Quarter-End Insights
Credit Sector Roundup
Banks
We expect the bifurcation in bank results we predicted last quarter to continue in the new year, as the strong get stronger while the weak face increased pressure to improve results or sell out to better-positioned rivals.
While continued divergence in earnings could result in gains for the equities of healthy, narrow- and wide-moat banks (and declines in the stock prices of struggling lenders), this thesis is not so easy to play in the credit space for two major reasons:
First, capital positions at the strongest banks are now nearing sufficiency, if not building to excess. As a result, we expect some banks to actively start returning capital to shareholders in the form of dividends or stock buybacks. Though good for equity investors, this type of activity will mean an end to the improvements in capital position that have benefited banks from a credit analysis perspective in recent months.
Second, we believe M&A activity in the sector is likely to heat up partly due to the same phenomenon. Purchases of weak banks by stronger rivals--such as M&Ts (ticker: MTB, rating: BBB+) pending acquisition of Wilmington Trust (ticker: WL, rating: BB+)--could conceivably have a neutral to negative effect on the credit quality of buyers while drastically reducing the risk of the sellers' bonds, assuming the deal takes place prior to outright failure. Now that the writing is on the wall for many struggling banks, we expect more "distressed" deals to happen without the intervention of the FDIC, especially if the laggards' stock prices decline significantly in response to weak fourth-quarter results. Thus, the bonds of weaker banks may actually offer a better risk/reward trade-off than those of the strong, in contrast to our typical views on investments in the equity portion of the capital structure.
Basic Materials
For most companies with direct exposure to emerging-markets growth, free cash flow is easy to come by, and balance sheets continue to strengthen. Mining firms fared particularly well in the fourth quarter, despite recurring worries that the Chinese government would take meaningful action to tamp down on the country's arguably overheated growth rates. Barring a setback in emerging-market growth, we're unlikely to see a significant drop in industrial metal prices in the first quarter of 2011, which should bolster the balance sheets of big miners like Freeport-McMoRan (ticker: FCX; rating: BBB), Southern Copper (ticker: SCCO, rating: BBB+), Teck (ticker: TCK, rating: BBB-), Vale (ticker: VALE, rating: BBB+), and Xstrata (ticker: XTA, rating: BBB-).
We continue to believe that, in contrast to the last cycle, massive M&A deals in mining will prove to be the exception rather than the norm. The memory of the late 2008 commodity price collapse, which imperiled the balance sheets of many firms that had levered up to undertake big acquisitions, is far too fresh in the minds of the industry's CEOs and CFOs. Rather, we expect free cash flows to find their way into organic expansion projects, which, all else equal, tend to be less risky endeavors from a credit perspective, owing to the gradual nature of the cash outflows.
By contrast, companies dependent upon the fortunes of OECD economies tended to muddle along, though we do see potential for improvement in some pockets in the developed world. Take the U.S. steel sector. In the past few weeks, multiple rounds of price increases were announced by U.S. steelmakers on nearly all products, and early indications are that these price hikes are sticking, with some order books closed until February. While steel demand is recovering at an admittedly slow pace, inventories are rather lean, and there isn't much blast furnace capacity sitting idle. Balance sheets at AK Steel (ticker: AKS, rating: BB-), Steel Dynamics (ticker: STLD, rating: BB), and U.S. Steel (ticker: X, rating: BB+) are poised to benefit. We have a similar outlook for aluminum, but the downside risk to aluminum producers is greater as the industry continues to suffer from massive overcapacity and plenty of excess inventories. In the absence of permanent capacity reductions, there is only a little room for aluminum prices to climb in the next year. We continue to hold a more bearish credit view of big aluminum producers like Alcoa (ticker: AA, rating: BB+) than the big rating agencies (S&P is BBB-, Moody's is Baa3).
