses totaled
approximately $134 million.
Summarized aggregate financial information for these generation and
midstream investments and Dynegy's equity share thereof was ($ in millions):
Six Months Ended June 30,
---------------------------
2002 2001
------------- -------------
Equity Equity
Total Share Total Share
------ ------ ------ ------
Revenues........ $1,851 $703 $2,455 $936
====== ==== ====== ====
Operating margin $ 397 $135 $ 388 $152
====== ==== ====== ====
Net income...... $ 210 $ 66 $ 253 $ 94
====== ==== ====== ====
21
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
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 $52 million and $84 million at June 30,
2002 and December 31, 2001, respectively. The change is primarily attributed to
the impairment of technology investments resulting from unfavorable market
conditions.
The Company also owns equity securities that have a readily determinable
fair market value and are considered available-for-sale. The market value of
these investments at June 30, 2002 and December 31, 2001 was determined to be
$12 million and $23 million, respectively. The change is primarily attributed
to the decline in value of available-for-sale technology investments resulting
from unfavorable market conditions. The Company wrote off the unrealized losses
related to such decline in the second quarter 2002. The Company is currently in
the process of selling these investments.
Note 13--Commitments and Contingencies
Please see Note 11, "Commitments and Contingencies," in the Form 10-K and
Note 10, "Commitments and Contingencies," in the Company's Form 10-Q for the
quarter ended March 31, 2002 (the "Form 10-Q") for a description of the
Company's material legal proceedings. Set forth below is a description of any
material developments that have occurred with respect to such proceedings since
the Company's filing of the Form 10-Q for the first quarter 2002 and a
description of any new matters that have arisen during the quarter.
Baldwin Station Litigation. 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 February 11, 2003
has been set.
The Company believes that it has meritorious defenses to the EPA allegations
and will vigorously defend against these claims. The Company has undertaken
activities to significantly reduce emissions at the Baldwin Station since the
complaint was filed in 1999. In 2000, the Baldwin Station was converted from
high to low sulfur coal. This conversion resulted in sulfur dioxide emission
reductions of over 90% from 1999 levels. Furthermore, selective catalytic
reduction equipment has been installed at two of the three units at Baldwin
Station resulting in significant emission reductions of nitrogen oxides.
However, the EPA may seek to require the installation of the "best available
control technology" (or the equivalent) at the Baldwin Station. Independent
experts hired by Dynegy estimate capital expenditures of up to $380 million if
the installation of best available control technology is required. The EPA also
has the authority to seek penalties for the alleged violations in question at
the rate of up to $27,500 per day for each violation. The Company has filed a
motion for summary judgment based on the five-year statute of limitations,
which could affect the EPA's ability to collect penalties.
None of the Defendants' other facilities are covered in the complaint and
NOV, but the EPA has officially requested information concerning activities at
the Defendants' Vermilion, Wood River, and Hennepin Plants as
22
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
well as Dynegy Northeast Generation's Danskammer and Roseton Plants. It is
possible that the EPA will eventually commence enforcement actions based on
activities at those plants as well.
On June 13, 2002, the EPA announced its intention to implement several
reforms to its regulations governing new source review. These reforms, if made,
would clarify the routine maintenance, repair and replacement exclusion,
provide more certainty in evaluating permit requirements and increase
operational flexibility for affected facilities.
California Market Litigation. Six class action lawsuits have been filed
against various Dynegy entities based on the events occurring in the California
power market. The complaints allege violations of California's Business and
Professions Code, Unfair Trade Practices Act and various other statutes. The
plaintiffs allege that the defendants, including the owners of in-state
generation and various power marketers, conspired to manipulate the California
wholesale power market to the detriment of California consumers. Included among
the acts forming the basis of the plaintiffs' claims are the alleged improper
sharing of generation outage data, improper withholding of generation capacity
and the manipulation of power market bid practices. The plaintiffs seek
unspecified treble damages.
