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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 000-29311
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DYNEGY HOLDINGS INC.
(Exact name of registrant as specified in its charter)
Delaware 94-3248415
(State or other (I.R.S. Employer
jurisdiction Identification No.)
of incorporation or
organization)
1000 Louisiana, Suite 5800
Houston, Texas 77002
(Address of principal executive offices)
(Zip Code)
(713) 507-6400
(Registrant's telephone number, including area code)
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
All outstanding equity shares of Dynegy Holdings Inc. are held by its
parent, Dynegy Inc.
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DYNEGY HOLDINGS INC.
TABLE OF CONTENTS
Page
----
PART I. FINANCIAL INFORMATION
Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS:
Condensed Consolidated Balance Sheets:
June 30, 2002 and December 31, 2001.............................. 3
Condensed Consolidated Statements of Operations:
For the three months ended June 30, 2002 and 2001................ 4
Condensed Consolidated Statements of Operations:
For the six months ended June 30, 2002 and 2001.................. 5
Condensed Consolidated Statements of Cash Flows:
For the six months ended June 30, 2002 and 2001.................. 6
Notes to Condensed Consolidated Financial Statements.................... 7
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS........................................... 32
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..... 64
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.............................................. 65
Item 6. EXHIBITS AND REPORTS ON FORM 8-K............................... 65
EXPLANATORY NOTE
This quarterly report includes financial statements which have not been
reviewed by an independent public accountant under Rule 10-01(d) of Regulation
S-X. We expect that our independent public accountant, PricewaterhouseCoopers
LLP, will complete the quarterly review required by Rule 10-01(d) of Regulation
S-X following their re-audit of our historical financial statements for the
three-year period ended December 31, 2001. This three year re-audit will
address, among other items, the restatements to our historical financial
statements relating to the balance sheet, statement of operations and cash flow
statement impacts resulting from revisions in accounting for a structured
natural gas transaction referred to as Project Alpha and a $124 million pre-tax
charge relating principally to our natural gas marketing business, each as
further described in Note 1 to the accompanying financial statements. In this
regard, Arthur Andersen LLP, our former independent public accountant, has
advised us that its audit opinion relating to 2001 should no longer be relied
upon. As a result of the three year re-audit, there may be other revisions to
the Company's historical financial statements in addition to those described
above, some of which may be material. Dynegy expects to file amended reports
under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), for
each of the three years in the period ended December 31, 2001, as well as each
quarterly period contained therein. In addition, Dynegy expects to file amended
Exchange Act reports for the quarters ended March 31, 2002 and June 30, 2002.
These amended reports will be filed with the SEC following the completion by
PricewaterhouseCoopers LLP of the three year re-audit and, for the quarterly
periods during 2002, their subsequent review of the interim financial
statements for these periods.
DYNEGY HOLDINGS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited) (in millions)
June 30, December 31,
2002 2001
-------- ------------
ASSETS
Current Assets
Cash and cash equivalents........................................................... $ 322 $ 144
Accounts receivable, net of allowance for doubtful accounts of $114 million and $102
million, respectively............................................................. 3,631 3,592
Accounts receivable, affiliates..................................................... 59 202
Inventory........................................................................... 249 358
Assets from risk-management activities.............................................. 4,756 4,046
Prepayments and other assets........................................................ 437 1,254
------- -------
Total Current Assets............................................................. 9,454 9,596
------- -------
Property, Plant and Equipment....................................................... 9,723 6,882
Accumulated depreciation............................................................ (964) (810)
------- -------
Property, Plant and Equipment, Net.................................................. 8,759 6,072
Other Assets
Investments in unconsolidated affiliates (Note 10).................................. 818 809
Assets from risk-management activities.............................................. 4,493 2,330
Goodwill............................................................................ 1,601 749
Other assets........................................................................ 550 327
------- -------
Total Assets..................................................................... $25,675 $19,883
======= =======
LIABILITIES AND STOCKHOLDER'S EQUITY
Current Liabilities
Accounts payable.................................................................... $ 3,362 $ 3,370
Accounts payable, affiliates........................................................ 62 40
Accrued liabilities and other....................................................... 738 1,189
Liabilities from risk-management activities......................................... 4,516 3,547
Notes payable and current portion of long-term debt................................. 1,363 200
------- -------
Total Current Liabilities........................................................ 10,041 8,346
------- -------
Long-Term Debt...................................................................... 3,605 2,139
Other Liabilities
Liabilities from risk-management activities......................................... 4,107 2,072
Deferred income taxes............................................................... 579 651
Other long-term liabilities......................................................... 700 700
------- -------
Total Liabilities................................................................ 19,032 13,908
------- -------
Minority Interest................................................................... 104 970
Company Obligated Preferred Securities of Subsidiary Trust.......................... 200 200
Commitments and Contingencies (Note 11)
Stockholder's Equity
Preferred Stock..................................................................... 1,501 --
Additional paid-in capital.......................................................... 2,395 2,392
Accumulated other comprehensive income, net of tax.................................. 2 2
Retained earnings................................................................... 1,409 1,379
Stockholder's equity................................................................ 1,032 1,032
------- -------
Total Stockholder's Equity....................................................... 6,339 4,805
------- -------
Total Liabilities and Stockholder's Equity....................................... $25,675 $19,883
======= =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
3
DYNEGY HOLDINGS INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited) (in millions)
Three Months
Ended June 30,
---------------
2002 2001
------ -------
Revenues............................................................ $9,695 $10,670
Cost of sales....................................................... 9,492 10,323
Depreciation and amortization....................................... 100 68
Impairment and other charges (Note 5)............................... 32 --
General and administrative expenses................................. 69 89
------ -------
Operating income.................................................... 2 190
Earnings from unconsolidated investments............................ -- 61
Other income (Note 5)............................................... 67 31
Interest expense.................................................... (56) (34)
Other expenses (Note 5)............................................. (188) --
Minority interest expense........................................... (11) (13)
Accumulated distributions associated with trust preferred securities (4) (4)
------ -------
Income (loss) before income taxes................................... (190) 231
Income tax provision (benefit)...................................... (55) 72
------ -------
Net Income (Loss)................................................... $ (135) $ 159
====== =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
4
DYNEGY HOLDINGS INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited) (in millions)
Six Months Ended
June 30,
----------------
2002 2001
------- -------
Revenues............................................................ $18,069 $23,278
Cost of sales....................................................... 17,432 22,566
Depreciation and amortization....................................... 179 132
Impairment and other charges (Note 5)............................... 32 --
General and administrative expenses................................. 169 167
------- -------
Operating income.................................................... 257 413
Earnings from unconsolidated investments............................ 31 90
Other income (Note 5)............................................... 81 49
Interest expense.................................................... (106) (63)
Other expenses (Note 5)............................................. (192) (29)
Minority interest expense........................................... (21) (35)
Accumulated distributions associated with trust preferred securities (8) (8)
------- -------
Income before income taxes and change in accounting principle....... 42 417
Income tax provision................................................ 15 134
------- -------
Income from operations.............................................. 27 283
Cumulative effect of change in accounting principle, net (Note 7)... -- 2
------- -------
Net Income.......................................................... $ 27 $ 285
======= =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
5
DYNEGY HOLDINGS INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited) (in millions)
Six Months Ended
June 30,
--------------
2002 2001
----- -------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income........................................................................... $ 27 $ 285
Items not affecting cash flows from operating activities:
Depreciation and amortization.................................................... 178 126
(Earnings) Losses from unconsolidated investments, net of cash distributions..... 12 (72)
Risk-management activities....................................................... 99 236
Deferred income taxes............................................................ 6 78
Gas marketing charge (Note 5).................................................... 124 --
Other............................................................................ 19 (9)
----- -------
Operating cash flow before changes in working capital............................ 465 644
----- -------
Change in assets and liabilities resulting from operating activities:
Accounts receivable.............................................................. 38 819
Inventory........................................................................ (34) 34
Prepayments and other assets..................................................... 4 (213)
Accounts payable and accrued liabilities......................................... (106) (970)
Other, net....................................................................... (8) 71
----- -------
Net cash provided by operating activities............................................... 359 385
----- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures............................................................. (465) (1,252)
Investment in unconsolidated affiliates.......................................... (12) (30)
Business acquisitions, net of cash acquired...................................... (20) --
Proceeds from asset sales........................................................ 5 996
Affiliate transactions........................................................... 61 (119)
Other investing, net............................................................. -- (158)
----- -------
Net cash used in investing activities............................................ (431) (563)
----- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from long-term borrowings........................................... 496 496
Repayments of long-term borrowings............................................... (144) --
Net proceeds from short-term borrowings.......................................... 245 --
Net cash flow from commercial paper and revolving lines of credit................ (255) (50)
Other financing, net............................................................. (55) 178
----- -------
Net cash provided by financing activities............................................... 287 624
----- -------
Effect of exchange rate changes on cash................................................. (37) (7)
Net increase in cash and cash equivalents............................................... 178 439
Cash and cash equivalents, beginning of period.......................................... 144 32
----- -------
Cash and cash equivalents, end of period................................................ $ 322 $ 471
===== =======
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
6
DYNEGY HOLDINGS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the Interim Periods Ended June 30, 2002 and 2001
Note 1--Restatements
As a result of certain events, which are described below, Dynegy Holdings
Inc. ("Dynegy" or the "Company") engaged PricewaterhouseCoopers LLP
("PricewaterhouseCoopers") to re-audit its 1999 through 2001 consolidated
financial statements. Following completion of these re-audits, Dynegy intends
to file amended reports under the Securities Exchange Act of 1934, as amended
(the "Exchange Act"), for each of the three years in the period ended December
31, 2001, as well as each quarterly period contained therein. In addition,
Dynegy will file amended Exchange Act reports for the quarters ended March 31,
2002 and June 30, 2002 following completion of PricewaterhouseCoopers'
subsequent review of the interim financial statements for these periods. As a
result of these re-audits and reviews, there may be revisions to the financial
statements contained in the above-referenced reports, including this quarterly
report, which are in addition to the known revisions described below, some of
which could be material. The Company expects that the re-audit of its 1999
through 2001 consolidated financial statements will take at least the remainder
of the year to complete.
