Treasury Bonds Take It on the Chin
Strong job growth sent Treasury rates upward, but corporate credit spreads held steady on a flood of new issues.
Corporate credit spreads were range-bound last week as the voluminous amount of new issue supply was able to quench the demand for corporate bonds. The average spread in the Morningstar Corporate Bond Index held steady and ended the week at +115, holding at its lowest level since before the 2008-09 credit crisis. Over the past year, our index averaged +137 and had peaked at +166 in June 2013. Credit spreads for high-yield bonds have also reached their lowest levels since before the credit crisis. For example, the option-adjusted spread of the Bank of America Merrill Lynch High Yield Master II has dropped to +378. During the past year, that index averaged +450 and had peaked at +534 in June 2013.
However, Treasury bonds took it on the chin last week as the 10-year Treasury rose 13 basis points to 2.79%. Part of the rise in Treasury rates was due to the strong showing of new job growth in the Employment Situation report. Nonfarm payrolls surprised everybody, having increased by 175,000 in February, substantially higher than economists' estimates. The strength of job growth crushed any lingering doubts that the Federal Reserve might decide to halt the tapering of its asset-purchase program when it meets later this month. For the remainder of the year, Robert Johnson, Morningstar's director of economic analysis, expects that the payroll reports will continue to get better, as he expects average monthly payroll growth will average around 190,000. Based on the economic data released thus far this year, Johnson forecasts real GDP growth for the first quarter of about 1.6%.
We continue to believe that from a fundamental, long-term perspective, corporate credit spreads are fairly valued--albeit at the tight end of the range that we view as fairly valued. Across our coverage universe, our credit analysts generally have a balanced view that corporate credit risk will either remain stable or improve slightly, but that the tightening in credit spreads on those names will probably be offset by an increase in idiosyncratic risk (debt-funded M&A, increased shareholder activism, and so on). With the Fed continuing to taper its asset-purchase program, we expect interest rates will rise toward normalized historical metrics as compared with inflation, inflation expectations, and the steepness of the Treasury curve. At a more normalized level, we think the yield on the 10-year Treasury could increase to 3.20%-3.70% to reach historical norms.
Flood of New Issues; Health Care Provides Both the Most and Least Attractive Deals of the Week
The floodgates opened two weeks ago, and the new issues continued to pour in last week. Of the issuers we cover, more than $43 billion of bonds were brought to market, easily surpassing the $30 billion priced the prior week. In our view, the cheapest bonds priced last week were Gilead Sciences's (GILD) (rating: A+, wide moat) 10- and 30-years. The 10-year tranche was priced at +102 and the 30-year was priced at +117. We had recently upgraded our credit rating on Gilead to A+ from A after the Food and Drug Administration approved its key hepatitis C product candidate, Sovaldi, and our rating is two to three notches higher than the rating agencies'. In her new issue note published before the deal was priced, Morningstar health-care analyst Julie Stralow opined that based on her view of the credit risk of the firm, fair value of the 10- and 30-year bonds is +85 and +95, respectively. As such, Stralow raised her recommendation to overweight from market weight. In the secondary market, the notes quickly rose in value and ended the week at +97 and +111, respectively. Conversely, the deal that we thought was the most expensive last week was also in the health-care sector. McKesson (MCK) (rating: BBB+, wide moat) priced several bonds ranging from 18-month notes to 30-year bonds. Of the longer-dated issues, the 5-, 10-, and 30-year bonds were priced at +75, +110, and +125, respectively. Proceeds will be used to repay the $5 billion bridge loan used initially to fund McKesson's recent acquisition of German drug distributor and retail pharmacy chain Celesio. We recently downgraded our credit rating on McKesson to BBB+ from A after incorporating the firm's recent purchase of Celesio into our rating. While details surrounding McKesson's long-term leverage goals remain scarce, we estimate debt leverage could remain elevated from historical norms for several years. Before the acquisition's close, McKesson's debt/EBITDA stood around 1.5 times on a trailing 12-month basis. By our estimates, McKesson's debt/EBITDA will double to about 3 times. Unless management aggressively repays debt early after this transaction, we do not believe McKesson's leverage will return to predeal levels until about fiscal 2018. Based on our credit rating and compared with where the firm's drug distribution peers trade, Stralow thinks fair value is about 20 basis points wider than where the bonds priced, at +95, +130, and +150, respectively.
