While there were pockets of weakness earlier last week, credit spreads in the United States were generally unchanged. The average credit spread in the Morningstar Corporate Bond Index closed at +136. In our view, nothing noteworthy came about from Federal Reserve chairman Ben Bernanke's congressional testimony, and we yawned along the with the rest of the credit market as the sequester went into effect. While the sequester will affect some sectors more than others, we don't view it as having a significant near-term impact on the credit markets.
In the near term, defense contractors will probably be some of the most affected by the sequester, although to varying degrees. From a credit viewpoint, we prefer firms with exposure to commercial aerospace and long-lived defense programs as well as those issuers with larger international exposure, which will help soften the blow of domestic spending cuts. We think firms with higher reliance on information technology will be the most negatively affected by the sequester. Narrow-moat Raytheon (RTN) leads the way for global exposure with 26% of 2012 sales to international customers. Narrow-moat Boeing (BA) and wide-moat General Dynamics (GD) are right behind at 24% and 21%, respectively. Wide-moat Lockheed Martin (LMT) benefits from its positioning in long-lived tactical aircraft and also has a comparatively smaller exposure to IT spending as a percentage of sales. To the downside, SAIC (SAI) has very high IT exposure and is also splitting into two companies later this year, which makes it a strong candidate for a rating downgrade. Below, we will discuss further detail on the sequester's impact in the defense sector.
A number of consumer cyclical names reported earnings over the past week, and for the most part, management teams appear mindful of debt leverage and internal targets and stated their desire to remain within those leverage targets. While many of these firms, such as Home Depot (HD) and Lowe's (LOW), continue to focus on rewarding shareholders through share-buyback programs, they are taking a balanced approach by conducting these programs within their stated debt leverage targets. Other firms, such as Macy's (M), are deleveraging as cash flows are increasing and some firms such as R.R. Donnelley & Sons (RRD) have reduced debt outright to decrease leverage. Please see below for more detailed information.
U.S. Financials Have Finished Their Run of Outperformance
Credit spreads widened across Europe as the average spread in the Morningstar Eurobond Corporate Bond Index widened 3 basis points to +141. Credit spreads in the European financial sector experienced the brunt of the widening as represented by Markit's iTraxx Europe Senior Financials credit default swap index, which widened 13 basis points. That compares to the iTraxx Europe credit default swap index, representing the broader European corporate bond market, which widened 5 basis points.
The impetus of the weakening in credit spreads in Europe was the results of the recent general election in Italy. The election failed to produce a clear winner and resulted in a potentially unstable government. This normally would not be that large of a concern, but the election called into question the willingness of the Italian people to adhere to austerity measures required by the European Central Bank. There are beliefs in the market that the strong showings from the coalition led by former prime minister Silvio Berlusconi, as well as the coalition led by Beppe Grillo, are essentially a referendum on an antieuro platform. While the antieuro stance in Italy could be exaggerated, the election may have put the problems of Europe back on center stage as far as the markets are concerned. Italian 10-year bonds widened 50 basis points to a spread of +338 over German bonds.
We remain skeptical that the markets will receive the desired clarity out of Italy in the near term. Even if this is achieved, we think the continuing growth in nonperforming loans in Spain and Italy will most likely lead the markets to further question the stability of many European banks. As such, we expect credit spreads of European banks will probably widen, which may then lead to widening credit spreads among U.S. banks. Therefore, we are changing our outlook to a neutral view from the prior opinion that credit spread tightening among large U.S. banks would outperform other sectors. For further information, please see Jim Leonard's March 1 publication, "We Are Changing Our Outlook on Financials."
Click to see our summary of recent movements among credit risk indicators.
Sequester a Mixed Bag for Defense Credits
The passage of the Budget Control Act (August 2011) put the term sequestration into our daily vocabulary. The hope was that a group in Congress would solve the sequestration spending cuts in the fall of 2011 and pave the path for the U.S. to avoid unintended consequences. Instead, the supercommittee punted, and other members of Congress did not want to attack the issue until after the 2012 elections. Following the elections, Congress did take up the issue of tax increases, but only pushed the date of the sequester out by two months, to March 1, 2013.