Dynegy entered into a structured natural gas transaction known as Project
Alpha in April 2001. As described in a Current Report on Form 8-K dated April
25, 2002 (the "Form 8-K"), Dynegy decided, after consultation with the Staff of
the SEC, to present the cash flow associated with the related gas supply
contract as a financing activity in its Consolidated Statements of Cash Flows
for 2001. Following the disclosure in the Form 8-K and in connection with a
further review of Project Alpha, Arthur Andersen ("Andersen") informed the
Company that it could no longer support its tax opinion relating to the
transaction. Andersen's change in position was based in part on its conclusion
that the reclassification of $300 million in cash flow from operations to cash
flow from financing lessened the factual basis for the opinion. Dynegy's
financial statement recognition of the tax benefit in 2001 was based
principally on the Company's assessment of the relevant issues, as corroborated
by Andersen's tax opinion. After the withdrawal of Andersen's tax opinion,
management concluded that sufficient support to include the income tax benefit
for financial statement presentation purposes no longer existed. Additionally,
as a result of further discussions with representatives of the SEC Division of
Enforcement, Dynegy will include in its restatement of its 2001 and 2002
financial statements the consolidation of ABG Gas Supply LLC, one of the
special purpose entities sponsored by Dynegy in the transaction.
The impact of Project Alpha restatement items on Dynegy's financial
statements are expected to be as follows:
. Previously reported operating cash flow for the year ended December 31,
2001 will be reduced by approximately $300 million with a corresponding
increase to financing cash flow;
. Previously reported operating cash flow for the six-month period ended
June 30, 2001 will be reduced from $385 million reported herein to
approximately $277 million, with a corresponding increase in financing
cash flow from the $624 million reported herein to approximately $732
million;
. Retained earnings at December 31, 2001 will be reduced by approximately
$79 million in relation to the balances previously reported by the
Company;
. Previously reported net income for the three-month period ended June 30,
2001 of $159 million will be reduced to approximately $132 million;
. Previously reported net income for the six-month period ended June 30,
2001 of $285 million will be reduced to approximately $258 million;
. Reported balance sheets for each Exchange Act reporting period in 2001
(beginning with June 30, 2001) will reflect a reclassification of
approximately $300 million from either minority interest or liabilities
7
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
from risk-management activities (or a combination of the two) to debt,
depending on the specific reporting period; and
. Reported balance sheets for each Exchange Act reporting period in 2002
will reflect a reclassification of approximately $300 million from
Liabilities from Risk-Management Activities to debt.
The Company's Condensed Consolidated Statements of Cash Flows for 2002 reflect
(and in all future Exchange Act filings will reflect) the cash flow associated
with the related gas supply contract as financing cash flow rather than
operating cash flow.
Andersen, Dynegy's former independent public accountant, has advised that
its audit opinion relating to 2001 should no longer be relied upon as a result
of the pending restatements relating to Project Alpha. The balance sheets,
statements of operations and cash flow statements for periods ended in 2001 and
2002 to date contained in Dynegy's Exchange Act reports have not been adjusted
to reflect the impacts of the restatements relating to Project Alpha. These
changes will be reflected in the amended Exchange Act reports once the
re-audits and reviews are completed by PricewaterhouseCoopers.
Please see Note 11 below for a description of the ongoing investigations by
the SEC and U.S. Attorney relating to Project Alpha. Note 11 also includes a
description of related shareholder litigation.
In addition to financial statement activities related to Project Alpha,
Dynegy recognized a pre-tax charge in Other Income and Other Expense of
approximately $124 million ($80 million after-tax) in the second quarter 2002
related principally to a balance sheet reconciliation project undertaken by the
Company at the beginning of 2002. The charge largely relates to the Company's
natural gas marketing business and is believed to have accumulated over a
number of years. As a result of the charge and the current inability of the
Company to allocate this charge to specific accounting periods, the Company
decided to extend the re-audits of its financial statements to each of the
three years in the period ended December 31, 2001, as described in the first
paragraph above. If necessary, the Company will correct prior period financial
statements based on the results of these re-audits.
Dynegy expects that one of the issues to be addressed in the re-audits is
hedge accounting under Financial Accounting Standards Board ("FASB") Statement
of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended ("Statement No. 133"). Please
see Note 7 for further discussion.
Note 2--Accounting Policies
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with the instructions to interim financial
reporting as prescribed by the SEC, except as provided in the Explanatory Note
on the Table of Contents. These interim financial statements should be read in
conjunction with the consolidated financial statements and notes thereto
included in the Company's Annual Report on Form 10-K for the year ended
December 31, 2001 (the "Form 10-K"), as filed with the SEC. The Company is a
wholly owned subsidiary of Dynegy Inc.
The financial statements include all material adjustments, which, in the
opinion of management, are necessary for a fair presentation of the results for
the interim periods, except for the specific items described in Note 1. Interim
period results are not necessarily indicative of the results for the full year.
The preparation of the
8
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
condensed consolidated financial statements in conformity with generally
accepted accounting principles requires management to develop estimates and
make assumptions that affect reported financial position and results of
operations and that impact the nature and extent of disclosure, if any, of
contingent assets and liabilities. Actual results could differ materially from
those estimates. Certain reclassifications have been made to prior period
amounts in order to conform to current year presentation.
Note 3--Liquidity and Industry Conditions
During 2002, a number of events negatively impacted Dynegy as well as the
merchant energy industry in general. These events have resulted in downgrades
in the Company's credit ratings to non-investment grade by each of the major
rating agencies and a reduction in available liquidity resulting from a
combination of lower than expected cash flow from operations, reduced access to
sources of capital and increased collateralization of its trading and
commercial obligations. The credit ratings downgrades have limited and will
likely continue to limit significantly the Company's ability to refinance its
debt obligations and to access the capital markets and will likely increase the
borrowing costs incurred by the Company in connection with any refinancing
activities. The Company's financial and operating flexibility is likely to be
similarly reduced as a result of restrictive covenants and other terms that are
typically imposed on non-investment grade borrowers. The Company has
significant debt maturities over the next 12 months, which are further
described in Note 9 below. Additionally, the increased collateralization of the
Company's trading and commercial obligations has decreased capital otherwise
available to satisfy the Company's debt service, debt maturities and other
obligations.
In response to these events, on June 24, 2002 Dynegy Inc. announced a $2
billion capital plan designed to enhance liquidity and reduce debt. Pursuant to
this capital plan, Dynegy negotiated the elimination of $301 million in credit
ratings triggers relating to its financings and completed several interim
financings. On July 28, 2002, Dynegy entered into an agreement to sell Northern
Natural Gas Company ("Northern Natural") to MidAmerican Energy Holdings Company
("MidAmerican") for $928 million in cash, subject to adjustment for working
capital changes.
The closing of the Northern Natural sale and the execution of the remaining
elements of the Company's capital plan are expected to provide sufficient
near-term liquidity for the Company. The Northern Natural sale is expected to
close in August 2002 and is subject to customary closing conditions, including
expiration of the Hart-Scott-Rodino waiting period, and the continuation of
certain transition services to Northern Natural. The remaining elements of the
capital plan are subject to a number of risks including factors beyond the
Company's control. These factors include, among others, market conditions for
asset sales, the timeliness and ability to obtain required regulatory
approvals, ongoing investigations and litigation, and the effect of commodity
prices and continued contraction in the markets in which the Company operates,
which may negatively impact its operating cash flow. The Company also must seek
to rationalize its customer and risk-management business either through the
formation of a joint venture or an alternative strategy that would reduce
Dynegy's capital commitments to this business.
As is discussed in greater detail in "Management's Discussion and Analysis
of Financial Condition and Results of Operations," the Company's liquidity will
be improved by the closing of the Northern Natural sale. Dynegy has no
significant maturities prior to April 2003 and believes that its current
liquidity will be sufficient to meet the collateral requirements of its
business through the expected closing of the Northern Natural sale. However, a
delay in the closing of the Northern Natural sale or other adverse developments
affecting the Company's liquidity could materially adversely affect Dynegy's
financial condition. If Dynegy is unable to
9
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
complete the Northern Natural sale in the near term or other elements of its
strategy prior to the second quarter 2003, it may be forced to consider other
strategic alternatives or a possible reorganization under the protection of
bankruptcy laws.
The accompanying unaudited condensed consolidated financial statements have
been prepared assuming that the Company will continue as a going concern. This
basis of accounting contemplates the recovery of the Company's assets and the
satisfaction of its liabilities in the normal course of conducting business,
which in turn is dependent upon the Company's ability to consummate the
Northern Natural sale and successfully execute its capital plan as well as the
performance of the Company's operations for the foreseeable future. Management
believes that actions presently being taken relative to the Company's capital
plan and other strategic alternatives should enable the Company to meet its
obligations in a manner consistent with this accounting treatment.
Note 4--Changes in Accounting Principles
In July 2001, the FASB issued Statement of Financial Accounting Standards
No. 142, "Goodwill and Other Intangible Assets" ("Statement No. 142").
Statement No. 142 discontinues goodwill amortization over its estimated useful
life and provides that goodwill is subject to at least an annual fair-value
based impairment test. The Company adopted Statement No. 142 effective January
1, 2002. The changes in the carrying amount of goodwill for each of Dynegy's
reportable business segments for the six-month period ended June 30, 2002 are
as follows (in millions):
Wholesale Dynegy Transmission
Energy Midstream &
Network Services Distribution Total
--------- --------- ------------ ------
Balances as of January 1, 2002..................... $733 $16 $ -- $ 749
Cumulative effect of change in accounting principle -- -- -- --
Goodwill acquired during the period................ -- -- 887 887
Purchase price adjustments......................... (7) -- (28) (35)
---- --- ---- ------
Balances as of June 30, 2002....................... $726 $16 $859 $1,601
==== === ==== ======
Goodwill acquired during the period relates to the acquisition of Northern
Natural, the previously announced sale of which is further described in Note 6
below. The purchase price adjustments relate to the United Kingdom natural gas
storage assets purchased in late 2001 and to the acquisition of Northern
Natural in early 2002.