China Experiences Its First Domestic Public Corporate Bond Default
After missing its interest payment, Shanghai Chaori Solar Energy Science & Technology has the dubious distinction of being China's first onshore public corporate bond default. While the size of the bond issue that defaulted is de minimis (approximately $160 million in U.S. dollar terms), it's not the size of this default that is concerning; the worry is that this default is just the harbinger of many more defaults to come. Previously, the Chinese banks and government have supported the bond and loan market by rolling over or extending maturing debt of those firms that were not able to otherwise repay or refinance. It now appears that the Chinese government is going to allow at least some amount of issuers to default. We suspect the government will allow deals to default that are small enough to be written off by the banking system, but will continue to support those issuers whose deals are large enough to potentially cause systemic financial issues. If the government successfully allows some debt to default but restrains the default rate from rising too far or too quickly, it should help brake the rapid rise in corporate debt. Total corporate debt outstanding has grown substantially faster than GDP in China over the past five years and is reportedly 125% of GDP, having grown from 92% of GDP in 2008.
While we will be keeping an eye on the default rate of China's domestic public corporate bonds, we are more concerned about the wealth management products that have supported China's shadow financing system. Many of these products are structured investment vehicles that use short-term debt to finance long-term loans, often of dubious value. There is reportedly about $2 trillion of these products outstanding, of which about 60% has a maturity of less than one year. Many of the investors in these vehicles do not realize that they are incurring liquidity and principal risk, as the products are oftentimes sold to them through the retail banking system. If investors for whatever reason decide that they want to cash out their existing loans, new investors are required to roll over the loans. However, if there are not enough new investors to provide liquidity and investors are not able to pull their investments out, it may begin a domino effect in which other investors attempt to cash out and refuse to roll over their investments. In this scenario, we could see an event similar to the auction-rate securities market in the United States, which froze during the credit crisis.
In addition to the rumblings of defaults and deteriorating credit quality on the horizon in China, Chinese officials are taking a page out of an investor relations handbook and slowly talking down expectations for Chinese GDP growth for this year. China's finance minister was recently quoted as stating that GDP growth of 7.2% in 2014 would be close enough to the 7.5% growth rate that officials had publicly targeted earlier. Similar to other policymakers across the globe, he is taking the position that the government's focus is on employment, as opposed to just economic growth alone. The economic slowdown from the double-digit growth rates of years past has taken its toll on the Chinese equity market. Whereas the S&P 500 continues to trade near its all-time highs, the Shanghai Composite Index is trading only slightly higher than its lowest levels over the past five years.
New Issue Notes
High-Yield Sector Pick Tenet Issuing New 5-Year Notes; We Maintain Overweight Recommendation (March 5)
Tenet Healthcare (THC) (rating: B, no moat) is issuing $400 million in new 5-year, noncallable senior notes today in a private placement. The proceeds from this new issuance will be used for general corporate purposes, including the repayment of existing debt and borrowings on its senior secured credit facility. At the end of December, Tenet had $405 million of borrowings and $189 million of standby letters of credit outstanding related to that facility. We do not anticipate changing our view of Tenet's credit profile based on these actions. We currently maintain an overweight recommendation on Tenet's notes, so investors who are able to purchase these notes should keep an eye out for a relatively attractive offering. We believe fair value on the new Tenet notes is around a 4.75% yield.
Tenet's notes typically offer significantly more compensation than notes from key peer, HCA Holdings (HCA) (rating: B+, no moat), which contributes to our overweight recommendation on Tenet and our underweight recommendation on HCA. For example, Tenet's 6.75% unsecured notes due 2020 are currently indicated at a yield of 5.32%, which is significantly higher than the 4.79% yield on HCA's 6.25% unsecured notes due 2021. Also, HCA's 8% unsecured notes due in 2018 are indicated at a yield of 3.52%. We suspect Tenet's new bonds will offer significantly more compensation than HCA's 2018s, making them relatively attractive.