All six lawsuits were consolidated before Judge Sammartino, Superior Court
Judge for the County of San Diego. Subsequent to the consolidation two
defendants filed cross complaints against a number of corporations and
governmental agencies that sold power in California's wholesale energy markets.
Four cross defendants removed the six cases to the United States District Court
for the Southern District of California (San Diego). Following removal, certain
cross defendants filed motions to dismiss the cross complaints, which motions
are currently pending. The original plaintiffs in the six consolidated
complaints have filed motions to remand the consolidated cases back to state
court, which motions are currently pending. The defendants in the six
consolidated cases have filed motions to dismiss the complaints based on the
filed rate doctrine and preemption defense, which motions are currently
pending. Federal Judge Whaley has decided that the Court will hear the motion
to remand and the cross defendants' motion to dismiss on September 19, 2002. If
the Court decides that it has jurisdiction over the claims, the defendants'
motion to dismiss will be heard as soon as possible after September 19th.
On March 11, 2002, the California Attorney General filed, on behalf of the
People of the State of California, complaints in San Francisco Superior Court
against several owners of power generation facilities, including subsidiaries
of West Coast Power. The complaints allege that since June 1998, these
generators sold power in the open market that should have been held in
emergency reserve for the State. In the aggregate, the complaints seek more
than $150 million in penalties, restitution and return of profits from the
generators. These lawsuits were subsequently removed to the United States
District Court for the Northern District of California. The California Attorney
General filed motions to remand the cases back to state court. By Order issued
on August 6, 2002, Judge Walker denied the motions to remand, thus keeping the
cases in federal court. The Company intends to vigorously defend against these
claims.
In addition to the six consolidated lawsuits discussed above, eight new
putative class actions were filed on behalf of business and residential
electricity consumers, including consumers residing in the State of Washington.
The lawsuits were filed in various state courts in Northern California, and in
respect to the lawsuit on behalf of consumers in the State of Washington, in
the United States District Court for the Northern District of California. Named
as defendants are various generators and marketers, including Dynegy and
certain affiliates. The complaints allege unfair, unlawful and deceptive
practices in violation of the California Unfair Business Practices Act and seek
to enjoin illegal conduct, restitution and unspecified damages. While some of
the
23
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
allegations in these lawsuits are similar to the allegations in the other six
lawsuits, these lawsuits include additional allegations based on events
occurring subsequent to the filing of the other six lawsuits. These additional
allegations include allegations similar to those made by the California
Attorney General in the March 11, 2002 lawsuit described above as well as
allegations that contracts between these generators and the California
Department of Water Resources (the "DWR") constitute unfair business practices
resulting from market manipulation. The lawsuits filed in state court have been
removed to federal courts in the Northern and Eastern Districts of California.
Certain defendants have filed a petition with the Judicial Panel For
Multidistrict Litigation seeking to consolidate the new cases with the six
cases consolidated in the United States District Court for the Southern
District of California. The Company intends to vigorously defend against these
claims.
On May 13, 2002, two California law firms filed suit in California State
Court against more than 20 energy generators, including those owned directly by
West Coast Power and indirectly by Dynegy. This suit principally alleges the
defendant generators, in connection with their execution of long-term power
supply contracts with the DWR, took advantage of a manipulated market to
overcharge for electricity. The suit, which was filed on behalf of California
taxpayers, seeks to halt enforcement of the existing DWR contracts to the
extent that the agreed prices are found to be unfair. The suit further seeks
damages in the amount of the alleged excess prices under the contracts. The
Company intends to vigorously defend against these claims.
Enron Litigation. As previously described, Dynegy 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 claims that Dynegy materially breached the
Merger Agreement dated November 9, 2001 between Enron and Dynegy and related
entities by wrongfully terminating that Agreement on November 28, 2001. Enron
also claimed that 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).