The following table sets forth what Dynegy's net income would have been in
the three- and six-month periods ended June 30, 2001, if goodwill had not been
amortized during those periods, compared to the net income (loss) Dynegy
recorded for the three- and six-month periods ended June 30, 2002 (in millions).
Three Months Six Months
Ended Ended
----------- ---------
2002 2001 2002 2001
----- ---- ---- ----
Reported net income (loss)..... $(135) $159 $27 $285
Add back: Goodwill amortization -- 3 -- 6
----- ---- --- ----
Adjusted net income (loss)..... $(135) $162 $27 $291
===== ==== === ====
10
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
In August 2001, the FASB issued Statement of Financial Accounting Standards
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
("Statement No. 144"). Statement No. 144 addresses the accounting and reporting
for the impairment or disposal of long-lived assets and supersedes FASB
Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of" and APB Opinion No. 30, "Reporting the
Results of Operations--Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions." The Company's adoption of Statement No. 144 on January 1, 2002
did not have any impact on its financial position, results of operations or
cash flows.
Accounting Principles Not Yet Adopted. FASB Statement No. 143. Also during
2001, the FASB issued Statement of Financial Accounting Standards No. 143,
"Accounting for Asset Retirement Obligations" ("Statement No. 143"). Statement
No. 143 requires that the fair value of a liability for an asset retirement
obligation be recognized in the period in which it is incurred with the
associated asset retirement costs being capitalized as a part of the carrying
amount of the long-lived asset. The Company is evaluating the future financial
effects of adopting Statement No. 143 and will adopt the standard effective
January 1, 2003.
FASB Statement No. 145. In April 2002, the FASB issued Statement of
Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4,
44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections"
("Statement No. 145"). The adoption of Statement No. 145 effective January 1,
2003 is not expected to impact the Company.
FASB Statement No. 146. In July 2002, the FASB issued Statement of
Financial Accounting Standards No. 146, "Accounting for Exit or Disposal
Activities" ("Statement No. 146"). Statement No. 146 addresses issues regarding
the recognition, measurement and reporting of costs that are associated with
exit and disposal activities, including restructuring activities that are
currently accounted for pursuant to the guidance that the Emerging Issues Task
Force ("EITF" or the "Task Force") has set forth in EITF Issue No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)." The scope of Statement No. 146 also includes (1) costs related
to terminating a contract that is not a capital lease and (2) termination
benefits that employees who are involuntarily terminated receive under the
terms of a one-time benefit arrangement that is not an ongoing benefit
arrangement or an individual deferred compensation contract. Statement No. 146
will be effective for exit or disposal activities that are initiated after
December 31, 2002, although early adoption of the standard is allowed. If the
Company had adopted Statement No. 146 early, it would not have affected the
Company's accounting for restructuring activities which occurred in the second
quarter 2002.
EITF Issue 02-3. In June 2002, the EITF reached consensus on two of three
issues presented in EITF Issue 02-3, "Accounting for Contracts Involved in
Energy Trading and Risk Management Activities" ("EITF Issue 02-3"). First, the
Task Force concluded that all mark-to-market gains and losses on energy trading
contracts (whether realized or unrealized) should be shown net in the income
statement, irrespective of whether the contract is physically or financially
settled. In addition, the Task Force concluded that an entity should disclose
the gross transaction volumes for those energy trading contracts that are
physically settled. Beginning in the third quarter 2002, Dynegy will present
all mark-to-market gains and losses on a net basis and will expand its
volumetric disclosures to comply with the consensus. Additionally, in
accordance with the transition provisions in the consensus, comparative
financial statements will be conformed to meet the requirements mandated by the
Task Force. This change in accounting classification will have no impact on
operating income, net income, earnings per share or cash flow from operations.
11
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
The second consensus reached by the Task Force related to required
disclosures regarding energy trading operations. The Task Force agreed to
clarify the application of APB Opinion No. 22, "Disclosure of Accounting
Policies" and SOP 94-6, "Disclosure of Significant Risks and Uncertainties" to
an entity's energy trading operations by requiring that entities disclose the
applicability of EITF Issue 98-10, "Accounting for Contracts Involved in Energy
Trading and Risk Management Activities," the types of contracts that are
accounted for as energy trading contracts, a description of the methods and
significant assumptions used to estimate the fair value of various classes of
energy trading contracts and the sensitivity of its estimates to changes in the
near term. The Task Force indicated that additional disclosure regarding the
fair value of contracts, aggregated by source or method of estimating fair
value and by maturity date, would also be meaningful. The Company will assess
its disclosures with respect to these matters.
The third issue addressed by the Task Force in EITF Issue 02-3 deals with
the recognition of unrealized gains and losses at inception of an energy
trading contract (commonly referred to as dealer profit). The Task Force
reached no consensus on this issue, and the issue was assigned to a working
group for resolution by the end of 2002. It is not possible to predict how the
working group will resolve issues related to the recognition of dealer profit.
Further, it is unclear how the working group will address the accounting
transition resulting from adoption of new guidance. Three transition
alternatives exist in practice. These transition alternatives include: (a) a
retroactive restatement to eliminate dealer profit recognized in previous
periods; (b) a cumulative effect adjustment for a change in accounting
principle, which eliminates the recognition of previous periods' dealer profit
in the current period; or, (c) as a prospective change, eliminating the
recognition of dealer profit on future transactions but leaving past
transactions unaffected.
Finally, it is unclear whether the scope of the working group's activities
will include a comprehensive conclusion regarding the appropriateness of the
use of models as a fundamental method for valuing transactions when market
quotations are unavailable. Should the Task Force issue definitive guidance on
any one or all of these issues, it will impact Dynegy. However, the extent of
the financial impact to Dynegy, if any, cannot be predicted with any degree of
certainty until the scope of the Task Force's conclusion is known and the
transition alternative is determined. If the Task Force prefers a retroactive
or a cumulative effect transition alternative, then Dynegy's historical
financial position and results of operations will be impacted negatively. If
the Task Force prefers a prospective transition alternative, then Dynegy's
current financial position will be unaffected and the impact to future
operations in the near term is not expected to be material (largely as a result
of a reduction in these types of transactions in the marketplace).
Note 5-- Restructuring and Impairment Charges
During the second quarter 2002, the Company recognized a $194 million
pre-tax ($126 million after-tax) charge principally related to the impairment,
write-off or obsolescence of certain assets and an accrual for severance
related to a corporate restructuring. The charge primarily relates to the
impairment of certain investments in securities of entities engaged in
technology-related ventures, a write-off of net assets related principally to
the Company's gas marketing business and a severance charge related to a plan
of restructuring of the Company's operations. The pre-tax charge, which was
substantially non-cash in nature, consisted of the following (in millions):
Impairment of technology investments $ 26
Gas marketing charge................ 124
Severance charge.................... 32
Write-off of other obsolete assets.. 12
----
$194
====
12
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
At June 30, 2002, the valuations of certain technology investments were
assessed as a result of industry and other factors . These investments were
originally entered into in order to leverage existing commercial relationships
or as a means of expanding new relationships. Historically, the Company viewed
these investments as strategic and core to Dynegy Inc.'s technology strategy.
These investments include ownership in public and private companies and
investment funds focused in the technology sector. Accordingly, Dynegy expected
to hold these investments for the long-term and viewed trends in the sector as
cyclical. The continued downturn in the technology sector during the second
quarter 2002 combined with Dynegy Inc.'s decision to pursue a managed exit from
its telecommunications business resulted in a decision to recognize an
impairment charge relative to these investments. After recognition of the
impairment, values for these investments represent expected realizable value at
June 30, 2002. The $26 million pre-tax ($17 million after-tax) charge was
recorded in Earnings of Unconsolidated Affiliates in the accompanying Condensed
Consolidated Statements of Operations for the three and six months ended June
30, 2002.
The non-cash gas marketing charge is the result of a balance sheet review
and reconciliation process started early in 2002. Management believes the
charge is largely associated with the process of reconciling accrued to actual
results principally in its natural gas marketing business and that it
accumulated over a number of years. Accrual accounting for natural gas
marketing involves the estimation of gas volumes bought, sold, transported and
stored, as well as the subsequent reconciliation from estimated to actual
volumes. The $124 million pre-tax ($80 million after-tax) charge was recorded
in Other Income and Other Expenses in the accompanying Condensed Consolidated
Statements of Operations for the three- and six-month periods ended June 30,
2002. Please read Note 1 above for additional information regarding the
previously announced re-audit of Dynegy's 1999-2001 financial statements.
The Company recognized a pre-tax charge of approximately $32 million ($21
million after-tax) for severance benefits for approximately 309 employees who
were from various segments and included all staffing levels, including the
Company's former Chief Executive Officer and Chief Financial Officer. The
charge is included in Impairment and Other Charges in the accompanying
Condensed Consolidated Statements of Operations. No severance amounts were paid
as of June 30, 2002, thus the entire amount is included within Accrued
Liabilities and Other in the accompanying June 30, 2002 Condensed Consolidated
Balance Sheet.
The remaining pre-tax non-cash charge of $12 million ($8 million after-tax)
relates to the retirement of partially depreciated information technology
equipment and software replaced during the quarter with new system applications
and arrangements as well as miscellaneous deposits that are not expected to
provide future value. The charge was recorded in Other Expenses in the
accompanying Condensed Consolidated Statements of Operations for the three and
six months ended June 30, 2002.