The Budget Control Act of 2011 cuts defense spending by $487 billion over nine years through fiscal 2021. The reduction was calculated as the spending target changes to the president's proposed budgets of fiscal 2013 compared with fiscal 2012. Rarely do these budgets come to fruition, as Congress holds the power in these areas. Still, Congress has held the base budget for defense at around $530 billion annually for fiscal 2010 through fiscal 2013, quite a change from the prior decade that saw a mid-single-digit increase, even before war funding. Spending in conflicts from fiscal 2004 through fiscal 2012 was $1.2 trillion. For comparison, the base budget totaled $4.2 trillion. The total amount of $5.4 trillion is staggering, but the expected spending for the upcoming nine-year period from fiscal 2013 through fiscal 2021 still will total $5.1 trillion, even after the Budget Control Act cuts. Our estimate for conflict funding from fiscal 2013 through fiscal 2017 is around $230 billion, and we expect a minimal level of troops in enemy zones. The big-picture takeaway is that the announced cuts appear reasonable and are about flat for the coming nine years compared with the prior nine years.
Sequestration introduces real cuts, for multiple years. The base budget would not reach the level of fiscal 2012 until fiscal 2019, a six-year period. The history of post-conflict defense spending is consistent with this type of outcome. We think the coming period of cuts is likely to lead to a difficult sales growth environment in the industry.
We believe all defense contractors will be affected by the sequester, although to varying degrees. We like firms with exposure to aerospace, international sales, and long-lived programs. International exposure helps soften the blow of domestic spending cuts, and narrow-moat Raytheon (RTN) (A-) leads the way with 26% of 2012 sales to international customers. Narrow-moat Boeing (BA) (A-) and wide-moat General Dynamics (GD) (A) are right behind at 24% and 21%, respectively. Information technology looks to be the most affected business segment.
In our base-case forecast, which includes the full BCA and a partial impact of the sequester, we expect positive annual revenue growth through 2017 from Boeing, General Dynamics, and narrow-moat Rockwell Collins (COL) (A). GD offers good balance across its four segments, as positive contributions in aerospace (business jets) and marine offsets weakness in combat and IT. Boeing's burgeoning commercial business should continue to drive positive top-line growth, notwithstanding short-term (in our opinion) issues with the 787. Rockwell Collins benefit from strong exposure to both commercial and business jets.
In the rest of our coverage, however, we see modest annual sales declines. Raytheon's and L-3 Communications Holdings' (LLL) (BBB-) thousands of contracts offer diversification against large contract risk, but also means sales could be hit with a "peanut butter approach" to sequestration where funding is cut for contracts across the board. This is somewhat less likely for long-cycle businesses such as submarines or tactical aircraft, where funding is already in place. However, Raytheon's positions in missiles, sensors, and international should continue to provide leading margins among the prime defense contractors, offsetting some of this impact. Wide-moat Lockheed Martin (LMT) (A-) benefits from its positioning in long-lived tactical aircraft and also has a smaller exposure to IT spending as a percentage of sales. Narrow-moat Northrop Grumman (NOC) (A-) has weak international sales and high exposure to IT spending, but also good exposure to aerospace, including unmanned aircraft. SAIC (SAI) (BBB+) has very high IT exposure and is splitting into two later this year, which makes it a strong candidate for a rating downgrade.
We don't expect any rating cuts in the foreseeable future (absent SAIC), as most firms have been diligent in managing their cost structures and keeping their balance sheets strong. Still, uncertainty is significant and 2013 guidance largely excluded any impact from sequestration, so headline risk remains an issue. Investors might consider hiding out in the three names with commercial aerospace exposure until clarity on defense spending emerges.
Contributed by Rick Tauber, CFA, CPA
Focus Remains on Balance Sheet for Consumer Cyclical Companies
An abundance of consumer cyclical names have reported earnings over the past week, and for the most part, management teams appear mindful of leverage and internal targets and their stated the desire to remain within those leverage targets.
Home Depot (HD) (A) and Lowe's (LOW) (A) both intend to return a great deal of cash to shareholders, but to do so within the constraints of previously stated leverage targets. With lease-adjusted leverage at 1.7 times, down from 1.9 times at the end of 2011 and below the target of 2 times, Home Depot plans to issue debt to repurchase shares. The firm announced a new $17 billion share-repurchase authorization, with $4.5 billion planned for 2013 (up from $4 billion in 2012), and raised its dividend 34%. Still, we are still comfortable with our A issuer credit rating as we expect leverage to hover around 2 times as it has in the past.