Consumer Cyclical
As 2010 comes to a close, most firms on our consumer cyclical coverage list have started to see the light at the end of the tunnel. Higher consumer confidence levels have led to firming demand at retailers and restaurants, and advertising spending continues to rise, bolstering media companies.
As they brush off the balance sheet concerns that surfaced during the recent credit crisis, we expect management teams to prioritize capital spending first on organic growth and/or acquisitions, and second, on returning value to shareholders through increased dividends and share repurchase activity. We should have a resolution to the potential Wendy's/Arby's (ticker: WEN, rating: BB) transaction discussions early in 2011, and we see potential for a Saks (ticker: SKS, rating: B) takeout. We would discourage bond investors from these two names as not all their bonds have change-of-control provisions, and therefore would likely become impaired under a leveraged buyout scenario. While many companies have favored bondholders by strengthening the balance sheet, we believe there will be a shift toward equityholders through increased dividends and share buybacks. Our fear is that this will trickle down to the lower credit qualities on our coverage list--which is exactly where it shouldn't be.
We expect consumer cyclical companies to continue to opportunistically access the credit markets to fund share repurchases and acquisitions, and for credit spreads to tighten, leading to a continued low-coupon credit environment. Treasuries have widened from recent lows, but coupons are still much lower than the historical 10-year average. We believe the persistent flight to quality that allowed stellar companies such as Wal-Mart (ticker: WMT; rating: AA) and McDonald's (ticker: MCD, rating: AA-) to issue debt with credit spreads well inside of the average for their respective credit qualities will fade in 2011. In our view, as investors gain more comfort with an improving economy, the demand for high-quality bonds relative to lower-quality should back off, which would cause weaker credit spreads to tighten and perhaps stronger credit spreads to widen slightly. In the consumer cyclical sector, we assert that International Speedway (ticker: ISCA, rating: A-), R.R. Donnelley (ticker: RRD, rating: BBB-), and Macy's (ticker: M, rating: BB+) offer attractive opportunities for bond investors.
Consumer Defensive
While we see value and the potential to outperform in several credit-specific situations, overall we expect credit spreads in the consumer defensive sector to underperform. As spreads in this sector are already tight, bonds have little room to benefit from a spread tightening environment or generate enough yield to benefit from a "muddle along" environment, where spreads remain unchanged. For those bearish on corporate credit, overweighting this sector would allow investors to outperform the credit benchmarks as spreads would not widen as quickly or to the same degree as a general index.
We expect the credit improvements we enjoyed in 2010 will subside. 2011 will be a tougher year for consumer product companies as the pace of credit improvement slows and bondholders will need to invest carefully in this sector to side-step potential credit deterioration. Firms in this sector face tough year-over-year comparisons, inflation headwinds, and struggling low-end consumers. We expect pricing power will be constrained as firms will be challenged to raise prices without negatively impacting volumes and profitability. As we also expect heightened shareholder activism and LBO activity in this sector, we recommend investors conduct covenant reviews to identify bonds with greater downside protection and steer away from those bonds that do not.
While the sector as a whole may be trading tight, there are several interesting credit-specific situations. For example, due to potential event risk as the FDA is investigating menthol tobacco, the credit spread for bonds issued by Lorillard (ticker: LO, rating: BBB) is wide as compared to the firm's credit metrics and Morningstar rating. In our opinion, we do not expect the FDA to make substantive changes to the menthol category. As such we would expect the credit spreads to tighten significantly after the FDA review is released. We're also bullish on Ralcorp (ticker: RAH, rating: BBB+), which recently issued debt to fund an acquisition. We expect that the firm will reduce leverage to pre-acquisition levels by fiscal year-end 2012 and that the credit spread will tighten as credit risk declines.