Tenet remains our Sector Pick in high-yield health-care services based on its relatively high yields and its deleveraging goals. Our B credit rating takes the recent Vanguard acquisition into account. When Tenet initially announced plans to acquire Vanguard, management also announced plans to reduce debt/EBITDA from around 5.5 times on a pro forma basis to premerger levels of 4.75-5.0 times by the end of 2014, which supports our existing B issuer credit rating. Management also expressed a desire to further deleverage to 4.25-4.75 times debt/EBITDA in the long run, which would put it close to B+ rated HCA's current debt leverage. Given that long-term leverage goal and Tenet's expansion in terms of size and geography (including doubling in the attractive Texas market) via the Vanguard acquisition, we may consider upgrading our credit rating by a notch if the company makes good on its deleveraging plans, meaning HCA and Tenet's credit ratings could converge in the long run.
McKesson Funding Celesio Deal; Initial Price Talk Looks Fair (March 5)
McKesson is in the market today issuing new 18-month (floating-rate), 3-year (floating- and fixed-rate notes), 5-year, 10-year, and 30-year notes. The proceeds will be used to repay the $5 billion bridge loan used initially to fund McKesson's recent acquisition of Celesio, which we have highlighted in our Potential New Issue Supply list. Initial price talk on the fixed-rate notes of 75, 95, 130, and 150 basis points over Treasuries, respectively, looks about fair. However, based on where existing McKesson notes are indicated, we would not be surprised to see these new notes eventually price at tighter spreads, which could reinforce our current underweight recommendation on McKesson's bonds.
Despite its plans to leverage up significantly to complete this deal, most of McKesson's existing notes do not offer a substantial discount relative to notes from key drug distribution peers AmerisourceBergen (ABC) (rating: A, wide moat) and Cardinal Health (CAH) (rating: A, wide moat). For example, McKesson's 2016s, 2018s, 2023s, and 2041s are indicated around 60, 60, 104, and 138 basis points over the nearest Treasuries, respectively. With the exception of the 30-year notes, those spreads look in line with spreads from both AmerisourceBergen and Cardinal, and we would require more compensation from McKesson's notes because of the higher expected leverage at this issuer. For example, AmerisourceBergen's 2019s and 2021s are indicated around 68 and 72 basis points over the nearest Treasuries, respectively. We maintain a market weight recommendation on AmerisourceBergen's notes. Except for its 30-year notes, Cardinal's bonds appear to offer the most compensation for the risk in this niche, which contributes to our overweight recommendation on the firm. For example, Cardinal's 2017s, 2018s, 2023s, and 2043s are indicated at 62, 68, 111, and 104 basis points over the nearest Treasuries.
We recently downgraded our credit rating on McKesson to BBB+ from A after incorporating the firm's recent purchase of German drug distributor and retail pharmacy chain Celesio into our rating. While details surrounding McKesson's long-term leverage goals remain scarce, we estimate debt leverage could remain elevated from historical norms for several years. Before the acquisition's close, McKesson's debt/EBITDA stood around 1.5 times on a trailing 12-month basis. By our estimates, McKesson's debt/EBITDA will double to about 3 times after the firm takes on Celesio's debt and issues additional debt to finance this $8 billion deal. Unless management aggressively repays debt early after this transaction, we do not believe McKesson's leverage will return to predeal levels until about fiscal 2018, which contributes to our lower rating for McKesson than its key distribution peers.