During the three months ended March 31, 2002, the Company incurred an $18
million pre-tax ($13 million after-tax charge associated with a commitment to
deliver gas assumed in the acquisition of Northern Natural. The pre-tax charge
is included in the accompanying Condensed Consolidated Statement of Operations
for the six months ended June 30, 2002.
Note 6--Business Combinations and Other Acquisitions
In November 2001, Dynegy Inc. acquired 1,000 shares of Series A Preferred
Stock ("Series A Preferred Stock") in Northern Natural for $1.5 billion. In
connection with the investment, Dynegy acquired an option to purchase all of
the equity of Northern Natural's indirect parent company. Dynegy exercised its
option to acquire the indirect parent of Northern Natural in November 2001 upon
termination of Dynegy's merger agreement with
13
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Enron Corp. ("Enron"), and the closing of the option exercise occurred on
January 31, 2002. Enron retained an option to reacquire Northern Natural, which
expired unexercised on July 1, 2002.
On July 28, 2002, Dynegy executed an agreement to sell Northern Natural to
MidAmerican for $928 million in cash, subject to adjustment for working capital
changes. Under the terms of this agreement, MidAmerican is expected to acquire
all of the common and preferred stock of Northern Natural and to assume all of
Northern Natural's $950 million of debt with a fair value of approximately $890
million. The transaction is expected to close in August 2002 and is subject to
customary closing conditions, including Hart-Scott-Rodino approval. No
assurance can be given as to the timing of such approval or the consummation,
if at all, of the transaction. Because Dynegy paid approximately $1.5 billion
for Northern Natural, Dynegy expects to incur a significant loss associated
with the sale.
Northern Natural was consolidated with Dynegy's operations beginning
February 1, 2002. The following table reflects certain unaudited pro forma
information for Dynegy for the periods presented as if Dynegy's acquisition of
Northern Natural had taken place on January 1, 2001 (in millions, except per
share data).
Three Months Six Months Ended
Ended June 30, June 30,
--------------- ---------------
2002 2001 2002 2001
------ ------- ------- -------
Pro forma revenues................................................. $9,695 $10,778 $18,127 $23,561
Pro forma income (loss) from operations before change in accounting
principle (Notes 4 and 7)........................................ (135) 176 58 348
Pro forma net income (loss)........................................ (135) 176 58 350
Note 7--Commercial Operations, Risk Management Activities and Financial
Instruments
Provisions in Statement No. 133, as amended, affect the accounting and
disclosure of certain contractual arrangements and operations of the Company.
Under Statement No. 133, as amended, all derivative instruments are recognized
in the balance sheet at their fair values and changes in fair value are
recognized immediately in earnings, unless the derivatives (which are not a
part of the Company's marketing activities) qualify and are designated as
hedges of future cash flows, fair values or net investments or qualify, and are
designated, as normal purchases and sales. Derivatives treated as normal
purchases or sales are recorded and recognized in income using accrual
accounting.
The nature of the Company's business necessarily involves certain market and
financial risks. The Company routinely enters into financial instrument
contracts in an attempt to mitigate or eliminate these various risks. These
risks and the Company's strategy for mitigating these risks are more fully
described in Note 3 to the Form 10-K.
Changes in stockholders' equity related to derivatives for the six-month
period ended June 30, 2002 were as follows, net of tax (in millions):
Balance at December 31, 2001............. $ 12
Current period changes in fair value, net (3)
Reclassifications to earnings, net....... (27)
----
Balance at June 30, 2002................. $(18)
====
14
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Accumulated other comprehensive income, net of tax is included in
Stockholders' Equity on the Condensed Consolidated Balance Sheets as follows
(in millions):
Statement No. 133, net.............................................. $(18)
Currency translation adjustment..................................... 20
Unrealized loss on available-for-sale securities, net............... --
----
Accumulated other comprehensive income, net of tax, at June 30, 2002 $ 2
====
Other comprehensive income is as follows (in millions):
Six Months
Ended
June 30,
---------
2002 2001
---- ----
Net income................ $27 $285
Other comprehensive income -- 29
--- ----
Total comprehensive income $27 $314
=== ====
Additional disclosures required by Statement No. 133, as amended, are
provided in the following paragraphs.
Effective January 1, 2001, the Company adopted Statement of Financial
Accounting Standards No. 133, "Accounting for Derivative Instruments and
Hedging Activities," as amended, realizing an after-tax cumulative effect gain
of approximately $2 million.
The Company enters into various financial derivative instruments which
qualify as cash flow hedges. For derivatives treated as hedges of future cash
flows, the effective portion of changes in fair value is recorded in other
comprehensive income until the related hedged items impact earnings. Any
ineffective portion of a hedge is reported in earnings immediately. Instruments
related to the Company's customer and risk-management and midstream liquids
businesses are entered into for purposes of hedging forward fuel requirements
for certain power generation facilities, locking in future margin in the
domestic midstream liquids business and hedging price risk in the global
liquids business. Interest rate swaps are used to convert the floating interest
rate component of certain obligations to fixed rates.
Dynegy recognized a charge of less than $1 million relating to hedge
ineffectiveness, during the six months ended June 30, 2002, and no amounts were
excluded from the assessment of hedge effectiveness related to the hedge of
future cash flows. Additionally, no amounts were reclassified to earnings in
connection with forecasted transactions that were no longer considered probable
of occurring.
The balance in other comprehensive income at June 30, 2002 associated with
these cash flow hedges is expected to be reclassified to future earnings,
contemporaneously with the related purchases of fuel, sales of electricity or
liquids, payments of interest and recognition of operating lease expense, as
applicable to each type of hedge. Of this amount, approximately $13 million
loss, net of taxes, is estimated to be reclassed into earnings over the
12-month period ending June 30, 2003. Actual amounts ultimately reclassed to
earnings over the next 12 months could vary materially from this estimated
amount as a result of changes in market conditions.
15
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
The Company also enters into derivative instruments which qualify as fair
value hedges. For derivatives treated as fair value hedges, changes in the fair
value of the derivative and changes in the fair value of the related asset or
liability are recorded in current period earnings. The Company uses interest
rate swaps to convert a portion of its fixed-rate debt into variable-rate debt.
During the six months ended June 30, 2002 and 2001, there was no
ineffectiveness from changes in fair value of hedge positions, and no amounts
were excluded from the assessment of hedge effectiveness. Additionally, no
amounts were recognized in relation to firm commitments that no longer
qualified as fair value hedge items.
The Company has investments in foreign subsidiaries, and the net assets of
these subsidiaries are exposed to currency exchange-rate volatility. The
Company uses derivative financial instruments, including foreign exchange
forward contracts and cross currency interest rate swaps, to hedge this
exposure. For derivatives treated as hedges of net investments in foreign
operations, the effective portion of changes in the fair value of the
derivative is recorded in the cumulative translation adjustment. For the six
months ended June 30, 2002, approximately $42 million of net losses related to
these contracts were included in the cumulative translation adjustment. During
the six months ended June 30, 2002, ineffectiveness from changes in fair value
of net investment hedge positions was immaterial. There were no net investment
hedges for the six months ended June 30, 2001.
As part of the re-audit process (see Note 1), Dynegy expects the criteria
for and interpretation of hedge accounting under Statement No. 133 to be one of
the issues addressed. During the six-quarter period ended June 30, 2002, Dynegy
accounted for certain derivative transactions as hedges of its generation
facilities. If Dynegy's accounting treatment relating to Statement No. 133 were
to change as a result of the re-audit, the income recognized over the six
quarters may be re-allocated within the period. Cash flow for the six-quarter
period would remain unaffected by any change in the timing of income statement
recognition.
Note 8--Capital Leases
In response to the initiatives currently underway at the FASB, on June 28,
2002 the Company unilaterally undertook actions, the effect of which altered
the accounting for some of its existing lease obligations and anticipated lease
obligations relating to assets under construction. These actions included the
delivery of guarantees of lessor debt in certain existing leases of power
generation facilities. In addition, the Company notified certain lenders of its
intent to purchase power generation facilities that are currently under
construction and that were expected to be placed in synthetic leases upon
completion of their construction. As a result of these actions, approximately
$528 million of obligations due in 2005 to 2007 were brought on-balance sheet.
This non-cash action resulted in an increase to Property, Plant and Equipment
and a corresponding increase in Long-Term Debt on the Company's June 30, 2002
Condensed Consolidated Balance Sheet. These obligations were previously
reported as lease obligations in the footnotes to the Company's financial
statements and in the Commercial Financial Obligations and Contingent Financial
Commitments tables in the Form 10-K. In addition, actions taken by the Company
relating to assets under construction required the reclassification of
approximately $673 million from Prepayments and Other Assets to Property, Plant
and Equipment on the Company's June 30, 2002 Condensed Consolidated Balance
Sheet. Property under capital leases of $528 million is included in Property,
Plant and Equipment and is amortized over the useful life of the asset, which
approximates 40 years.
16
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
The following is a schedule of future minimum lease payments under capital
leases together with the present value of the net minimum lease payments as of
June 30, 2002 (in millions):
Six months ending December 31, 2002........ $ 6
Year ending December 31:
2003.................................... 13
2004.................................... 13
2005.................................... 176
2006.................................... 186
2007.................................... 185
----
Total minimum lease payments............... 579
Lease: Amount representing interest........ (51)
----
Present value of net minimum lease payments $528
====
Note 9--Debt
As of August 12, 2002, the Company's debt maturities through December 31,
2003, inclusive of letters of credit issued under revolving credit facilities,
were as follows: remainder of third quarter 2002--zero; fourth quarter
2002--$59 million (not including a $450 million secured line of credit at
Northern Natural that will be assumed by MidAmerican in the sale of Northern
Natural, as further described in Note 6 above); first quarter 2003--$219
million; second quarter 2003--$1,534 million; third quarter 2003--$22 million;
and fourth quarter 2003--$22 million. Please read "Management's Discussion and
Analysis of Financial Condition and Results of Operations-- Liquidity and
Capital Resources" for a discussion of the Company's current liquidity and
capital plans.