Energy
We expect near-term credit deterioration for E&P companies focused primarily on gas-directed drilling, as low 2011 gas prices weigh on 2011 cash flows. We could also see some borrowing base contraction for E&P companies with gas-weighted portfolios, too, as the futures curve suggests lower gas prices in 2011 compared with 2010. Looking beyond next year, we think natural gas pricing fundamentals should improve, leading to a wave of long-awaited credit enhancement in 2012 and beyond, which could make 2011 an interesting year to consider gas-weighted E&P debt securities. Alternatively, oil weighted firms appear set for credit improvement in 2011, as both cash flows and borrowing bases benefit from higher oil prices in the next year.
A combination of low gas prices, high service costs, less drill-to-hold acreage pressure, and weak internal cash flow generation at E&P companies will sap the desire and ability to perpetuate the presently high active gas rig count. Although this still argues for a weak gas price in 2011, it should set up better fundamentals for gas in 2012 and beyond. Near-term oil price fundamentals continue to contrast sharply with gas fundamentals, and we think the market is largely factoring in better times ahead for those exposed to oil. Given what we know of megaprojects ramping up over the next 12-18 months, and barring a collapse in demand due to economic weakness, marketplace fundamentals appear to support another near-term oil price spike.
Given all of the pain being experienced by gas-oriented E&P companies, it's somewhat unusual to note that U.S.-focused oil and gas services companies have experienced a period of incredible pricing power in 2010. Service company consolidation and high oil and natural gas liquids prices combined with a desire to drill-to-hold gas prospective acreage (even despite low gas prices), have contributed to strong services demand from the U.S. E&P companies and exceptional pricing power for the services companies. Many E&P companies have thus felt the squeeze from both ends--lower gas selling prices and higher services costs, and earnings power has suffered. We think these dynamics are unsustainable longer term. Much like we expect higher gas prices in a few years, we question the ability for services companies to maintain present pricing power well beyond mid-year 2011.
Health Care
Last quarter, we theorized that depressed share prices at both established and developing health-care firms would encourage two activities--share repurchases and acquisitions--because those activities help established health-care operators boost earnings growth expectations during uncertain times. We saw that theory come to fruition in recent months particularly at medical device and equipment firms, where weak volumes and potential regulatory changes continue to pressure shares. We lowered our credit ratings on Baxter (ticker: BAX, rating A+), Becton Dickinson (ticker: BDX, rating: AA), Stryker (ticker: SYK, rating: AA), Thermo Fisher (ticker: TMO, rating AA), and Zimmer (ticker: ZMH, rating: AA) recently to reflect increasing cash outflows for acquisitions and share repurchases. All of the above firms remain low risk credits, in our opinion, but their cushions to ensure debt repayment are being reduced somewhat by managers looking to capitalize on attractive investment opportunities with those activities.
Going forward, we think acquisitions and share repurchases may continue, at least for a little while. In fact, we've seen leveraged buyout firms sniffing around some of our medical device and equipment companies in recent weeks, including Beckman Coulter (ticker: BEC, rating: BBB) and Smith & Nephew (ticker: SNN). There may be a relatively short remaining window for action, as we expect an improving economy and more certainty around regulations to boost the outlook for many health-care firms in 2011.
We currently see signs of an improving economy, and if the economic and employment situation solidifies, we'd expect demand for health-care products and services to increase from currently depressed levels, which could buoy shares in the sector. We also look forward to hearing from the Food and Drug Administration in the near future on how a widely used approval pathway for medical devices could change. We'll keep a close watch on the final ruling, as the cost and time associated with launching new technology looks set to change somewhat.
Industrials
We largely expect the trends we have seen in the fourth quarter to carry into the first quarter, which suggests continued modest improvement in credit fundamentals and the potential for additional spread tightening. We expect early- and mid-cycle industries will continue to outperform, while late-cycle industries are just now getting started in their recovery.