Dynegy also previously described a suit filed against Dynegy and DHI by Ann
C. Pearl and Joel Getzler in the United States District Court for the Southern
District of New York, Cause No. 01 CV 11652. Plaintiffs filed the lawsuit as a
purported class action on behalf of all persons or entities who owned common
stock of Enron Corp. as of November 28, 2001. A similar suit was filed by
Bernard D. Shapiro and Peter Strub in the 129th Judicial District Court for
Harris County, Texas, Cause No. 2002-00080. Plaintiffs in each case allege that
they are intended third party beneficiaries of the Merger Agreement dated
November 9, 2001 between Enron and Dynegy and related entities. Plaintiffs
claim that Dynegy materially breached the Merger Agreement by, inter alia,
wrongfully terminating that agreement. Plaintiffs also claim that Dynegy
breached the implied covenant of good faith and fair dealing. Plaintiffs seek
an award of damages and other relief. Enron moved for an order of the
Bankruptcy Court in the Southern District of New York, directing that the Pearl
and Shapiro plaintiffs be enjoined from prosecuting their actions and
immediately dismiss those actions. The Bankruptcy Court held that the claims
asserted by the Pearl and Shapiro plaintiffs were the exclusive property of the
Enron bankruptcy estate, and that the plaintiffs lacked standing to sue as
third party beneficiaries of the Merger Agreement. Accordingly, by an order
entered on April 19, 2002, the Bankruptcy Court granted Enron's motion,
enjoined the prosecution of both actions, and directed that they be dismissed.
The Pearl and Shapiro plaintiffs thereafter complied with that order, but filed
an appeal to the United States District Court for the Southern District of New
York, which remains pending.
24
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Dynegy believes the allegations in Enron's claim against Dynegy and the
Pearl and Shapiro matters arising out of the terminated merger are without
merit and will vigorously defend against these claims. An adverse result in any
of these proceedings, however, could have a material adverse effect on the
Company's financial position or results of operations.
As previously described, as a result of Enron's bankruptcy filing, Dynegy
recognized in its fourth quarter 2001 financial results a pre-tax charge
related to the Company's net exposure for commercial transactions with Enron.
As of June 30, 2002, the Company's net exposure to Enron, inclusive of certain
liquidated damages and other amounts relating to the termination of the
transactions, was approximately $94 million and was calculated by setting off
approximately $220 million owed from various Dynegy entities to various Enron
entities against approximately $314 million owed from various Enron entities to
various Dynegy entities. The master netting agreement between Dynegy and Enron
as well as the valuation of the commercial transactions covered by the
agreement remain subject to negotiation between the parties and, if any
disputes cannot be resolved by the parties, to arbitration as called for by the
terms of the agreement. If the setoff rights were modified, either by agreement
or otherwise, the amount available for Dynegy entities to set off against sums
that might be due Enron entities could be reduced materially.
Shareholder Litigation. Since April 2002, a number of class action lawsuits
have been filed on behalf of purchasers of publicly traded securities of Dynegy
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. Under the
Private Securities Litigation Reform Act of 1995, the court in which the cases
have been consolidated will appoint a lead plaintiff, and the lead plaintiff
will, in turn, select class counsel. Following that process, a consolidated
complaint will be filed which may differ materially from the complaints
presently on file. Dynegy 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, three derivative lawsuits have been filed in which the Company
is a nominal defendant. Two of these three lawsuits relate to Project Alpha and
the third relates to severance for the Company's former Chief Executive
Officer. All three lawsuits seek recovery on behalf of the Company from various
present and former officers and directors. These actions have only recently
been filed and the Company is currently analyzing them. The Company does not
expect to incur any material liability with respect to these derivative claims.
Farnsworth Litigation. On August 2, 2002, Bradley Farnsworth filed a
lawsuit against Dynegy in Texas state district court claiming that he was
demoted and ultimately fired from the position of Controller for refusing to
participate in alleged accounting irregularities. Specifically, Mr. Farnsworth
alleges that certain present and former executive officers of the Company
requested that he shave forward price curves for natural gas in order to
improve the Company's results of operations for the third quarter 2000. Mr.