In July 2002, the Company completed a $200 million interim financing,
bearing interest at LIBOR plus 1.38 percent. This loan matures in January 2003
and is secured by interests in Dynegy's Renaissance and Rolling Hills merchant
power generation facilities.
In June 2002, the Company completed a $250 million interim financing,
bearing interest at LIBOR plus 1.75 percent. This loan matures in June 2003 and
represents an advance on a portion of the proceeds from the expected sale of
certain of the Company's United Kingdom natural gas storage facilities.
Dynegy completed an amendment to the Catlin Associates, LLC minority
interest transaction (also referred to as "Black Thunder") in June 2002, which
permanently removed a $270 million obligation which could have been triggered
by declines in Dynegy's credit ratings. The amended agreement requires a
subsidiary of Dynegy to amortize $275 million over the remaining three years of
the transaction. The subsidiary has already paid approximately $73 million of
the amortization. Quarterly maturities are approximately $20 million through
the first quarter 2005. In addition, Dynegy agreed to grant mortgages on the
midwest generation assets covered by the transaction, post a letter of credit
to secure a contingent obligation expiring December 31, 2002 and make certain
structural changes to enhance the security of the third-party lenders involved
in the transaction. As a result of this amendment, $796 million related to
Catlin Associates, LLC was reclassified from Minority Interest to debt on
Dynegy's Condensed Consolidated Balance Sheets at June 30, 2002.
17
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Also in June 2002, West Coast Power, LLC ("West Coast Power"), a joint
venture owned equally by Dynegy and NRG Energy with generation assets in
California, repaid a non-recourse project financing with cash on hand within
the joint venture entity. This payment eliminated a $31 million obligation
triggered by declines in Dynegy's credit ratings. Concurrent with the
retirement of the project financing, West Coast Power entered into an amended
$120 million bank facility consisting of a $100 million letter of credit
facility that will be used to collateralize West Coast Power's obligations, a
$10 million term loan and a $10 million working capital facility. The facility
has resulted in the release of approximately $100 million in letters of credit
previously posted by Dynegy on behalf of West Coast Power.
Dynegy incurred upfront fees aggregating approximately $19 million in
connection with the interim financings, Black Thunder amendment and West Coast
Power transactions described above. Such amounts are capitalized and amortized
over the terms of the respective financing transactions.
On April 29, 2002, Dynegy closed a $900 million unsecured revolving credit
agreement with a syndicate of commercial banks. This facility, which matures on
April 28, 2003, replaced an expiring $1.2 billion revolving credit agreement.
The new facility provides funding for working capital, capital expenditures and
general corporate purposes. Generally, borrowings under the credit agreement
bear interest at a Eurodollar rate plus a margin that is determined based on
designated unsecured debt ratings. Facility fees are payable on the full amount
of the facility and are determined based on designated unsecured debt ratings.
Dynegy will incur higher interest costs and fees associated with the new
facility as compared to those incurred under the expired facility.
Specifically, assuming that all amounts were outstanding under this facility,
Dynegy would pay approximately $10 million in additional interest expense on
the new facility compared to what it would have paid under the expired
facility. Additionally, as compared to similar fees paid by the Company under
the expired facility, Dynegy expects to pay approximately $2 million in
additional facility fees during the term of the new facility and paid
approximately $3 million in additional upfront fees.
Financial covenants under the new revolver include a debt-to-capitalization
test (which takes into account certain lease and similar commitments of Dynegy
and its subsidiaries) and newly added 3.5 times earnings before interest, taxes
and depreciation and amortization ("EBITDA")-to-interest test. The permissible
threshold for the debt-to-capitalization test was lowered in the new facility
from 65% to 60%. Other newly added covenants in the facility include
subordination of certain intercompany debt owed to Dynegy Inc. and its
subsidiaries (other than Dynegy and its subsidiaries), restrictions on liens
and limitations prohibiting subsidiary debt at Dynegy Marketing & Trade, Dynegy
Power Marketing, Inc. and Dynegy Midstream Services, Limited Partnership.
Default provisions include cross payment default of Dynegy Inc., Dynegy or any
principal subsidiary with respect to debt or other similar obligations that
exceed $100 million, cross acceleration of Dynegy Inc., Dynegy or any principal
subsidiary under any instrument covering debt or similar obligations that
exceed $100 million and bankruptcy or receivership of Dynegy Inc., Dynegy or
any principal subsidiary. The new facility does not contain any defaults
relating to material adverse changes in the condition of Dynegy Inc. or Dynegy
after the closing date or to changes in Dynegy Inc.'s or Dynegy's credit
ratings. The new facility also does not contain a "term-out" provision that
would permit Dynegy to extend the maturity for borrowings under the facility
beyond the facility's April 28, 2003 maturity date. As such, the amounts
outstanding under this facility are classified as current. Management currently
believes Dynegy is in compliance with the covenants contained in this agreement.
On February 21, 2002, Dynegy issued $500 million of 8.75% senior notes due
2012. Interest on the notes is due on February 15 and August 15 of each year,
beginning August 15, 2002. The notes are unsecured and are not
18
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
subject to a sinking fund. Dynegy may redeem the notes prior to maturity, in
whole or in part, at a redemption price equal to the greater of the principal
amount of the notes and the make-whole price specified in the indenture
relating to the notes.
On January 31, 2002, the Company acquired debt with a face value of
approximately $950 million (and a fair value of approximately $890 million)
through the acquisition of Northern Natural. Approximately $500 million of the
Northern Natural debt consists of senior unsecured notes with maturities
ranging from 2005 to 2011. The remaining $450 million consists of a secured
line of credit that matures in November 2002. See Note 6 for discussion of
Dynegy's previously announced sale of Northern Natural. In the event the
Company cannot consummate the sale of Northern Natural, management believes,
based on an internal analysis of Northern Natural's credit capacity, including
a review of other regulated pipelines, that Northern Natural will be able to
refinance the $450 million secured line of credit, and it is Northern Natural's
management's current intention to do so. On April 26, 2002, Dynegy purchased
$90 million of Northern Natural's senior unsecured notes due 2005 pursuant to a
tender offer. The Company is currently considering alternatives relating to the
sale of these notes.
During the six-month period ended June 30, 2002, the Company repaid
commercial paper borrowings and revolving credit facilities of approximately
$255 million. Additionally, during the six months ended June 30, 2002, Dynegy
issued an aggregate of $193 million of letters of credit under its revolving
credit facilities. During the period from June 30, 2002 through August 12,
2002, Dynegy paid at maturity $200 million in senior notes, borrowed $53
million and issued an aggregate $289 million of letters of credit under the
revolving credit facilities.
Note 10--Investments in Unconsolidated Affiliates
Investments in affiliates that are not controlled by the Company but where
the Company has significant influence over operations are accounted for by the
equity method. The Company's share of net income from these affiliates is
reflected in the Condensed Consolidated Statements of Operations as Earnings
from Unconsolidated Investments. The Company's principal equity method
investments consist of entities that operate generation assets and natural gas
liquids assets. These equity investments totaled $778 million and $768 million
at June 30, 2002 and December 31, 2001, respectively. The Company entered into
these ventures principally for the purpose of sharing risk and leveraging
existing commercial relationships. These ventures maintain independent capital
structures and have financed their operations on a non-recourse basis to the
Company.
Generation Assets. These investments primarily include ownership interests
in eight joint ventures that own fossil fuel electric generation facilities in
diverse geographic regions as well as a limited number of international
ventures. The Company's ownership is generally 50 percent in the majority of
these ventures. The Company's aggregate net investment of $644 million at June
30, 2002 represents approximately 2,400 MW of net generating capacity. Dynegy's
most significant investment in generating capacity is its interest in West
Coast Power, representing approximately 1,400 MW of net generating capacity in
California. The net investment in West Coast Power totaled approximately $348
million at June 30, 2002. West Coast Power provided equity earnings of
approximately $37 million and $70 million for the six months ended June 30,
2002 and 2001, respectively.
Midstream Investments. These investments primarily include ownership
interests in three ventures that operate natural gas liquids ("NGL")
processing, extraction, fractionation and storage facilities in the Gulf Coast
region as well as an interstate NGL pipeline. The Company's ownership interest
in these ventures ranges from 23 percent to 39 percent. At June 30, 2002, the
Company's aggregate net investment in these midstream businesses totaled
approximately $134 million.
19
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Summarized aggregate financial information for these generation and
midstream investments and Dynegy's equity share thereof was (in millions):
Six Months Ended June 30,
---------------------------
2002 2001
------------- -------------
Equity Equity
Total Share Total Share
------ ------ ------ ------
Revenues........ $1,594 $662 $2,153 $891
====== ==== ====== ====
Operating margin $ 316 $123 $ 313 $139
====== ==== ====== ====
Net income...... $ 155 $ 57 $ 210 $ 88
====== ==== ====== ====
Other Investments. In addition to these equity investments, the Company
holds interests in non-public companies for which it does not have significant
influence over operations. These investments are generally accounted for by the
cost method. Such investments totaled $28 million and $32 million at June 30,
2002 and December 31, 2001, respectively. The change is primarily attributed to
the impairment of technology investments resulting from unfavorable market
conditions.
The Company also owns equity securities that have a readily determinable
fair market value and are considered available-for-sale. The market value of
these investments at June 30, 2002 and December 31, 2001 was determined to be
$12 million and $9 million, respectively.
Note 11--Commitments and Contingencies
Please see Note 11, "Commitments and Contingencies," in the Form 10-K and
Note 8, "Commitments and Contingencies," in the Company's Form 10-Q for the
quarter ended March 31, 2002 (the "Form 10-Q") for a description of the
Company's material legal proceedings. Set forth below is a description of any
material developments that have occurred with respect to such proceedings since
the Company's filing of the Form 10-Q for the first quarter 2002 and a
description of any new matters that have arisen during the quarter.