Lowe's shareholder friendliness was at a near-term high in 2012 as the firm spent around $4.4 billion on share repurchases and $700 million in dividends, which combined is more than double free cash flow during the year. While the firm's share repurchases have exceeded free cash flow every year for the past three years, they have never been so high relative to free cash flow. However, thanks to strong earnings, lease-adjusted leverage is still within management's target of below 2.25 times, at 2.2 times.
Macy's (M) (BBB) reported another solid quarter for the period ended January. Stronger earnings and lower debt levels brought lease-adjusted leverage down to 2.2 times (from 2.4 times in the prior-year period), which management stated was at the low end of internal targets.
While we would prefer Limited Brands (LTD) (BB+) reduce its debt load as we view its leverage as high for a cyclical firm, management did not appear to want to add additional leverage to the balance sheet. The firm stated in its recent earnings call that it believes the current amount of leverage (mid-3 times) is appropriate. This level is higher than most of its retail peers and keeps its credit rating below investment grade, in our opinion. In our view, Limited Brands' excessive shareholder-friendly activities (share repurchases and special dividends) pose the greatest risk to its bondholders, and the firm is on our Bonds to Avoid list.
Despite soft results, high-yield credit Best Idea R.R. Donnelley (RRD) (BB) reduced debt by $222 million during the year, bringing leverage down slightly to 2.8 times from 2.9 times at the end of 2011. Management announced that it was bringing its leverage target down to 2.25-2.75 times from 2.5-3.0 times. We believe this is achievable in 2013, if the firm uses at least $200 million of its expected $400 million-$500 million of free cash flow to reduce debt, even if earnings remain soft.
Contributed by Joscelyn MacKay
New Issue Notes
High-Yield credit Best Idea R.R. Donnelley to Issue Debt; We Expect It to Be Attractive (Feb. 28)
High-yield credit Best Idea R.R. Donnelley plans to issue $350 million in 8-year non-call notes today, and we expect them to price attractively. The firm reported fourth-quarter results earlier this week, ending the year at 2.8 times leverage, and management reduced its leverage target to 2.25-2.75 times from 2.5-3.0 times. For background, in May 2011, R.R. Donnelley increased leverage target to 2.5-3.0 times for an accelerated share repurchase that brought leverage to 3.2 times. We believe management realized its mistake and that it needed to focus on maintaining a solid balance sheet amid a persistently difficult economic climate and the secular headwinds its industry is facing. The firm stated it would like to gradually reduce leverage, and we could see the targets reduced yet again, likely back to 2.0-2.5 times.
This issuance will be used to pay down existing debt rather than add to the debt burden. Management stated that it plans to tender for up to $400 million of its following issuances: 6.125% notes due 2017 ($525 million outstanding), 8.600% notes due 2016 ($350 million outstanding) and 7.25% notes due 2018 ($600 million outstanding), all callable with a make-whole premium. R.R. Donnelley has tendered for debt a few times over the past few years and has typically elected to pay down its higher coupon debt rather than focus on earlier maturities. Its next debt maturities are $258 million in 4.95% notes due in 2014 and $300 million 5.5% notes due 2015, both callable at a make-whole.
Having rallied quite a bit since the earnings announcement and leverage reduction, the firm's bonds yields are well wide of where an average BB issuer trades. R.R Donnelley's 8.25% notes due 2019 currently yield 7.16%, relative to Merrill Lynch's BB index at 4.67%.
We Like Rogers' U.S. Dollar Bond Issuance (Feb. 28)
Rogers Communications (RCI) (A-) plans to issue $1 billion of 10- and 30-year notes, its first U.S. dollar issuance in several years. The firm faces several U.S. dollar bond maturities over the next year, totaling nearly $1.5 billion. Initial price talk is in the range of 125 basis points over Treasuries for the 10-year offering and 155 basis points over the 30-year. At these levels, we believe the new bonds are attractively priced. For comparison, Comcast's (CMCSA) (CMCSK) (A-) 2.85% notes due in 2022, issued last month, have tightened to +97 basis points following its decision to buy the remainder of NBC Universal and ratings upgrades at the major agencies. Rogers carries net leverage of 2.3 times EBITDA, which is similar to the level Comcast will hit once the NBCU deal closes. Comcast has taken a more conservative approach to future leverage, though, implementing a muted buyback for 2013 and setting a new leverage target of 1.5-2.0 times EBITDA. Rogers has instituted a CAD 500 million buyback for 2013, which will consume the large majority of cash flow after funding its dividend payout. Rogers' leverage isn't likely to change much over the near term, as the firm targets a range of 2.0-2.5 times EBITDA.