We continue to have favorable short-term views of the airline, aerospace, auto, trucking, and diversified industrials space. We have a more tepid short-term view of the housing and building materials sectors, for example, but believe these sectors may be in the process of healing as well. As such, we find some of the better yields in the latter sectors (including our Best Pick Lennar LEN, rating: BB) and are fairly sanguine about the long-term prospects. With liquidity generally strong, we are comfortable trading down in quality into the lagging sectors, which should outperform once the cycles turn. We are also cautious on the high-grade defense firms as ongoing uncertainty about defense spending is compounded by tight trading levels. We also expect further supply in the space as L-3 Communications (ticker: LLL, rating: BBB+), for one, looks likely to come to the market with potentially a $2 billion-plus offering to address some subordinated debt coming due or callable (our yield-to-call Best Pick).
We expect that firms will continue to be aggressive in issuing new bonds to redeem high coupon debt and/or extend maturities. Northrop (ticker: NOC, rating: A), for example, issued $1.5 billion of new five-year, 10-year, and 30-year bonds at average rates of about 3.5% to tender for bonds with 7%+ coupons. Bombardier (ticker: BBD, rating: BBB), Polypore (ticker: PPO, rating: BB-), and Tenneco (ticker: TEN, rating: BB) are examples of companies which issued longer-dated, lower-coupon bonds to call or redeem shorter-dated, higher-coupon bonds. These transactions are typically accretive to earnings and improve firms' credit profiles as interest expense is lowered (and thus interest coverage improved), while our Cash Flow Cushion improves as maturities are extended. With Treasury rates ramping up substantially in the quarter, however, these types of transactions may be less attractive, although we expect to continue to see select refinancing activity. That said, bondholders of short-dated maturities can often realize excess returns as these securities are taken out for a premium ahead of maturity. Thus we tend to focus on short-dated maturities for these opportunities combined with long-term maturities, which may provide the best yields.
Technology
Technology spending has remained strong lately and cash continues to pour into firms' coffers faster than it can be spent. All told, we calculate that cash on hand among the tech firms we've rated to date now stands north of $250 billion. As a result, credit quality has generally improved across the board, but we are seeing a growing divergence between certain of the sector's giants, with clear delineation by economic moat.
Wide-moat firms like Oracle (ticker: ORCL, rating: AA), Cisco (ticker: CSCO, rating: AA), Microsoft (ticker: MSFT, rating: AAA), and IBM (ticker: IBM, rating: AA-) continue to enjoy phenomenal access to the capital markets, though they certainly don't need the cash. IBM, for example, issued $2 billion in new debt during the fourth quarter, including 18-month floating rate notes at 3 basis points over LIBOR (yes, 0.03%) and five-year notes at 55 basis points over Treasuries. While we have little doubt that the firm will continue to spend heavily on acquisitions, these debt offerings can only be viewed as opportunistic: IBM generated more than $3.5 billion in free cash flow during the third quarter and ended the period with more than $11 billion in cash and investments on hand.
On the other side of the coin, no-moat firms like Nokia (ticker: NOK, rating: A-) and Dell (ticker: DELL, rating: A+) have seen trends move against them in recent years. We downgraded Nokia's credit rating back in June, and our concerns at the time--the firm's poor smartphone strategy and growing competition for low-end customers--are just as worrisome now. While Nokia has managed to return to growth in its wireless phone segment, margins continue to get squeezed and free cash flow barely topped EUR 250 million during the third quarter. The market has taken a dim view of the firm, with its dollar-denominated debt hitting about 170 basis points over Treasuries recently, significantly wider than our rating would suggest.
With the strongest tech giants offering investors skimpy spreads, we think the best place to look for credit opportunities is among smaller, but competitively advantaged, firms. Analog chip makers, including wide-moat rated Linear Technology (ticker: LLTC, rating: A+) and Maxim Integrated Products (ticker: MXIM, rating: A+), fit this bill nicely. Also, semiconductor equipment maker KLA-Tencor (ticker: KLAC, rating: A+) currently sits on our best ideas list.