Baldwin Station Litigation. Illinois Power ("IP"), an indirect wholly owned
subsidiary of Dynegy Inc., and Dynegy Midwest Generation, Inc. (collectively,
the "Defendants") are currently the subject of a Notice of Violation ("NOV")
from the Environmental Protection Agency (the "EPA") and a complaint filed by
the EPA and the Department of Justice alleging violations of the Clean Air Act
(the "Act") and the regulations promulgated under the Act. Similar notices and
complaints have been filed against a number of other utilities. Both the NOV
and the complaint allege that certain equipment repairs, replacements and
maintenance activities at the Defendants' three Baldwin Station generating
units constituted "major modifications" under the Prevention of Significant
Deterioration and/or the New Source Performance Standards regulations. When
activities that meet the definition of "major modifications" occur and they are
not otherwise exempt, the Act and related regulations generally require that
generating facilities meet more stringent emissions standards, which may entail
the installation of potentially costly pollution control equipment. The
Defendants filed an answer denying all claims and asserting various specific
defenses and a trial date of February 11, 2003 has been set.
The Company believes that it has meritorious defenses to the EPA allegations
and will vigorously defend against these claims. The Company has undertaken
activities to significantly reduce emissions at the Baldwin Station since the
complaint was filed in 1999. In 2000, the Baldwin Station was converted from
high to low sulfur coal. This conversion resulted in sulfur dioxide emission
reductions of over 90% from 1999 levels.
20
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Furthermore, selective catalytic reduction equipment has been installed at two
of the three units at Baldwin Station resulting in significant emission
reductions of nitrogen oxides. However, the EPA may seek to require the
installation of the "best available control technology" (or the equivalent) at
the Baldwin Station. Independent experts hired by Dynegy estimate capital
expenditures of up to $380 million if the installation of best available
control technology is required. The EPA also has the authority to seek
penalties for the alleged violations in question at the rate of up to $27,500
per day for each violation. The Company has filed a motion for summary judgment
based on the five-year statute of limitations, which could affect the EPA's
ability to collect penalties.
None of the Defendants' other facilities are covered in the complaint and
NOV, but the EPA has officially requested information concerning activities at
the Defendants' Vermilion, Wood River, and Hennepin Plants as well as Dynegy
Northeast Generation's Danskammer and Roseton Plants. It is possible that the
EPA will eventually commence enforcement actions based on activities at those
plants as well.
On June 13, 2002, the EPA announced its intention to implement several
reforms to its regulations governing new source review. These reforms, if made,
would clarify the routine maintenance, repair and replacement exclusion,
provide more certainty in evaluating permit requirements and increase
operational flexibility for affected facilities.
California Market Litigation. Six class action lawsuits have been filed
against various Dynegy entities based on the events occurring in the California
power market. The complaints allege violations of California's Business and
Professions Code, Unfair Trade Practices Act and various other statutes. The
plaintiffs allege that the defendants, including the owners of in-state
generation and various power marketers, conspired to manipulate the California
wholesale power market to the detriment of California consumers. Included among
the acts forming the basis of the plaintiffs' claims are the alleged improper
sharing of generation outage data, improper withholding of generation capacity
and the manipulation of power market bid practices. The plaintiffs seek
unspecified treble damages.
All six lawsuits were consolidated before Judge Sammartino, Superior Court
Judge for the County of San Diego. Subsequent to the consolidation two
defendants filed cross complaints against a number of corporations and
governmental agencies that sold power in California's wholesale energy markets.
Four cross defendants removed the six cases to the United States District Court
for the Southern District of California (San Diego). Following removal, certain
cross defendants filed motions to dismiss the cross complaints, which motions
are currently pending. The original plaintiffs in the six consolidated
complaints have filed motions to remand the consolidated cases back to state
court, which motions are currently pending. The defendants in the six
consolidated cases have filed motions to dismiss the complaints based on the
filed rate doctrine and preemption defense, which motions are currently
pending. Federal Judge Whaley has decided that the Court will hear the motion
to remand and the cross defendants' motion to dismiss on September 19, 2002. If
the Court decides that it has jurisdiction over the claims, the defendants'
motion to dismiss will be heard as soon as possible after September 19th.
On March 11, 2002, the California Attorney General filed, on behalf of the
People of the State of California, complaints in San Francisco Superior Court
against several owners of power generation facilities, including subsidiaries
of West Coast Power. The complaints allege that since June 1998, these
generators sold power in the open market that should have been held in
emergency reserve for the State. In the aggregate, the complaints seek more
than $150 million in penalties, restitution and return of profits from the
generators. These lawsuits were subsequently removed to the United States
District Court for the Northern District of California. The California Attorney
General filed motions to remand the cases back to state court. By Order issued
on August 6, 2002,
21
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Judge Walker denied the motions to remand, thus keeping the cases in federal
court. The Company intends to vigorously defend against these claims.
In addition to the six consolidated lawsuits discussed above, eight new
putative class actions were filed on behalf of business and residential
electricity consumers, including consumers residing in the State of Washington.
The lawsuits were filed in various state courts in Northern California, and in
respect to the lawsuit on behalf of consumers in the State of Washington, in
the United States District Court for the Northern District of California. Named
as defendants are various generators and marketers, including Dynegy and
certain affiliates. The complaints allege unfair, unlawful and deceptive
practices in violation of the California Unfair Business Practices Act and seek
to enjoin illegal conduct, restitution and unspecified damages. While some of
the allegations in these lawsuits are similar to the allegations in the other
six lawsuits, these lawsuits include additional allegations based on events
occurring subsequent to the filing of the other six lawsuits. These additional
allegations include allegations similar to those made by the California
Attorney General in the March 11, 2002 lawsuit described above as well as
allegations that contracts between these generators and the California
Department of Water Resources (the "DWR") constitute unfair business practices
resulting from market manipulation. The lawsuits filed in state court have been
removed to federal courts in the Northern and Eastern Districts of California.
Certain defendants have filed a petition with the Judicial Panel For
Multidistrict Litigation seeking to consolidate the new cases with the six
cases consolidated in the United States District Court for the Southern
District of California. The Company intends to vigorously defend against these
claims.
On May 13, 2002, two California law firms filed suit in California State
Court against more than 20 energy generators, including those owned directly by
West Coast Power and indirectly by Dynegy. This suit principally alleges the
defendant generators, in connection with their execution of long-term power
supply contracts with the DWR, took advantage of a manipulated market to
overcharge for electricity. The suit, which was filed on behalf of California
taxpayers, seeks to halt enforcement of the existing DWR contracts to the
extent that the agreed prices are found to be unfair. The suit further seeks
damages in the amount of the alleged excess prices under the contracts. The
Company intends to vigorously defend against these claims.
Enron Litigation. As previously described, Dynegy Inc. and Dynegy were sued
on December 2, 2001 by Enron and Enron Transportation Services Co. in the
United States Bankruptcy Court for the Southern District of New York, Adversary
Proceeding No. 01-03626 (AJG). Enron claims that Dynegy materially breached the
Merger Agreement dated November 9, 2001 between Enron and Dynegy and related
entities by wrongfully terminating that Agreement on November 28, 2001. Enron
also claimed that Dynegy wrongfully exercised its option to take ownership of
Northern Natural under an Option Agreement dated November 9, 2001. Enron sought
damages in excess of $10 billion and declaratory relief against Dynegy for
breach of the Merger Agreement. Enron also sought unspecified damages against
Dynegy Inc. and Dynegy for breach of the Option Agreement. Dynegy filed an
answer on February 4, 2002, denying all material allegations. On April 12,
2002, the Bankruptcy Court granted Dynegy's motion to transfer venue in the
proceeding to the United States District Court for the Southern District of
Texas (Houston Division).
Dynegy also previously described a suit filed against Dynegy and DHI by Ann
C. Pearl and Joel Getzler in the United States District Court for the Southern
District of New York, Cause No. 01 CV 11652. Plaintiffs filed the lawsuit as a
purported class action on behalf of all persons or entities who owned common
stock of Enron Corp. as of November 28, 2001. A similar suit was filed by
Bernard D. Shapiro and Peter Strub in the 129th Judicial District Court for
Harris County, Texas, Cause No. 2002-00080. Plaintiffs in each case allege that
they are intended third party beneficiaries of the Merger Agreement dated
November 9, 2001 between Enron and Dynegy and related entities. Plaintiffs
claim that Dynegy materially breached the Merger Agreement by, inter
22
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
alia, wrongfully terminating that agreement. Plaintiffs also claim that Dynegy
breached the implied covenant of good faith and fair dealing. Plaintiffs seek
an award of damages and other relief. Enron moved for an order of the
Bankruptcy Court in the Southern District of New York, directing that the Pearl
and Shapiro plaintiffs be enjoined from prosecuting their actions and
immediately dismiss those actions. The Bankruptcy Court held that the claims
asserted by the Pearl and Shapiro plaintiffs were the exclusive property of the
Enron bankruptcy estate, and that the plaintiffs lacked standing to sue as
third party beneficiaries of the Merger Agreement. Accordingly, by an order
entered on April 19, 2002, the Bankruptcy Court granted Enron's motion,
enjoined the prosecution of both actions, and directed that they be dismissed.
The Pearl and Shapiro plaintiffs thereafter complied with that order, but filed
an appeal to the United States District Court for the Southern District of New
York, which remains pending.
Dynegy believes the allegations in Enron's claim against Dynegy and the
Pearl and Shapiro matters arising out of the terminated merger are without
merit and will vigorously defend against these claims. An adverse result in any
of these proceedings, however, could have a material adverse effect on the
Company's financial position or results of operations.
As previously described, as a result of Enron's bankruptcy filing, Dynegy
recognized in its fourth quarter 2001 financial results a pre-tax charge
related to the Company's net exposure for commercial transactions with Enron.
