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SCIENTECH IssueAlert, November 3, 2000
AEP Restructures, Moves Away from Distribution Focus
By: Will McNamara, Director, Electric Industry Analysis
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Earlier this week, AEP announced its plans to restructure into two companies
to support a new focus on power generation, marketing and trading. "Our
focus for moving forward, plain and simple, will be the wholesale business*
generation
and related energy assets, wholesale marketing and trading," said Dr. Linn
Draper, AEP's CEO. Draper added that AEP has no plans to expand its utility
distribution operations in the United States and overseas.

ANALYSIS: First, let's be clear about what AEP is doing. Under the 
restructuring,
one corporation will hold AEP's utility and non-utility subsidiaries whose
revenues are derived from competitive (unregulated) business ventures.
The second corporation will hold AEP's utility subsidiaries (primarily
T&D subsidiaries) that are subject to regulation by at least one state
regulatory commission, or foreign subsidiaries subject to rates or tariffs
regulation.

This announcement represents a 180-degree turn from what AEP has previously
espoused as its competitive strategy, both during and after the recent
completion of its merger with CSW. It's not so surprising that AEP would
want to focus on generating, marketing and trading, or separate its high-risk
and low-risk operations into two companies. What's most surprising about
this restructuring is AEP's move away from the T&D side of its business,
since up until a few weeks ago distribution remained a key part of AEP's
core business strategy.

For instance, when the merger with CSW was completed in June, Draper said,
"AEP's post-merger strategy consists of three key elements: wholesale,
energy delivery and retail. The two that will be most important for us
initially are the wholesale and energy delivery businesses." This made
sense because, as a combined company, the new AEP owns more than 38,000
miles of transmission lines and 186,000 miles of distribution lines. As
recently as October, this remained AEP's strategy. Draper told me in an
exclusive interview, "At least for the foreseeable future, being in the
distribution business is a good idea. We're not going to make a fortune
at it [because rates are continually going to be regulated by state 
commissions],
but AEP is going to be in the wires business." If anything, Draper questioned
whether or not AEP would remain in the retail business, as he was unsure
that AEP was "skilled enough" to succeed in this end of the business.

Thus, this seemingly sudden decision to put no further emphasis on expanding
the T&D operation is rather surprising. We can speculate about the various
reasons why AEP would be changing its path. For starters, unquestionably
AEP's wholesale generation and trading business has grown considerably
over the last two years. According to figures released this week in AEP's
Fact Book 2000 (presented at the EEI Financial Conference earlier this
week), the company's trading volumes continue to increase (2Q 2000 reflects
103.7 million/MWh, compared to 78.5 million/MWh in 2Q 1999). (Third-quarter
figures were not yet available). Regarding gross profits, for the first
six months of 2000, trading contributed $112 million, while wholesale 
marketing
contributed $138 million. On the other hand, the regulated T&D business
currently is characterized by both slow growth and a low rate of return.
Thus, it would make little sense for AEP to continue to expand this part
of its business, as further expansion would bring little value to its 
shareholders.


This theory may be supported by the fact that Draper clearly stated the
restructuring is "focused on obtaining higher profit margins in the 
unregulated
wholesale energy markets." I confirmed this with a quick call to AEP yesterday
afternoon. I was told by my contact there that from this point "any 
discretionary
cash is going into the wholesale side." By splitting the company's operations
in two, undivided attention can now be placed on growing the unregulated
side of the business, where AEP's sees the most growth for its operation.

For the most part, separating its business into two companies*essentially
one regulated and other unregulated*appears to be a smart move for AEP
as the two business offer strikingly different risk portfolios. The 
restructuring
is part of a growing trend among companies that have scale on both the
generation and T&D sides, and realize these two very different operations
attract a different kind of investor. Just recently, Reliant Energy announced
that it is initiating a similar restructuring, separating into two publicly
traded companies (one regulated and one unregulated). Reliant's decision
was motivated in part because of Texas' mandate that utilities in the state
must construct firewalls between their operating companies. In other words,
Texas utilities must have separate companies*with separate financial records*
for
energy services, distribution, generation, etc. Yet, beyond the mandate,
it is a smart move for Reliant because it can now attract two different
sets of investors*one attracted to high-risk ventures and the other averse
to them. In addition, high-risk ventures such as power generation, marketing
and trading, telecom, etc., will not have a negative impact on the unregulated
company's stock value. The same logic applies to the restructuring that
AEP has announced. Other companies that recently have spun off high-risk
subsidiaries into separate companies are Southern Company (Southern Energy)
and Xcel Energy (NRG Energy, Inc).

One difference between these examples and AEP is that AEP has not confirmed
that its two companies will become two stand-alone, publicly traded companies.
Draper has said that the company is reserving that decision until the end
of next year, the time at which he believes the restructuring will have
received all the necessary regulatory approvals (considering how long the
AEP/CSW merger took to complete, the restructuring could take longer than
a year). Draper did allude to the fact that AEP has "a number of options
to consider." This statement may or may not support speculation that the
company is planning an imminent acquisition, one that might dramatically
expand its generation portfolio and further support its trading and wholesale
marketing efforts. In addition, I think it's valid to speculate that AEP
might eventually divest itself of the T&D business altogether. Certainly,
the restructuring does not place this end of the company's business very
high on the totem pole, as it was only a few months ago.

Another question that probably cannot be answered at this point is whether
or not AEP, as a holding company, will remain under regulation from the
Public Utilities Holding Company Act of 1935 (PUHCA). After the restructuring
has been completed, AEP will have several options. It could operate as
it is now, that is with a holding company structure under which the two
stand-alone corporations would be held. Or it could issue two IPOs for
the two companies. Assuming that after the restructuring has been completed
AEP decides to issue IPOs for both its unregulated and regulated companies,
thereby eliminating a holding company entity, it is questionable whether
or not AEP would still be bound by PUHCA restrictions. This could be an
important part of AEP's strategy regarding the restructuring. As AEP continues
to compete in deregulated markets, it faces an array of restrictions under
PUHCA that, for example, Enron does not face as it is not a registered
holding company. Disengaging itself from PUHCA restrictions (assuming that
PUHCA has not been repealed by that point) would certainly offer AEP a
new level of competitive agility. However, perhaps most interesting of
all will be what AEP decides to do with its T&D business, which represents
approximately 5 million customers that are connected to AEP's transmission
system. Certainly, once this regulated business is fully separated from
the deregulated businesses, AEP will be able to do a more accurate 
cost/benefit
analysis and determine if it wants to remain in the T&D business at all.

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Sincerely,

Will McNamara
Director, Electric Industry Analysis
wmcnamara@scientech.com
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