Description

Westar Energy (WR) is a holding company with $7 billion of assets whose regulated electric utility subsidiaries are the largest in Kansas. (See 3/4/2001 VIC writeup for additional background information). The Company’s CEO for the last 5 years, David Wittig, has recently resigned (probably forcibly) due to an indictment by a federal grand jury on charges relating to an illegal loan transaction. This recommendation to sell short is based on the premise that the Company’s finances are shaky, that the $1.20 annual dividend will be cut back by at least 80%, and that Wittig’s agenda will be totally abandoned. Given Wittig’s wheeler dealer reputation and the contempt in which he is held by many constituents, it appears to me that there is a high likelihood that other information will come to light that is detrimental to the Company. His replacement, James Haines, was an assistant district attorney for Missouri and most recently, the CEO of El Paso Electric (EE). He was instrumental in rebuilding that Company after it emerged from bankruptcy in 1996 (see 3/30/01 VIC writeup). The recent bounce in Westar’s stock price is a reflection of Haines’ reputation, the expectation that he will get the Company back on track and restore a working relationship with the regulators. More to the point, some of the large short position in the stock has probably been covering. Additionally, Westar may be the beneficiary of the recent strength in Oneok (OKE), of which Westar owns 45%.

History
Although not in a league with Dennis Kozlowski or Ken Lay, David Wittig is a potential poster child for executives who line their own pockets at the expense of the investing public. Wittig was previously a hotshot New York investment banker and was brought into Western Resources – now Westar Energy – to take advantage of the deregulated energy environment that emerged in the mid 1990s. After less than a year with the Company, he became President in 1996 at the age of 40, and fulfilling his mandate, launched a hostile takeover bid for ADT. That action resulted in a spectacular gain of roughly $750 million when Westar’s block was sold to Tyco in March 1997. The logic of going after ADT was that security services were a natural sale to many utility customers – in fact, the grand scheme was for Westar to build a mega utility holding company with a sizeable deregulated business that could cross-sell all kinds of energy and “related” services. In that vein, Westar made attempts to merge with Kansas City Power and Light (1997, cancelled early 2000) and PNM Resources (Public Service Company of New Mexico, late 2000, cancelled early 2002). Those transactions failed because of Westar’s falling stock price, concerns over high debt levels and the regulator’s (Kansas Corporation Commission, KCC) hostility to Wittig’s empire building schemes. Westar did purchase 45% of Oneok in 1997 when it traded its natural gas pipeline business for Oneok stock (at today’s prices and assuming no taxes on a sale, the stock, by itself, is worth more than the present market cap of WR. OKE dividends produce roughly 35% of WR’s after tax income). Since this past summer, Westar has indicated that it would like to sell its Oneok stock, but the agreement negotiated by Wittig is extremely restrictive to Westar’s interests. Raising significant proceeds from a sale appears to be unlikely.
It turned out that the ADT transaction was a curse in disguise because it convinced Wittig of the merits of subsequently investing around $2 billion to create a home security conglomerate. Instead, Protection One (88% owned, symbol = POI) has turned into a sinkhole. POI’s losses have been the primary reason that Westar’s mortgage bonds have dropped from Baa1 to Ba1 over the last few years while POI’s own bonds are Caa1. Westar presently has net consolidated debt of $3.4 billion, more than 4 times it’s market capitalization. Shareholders of what used to be a staid utility have seen the stock go from $43 in March 1998 to approximately $11.42 today while the annual dividend has been cut from $2.14 in 1998 to the present $1.20.
With POI’s large losses weighing down Westar’s results and the regulators blocking utility acquisitions, the deregulated entity within Westar (Westar Industries) became Wittig’s focus for salvaging his reputation. His solution was to try to spin Industries out to Westar’s shareholders as an independent company, and then (it is logical to surmise), leave the parent to run Industries himself. This has led to questionable behavior whereby Industries has engaged in such actions as buying WR stock in the open market despite a deteriorating WR debt rating and investing Industries’ cash to bail out POI. Industries is in the bizarre position of being the parent’s largest shareholder (21.8% of total shares) and had plans to increase the position to more than 50% (from selling the Oneok stock and trading the cash received for more WR shares). While the ownership of the treasury stock doesn’t affect the consolidated statement, it is an indication of Wittig’s penchant for financial maneuvering instead of dealing with the basics of running a utility.
There are other red flags that could lead to substantial additional charges and/or lawsuits against management and the Company:
· In addition to the illegal loan charges ($1.5 million transaction, not particularly noteworthy in itself), Wittig and Westar are under federal grand jury investigation for improper use of corporate aircraft and executive compensation agreements. The board is conducting its own internal investigation.
· It is not yet clear if Wittig resigned voluntarily or was fired. Substantial compensation issues for Wittig and his management cronies could be contentious.
· Due to reclassifications related to discontinued operations, the adoption of new accounting standards for energy trading revenues and the classification of gains and losses from the extinguishment of debt, Westar’s 2000 and 2001 statements will be reaudited (Deloitte has replaced Andersen).
· There are numerous intercompany dealings between POI and WR - extraordinary gains from sizeable purchases of POI debt below par, purchase of POI Europe by WR to inject funds into POI, administrative services rendered to POI by WR and POI’s takeover of all the WR’s IT functions for $21 million a year. As mentioned below, Westar Industries has extended a revolver to POI (no bank will) with $216 million outstanding at 9/30/02. WR is in a delicate conflict of interest position as the majority shareholder and largest creditor. The KCC has largely prohibited Westar from funneling more funds to POI.