As of June 30, 2002, the Company's net exposure to Enron, inclusive of certain
liquidated damages and other amounts relating to the termination of the
transactions, was approximately $94 million and was calculated by setting off
approximately $220 million owed from various Dynegy entities to various Enron
entities against approximately $314 million owed from various Enron entities to
various Dynegy entities. The master netting agreement between Dynegy and Enron
as well as the valuation of the commercial transactions covered by the
agreement remain subject to negotiation between the parties and, if any
disputes cannot be resolved by the parties, to arbitration as called for by the
terms of the agreement. If the setoff rights were modified, either by agreement
or otherwise, the amount available for Dynegy entities to set off against sums
that might be due Enron entities could be reduced materially.
Shareholder Litigation. Since April 2002, a number of class action lawsuits
have been filed on behalf of purchasers of publicly traded securities of Dynegy
Inc. generally during the period between April 2001 and April 2002. These
lawsuits principally assert that Dynegy Inc. and certain of its executive
officers violated the federal securities laws in connection with Dynegy Inc.'s
accounting treatment and disclosure of Project Alpha. These lawsuits have been
consolidated in the United States District Court for the Southern District of
Texas. Under the Private Securities Litigation Reform Act of 1995, the court in
which the cases have been consolidated will appoint a lead plaintiff, and the
lead plaintiff will, in turn, select class counsel. Following that process, a
consolidated complaint will be filed which may differ materially from the
complaints presently on file. Dynegy Inc. intends to vigorously defend against
these lawsuits. It is not possible to predict with certainty whether Dynegy
Inc. will incur any liability or to estimate the damages, if any, that might be
incurred in connection with such lawsuits, but an adverse outcome could have a
material adverse effect on the Company's financial condition or results of
operations.
In addition, three derivative lawsuits have been filed in which the Company
is a nominal defendant. Two of these three lawsuits relate to Project Alpha and
the third relates to severance for the Company's former Chief Executive
Officer. All three lawsuits seek recovery on behalf of the Company from various
present and former officers and directors. These actions have only recently
been filed and the Company is currently analyzing them. The Company does not
expect to incur any material liability with respect to these derivative claims.
23
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Farnsworth Litigation. On August 2, 2002, Bradley Farnsworth filed a
lawsuit against Dynegy in Texas state district court claiming that he was
demoted and ultimately fired from the position of Controller for refusing to
participate in alleged accounting irregularities. Specifically, Mr. Farnsworth
alleges that certain present and former executive officers of the Company
requested that he shave forward price curves for natural gas in order to
improve the Company's results of operations for the third quarter 2000. Mr.
Farnsworth, who seeks actual and exemplary damages and other compensation, also
alleges that he is entitled to termination payments under his employment
agreement. Dynegy intends to vigorously defend against these claims. The
Company does not believe that any liability it might incur as a result of this
litigation would have a material adverse effect on its financial condition or
results of operations.
Roundtrip Transactions. On November 15, 2001, Dynegy executed two sets of
simultaneous buy and sale trades with CMS Energy Corp. In the first set of
trades, Dynegy purchased 5 million megawatts of power from CMS Energy for
delivery in December 2001 at $25.50 per megawatt hour; concurrently, CMS Energy
purchased from Dynegy the same amount of power at the same price per megawatt
hour for delivery during the same period. In the second set of trades, Dynegy
purchased 20 million megawatts of power from CMS Energy for delivery in the
period January-December 2002 at $34.00 per megawatt hour; concurrently, CMS
Energy purchased from Dynegy the same amount of power at the same price per
megawatt hour for delivery during the same period. Dynegy and CMS have
terminated the 2002 trades.
During the second quarter of 2002, the Company undertook a comprehensive
review of these CMS Energy trades and its trading operations generally. The
Company's review confirmed that the CMS Energy trades were consummated outside
the view of other trading parties and could not have impacted market prices.
The results of the CMS Energy trades were not included in the Company's
December 31, 2001 Consolidated Statement of Operations, and the volumes from
these trades were not included in the operating statistics for the Wholesale
Energy Network ("WEN") segment in the Form 10-K, nor were such results or
volumes included in the Company's first quarter Form 10-Q. In an April 30, 2002
press release, 2002 first quarter Revenues and 2002 first quarter Costs of
Sales each contained $236 million related to these trades. These amounts netted
to zero in the operating margin line, resulting in no net income effect from
the trades in that press release. The Company eliminated these amounts from
Revenues and Costs of Sales in its Form 10-Q for the first quarter and in this
report.
Based on the Company's review of its trading operations to date, Dynegy
believes that it has not executed any simultaneous buy and sell trades with
counterparties for the purpose of artificially increasing its trading volumes
or revenues.
SEC Investigation. The SEC has commenced an investigation into the facts
and circumstances surrounding Project Alpha and the roundtrip trades described
above. The Company has produced documents and witnesses for interviews in
connection with this investigation. The Company has assured the SEC that it
intends to cooperate fully with this investigation. Dynegy has been informed
that the staff of the SEC Division of Enforcement intends to allege that, among
other things, Dynegy's disclosures and reports relating to both Project Alpha
and the CMS Energy trades violate various antifraud and other provisions of the
federal securities laws. The Company cannot predict the ultimate outcome of
this matter.
CFTC Investigation. The U.S. Commodity Futures Trading Commission ("CFTC")
has commenced an investigation relating to, among other things, trading
activities on Dynegydirect, the Company's on-line trading platform, and any
roundtrip gas or power trades since January 2000, including all trades or
trading activities between Dynegy and CMS Energy in November 2001. The
investigation also relates to the Company's trading
24
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
activities in the California power market. The Company has produced documents
in connection with this investigation. The Company has assured the CFTC that it
intends to cooperate fully with this investigation. The Company cannot predict
the ultimate outcome of this matter.
FERC and Related Regulatory Investigations. On February 13, 2002, the FERC
initiated an investigation of possible manipulation of natural gas and power
prices in the western United States during the period from January 2001 through
the present. On May 8, 2002, in response to three memoranda (authored by
individuals employed by or previously employed by Enron) discovered by the FERC
allegedly containing evidence of market manipulation by Enron in California,
the FERC issued requests for information to all sellers in the California
Independent System Operator (the "ISO") and the California Power Exchange (the
"PX") markets during 2000 and 2001 seeking information with respect to whether
those sellers engaged in trading strategies described in the three Enron
memoranda.
Dynegy responded to these requests on May 22, 2002, and updated its
responses on July 30, 2002 at the conclusion of its due diligence. A California
State Senate committee subsequently issued similar requests, and Dynegy's
responses were consistent with those submitted to the FERC. Based on its
investigation to date, Dynegy believes that its trading practices are
consistent with applicable law and tariffs and will continue to cooperate fully
with these investigations. The California State Senate committee has not issued
its preliminary findings on its investigation, and Dynegy cannot predict with
certainty how such allegations will ultimately be resolved.
On August 13, 2002, the FERC issued a notice requesting comments on a
proposal made by the FERC staff to change the method for determining natural
gas prices for purposes of computing the market mitigation clearing price that
it intends to utilize in calculating refunds for sales of power in California
power markets during the period from October 2, 2000 to June 19, 2001. The
proposed adjustments generally would result in lower gas prices which in turn
would lower the market mitigation clearing price for power, potentially
increasing calculated refunds. However, the FERC staff proposal contains a
provision that provides generators with an "uplift" for gas costs purchased
from unaffiliated suppliers, which would allow generators to fully recover
their gas costs. It is not clear whether the FERC will adopt the staff's
recommendation or, if it does, that a retroactive application of the proposal
would be lawful. Dynegy is evaluating the staff's recommendation and is unable
to assess at this time the impact, if any, that this proposal may have on any
refunds which FERC may order from Dynegy or West Coast Power pursuant to the
FERC's investigation of the California power market for the period from October
2, 2000 to June 19, 2001.
On May 21, 2002, the FERC issued requests for information to all sellers of
wholesale electricity and/or ancillary services in the Western Systems
Coordinating Council ("WSCC") seeking information with respect to whether those
sellers engaged in "wash," "round trip" or "sale/buyback" transactions in the
WSCC during the years 2000-2001. Dynegy responded on May 31, 2002. On May 22,
2002, the FERC issued requests for information to all sellers of natural gas in
the WSCC or Texas seeking information with respect to whether those sellers
engaged in "wash," "round trip" or "sale/buyback" transactions in the WSCC or
Texas during the years 2000-2001. Dynegy responded on June 5, 2002. On August
12, 2002, Dynegy updated its May 31 and June 5 responses at the conclusion of
its due diligence. Requests for similar information with respect to electric
power trading activities in the Electric Reliability Council of Texas were
received from the Texas Public Utility Commission on June 12, 2002. Dynegy
responded to these requests on July 2, 2002.
Based on the investigation conducted in order to make these filings, Dynegy
believes that it has not executed any simultaneous buy and sell trades with
counterparties for the purpose of artificially increasing its trading volumes
or revenues in these markets.
25
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
In addition, on February 25, 2002 the California Public Utilities Commission
and the California Electricity Oversight Board filed complaints with the FERC
asking that it void or reform power supply contracts between the DWR and, among
others, West Coast Power. A rehearing order issued on July 23, 2002 affirmed
the underlying findings and conclusions related to West Coast Power's contract
with the DWR. The complaints allege that prices under the contracts exceed just
and reasonable prices permitted under the Federal Power Act. The FERC recently
set these complaints for evidentiary hearing. The hearing, however, is being
held in abeyance pending completion of settlement talks. While West Coast Power
continues in good faith negotiations with the State of California on reforming
the terms of its DWR contract, settlement ultimately may not be possible. If a
hearing on the contracts entered into by West Coast Power or others is
necessary, the first phase of the hearing will be limited to the question of
whether the California real-time market adversely affected the long-term
bilateral markets. While the Company believes the terms of its contracts are
just and reasonable and do not reflect alleged market manipulation, it cannot
predict the outcome of this matter.
