Corporations Take Advantage of Low Yields
Considering the uncertainty in future tax policy driven by the fiscal cliff negotiations, we suspect there will be one last push of new bond issues as corporations evaluate debt-funded special dividends.
It was a relatively quiet week in the secondary market as the real action was once again in the new issue market. The average credit spread in the Morningstar Corporate Bond Index tightened 2 basis points last week to +145, which brought the spread down to its average level over the past two months. The average yield of the Morningstar Corporate Bond Index dropped to 2.58%, matching its lowest level since the index's inception in 1999.
Corporations took advantage of low interest rates as those issuers for which we provide credit ratings priced approximately $25 billion of debt. This new debt was easily absorbed by the marketplace, and new issuers generally traded well in the secondary market. Considering the uncertainty in future tax policy driven by the fiscal cliff negotiations, we suspect there will be one last final push of new issues this week as corporations evaluate debt-funded special dividends in order to return cash to shareholders before the tax rate on dividends increases. In addition, the new issue window will close for the holidays after this week, shutting the market for the rest of the year.
Intel's (INTC) (AA) $6 billion bond placement made it the biggest issuer last week. The offering provided yet another indication that investors are shunning any firm with heavy exposure to the PC market. The firm's 10-year notes priced at a spread of 115 basis points over Treasuries, 10 basis points wider than AT&T's (T) (A-) new 10-year issuance last week. Our rating on Intel reflects the strength of the firm's balance sheet, solid cash flow, and continued dominance of the microprocessor market. Following the new debt issuance, the firm now holds $21 billion in cash and investments versus about $13 billion in debt (less than 0.6 times EBITDA).
While Intel will certainly continue to buy back stock, it could, if it chose, repay its entire debt load solely out of cash flow in about three years while also funding its dividend. AT&T also generates steady cash flow, but it carries far greater leverage today and recently indicated a willingness to take net leverage higher still to 1.8 times. That ratio ignores the firm's sizable pension obligations. Investors have clearly placed more weight on potential disruption in the PC market than any risk to AT&T's business. We expect both firms will successfully navigate the challenges in front of them, but each still face risks to future cash flow.
New Issue Notes
AT&T Issuance Looks Modestly Attractive, Especially Relative to Verizon (Dec. 6)
AT&T (T) (A-) plans to tap the bond market for the second time this year, looking to issue 3-, 5-, and 10-year notes. The firm's bonds have underperformed rivals Verizon (VZ) (A-) and Comcast (CMCSA) (A-) since its Nov. 7 investor day. AT&T announced an increase to its capital spending budget over the next three years and raised its leverage target.
With the spreads on its debt roughly 30 basis points wider than a month ago, we now view AT&T's existing bonds as close to fair value. However, we continue to prefer Comcast debt at equal or greater spreads to AT&T. For example, we'd rather hold Comcast's 3.125% notes due 2022, currently trading at a spread of about +103 basis points over Treasuries, than AT&T's 3.0% notes due in 2022, currently at around +95 basis points. Whisper talk on the new AT&T 10-year note is +110 basis points, which would be modestly attractive, in our view, if it holds. We would also strongly prefer the new AT&T notes to Verizon. Verizon's recently issued 2.45% notes due in 2022 currently trade at about +77 basis points. AT&T debt is similarly attractive relative to Verizon's at shorter maturities. Whisper talk on the new 3- and 5-year notes is +62.5 and +87.5, respectively, a pickup of around 30 basis points versus Verizon notes of comparable maturity.
With regard to AT&T's recent capital spending announcement, we believe that the firm is taking steps that will improve its long-term competitive positioning, especially if it can successfully alter the cost structure of the fixed-line business. To ensure flexibility during this investment period, management introduced a new leverage ceiling 1.8 times EBITDA, up from its prior 1.5 times target. Bond investors have latched onto this increased leverage figure as a point of concern, but we point out that management has committed to maintaining its current credit ratings (weak to mid-A). Importantly, the firm expects that it will generate ample cash flow over the next three years to fully cover its dividend. As a result, any increase in leverage should come largely at management's discretion around share repurchases. Also, we view capital spending announcements such as this as one of the risks inherent in the telecom business. Keeping pace with customer demand and competitive pressure is an undertaking fraught with uncertainty. This sort of risk weighs on our credit rating relative to what one might otherwise expect given the stable, recurring cash flow that telecom carriers tend to produce.
New Cliffs Debt Likely to Carry Fat Coupon, But We'd Exercise Caution With This Falling Knife (Dec. 6)
U.S.-based miner Cliffs Natural Resources (CLF) (BBB-/UR-) is in the market today looking to place $350 million in new 5-year debt. Judging by prevailing spreads on existing notes (2020s indicated at +441 basis points and a yield of 5.4%), the bonds are likely to carry a comparably hefty coupon, at least by today's standards. Nonetheless, we'd be very wary of the offering based on our negative medium-term price outlook for iron ore and metallurgical coal. As a comparably high cost producer of both commodities, a less favorable price environment would have major consequences on cash flows, resulting in a material deterioration of key credit metrics.
