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Four Corporate Bond Picks With Upside Potential

Jeremy Glaser

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser.

It's Ideas Week and here with the best credit ideas in corporate credit are credit analysts Joscelyn MacKay and Julie Stralow.

Thanks for joining me today.

Julie Stralow: No problems, thanks for having us.

Glaser: So, Julie, first off, what do you have for us today?

Stralow: Well, I have two bond ideas. One is from AmerisourceBergen and one is from Medco. So, they are both A-rated credits. We like the business quality, and we think they line up pretty well against each other, but also within our niche, they look like really good relative value plays.

Glaser: Can you talk to us a little bit about what those companies do?

Stralow: Sure. AmerisourceBergen and Medco are both in kind of the back-end. They don't produce drugs, and they are not pharmacies. So, that's not where the end users are going. They work in the middle, between those two different suppliers and customers. And so, basically, AmerisourceBergen is a drug distributor, and it works with a variety of different drugmakers and repackages and manages inventory for them, before going off to the thousands of pharmacies across the United States that they service.

Medco is a pharmacy benefit manager, and Medco is considered the thought leader in this business, and they are also the market share leader. And what they do is they really focus on trying to keep costs lower, particularly for pharmaceutical drugs, and so they are really trying to work with their end users, which – their customers are mainly large employers and managed care organizations, and so they use all their members and employees of those organizations, and they try to make sure that they are using the right sort of drug. If there's a generic available, they want them to go on the generic. If there is a lower-price branded drug, they want to go there, and also they want to use lowest way to get the drugs, so that could be the retail pharmacy or their own proprietary mail order business. So, we like both of these businesses, they are both narrow moats, and we think their credit qualities are both at A, which is low risk.

Glaser: So, they have that low risk. Do you think that the competitive advantages between the two of them are going to stay stable over time?

Stralow: We actually think that Medco has a positive moat trend, while AmerisourceBergen actually has a negative moat trend. So when we are looking at both of those in between, I think we favor Medco just a little bit more than we would favor AmerisourceBergen. But in terms of bond picks, we think that they both look pretty good right now.

Glaser: What particular bonds of both these companies do you think investors should take a look at?

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Stralow: Well, for AmerisourceBergen we would take a look at the 2019 issue. When we compare it to another drug distributer--AmerisourceBergen's key competitor is McKesson--and it also has an A rating, and they literally look identical across the board when we look at our credit metrics.

However, AmerisourceBergen's 2019 issues trade about – well, they offer yield about 25 basis points higher than McKesson's 2019 issue. So, we think that is a good relative value play.

For Medco, it competes with actually CVS Caremark, which many people know for their retail distribution outlets, but they also have a very large pharmacy benefit management business. And we think that they have similar business qualities. However, on our other three metrics, we think that CVS rates lower than Medco, and it actually has a two notch differential in terms of being a little bit lower credit quality than Medco. But Medco's 2020 issue yields 50 basis points higher than CVS' 2020 issue. So, we think that's another relative valuation play.

Glaser: Then what are few of the risks that we need to keep in mind?

Stralow: Well, we have negative moat trend on AmerisourceBergen because it's a middleman industry: drug distribution. It could get cut out eventually in the long term. It also could just get its returns whittled away by its suppliers and customers. So, we think that that is a little bit less of a compelling business quality than say a Medco, which has a positive moat trend, and we think that its influence is growing.

Glaser: Joscelyn, what are some of the names that you think look attractive right now?

Joscelyn MacKay: Well, in my sector I think there are two consumer cyclical names that I find pretty attractive at the moment. One is International Speedway and the other is Macy's. Very different ends of the credit spectrum. International Speedway is A-minus, Macy's is BB-plus, but I see them both as very attractive absolute value plays.

Glaser: Let's start with International Speedway. People probably know them as the NASCAR racetrack owner. What are some of the credit metrics they have? Do they seem like a strong credit?

MacKay: Sure. This is a company that is very conservatively levered, and we don't think that's going to change at any time soon. The bonds have been hit pretty hard because of the downturn. Unemployment is very tied to racetrack attendance, and International Speedway's cash flows have suffered a bit because of that. But even in the downturn, the company has generated very substantial free cash flow, which coupled with a very low conservative capital structure, really leads to a lot of bond opportunities for us.

Glaser: So, what are some of those specific opportunities?

MacKay: Well, the company only has one bond outstanding and it's due in 2014. This bond trades a lot more like a BBB company. As I said, we view the firm as an A-minus credit, and I think those bonds really should tighten, and as we start to get a little bit more comfortable with the economic environment, and we start to see an uptick in employment, that's when I think that spread compression will happen.

Glaser: And then, are there any risks that they could end up having to take on more leverage or that the racetrack attendance will never come back. Is that something people should be concerned about?

MacKay: I do think that a prolonged downturn in the economy will hurt International Speedway. But this is a wide-moat firm. They own Daytona, Talladega, all the major speedways, and we don't see that wide moat eroding anytime soon.

Another big risk to International Speedway as a whole is that they're renegotiating their contracts in 2014 for their television stations. But this won't impact those bonds because they are due in the same year.

Glaser: And now moving to Macy's. I think people are familiar with the company, but might not be familiar with its credit worthiness. Can you tell us a little bit about that?

MacKay: Sure. Macy's was very negatively impacted during the economic downturn. They took on a large amount of debt as we were headed into the downturn to benefit shareholders through share repurchase activity, and this was a detriment to bondholders.

Since then the company has really focused on strengthening its balance sheet. In the past year alone the firm has paid a billion dollars in debt ahead of maturity and reduced its pension liability greatly, and we really think this has benefited bondholders because the spreads have tightened quite a bit over that time.

That said, we still think there's a lot of room for upside. Management has stated its attention of being an investment-grade credit. Macy's is BB-plus, which is right on the edge. We think if the firm continues to reduce its leverage that bump up to BBB-minus will tighten spreads.

Glaser: Which of Macy's bonds do you think are the best to play that potential tightening of the spreads?

MacKay: We focused a lot on their medium-term notes. In particular, they have a 2016 bond that trades in the mid- to high 300s. As a point of reference, investment grade bonds trade more in the mid-200s. So, if the firm does get upgraded to investment grade, there's going to be a lot of spread compression there.

Glaser: All right, Joscelyn, Julie, thanks so much for talking with me today.

Stralow: Thanks for having us.

MacKay: Thank you.

Glaser: For Morningstar.com, I'm Jeremy Glaser.\