Farnsworth, who seeks actual and exemplary damages and other compensation, also
alleges that he is entitled to termination payments under his employment
agreement. Dynegy intends to vigorously defend against these claims. The
Company does not believe that any liability it might incur as a result of this
litigation would have a material adverse effect on its financial condition or
results of operations.
Roundtrip Transactions. On November 15, 2001, Dynegy executed two sets of
simultaneous buy and sale trades with CMS Energy Corp. In the first set of
trades, Dynegy purchased 5 million megawatts of power
25
90
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
from CMS Energy for delivery in December 2001 at $25.50 per megawatt hour;
concurrently, CMS Energy purchased from Dynegy the same amount of power at the
same price per megawatt hour for delivery during the same period. In the second
set of trades, Dynegy purchased 20 million megawatts of power from CMS Energy
for delivery in the period January-December 2002 at $34.00 per megawatt hour;
concurrently, CMS Energy purchased from Dynegy the same amount of power at the
same price per megawatt hour for delivery during the same period. Dynegy and
CMS have terminated the 2002 trades.
During the second quarter 2002, the Company undertook a comprehensive review
of these CMS Energy trades and its trading operations generally. The Company's
review confirmed that the CMS Energy trades were consummated outside the view
of other trading parties and could not have impacted market prices. The results
of the CMS Energy trades were not included in the Company's December 31, 2001
Consolidated Statement of Operations, and the volumes from these trades were
not included in the operating statistics for the Wholesale Energy Network
("WEN") segment in the Form 10-K, nor were such results or volumes included in
the Company's first quarter Form 10-Q. In an April 30, 2002 press release, 2002
first quarter Revenues and 2002 first quarter Costs of Sales each contained
$236 million related to these trades. These amounts netted to zero in the
operating margin line, resulting in no net income effect from the trades in
that press release. The Company eliminated these amounts from Revenues and
Costs of Sales in its Form 10-Q for the first quarter and in this report.
Based on the Company's review of its trading operations to date, Dynegy
believes that it has not executed any simultaneous buy and sell trades with
counterparties for the purpose of artificially increasing its trading volumes
or revenues.
SEC Investigation. The SEC has commenced an investigation into the facts
and circumstances surrounding Project Alpha and the roundtrip trades described
above. The Company has produced documents and witnesses for interviews in
connection with this investigation. The Company has assured the SEC that it
intends to cooperate fully with this investigation. Dynegy has been informed by
the Staff of the SEC that they believe that, among other things, Dynegy's
disclosures and reports relating to both Project Alpha and the CMS Energy
trades violate various antifraud and other provisions of the federal securities
laws. The Company cannot predict the ultimate outcome of this matter.
CFTC Investigation. The U.S. Commodity Futures Trading Commission ("CFTC")
has commenced an investigation relating to, among other things, trading
activities on Dynegydirect, the Company's on-line trading platform, and any
roundtrip gas or power trades since January 2000, including all trades or
trading activities between Dynegy and CMS Energy in November 2001. The
investigation also relates to the Company's trading activities in the
California power market. The Company has produced documents in connection with
this investigation. The Company has assured the Staff of the CFTC that it
intends to cooperate fully with this investigation. The Company cannot predict
the ultimate outcome of this matter.
FERC and Related Regulatory Investigations. On February 13, 2002, the FERC
initiated an investigation of possible manipulation of natural gas and power
prices in the western United States during the period from January 2001 through
the present. On May 8, 2002, in response to three memoranda (authored by
individuals employed by or previously employed by Enron) discovered by the FERC
allegedly containing evidence of market manipulation by Enron in California,
the FERC issued requests for information to all sellers in the California
Independent System Operator (the "ISO") and the California Power Exchange (the
"PX") markets during 2000 and 2001 seeking information with respect to whether
those sellers engaged in trading strategies described in the three Enron
memoranda.