Utilities
There were two dominant themes in utility credit in the fourth quarter of 2010: M&A and robust bond issuance. Looking ahead, we anticipate that the pace of M&A will slow as we believe that the lion's share of this most recent wave of acquisition activity is behind us. However, despite the recent back up in Treasury rates, we expect to see a continued heavy forward calendar as utility issuers look to extend maturities while rates and spreads are still relatively low. Overall, we expect credit spreads in the utility sector to underperform.
The flurry of M&A activity in the fourth quarter began with a $9.5 billion all-stock merger announced in October between Northeast Utilities (ticker: NU, rating: BBB) and NSTAR (ticker: NST, rating A), which will create one of the largest fully regulated utilities in the United States. In November, we saw the closing of PPL's (ticker: PPL, rating: BBB) $7.6 billion acquisition of Kentucky Utilities and Louisville Gas & Electric from E.ON (ticker: EONGY, rating: BBB+), representing the largest acquisition in the utility sector since Iberdrola (ticker: IBE) bought Energy East in 2007 for $8.6 billion. In December, AGL (ticker: AGL, rating: BBB+) made an aggressive grab for gas infrastructure with a $3.2 billion part-cash, part-stock acquisition of Nicor (ticker: GAS, rating: A-). Finally, Dynegy (ticker: DYN, rating: suspended) remains a key target after Blackstone's failed buyout attempt in the fall. We continue to believe a debt exchange or bankruptcy reorganization are the likely outcomes for Dynegy bondholders.
On the bond issuance front, we saw an extremely busy fourth quarter as issuers looked to take advantage of the low interest rate and tight spread environment. In terms of large issuances, in November, PPL went to market early in the month with $2.9 billion of debt issues to complete the permanent financing of the previously mentioned acquisition of Kentucky Utilities and Louisville Gas & Electric. The offering included $1.035 billion of 30-year first mortgage notes, which priced at a spread of just 108 basis points over 30-year Treasuries, highlighting the level of investor demand for utility paper. In Europe, EDF (ticker: EDF) raised EUR $1.5 billion with coupons averaging 4.25%. Overall, we estimate that over $15 billion of utility bonds priced in the fourth quarter.
From an operating perspective, we expect to see several earnings headwinds during the next year as a result of a subdued demand outlook and normalized weather. Increasing maintenance and capital expenditures to upgrade and replace infrastructure to meet tougher environmental regulations, energy efficiency standards, and renewable energy requirements also could be headwinds that utilities will face over the intermediate term. While there may be some upside in the near term for investors in utility bonds, we believe downside risks still outweigh upside return potential in the sector.
Our Top Bond Picks
We pick bonds on a relative value basis. Typically, this means comparing a bond's spread against spreads on bonds that involve comparable credit risk and duration.
When selecting from bonds of different maturities from a single issuer, we weigh a variety of factors, including liquidity, our moat rating (we're willing to buy longer-dated bonds from a firm with a sustainable competitive advantage), and our year-by-year forecast of the firm's cash flows in comparison to the yield pick-up along the curve.
| Top Bond Picks | |||||||
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| Ticker | Issuer Rating | Maturity | Coupon | Price | Yield (%) | Spread to U.S. Treas | |
| |||||||
| Medco | MHS | A | 2020 | 4.13% | $96.10 | 4.63% | 129 |
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| International Speedway | ISCA | A- | 2014 | 5.40% | $106.7 | 3.36% | 236 |
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| Lorillard | LO | BBB | 2019 | 8.13% | $110.7 | 6.47% | 313 |
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| Actuant | ATU | BBB- | 2017 | 6.88% | $102.0 | 6.33% | 463 |
| |||||||
| Advanced Micro Devices | AMD | BB+ | 2012 | 5.75% | $102.0 | 4.63% | 403 |
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| Data as of 12-20-10. |
Medco (ticker: MHS, rating: A) operates with reasonable debt leverage in the attractive pharmacy benefit management (PBM) business. As the independent leader of the PBM industry, we view Medco's business model more favorably than the PBM-retail pharmacy business model that CVS Caremark operates, and our opinion is reflected in Medco's credit rating, which is two notches higher than CVS' rating. However, Medco's 2020 notes offer yields about 35 basis points higher than CVS' 2020 notes. Since we'd argue Medco notes should trade at a tighter spread than CVS notes, we'd see this as an opportunity for investors to trade up in credit quality and potential return. Medco issued its 2020 maturity in early September to refinance its credit facility and pay for an acquisition. Depending on liquidity and investor needs, we could see both of the above Medco issues as attractive for investors.