While Rogers carries more leverage than its similarly rated U.S. peers, we believe it possesses a unique mix of cable and wireless assets that hold solid competitive positions. The Canadian wireless market is highly consolidated, and rivals have historically prioritized profitability over customer growth. The wireless business has grown more competitive, with new entrants applying some pressure, especially at the low end of the market. This competition has pressured profitability, but Rogers' margins remain among the best globally. Longer term, we expect the firm's scale and resources will enable it to maintain its strong position in the wireless market. Rogers is also a solid cable operator, with more than 60% of the households in its territory taking its television service (less than 45% penetration is typical in the United States).
FirstEnergy to Issue Benchmark 5-Year and 10-Year New Issues at Fair Value (Feb. 28)
FirstEnergy (FE) (BBB-, narrow moat) announced today that it plans to issue benchmark 5-year and 10-year new issues at parent company level. Price talk on the new issues is mid-200s for the 5-year and high 200s for the 10-year which we view as fairly valued should they come at these levels. We note that existing FirstEnergy Corp's (parent company) 6.05% senior bonds due 2021 and its 7.375% senior bonds due 2031 recently traded at 245 basis points and 291 basis points above Treasuries, respectively. In comparison, slightly higher-rated diversified peer Entergy's (ETR) (BBB, narrow moat) 4.7% senior bonds due 2017 and 5.125% senior bonds due 2020 traded at T+200 basis points and T+238 basis points, respectively. Given Entergy's modestly stronger credit quality, we believe the spread between Entergy and FirstEnergy should be 50 basis points. Thus initial price talk on the new issues is close to our fair value estimate.
FirstEnergy reported flat full-year 2012 EBITDA on Tuesday, albeit with slightly improved EBITDA margins of 23.6% versus 22.6% in 2011. While 2012 interest coverage was flat at 3.6, FirstEnergy's total leverage spiked 60 basis points to 5.3 year over year, partially resulting from its buyout of a leveraged plant lease. Moreover, FirstEnergy faces some regulatory risk in 2013 as its Jersey Central Power & Light operating utility filed for recovery of $603 million related to system destruction from Hurricane Sandy. Additionally, FirstEnergy announced that it plans to sell 1,181 MW of hydro generation in 2013. We believe the funds will used to finance the intercompany coal plant sale (Harrison Power Station) from unregulated generating company Allegheny Energy Supply to regulated utility Mon Power for $1.1 billion. The proceeds will be used for debt redemption at unregulated FirstEnergy Solutions and Allegheny Energy Supply. While liquidity totaled $3.3 billion through 2012, FirstEnergy only reported $172 million of cash on its balance sheet leaving little room for net debt reduction.
With Leverage Well Below Target, Home Depot Plans to Issue Debt to Fund Share Repurchases in 2013 (Feb. 26)
Home Depot's economic moat remains as wide as ever following robust fourth-quarter results. With lease-adjusted leverage at 1.7 times, down from 1.9 times at the end of 2011, and below the firm's target of 2 times, management stated it will issue debt to repurchase shares. Home Depot announced a new $17 billion share repurchase authorization, with $4.5 billion planned for 2013 (up from $4 billion in 2012). The firm also substantially raised its dividend by 34%. We are still comfortable with our A issuer credit rating as we expect leverage to hover around 2 times as it has in the past. We continue to view the world's largest home improvement retailer as well-positioned as both the U.S. economy and the housing market gradually improve.