U.S. Attorney Investigation. In May 2002, Dynegy received a subpoena from
the U.S. Attorney's office in Houston requesting documents relating to Project
Alpha, roundtrip trades with CMS Energy and the Catlin/Black Thunder
transaction. The Company is cooperating fully with the U.S. Attorney's office
in its investigation of these matters. The Company cannot predict the ultimate
outcome of this matter.
Note 12--Regulatory Issues
The Company is subject to regulation by various federal, state, local and
foreign agencies, including extensive rules and regulations governing
transportation, transmission and sale of energy commodities as well as the
discharge of materials into the environment or otherwise relating to
environmental protection. Compliance with these regulations requires general
and administrative, capital and operating expenditures including those related
to monitoring, pollution control equipment, emission fees and permitting at
various operating facilities and remediation obligations. In addition, the U.S.
Congress has before it a number of bills that could impact regulations or
impose new regulations applicable to Dynegy and its subsidiaries. The Company
cannot predict the outcome of these bills or other regulatory developments or
the effects that they might have on its business. For a more detailed
description of regulatory issues affecting the Company's business, please refer
to "Item 1. Business--Regulation" in the Form 10-K.
Note 13--Related Party Transactions
ChevronTexaco Commercial Arrangements. In March 2002, Dynegy and
ChevronTexaco executed agreements to expand their commercial relationships to
include substantially all of the natural gas and domestic mixed NGLs and NGL
products produced or controlled by the former Texaco. The expanded term
agreements extend through August 2006. This expanded relationship increased the
volume of natural gas Dynegy purchases from ChevronTexaco from approximately
1.7 Bcf/d to approximately 2.9 Bcf/d. Dynegy also provides supply and service
for in excess of 1.6 Bcf/d of natural gas for the combined ChevronTexaco
facilities and third-party term markets. In addition, the expanded contract
with ChevronTexaco includes substantially all of the U.S. NGL production of the
former Texaco.
Concurrent with the expanded commercial agreements, the two companies
executed a new security agreement designed to improve Dynegy's liquidity
position by reducing its reliance upon the financial markets for surety bonds
and letters of credit and to significantly reduce ChevronTexaco's open credit
exposure. The new security agreement involved the replacement of historic
credit support arrangements with a perfected security interest in a portion of
Dynegy's domestic natural gas receivables. Dynegy has the option to revert back
to historic credit support arrangements, which included the issuance of surety
bonds and/or letters of credit.
26
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
In July 2002, Dynegy and ChevronTexaco executed a 90-day amendment to their
security agreement. This amendment was designed to address the reduction in
activity in Dynegy's gas marketing business and the corresponding reduction in
Dynegy's gas marketing receivables relative to the required coverage ratio
contained in the security agreement. The amendment, which was executed in
conjunction with a six-month netting agreement between the parties that has
since been made permanent, reduced the required coverage ratio contained in the
security agreement.
In August 2002, in partial satisfaction of certain of its obligations to
ChevronTexaco under these agreements, Dynegy transferred to ChevronTexaco its
39.2% ownership interest in West Texas LPG Pipeline Limited Partnership
("WTLPS"), which is the owner of West Texas LPG Pipeline. ChevronTexaco was
already the owner of the largest interest in WTLPS and the operator of the
pipeline. The interest transferred to ChevronTexaco was valued at approximately
$45 million.
Also in August 2002, Dynegy and ChevronTexaco executed an agreement pursuant
to which the parties amended their gas purchase agreement, security agreement,
netting agreement and certain related agreements. Under this new agreement,
Dynegy agreed to accelerate payment to the month of delivery for a portion of
the natural gas it purchases from ChevronTexaco, with the amount of the earlier
payment generally being equal to 75 percent of the value of the prior month's
gas deliveries, after reduction pursuant to the netting agreement described
above. This payment arrangement will be effective upon the closing of the sale
of Northern Natural described in Note 6 above. The initial payment amount, upon
consummation of the Northern Natural sale, will be $187.5 million. The amount
of the payment could change materially as a result of changes in commodity
prices. If the Northern Natural sale does not close on or prior to August 30,
2002, then a special report concerning the security agreement coverage ratios
would be due by September 4, 2002. Dynegy's right to withdraw sums from the
designated account in which the proceeds from the gas receivables covered by
the security agreement in favor of ChevronTexaco are deposited would be
suspended pending receipt of that report, and that report demonstrating
compliance with the required coverage ratios. Management believes that absent
the agreed payment with proceeds from the Northern Natural sale, this special
report likely would require Dynegy to pay additional amounts in order to be in
compliance with the required ratios under the security agreement. The new
agreement also suspends ChevronTexaco's right to request special reports
concerning the security agreement coverage ratios as long as those payments are
made, and makes permanent the netting agreement and reduction in the coverage
ratios referred to above.
The obligation to make payments as described above will be suspended if
Dynegy or a successor to its gas and natural gas liquids customers and
risk-management business carries at least two of the following three credit
ratings: at least BBB+ by Standard & Poor's, at least Baa1 by Moody's and at
least BBB+ by Fitch.
Dan Dienstbier Contract for Services. Dynegy entered into a services
agreement with Daniel L. Dienstbier effective as of May 28, 2002, the date on
which Mr. Dienstbier assumed the position of interim Chief Executive Officer.
Mr. Dienstbier agreed to serve as Dynegy's interim Chief Executive Officer
until either Dynegy or Mr. Dienstbier terminate the arrangement on 30 days'
written notice. Pursuant to the terms of the agreement, Dynegy agreed to pay
Mr. Dienstbier $1 million per year, to be paid ratably once per month, in the
form of cash or Dynegy Class A common stock as the parties shall agree. Upon
termination of the agreement, Mr. Dienstbier is eligible to receive a bonus
payment and a Class A common stock grant, in each case at Dynegy's discretion.
The agreement contains customary indemnification, confidentiality and
non-compete provisions relating to Mr. Dienstbier's provision of services.
Preferred Stock. Dynegy Inc. owns the approximately $1.5 billion in
preferred stock on the accompanying Condensed Consolidated Balance Sheet. This
is preferred stock in Northern Natural. (See Note 6.)
27
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Note 14--Segment Information
Dynegy's operations are divided into three reportable segments: WEN, Dynegy
Midstream Services ("DMS") and Transmission and Distribution ("T&D"). WEN is
engaged in a broad array of businesses, including physical supply of and
risk-management activities around wholesale natural gas, power, coal and other
similar products. This segment is focused on optimizing the Company's and its
customers' global portfolio of energy assets and contracts, as well as direct
commercial and industrial sales and retail marketing alliances. DMS consists of
the Company's North American midstream gas processing and liquids marketing
businesses and worldwide natural gas liquids marketing and transportation
operations. Dynegy's T&D segment includes the operations of Northern Natural.
Northern Natural's 16,600 miles of pipeline extend from the Permian Basin in
Texas to the Upper Midwest, providing extensive access to major utilities and
industrial customers. Northern Natural's storage capacity is 59 billion cubic
feet ("Bcf") and its market area capacity is approximately 4.3 Bcf per day. As
reflected in Note 6, the Company is expecting to close the sale of Northern
Natural in August 2002. Dynegy accounts for intercompany transactions at
prevailing market rates. Unaudited operating segment information for the three-
and six-month periods ended June 30, 2002 and 2001 is presented below.
Dynegy's Segment Data for the Quarter Ended June 30, 2002
($ in millions)
WEN DMS T&D Eliminations Total
------- ------ ------ ------------ -------
Unaffiliated revenues:
Domestic........................................... $ 6,204 $ 778 $ 74 $ -- $ 7,056
Canadian........................................... 725 361 -- -- 1,086
European and other................................. 1,429 -- -- -- 1,429
------- ------ ------ ---- -------
8,358 1,139 74 -- 9,571
Affiliated Revenues................................... 124 -- -- -- 124
Intersegment revenues:
Domestic........................................... 50 41 5 (96) --
------- ------ ------ ---- -------
Total revenues................................. 8,532 1,180 79 (96) 9,695
Depreciation and amortization......................... (59) (24) (17) -- (100)
Impairment and other charges.......................... (25) (3) (4) -- (32)
Operating income (loss)............................... (19) 11 10 -- 2
Interest expense...................................... (27) (13) (16) -- (56)
Other expense, net.................................... (122) (13) (1) -- (136)
Earnings (losses) from unconsolidated investments..... (6) 6 -- -- --
Income tax benefit.................................... (50) (2) (3) -- (55)
Net loss.............................................. $ (124) $ (7) $ (4) $ -- $ (135)
Identifiable assets:..................................
Domestic........................................... $17,543 $1,971 $2,764 $ -- $22,278
Canadian........................................... 605 139 -- -- 744
European and other................................. 2,653 -- -- -- 2,653
Investments in unconsolidated affiliates.............. 672 146 -- -- 818
Capital expenditures and investments in unconsolidated
affiliates.......................................... (322) (22) (5) -- (349)
See the Explanatory Note on the Table of Contents and the notes to condensed
consolidated financial statements.
28
DYNEGY HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Interim Periods Ended June 30, 2002 and 2001
Dynegy's Segment Data for the Quarter Ended June 30, 2001
($ in millions)
WEN DMS Eliminations Total
------- ------ ------------ -------
Unaffiliated revenues:
Domestic...................................................... $ 7,742 $ 580 $ -- $ 8,322
Canadian...................................................... 1,188 327 -- 1,515
European and other............................................ 715 -- -- 715
------- ------ ----- -------
9,645 907 -- 10,552
Affiliate Revenues............................................... 118 -- -- 118
Intersegment revenues:
Domestic...................................................... 38 68 (106) --
------- ------ ----- -------
Total revenues............................................ 9,801 975 (106) 10,670
------- ------ ----- -------
Depreciation and amortization.................................... (48) (20) -- (68)
Interest expense..................................