Dynegy Enters Bankruptcy: The Warning Signs

| About: Dynegy Inc. (DYN)

Dynegy Inc. (DYN) recently announced that they had filed for Chapter 11 bankruptcy in New York. This move should be no surprise as creditors hold over $2.5 billion in claims, analysts' downgrades and falling earnings.

Dynegy's subsidiary, Dynegy Holdings, is already in bankruptcy and it was announced that the two entities would merge during bankruptcy. Unfortunately, bankruptcy has been a rocky start for Dynegy and its subsidiary as they were accused of fraud. When Dynegy Holdings originally filed for bankruptcy, they transferred several coal power plants to the parent company so that it would not be harmed during the hearings. The company maintains that it was the best decision for shareholders but the courts may not look at it that way.

In some cases, it can be pretty clear that a company is in danger of filing for bankruptcy. Dynegy is one of those companies. Just looking from analyst recommendations, it is very clear. Since 2008, the company has received only two upgrades compared to its nine downgrades and six negative reiterations. While you should never base investment decisions alone on analyst recommendations, it is something that investors should look at to determine how Wall Street views the stock currently. In this case, the Street has been bearish for years and in the end they were right about Dynegy.

The most reliable way an investor could have determined that bankruptcy was a possibility for Dynegy is if they looked at recent earnings over the past few years. In 2010, Dynegy reported full year earnings of -$1.95 a share on revenue of $2.32 billion. However, in 2011, Dynegy reported earnings of -$13.48 a share on revenue of $1.59 billion. As you can see, that is a serious drop in earnings in just a year.

As you can see, the signs were all there: growing debt, four years of bearish analysts and earnings dive. Dynegy's management was just simply out of touch with its business and customers in addition to borrowing too much money. Now that Dynegy is having problems in bankruptcy, this could be yet another reason to stay away from Dynegy when it comes out of bankruptcy.

The bottom line here is sometimes bankruptcy is not hard to predict. In cases like Dynegy, there were multiple red flags since 2008 and it is quite clear after last year's earnings dive that bankruptcy was a serious option for Dynegy and in the near future. The primary indicators for determining whether a company has a chance to enter bankruptcy or not are: rising debt load, multi-year analyst bearishness and diving earnings. These indicators together tell you the majority of what you need to know. Rising debt loads cause a lot of stress on a company's balance sheet and sources for raising capital. When a company does not have capital, it can be extremely difficult to invest and improve your products. This leads to falling earnings and bearish analyst forecasts. While it is not always this simply, this is the bare bones explanation. Keep an eye of Dynegy as it progresses through bankruptcy to determine if the company has made a turnaround or if the company continues to be stuck in a rut.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.