Total fourth-quarter company revenue grew to $18.2 billion, a 13.9% year-over-year increase, well ahead of both our projection and management's own expectation for a high-single-digit gain. Consolidated same-store sales growth of 7% was aided by the combination of favorably warmer winter weather, and the benefit of Hurricane Sandy cleanup efforts. However, the performance is particularly impressive given that the company lapped a positive 5.7% comp in the year-ago period. Operating margins spiked to 9.6%, up 130 basis points year over year, reflecting the top-line gains as well as management's ongoing supply chain improvement initiatives.
Heading into 2013, we continue to view Home Depot as well-positioned to benefit from a cyclical recovery in consumer spending and housing-related expenditures. We believe that management's 3% comparable sales growth goal is appropriately conservative and, despite posting more than 400 basis points of operating margin expansion since the end of 2008, we think there's still more leverage inherent in the model.
Bonds trade at fair value in our view, in line with other single-A retailers. Home Depot's 4.4% notes due 2021 trade around 72 basis points over Treasuries, roughly on top of similarly rated Target's (TGT) (A) 10-year bonds. Nordstrom's (JWN) (A-) 10-year bonds trade around 93 basis points over Treasuries, which is also fair to us given the notch weaker rating. Despite Nordstrom's similar leverage at around 2 times, it is a fraction of the size of Home Depot and we think it merits a narrow economic moat relative to Home Depot's wide moat. We think home superstore peer Lowe's trades slightly cheap at 90 basis points over Treasuries, as the market has unfairly punished the retailer for increasing its leverage target more than a year ago.
Pitney Bowes Announces Tender Offer; We Would Still Avoid the Bonds (Feb. 26)
Pitney Bowes (PBI) (BBB-) today announced its intention to tender for up to $310 million of existing debt with maturities ranging from 2014 to 2016. Management intends to utilize the proceeds from a $150 million retail bond offering and existing cash to fund the transaction. The company had approximately $900 million of cash at the end of December. Although we welcome management's efforts to improve the balance sheet, we are still concerned about the longer-term trends facing the company and would avoid the bonds. We also recommend investors take advantage of the tender offer.
The bonds included in the tender offer are the 4.875% due 2014 ($450 million outstanding; maximum tender of $160 million at a spread of 50 basis points over Treasuries); the 5.0% due 2015 ($400 million outstanding; maximum tender of $100 million at a spread of +150); and the 4.75% due 2016 ($500 million outstanding; maximum tender of $50 million at a spread of +200). Although the tender will help a bit with the near-term maturity profile, the company still has a steady stream of debt maturities beyond 2016, including $1 billion in 2017 (including the 2037 putable bonds), $600 million in 2018, and $300 million in 2019. We are also concerned about Pitney's reliance on the retail market to raise funds (the company also raised $110 million in 2012). Absent renewed growth in earnings and cash flow, which we think will be challenging, we think the company's ratings could fall to below investment grade, likely eliminating this funding avenue. With institutional investors apparently disinterested in the name, refinancing headwinds could intensify over the next couple years.
Con Edison to Issue $500 Million 30-Year Notes at Fair Value (Feb. 25)
Consolidated Edison (ED) (rating BBB+, narrow moat) of New York (utility subsidiary) announced Monday that it plans to issue $500 million of 30-year bonds. Price talk is in the mid-90s, which we view as fairly valued. We view Consolidated Edison of New York as having a similar risk profile to that of its parent, Consolidated Edison, given Con Edison's single state regulatory governance (New York). Con Edison of New York's existing 4.2% notes due 2042 trade in the T+78 basis points range, which we view as rich. When compared to peer regulated utility, Xcel Energy (XEL) (BBB+, narrow moat) 4.8% senior notes due 2041, which trade in the 30-year T+102 range, Con Edison's new issue appears fully valued.
Con Edison operates two regulated utilities in New York, with the larger being Con Edison of New York followed by Orange & Rockland Utilities. While Hurricane Sandy wreaked havoc on Con Edison's system, its relatively favorable rate environment supports earnings and cost recoveries despite the near-term drain on cash. We believe Con Edison will be able to recover a significant portion of its estimated $425 million-$550 million of hurricane-related system repair costs via its next rate case. Decoupling also minimizes outage-related revenue losses as lost revenues resulting from weather are recoverable via fast-track approval mechanisms. Moreover, Con Edison benefits from more than adequate liquidity of just over $2.3 billion at the third quarter of 2012, including $1.8 billion of revolver availability and $514 million of cash, enabling it to bridge the cash drain until its next rate case.
