AEP mandatory would benefit greatly from cut in common dividend

By Ronda Fears

Nashville, Dec. 12 -American Electric Power Co.'s mandatory convertible could benefit if the company responded to a concern raised by Moody's Investors Service by cutting its common dividend.

In its downgrade of AEP Wednesday, Moody's cited the high level of dividend payments as one factor. If the dividend is reduced, the mandatory's theoretical value would get a boost from the increased yield advantage over the stock.

AEP spokesman David Hagelin said there are no plans to cut the dividend but added that the company is aware of Moody's concerns.

"We realize the dividend is very important," Hagelin said.

"There are no immediate plans to reduce our dividend. But we're not in a position to guarantee that the dividend will remain at any level."

The next AEP board meeting where the dividend would be voted on is Jan. 22.

"If the common dividend reduced by 25%, we estimate a $1.73 boost for the mandatory convertible," said Kimberlee Brody, convertible analyst at Wachovia Securities, in a report Thursday.

She said, with all else equal, the mandatory is 3.81% rich with the current $2.40 dividend.

With the dividend at $1.80, she said it would be 0.98% cheap.

Those valuations put the mandatory's fair value at $34.77, assuming a credit spread of 200 basis points over Treasuries, 36% volatility in the stock and the 7.11% current yield on the common. Also, the valuation is based on the mandatory at $36.15 and stock at $25.30.

AEP shares closed Thursday down 43 cents at $25.80 and the mandatory ended down 0.48 at 36.63.

Moody's downgraded AEP's senior unsecured rating to Baa2 from Baa1 and put its commercial paper under review for possible downgrade, as well as keeping the long-term ratings on review for possible downgrade.

Along with the "high dividend payout ratio, which reduces financial flexibility," Moody's said the downgrade and continuing review reflect declining earnings and operating cash flow, weaker operating performance relative to debt obligations and a continuing financial drag from the large energy trading business.

Volatility in AEP's operating performance and working capital requirements partly result from its large trading and marketing platform, Moody's said. While the company has decided to exit the speculative energy trading business, Moody's expects the actual unwinding could take at least two years.

Moody's said, though, that it does not expect AEP's ratings to fall below investment grade.

AEP said in a statement late Wednesday that it is encouraged that Moody's recognized its strong liquidity, despite the downgrade.

"Although we are disappointed with the negative actions taken by Moody's, there were several important positive observations in their report," said AEP chief financial officer Susan Tomasky in the statement.

AEP has some $1 billion in commercial paper maturing by year-end and another $500 million has already been placed beyond year-end.

The company also has $5 billion available in its liquidity portfolio, which it plans to draw on to have sufficient cash on hand to retire commercial paper maturities if necessary.

Merrill Lynch & Co. utility analysts Steven I. Fleishman, Sharina M. Chowdhury and Elizabeth A. Parrella said in a report that they also viewed the Moody's comment "as a suggestion to AEP that it reconsider its dividend policy."

"The credit had been on review for potential downgrade by Moody's since last spring, so this comes as no surprise. The tone of Moody's comment, however, was somewhat more negative than expected in a few key respects.

"Management reiterated its support for the $2.40 dividend in the recent past. While we do not believe any negative action on the dividend is imminent, we continue to view it as having a degree of risk," the Merrill analysts said.

"We also would note that should AEP elect to issue equity in order to enhance financial flexibility/shore up its credit ratings, a dividend cut might become more likely given the higher cash dividend requirement."

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