26
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Dynegy responded to these requests on May 22, 2002, and updated its
responses on July 30, 2002 at the conclusion of its due diligence. A California
State Senate committee subsequently issued similar requests, and Dynegy's
responses were consistent with those submitted to the FERC. Based on its
investigation to date, Dynegy believes that its trading practices are
consistent with applicable law and tariffs and will continue to cooperate fully
with these investigations. The California State Senate committee has not issued
its preliminary findings on its investigation, and Dynegy cannot predict with
certainty how such allegations will ultimately be resolved.
On August 13, 2002, the FERC issued a notice requesting comments on a
proposal made by the FERC staff to change the method for determining natural
gas prices for purposes of computing the market mitigation clearing price that
it intends to utilize in calculating refunds for sales of power in California
power markets during the period from October 2, 2000 to June 19, 2001. As
drafted, the proposal would likely reduce gas prices used in the computation,
thus reducing the market mitigation clearing price for power and potentially
increasing calculated refunds, subject to a provision that would generally
provide full recoverability of fuel costs by the generators. The FERC has
provided parties to the refund proceeding with 30 days to provide comments and
it may or may not adopt the staff's recommendation. Dynegy is evaluating the
staff's recommendation and is unable to assess at this time the impact, if any,
that this proposal may have on any refunds which the FERC may order from Dynegy
or West Coast Power pursuant to the FERC's investigation of the California
power market for the period from October 2, 2000 to June 19, 2001.
On May 21, 2002, the FERC issued requests for information to all sellers of
wholesale electricity and/or ancillary services in the Western Systems
Coordinating Council ("WSCC") seeking information with respect to whether those
sellers engaged in "wash," "round trip" or "sale/buyback" transactions in the
WSCC during the years 2000-2001. Dynegy responded on May 31, 2002. On May 22,
2002, the FERC issued requests for information to all sellers of natural gas in
the WSCC or Texas seeking information with respect to whether those sellers
engaged in "wash," "round trip" or "sale/buyback" transactions in the WSCC or
Texas during the years 2000-2001. Dynegy responded on June 5, 2002. On August
12, 2002, Dynegy updated its May 31 and June 5 responses at the conclusion of
its due diligence. Requests for similar information with respect to electric
power trading activities in the Electric Reliability Council of Texas were
received from the Texas Public Utility Commission on June 12, 2002. Dynegy
responded to these requests on July 2, 2002.
Based on the investigation conducted in order to make these filings, Dynegy
believes that it has not executed any simultaneous buy and sell trades with
counterparties for the purpose of artificially increasing its trading volumes
or revenues in these markets.
In addition, on February 25, 2002 the California Public Utilities Commission
and the California Electricity Oversight Board filed complaints with the FERC
asking that it void or reform power supply contracts between the DWR and, among
others, West Coast Power. A rehearing order issued on July 23, 2002 affirmed
the underlying findings and conclusions related to West Coast Power's contract
with the DWR. The complaints allege that prices under the contracts exceed just
and reasonable prices permitted under the Federal Power Act. The FERC recently
set these complaints for evidentiary hearing. The hearing, however, is being
held in abeyance pending completion of settlement talks. While West Coast Power
continues in good faith negotiations with the State of California on reforming
the terms of its DWR contract, settlement ultimately may not be possible. If a
hearing on the contracts entered into by West Coast Power or others is
necessary, the first phase of the hearing will be limited to the question of
whether the California real-time market adversely affected the long-term
bilateral markets. While the Company believes the terms of its contracts are
just and reasonable and do not reflect alleged market manipulation, it cannot
predict the outcome of this matter.
27
DYNEGY INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
U.S. Attorney Investigation. In May 2002, Dynegy received a subpoena from
the U.S. Attorney's office in Houston requesting documents relating to Project
Alpha, roundtrip trades with CMS Energy and the Black Thunder transaction. The
Company is cooperating fully with the U.S. Attorney's office in its
investigation of these matters. The Company cannot predict the ultimate outcome
of this matter.
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 ve