Although attendance and concessions spending has faltered during the economic downturn, we do not believe the popularity of motorsports entertainment has been permanently impaired. In addition, in spite of the macroeconomic headwinds, International Speedway (ticker: ISCA, rating A-) generated more than $3 per share in free cash flow in 2010. We assert that the firm's bonds should tighten with improving fundamentals, such as unemployment levels. In our view, the firm's primary risk is that its TV contracts will be negotiated at a lower rate in 2014--but this fact has no implication for International Speedway's bonds as they mature in 2014.
Lorillard's (ticker: LO, rating: BBB) credit metrics are the strongest of the tobacco companies, but they could be adversely impacted in the near term. The FDA is investigating menthol tobacco products and is expected to announce its findings soon. As 94% of Lorillard's revenue is generated from menthol cigarettes, its future performance depends heavily on any potential regulatory changes. We expect the FDA will impose greater restrictions on the marketing and sales of menthol cigarettes, but we think an outright ban is highly unlikely. Our rating incorporates the impacts from additional restrictions over our forecast period. In our view, the bonds have an attractive risk/reward profile. LO bonds currently trade at approximately +317 as compared with Altria at +172 and Philip Morris at +74. After the FDA review, we think LO bonds could tighten 100 basis points to +210, which is a 7 5/8 point gain. In the event FDA regulations are worse than we expect, based on our downside scenario, the bonds could widen to where BB bonds trade or +450, down 9 1/4 points. Based on our outlook on a probability-weighted basis, we think the risk/reward profile is attractive.
Our investment-grade rating on Actuant (ticker: ATU, rating: BBB-) reflects the firm's solid positioning in niche markets and relatively sound financial metrics. Actuant's senior note trades at over 200 basis points wider than the Morningstar BBB- index as well as diversified industrial comps such as Textron (BBB-), and in line with "BB" levels, offering compelling compensation for the risk. The firm's recently announced $150 million cash acquisition will add some secured revolving debt ahead of the bonds in the capital structure, but we expect this will be paid down with free cash flow and the sale of a European asset. We estimate pro forma total leverage of 2.2 times, which includes the subordinated convertibles below the bond in the capital structure. We forecast leverage to decline modestly in 2011 due to increased EBITDA and reduced revolving debt. The company continues to generate ample free cash flow, which will allow it to make smaller bolt-on acquisitions.
Advanced Micro Devices (ticker: AMD, rating: BB+) has perpetually operated at a disadvantage to far larger rival Intel, but we expect that a new generation of chips, set to launch in 2011, will allow it to recapture market share in the lucrative server segment. The firm has also taken steps in recent years to improve its financial condition, notably the spin-off of its capital-intensive manufacturing operations. The 2012 convertible notes offer a decent yield with a very low probability of financial distress before maturity, as AMD's cash balance should easily cover this obligation when it comes due. The notes are convertible at about $20 per share, a large premium to our $15 fair value estimate on the stock. If AMD starts grabbing share in late 2011 and the shares get on a roll, though, the convert option on these notes could provide nice upside.
Daniel Rohr, Joscelyn Mackay, Julie Stralow, Michael Hodel, Patrick Goff, Travis Miller, Rick Tauber, Eric Chenoweth, and James Sinegal also contributed to this report.
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