Financials
Westar has $3.6 billion of consolidated debt, less $200 million of cash defeasance balances, less $150 million of cash. Total debt does not include roughly $100 million of advances against sold receivables and at 12/31/01, $723 million of loans against $773 million of Corporate Owned Life Insurance policies (yes, those are the right numbers – the loans are mostly against the remaining lives of 82 present and former executives of Kansas Gas & Electric at an average of $8.7 million each). $340 million of the net $3.25 billion WR debt belongs to POI, which neither Westar Industries or Westar itself has guaranteed. POI is all but bankrupt so it’s easiest to assume that WR would walk away from those obligations under the new management. (POI debt is actually $556 million, but $216 million of that amount is provided by Westar Industries and is netted out in the consolidated statement). All of this means that Westar’s core debt is roughly $2.9 billion against a book net worth of about $900 million if POI’s $275 million 9/30/02 net worth is subtracted out (this calculation ignores POI Europe, which is owned by WR, although its $100+ million book value is almost certainly overstated). The resulting 76% debt to capitalization is way above the 55% that the KCC deems to be acceptable
Most of the book net worth is tied up in the Oneok stock, carried at $700 million. As an aside, the value of the Oneok stock was written up by $100 million without explanation (or passage through the income statement) in the second quarter of this year, possibly because the holding was deemed to be a marketable security as a result of Westar’s announcement that they wanted to sell the shares. While the Oneok position is potentially worth considerably more than its carrying value (44.5 million equivalent shares * $19 = $845 million), per a shareholder agreement between the two companies, the Westar block can only be sold to a buyer who tenders for all of Oneok or to Oneok itself (which Oneok has rejected). If Westar sells its Oneok shares in smaller portions, the agreement and the Public Utility Holding Act prohibit any one buyer from purchasing more than 9.9% of OKE. Additionally, most of WR’s position is held as a convertible preferred which is earning a 5% tax-advantaged yield. Any partial sale of the preferred must be accomplished by first converting the preferred into common, but that would result in a 30% lower yield to the buyer (OKE’s common dividend is 62 cents/share vs 90 cents/equivalent share for the preferred). In summary, while the dividend from the OKE shares covers the after tax cost of the debt supporting the position, there is little likelihood of selling the entire position at a substantial premium and retiring a like amount of debt. Given the present market environment and the 9.9% restriction, it appears that Westar is stuck with the OKE stock for the foreseeable future.
In early November, the KCC issued an order requiring a financial restructuring of Westar. Much of the text deals with a categorical renunciation of Wittig’s policies that is somewhat moot with the new leadership in place. The order does indicate that applying discounted cash flow and equity funding analyses shows that the utility business should carry no more than $1.47 billion of debt. Given the present circumstances, the regulators recommend reducing debt by $100 million a year and although it doesn’t prohibit the payment of dividends, it clearly indicates that dividends should be drastically reduced and/or eliminated. Its approach is somewhat disingenuous because it states that the utility cash flow in 2003 and 2004 should be $344 million and $306 million respectively. Since these numbers apparently (the schedule with details was not attached) omit $230 million a year of capex, the only way to squeeze out $100 million of debt reduction is to eliminate the $85 million a year of common dividends.
Westar has a reset note due 8/15/03, which has been reduced from the original $400 million to $146 million at present. The note calls for a penalty if 10 year Treasury rates are below 5.44% and accordingly, the Company has reserved for a $69 million loss (the underlying option is separate from the note so that the penalty is not reduced by retiring additional notes). Although Westar presently has enough cash to retire the rest of the notes, they don’t have enough cash to take care of the $69 million as well (which reduces/increases $5 million for every 10 basis points that the 10 year is above/below 4.10%). The Company’s $585 million bank term loan and $150 million revolver (nothing outstanding) are due if the reset notes haven’t been defeased or paid off by 6/15/03. If the notes are reset, the rate will be substantially higher than the present 6.25%.
Summary
The KCC is a notoriously difficult regulator. During the past five years, Wittig has managed to layer on huge amounts of debt with no offset to income. Although the Commission may be sympathetic to the new management, they are not in the political position to allow rates to be raised. For the next many years, Westar will be forced to do nothing more than pay down debt and forget about the consequences to the stock of paring the dividend to a nominal amount.
Consensus earnings for next year are $1.33/share (about the same as free cash flow) which using a discounted cash flow model, would imply a fair market price considerably higher than $11. However, the market is likely to recognize that payouts will be diminimus for many years and that as a pure utility going forward, the Company is always subject to downward rate adjustments if the return on equity is too high (there are already cries for industrial electric rates to be reduced). It also seems logical to assume that where there is smoke (Wittig’s grand jury indictment for a minor league scheme, a grand jury investigation for the misuse of corporate assets), there is fire (corporate malfeasance). Offsetting that point, a number of savvy investors have owned the stock for sometime at prices much higher than today’s – Wally Weitz (slightly less than 10%), Leon Cooperman (2.8%), and Mario Gabelli (6%).

Catalyst

New management will sweep a clean broom. The result will be virtual elimination of the dividend as well as lots of dirty laundry that could take years and lots of money to clean up.
30 cent quarterly payout goes ex dividend on December 5, payable January 2, 2003. The next board meeting (Haines’ first) will be December 11.