We understand the bonds will carry a provision for a coupon bump in the event either S&P or Moody's downgrades the company. The coupon would increase 25 basis points for each downgrade to a maximum bump of 100 basis points. Moody's rates Cliffs Baa3 (negative outlook) and S&P rates Cliffs BBB- (negative outlook). We recently placed our BBB- issuer rating under review for downgrade as we reassess the likely implications of our fairly negative long-term outlook for iron ore and metallurgical coal prices on the company's credit quality. While we admit no special insight on the decision-making process at the agencies, we'd expect downgrades into speculative grade territory should our commodity price outlook come to pass.
Cliffs ended a rough third quarter on the operational front with $3.9 billion in gross debt on its books and $36 million in cash. EBITDA in the 12 trailing months was $1.5 billion, putting gross leverage at 2.3 times. We expect this measure of leverage to tick higher in the quarter to come as the high iron ore prices enjoyed in prior quarters roll out of the denominator and low prevailing iron ore prices roll in.
Our principal concern resides in the medium- to long-term time frame, when we expect that a combination of rising iron ore supply from lower-cost producing regions (i.e., Australia and Brazil) and tepid Chinese steel production growth will push prices to levels where comparably high-cost Cliffs finds strong profits much harder to come by and balance-sheet strength more difficult to maintain.
Specifically, we see benchmark prices for iron ore, far and away Cliffs' most important commodity, falling to $90 per metric ton by 2015 (2012 dollars) compared with a price of $169 in 2011 and roughly $128 this year. This would make for very rough sledding at Cliffs, where cash costs averaged $78 in the most recent quarter. For benchmark metallurgical coal, we forecast prices falling to $160 per metric ton by 2015, down from an average of $289 per metric ton in 2011 and $209 this year.
NetApp Notes May Provide a Nice Opportunity (Dec. 5)
NetApp (NTAP) (A+) is in the market looking to issue 5- and 10-year notes, likely to replace $1.3 billion of convertible notes that mature next June. We've seen several pockets of opportunity among technology hardware firms recently and this issuance may provide another. Based on comparable trading levels, we would expect NetApp's new 10-year notes to price modestly inside 200 basis points over Treasuries (whisper talk is around +187.5 basis points), a level we would view as very attractive. Based on our rating, we would put fair value on these bonds around the +100 basis points level.
NetApp holds $5.6 billion of cash and investments, though only $2.5 billion of this amount is available in the U.S. Rather than deplete domestic cash, NetApp looks to be taking advantage of currently low interest rates to replace the maturing convertibles, its only outstanding debt issue. In addition to a solid balance sheet, our rating on NetApp reflects our view that the firm is well positioned to benefit from the inexorable growth in data storage demand. Though economic headwinds have pressured growth recently, NetApp's solid portfolio of midrange products has enabled it to produce steady growth and cash flow over the past several years. The firm will need to use acquisitions to ensure that it stays at the forefront technologically. But future deals are likely to be on the small side, easily financed out of NetApp's large cash balance or cash flow. NetApp recently authorized an additional $1.5 billion share-repurchase program, but it has historically used buybacks to primarily offset stock-based compensation.
NetApp's existing convertible notes don't provide much insight into where its new 5- and 10-year notes should trade. The technology hardware industry has bifurcated in recent months, with the strongest firms trading relatively tightly and weaker firms trading very wide. Juniper Networks (JNPR) (A) provides a reasonable comparable to NetApp as it is also cash rich and focused on a narrow slice of the hardware industry. Juniper, however, falls in the "shunned" camp in the industry. Its 4.60% notes due 2021 currently trade at a spread of about 235 basis points over Treasuries, a level appropriate for a weak BBB rated issue based on spreads within the Morningstar Industrials Index. We recently recommended overweighting Juniper bonds. Dell (DELL) (A+) also fits fairly well as a comparable for NetApp, though the firm's heavy PC exposure is considerably less attractive than NetApp's storage portfolio. Dell's 4.625% notes due 2021 currently trade at about +215 basis points.
With Weak PC Demand Pushing Spreads Wider, We Like Intel's New Issue (Dec. 4)
Intel (INTC) (AA) is planning a benchmark-size offering of 5-, 10-, and 30-year notes, marking the firm's second debt offering over the past 15 months. Before these debt offerings, Intel's balance sheet included only a handful of smaller convertible issues. The $8 billion acquisition of McAfee, a $3 billion investment in ASML (ASML) (A-), and heavy share repurchases have also cut into the firm's cash balance over the past two years. At the end of the third quarter, cash, investments, and trading assets stood at $15 billion, down from $26 billion at the end of 2010. Still, we believe Intel possesses a solid balance sheet, with gross debt of about $7.2 billion.