We See Better Value in the Managed-Care Niche Than UnitedHealth's New Issue (Feb. 25)
UnitedHealth Group (UNH) (A-) is in the market today with 6-year, 10-year, and 30-year notes. The proceeds from this offering will be used for general corporate purposes, including share repurchases and potentially acquisitions. In the managed care niche, UnitedHealth sports the highest credit rating in our coverage universe due to its large, diverse revenue mix and manageable leverage. However, its notes are offered at the slimmest spreads in this niche. So while we view UnitedHealth's notes as fairly valued for its current risk profile, we see better opportunities for long-term investors in managed care peer WellPoint (WLP) (BBB+). Overall, we see the potential for ratings on these top-tier, narrow-moat managed-care companies to converge in the long run due to their similar business risk profiles and capital-allocation strategies. Therefore, the wider spreads available at WellPoint appear more attractive to us than the spreads available at UnitedHealth for long-term investors.
Based on our analysis of spreads in the managed care industry, we believe UnitedHealth's notes are fairly valued for its A- rating. Specifically, UnitedHealth's 2017s, 2023s, and 2042s were recently indicated around 57, 91, and 113 basis points over Treasuries, and we see fair value for UnitedHealth's new 6-year, 10-year, and 30-year issues around 65, 90, and 115 basis points over Treasuries, respectively. Instead of investing in UnitedHealth's new notes though, we think investors may be better served by investing in WellPoint's notes. Although its ongoing integration of the Amerigroup acquisition has increased debt leverage above historical norms, deleveraging efforts may put WellPoint on more equal footing from a leverage and coverage perspective to UnitedHealth in the long run, which could lead to rating convergence. In the meantime, debt investors can benefit from WellPoint's relatively wider spreads. Specifically, its 2018s, 2023s, and 2043s were recently indicated around 90, 127, and 148 basis points over Treasuries, which are about 30-35 basis points wider than spreads available on similar UnitedHealth issues.
Fifth Third's New 3- and 5-Year Notes Are Fairly Valued (Feb. 25)
Fifth Third Bancorp (FITB) (A-) announced Monday that it is issuing new benchmark 3- and 5-year notes out of its banking subsidiary, Fifth Third Bank. Although we do not rate Fifth Third Bank, we view it as a similar credit risk to its holding company, Fifth Third Bancorp. Initial price talk is a spread in the area of 55 basis points above the Treasury curve for the 3-year and 75 basis points for the 5-year. Assuming these notes are senior bank notes, we would view these notes as fairly valued. Earlier this month, Discover Financial Services (DFS) (BBB+) issued new benchmark 5-year notes out of its banking subsidiary, Discover Bank. Like Fifth Third, although we do not rate Discover Bank, we view it as a similar credit risk to its holding company, Discover Financial Services. Those senior notes are currently trading with a credit spread in the area 115 basis points above the Treasury curve. We recommend investors go down one notch in rating to pick up 40 basis points in spread.
From a credit perspective, we are very comfortable with Fifth Third and it had been on our investment-grade Best Ideas for much of last year. Last year, Fifth Third was able to repay its preferred stock and associated warrants from the Troubled Asset Relief Program and was able to improve both its regulatory and actual capital levels. The bank's Tier 1 capital ratio is now a healthy 12% and stands in line with peers. More impressive is Fifth Third's ratio of tangible common equity/tangible assets, which is now greater than 9%, as we calculate it, and better than the average for its peer group. The company has done a good job of improving its credit quality as it has been able to reduce its percentage of nonperforming assets. To be sure, its nonperforming loan balance is currently less than half of its peak level from 2009. Also, its percentage of reserves to nonperforming loans is now more than 150%.
Caterpillar Finance Back in Market With Benchmark Offering; Initial Price Talk Sounds Fair (Feb. 25)
Caterpillar Financial Services (A-) announced plans for a benchmark sized offering of 3-, 5-, and 10-year notes, with proceeds likely used for repayment of maturing debt and to fund growth in finance receivables. Our A- rating on Cat Finance is directly linked to the rating of Caterpillar (CAT) (A-) based on the strong interrelationships between the two entities. Caterpillar enjoys a wide-moat position as the world's largest manufacturer of heavy equipment and has a very substantial dealer network, which allows it to dominate the U.S. market and provide competitive advantages. However, the cyclicality inherent in the company's business combined with the largely debt-financed acquisition of Bucyrus and sizable pension obligations, constrains our rating.
