Best Buy dividend in line with expectations, converts flattish; Kodak holds pat amid stock furor

By Ronda Fears

Nashville, Oct. 21 - As earnings reports peak this week, the most noise in the convertible market was the sound of numbers being crunched and cries of lament as volatility continued to slump. Meanwhile, the primary market perked up slightly with a small overnighter from advertising firm Grey Global Group.

"There were a few wild swings in some stocks but the converts held up quite well," said a sellside trader.

In the broader market, the major stock indexes were flat and bonds were firmer but convert players were more concerned with the lagging VIX, at 16.55, which one buyside trader referred to in context with a string of expletives.

Still, healthy conversion premiums, although in a contracting trend, have given many issues some insulation against stock drops, many observers point out, such as with Brinker International Inc.

Brinker's converts fell in dollar points but were flat on a dollar-neutral basis while the stock plunged 12.5% in reaction to a miss on the earnings and a warning going for quarters to come.

Eastman Kodak Co. also was little changed ahead of its earnings and the controversy brewing among its largest institutional stockholders over its big dividend cut. Kodak reports earnings before the open Wednesday and the stockholders are meeting after the close.

Best Buy Co. Inc. also was making headlines with its initiation of a common stock dividend but it was within the range expected by convertible players, so the converts were essentially flat on a dollar-neutral basis.

Brinker and Kodak got the most attention in the convertible market, with some active markets in the morning but even those dried up in the afternoon.

"There was a spurt of activity this morning, but everything got very quiet this afternoon," a buyside trader in New York said.

Brinker was a name that's been in the "at risk" column for a number of reasons, including a potential negative earnings surprise plus the Oct. 10 put.

In fact, one market source said the convertible market may have priced too much risk into the converts.

Brinker's 0% due 2021 were quoted at 64.625 bid, 65.125 offered versus a drop of $4.21, or 12.45%, in the stock to $29.60. A buyside trader said the convert lost 2-3 points, bringing the decline to around 7 points on an outright basis over the past month.

Still, in the face of the extreme reaction in the stock market to the earnings news, convertible market sources said the convert "held up quite well" on swap.

"The convert has done it's job," said Venu Krishna, head of U.S. convertible research at Lehman Brothers.

Brinker posted fiscal first quarter earnings of $44.6 million, or 45c a share, on revenue of $870.9 million, compared with earnings of $45 million, or 45c a share, on revenue of $773.9 million a year ago.

The numbers missed analysts' expectations, and more downward pressure came from the company revising its forecast downward for fiscal second quarter as well as fiscal 2004.

Brinker now expects to earn $2.13 to $2.17 per share in fiscal 2004, down from its previous target of $2.19 to $2.23. In second quarter, Brinker sees profits of 44-45c a share, whereas analysts have been forecasting 49c.

"Our first quarter earnings, while in line with guidance, were not as strong as we would have liked," said Douglas H. Brooks, president of Brinker, on the earnings call.

"Long-term trends remain favorable for the restaurant industry. People continue to dine out, as evidenced by our 12.5% top-line growth. But the cost environment made our earnings growth difficult."

He described the cost pressures as "long term" but said the company remains committed to its long-term growth targets.

On the call, Brooks was asked whether the company had miscalculated on costs, or was there another specific reason that earnings were lower.

"We had hoped to get some leverage on fixed costs and some of the cost pressures we had seen in that 2% range," Brooks said.

"When we got the actual results we didn't get that leverage. If you want to call that a miscalculation, I'm not sure."

The costs were payroll taxes, utilities, property taxes and insurance.

In a report Sept. 26, Lehman's Krishna noted a decline in the Brinker convert was due to confusion about its contingent conversion feature in the face of a negative earnings surprise. He advocated a buy on the weakness, as the potential dilutive effective of the contingent conversion feature was blown out of proportion.

The Brinker convert was putable Oct. 10 at 61.163, but that was widely expected to be a non-event unless the stock dropped below $22.625. The issue now is trading closer to the October 2005 put price of 64.587, a buyside trader pointed out.

Kodak activity was fairly muted ahead of its earnings and amid the stockholder furor, traders said.

The controversy at Kodak is mounting over its new business strategy announced Sept. 25 that targets 6% growth and cut the common stock dividend by 72%.

Convertible investors, like Standard & Poor's, are concerned that stockholder pressure might cause Kodak to reverse its dividend cut. But the cut was made before the convertible was sold two weeks ago and it was a positive point for convertible investors.

Kodak's 3.375% convertible due 2033 edged up 0.625 point to 106.625 bid, 107.125 offered while the stock gained 52c, or 2.25%, to $23.64.

Key points of the company's turnaround plan were the dividend cut and plans to focus on digital technology through some $3 billion in investments, including acquisitions.

Standard & Poor's said a lack of stockholder support could affect Kodak's rating or outlook if any pressure causes Kodak to reconsider its dividend cut or makes its strategy more difficult to implement.

Kodak reports earnings Wednesday and has a conference call scheduled for 11 a.m. ET.

Also, Providence Capital Inc. has called a meeting for institutional shareholders of Kodak for 4.15 p.m. ET on Wednesday to discuss the risks and rewards of Kodak's turnaround strategy, along with "alternative strategies to maximize shareholder value," and a possible shareholder proposal.

Bert Denton, president of Providence Capital, said in a statement that the meeting "is to provide a forum for Eastman Kodak's major shareholders to discuss the critical issues which have brought the Kodak's share price to a 20-year low. We will focus on the advisability of, and the alternatives to, the challenging turnaround strategy."

Previously, Providence has held similar meetings for the institutional shareholders of The Walt Disney Co., HealthSouth Corp., Tyco International Ltd. and others.

S&P noted that some 60 institutional investors holding around 25% of Kodak stock are reportedly going to attend the Providence meeting, and such broad participation highlights the level of concern.

S&P said it shares the concern about the aggressiveness of Kodak's growth strategy, but added that the dividend cut is critical to the company's ability to fund this strategy while still maintaining an appropriate financial profile.

Any change in the company's dividend policy due to shareholder pressure would be an immediate rating concern, S&P said.

"If they [Kodak] are pressured into reinstating the dividend, or some part of it, that will be a black eye for the convert," said a buyside trader.

"Right now, we're just sitting tight with this. We don't think that's going to happen."

Best Buy initiated a cash annual dividend of 40c a share, but it was an anticipated move so the convert market was prepared.

"A certain amount of dividend risk was factored in for Best Buy. The question was how much," said a sellside source.

Another sellside source said, "We were looking for something between 0.5% and 2% [from Best Buy] and it came in at about 1%, so it was within that range."

Traders said the Best Buy converts were essentially flat, with the 0.684% due 2021 issue off 0.125 point to 76 bid, 76.5 offered and the 2.25% due 2022 up 0.5 point to 108.5 bid, 109 offered. Some convert holders were buying the stock, too, to get involved with the common dividend payout, traders said.

Best Buy shares rose $1.28, or 2.42%, to $54.08.

The initial annual dividend will be made in two payments, one of 30c a share payable Dec. 9 to shareholders of record on Nov. 18 and a second, quarterly dividend of 10c a share payable Jan. 28 to holders of record on Jan. 7.

"I don't think it was a big surprise to the market, the level of dividend," one source said.

The market wasn't entirely surprised by the Grey Global Group deal, either.

Throughout the session, convertible market players were talking about a new deal getting launched after the close. (For details, see page 1 of this issue.)

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