In addition, we view the firm's position in the microprocessor market as virtually unassailable at this point, and we expect that its position in the broader semiconductor industry will enable it to navigate the maturation of the PC market successfully. Even with the new debt issuance, the proceeds of which will likely be used to maintain domestic cash and fund share repurchases, the balance sheet will remain in excellent shape given that the firm has generated more than $23 billion in EBITDA and $8.5 billion of free cash flow over the past year.
Spreads on Intel's existing bonds have widened considerably more over the past month than other large-cap tech companies with similar ratings, likely on continued weak PC sales at firms like Dell and Hewlett-Packard (HPQ) (BBB+). The firm's 3.3% notes due in 2021 currently trade at a spread of 95 basis points over Treasuries, about 30 basis points wider than a month ago. At current levels we view Intel bonds as attractive. For comparison, IBM's (IBM) (AA-) 1.875% notes due 2022 currently trade at +70 basis points, only about 15 basis points wider than a month ago. We view the current gap between Intel and IBM as too wide. Other relevant comparables, all trading tighter than current Intel levels, include Cisco's (CSCO) (AA) 4.45% notes due 2020 (+89 basis points), Oracle's (ORCL) (AA) 2.50% notes due 2022 (+75 basis points), and Google's (GOOG) (AA) 3.625% notes due 2021 (+80 basis points). Any new issue concession would (make Intel's new notes all the more attractive, in our view.
ConocoPhillips to Issue 5-Year and 10-Year Notes in Benchmark Size (Dec. 4)
ConocoPhillips (COP) (A) announced Tuesday that it plans to issue 5-year and 10-year notes in benchmark size for general corporate purposes. Based on our rating, ConocoPhillips' leading position and balance sheet discipline, we believe fair value on the new issues is +50 basis points for the 5-year, and +80 basis points for the 10-year. Comparables within our coverage universe are leading E&P companies Apache (APA) (A+), which we view as a weak A+ due to increasing debt levels, and EOG Resources (EOG) (A). Similar to ConocoPhillips, we rate both with a narrow moat.
Apache's newly issued 2.625% notes due 2023 recently traded at a spread of +93 basis points over the 10-year Treasury, which we view as fair value given Apache's weakening credit metrics. EOG's 5.875% notes due 2017 traded at a spread of +48 basis points over the 5-year Treasury, while its recently-minted 2.625% notes due 2023 traded at a spread of +85 basis points over the 10-year Treasury. We view EOG's spreads as close to fair value based on the company's strong production gains in the third quarter.
Following the spin-off of its refining assets in May 2012, ConocoPhillips ranks as the largest U.S.-based independent exploration and production company. Based on its resource potential and production costs, we award ConocoPhillips a narrow economic moat. As a result of lower oil and gas prices, we anticipate that capital expenditures will outstrip operating cash flow in 2012 and 2013. Showing balance sheet discipline, management has sacrificed share repurchases so that asset sales can make up the funding shortfall, while the company maintains its healthy dividend.
HCA Funding Special Dividend With New Debt Issue (Dec. 3)
HCA (HCA) (B+) is in the market today with $1 billion worth of 8-year noncallable senior notes that will fund a special dividend. While we don't anticipate changing our credit rating, leverage will rise to about 4.5 times adjusted EBITDA including this new issuance and the special dividend. Given the firm's ongoing need to tap the market for debt refinancing going forward, we don't think this capital allocation decision was wise from a debtholder's perspective.
Also, we don't think debtholders will be paid enough for the risks they take on with HCA's new notes. In general, we think HCA's existing notes trade too tight for the risk, and we prefer Tenet (THC) (B) in the high-yield hospital sector. We'd note that HCA and Tenet score identically in their Business Risk and Cash Flow Cushion pillars, but Tenet operates with a bit more debt than HCA, which cuts into Tenet's Solvency Score and Distance to Default. However, we think the credit ratings for HCA and Tenet could converge over time depending on their financing activities. Given that potential, we think HCA's notes are trading too tight relative to the risk. For example at the end of last week, HCA's recently issued 5.875% senior unsecured notes due in 2023 were indicated at a yield of 5.40% and a spread of 378 basis points compared with Tenet's recently issued 6.75% senior unsecured notes due in 2020, which were indicated at a yield of 6.53% and spread of 552 basis points. Although both bonds are subordinated to secured debt, we view Tenet's pricing as closer to fair value in the hospital sector and would place fair value for a new HCA 8-year offering around 6.00%-6.25%, or about 475-500 basis points over Treasuries. If HCA's new notes are priced significantly inside those levels, as we suspect they might be, we'd avoid them.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.