Initial price talk on the 10-year tranche is +95, which sounds fair to us, although given where existing Cat Finance bonds are trading we think final pricing could be meaningfully tighter. The Cat Finance 2.85% due 2022 recently traded around a spread of 75 basis points over Treasuries, which we view as rich. For comparison, John Deere Capital, which we rate one notch higher at A, has a 2023 bond that was recently quoted around 80 basis points over Treasuries, which we view as fair. If the price talk on the new Cat Finance 10-year moves inside +90, we would rather own Deere. We would place fair value on the new 5-year tranche about 25 basis points inside 10-year pricing, or roughly 65-70 basis points over Treasuries.
Last month, Caterpillar reported fourth-quarter earnings, with revenue and earnings down compared with last year, but credit metrics remained stable. The firm had previously outlined that it would need to curtail manufacturing during the quarter to reduce inventory at the company level and on dealer lots, and sales, excluding financial services, declined about 7% from a year ago, driven by a 10% drop in volume mitigated by a 2.5% positive price contribution. Still, we're encouraged that the company was able to hold on to positive pricing given the need to liquidate inventory; we think this speaks to Cat's continued strong reputation and perceived product advantage.
The balance remains in good shape, with key credit metrics holding steady compared to the prior year. Leverage at the manufacturing operations remains low, with TD/EBITDA of 1.0 times for 2012, down slightly from 1.1 times in 2011. However, after adjusting for operating leases and the sizable pension deficit, adjusted leverage is closer to 2.5 times, which factors into our A- rating. TD/total capital was 37%, down from 41% at the end of 2011. Free cash flow was pretty weak for the year, with the manufacturing arm generating about $860 million after capital expenditures, compared with $5.5 billion the prior year. A sharp decline in accounts payable due to lower production levels, combined with higher capital expenditures contributed to the decline. Management expects 2013 cash flow to be substantially better, aided by reduced inventory levels and stable accounts payable.
TRW Offering New Bonds to Boost Cash Coffers Ahead of Debt Maturities (Feb. 25)
TRW Automotive Holdings (TRW) (BBB-) is in the market today with a new $400 million 8-year senior note. In our earnings note on Feb. 15 we highlighted that TRW ended the year with cash of $1.2 billion but also has three bonds coming due or callable within a year or so totaling over $750 million. Our expectation is that TRW will use the new proceeds, along with existing cash, to retire all of that debt and use the remaining cash plus any free cash flow to invest in the business, make acquisitions, or engage in shareholder friendly activities. That said, we have not heard specific plans on the firm's target capital structure from management. We note that TRW has a senior secured bank facility which could be tapped and layered ahead of the bonds. Still, the firm ended the year with gross leverage of slightly below 1 times and thus has additional room for modestly higher debt to support investment grade ratings, in our view. Moody's and S&P remain in junk territory, however, so this deal will be issued in the high yield market. Nonetheless, we view fair value on the new bonds at a yield of about 4.0%, representing a spread of about +250 basis points over Treasuries. This compares to Delphi (DLPH, BBB), whose recent 10-year noncall 5 senior note was issued at 5.0%, or a spread of +300, which we viewed as about 100 basis points cheap. This is now trading at about 4.5%. On the flip side Tenneco's (TEN) (BB) 2020 maturity notes, also subordinated to secured bank debt, offer a yield to the 2015 call date of about 4.5% and an OAS of about +380, which we view as fairly valued.
While we do not assign a moat to TRW, we do have a positive moat trend based on the firm's global footprint and good positioning in the automotive supplier market emphasizing safety. We believe TRW will benefit from new technologies and innovations which meet the increasing government regulations among both developing and developed markets. With Europe representing more than 40% of revenue, TRW has some near-term headwinds to deal with. However, we expect the industry's secular trends along with good growth opportunities in other markets to allow the firm to generate modest growth and healthy free cash flow.
Click here to see more new bond issuance for the week ended March 1, 2013.