AT&T Notes May Price Attractively, Especially Relative to Verizon (March 5)
AT&T (T) (rating: A-, narrow moat) plans to issue new bonds, split between 5-year floating-rate notes and 5- and 10-year fixed-rate notes. We view AT&T favorably, especially relative to Verizon Communications (VZ) (rating: BBB, narrow moat), although AT&T's bonds have tightened sharply over the past couple of weeks. Initial price talk on the new AT&T notes looks very attractive at 85-90 and 135-140 basis points over Treasuries for the 5- and 10-year fixed-rate notes, respectively, but we expect considerable tightening from there. AT&T's 2.625% notes due in 2022 are indicated at 108 basis points over the nearest Treasury, about 20 basis points tighter versus a month ago. On the other hand, Verizon's 2.45% notes due in 2022 have tightened only 2 basis points during this same period to 116 basis points over the nearest Treasury. Moreover, the A- tranche of the Morningstar Industrials Index has similarly moved only 2 basis points tighter during the same time period to +97. Despite AT&T relative outperformance of late, we still believe its bonds are attractive. We would place fair value on the new 10-year notes in line with the A- index at +97 basis points. Relative to Verizon, we believe AT&T deserves to trade about 30 basis points tighter.
AT&T bonds have traded wide over the past several months on fears that it will make a major move into Europe. The firm recently stated to U.K. regulators that it has no intention of bidding for Vodafone Group (VOD) (rating: BBB+, narrow moat), a heavily speculated potential acquisition target. This declaration prohibits AT&T from bidding for Vodafone for six months. AT&T continues to maintain that its interest in Europe is primarily based on valuations. We believe the fact that AT&T hasn't moved on a transaction in Europe, more than a year after initially indicating its interest, demonstrates that management is taking a disciplined approach to any investment on the Continent. More broadly, we believe AT&T management will remain committed to the 1.8 times leverage target it put in place last year.
While we expect Verizon will reduce leverage over the next several years, AT&T already has metrics worthy of an A- rating. Verizon will probably need three years or more to bring its leverage back into the range typical for an A- telecom issuer. By contrast, we expect AT&T will maintain net leverage at about 1.8 times EBITDA through 2014, with leverage then beginning to tick down toward management's previous long-term target of 1.5 times.
Texas Instruments' Note Issuance Probably Rich; We Prefer Maxim and Intel (March 5)
Texas Instruments (TXN) (rating: A+, narrow moat) plans to issue $500 million of new debt split between 3- and 7-year maturities. TI's capital allocation strategy calls for the firm to return all free cash flow to shareholders, except cash used to meet debt maturities which are not refinanced. The firm faces a $1 billion bond maturity in May, so today's $500 million offering indicates that it will probably reduce gross leverage by $500 million in 2014.
We have an unfavorable view of TI bonds and believe other semiconductor firms offer better value. Initial price talk is in the area of 35 and 80 basis points over Treasuries on the new 3- and 7-year notes, respectively. We expect those levels to tighten further. TI's 2.25% notes due in 2023 were recently indicated at 81 basis points over the nearest Treasury, and its 1% notes due in 2018 were indicated at +35 basis points. While these levels are comparable with the average spread for the A+ category of the Morningstar Industrial Index (+81 basis points with roughly 10 years to maturity), they compare unfavorably with other firms in the industry. We prefer Maxim Integrated Products (MXIM) (rating: A+, wide moat), which is on our Best Ideas list. The firm's 2.5% notes due 2018 and 3.375% notes due in 2023 are indicated at 92 and 148 basis points over the nearest Treasury, respectively. We also prefer Intel (INTC) (rating: AA, wide moat) to TI. Intel notes trade at a similar spread to TI's, with Intel's 3.3% notes due in 2021 recently indicated at 62 basis points over the nearest Treasury.
We view both Intel and Maxim as very strongly positioned competitively, as our wide moat ratings suggest. Intel benefits from its massive manufacturing scale, which allows it to produce faster processors at a lower cost than its rivals. We expect that Intel will increasingly apply this cost advantage to chips aimed at the smartphone and tablet markets over the next couple of years. While Maxim is a much smaller firm, we like its position as a premier supplier of highly differentiated high-performance analog chips used in a wide variety of end markets. TI also has a strong position in analog chip manufacturing. However, TI's debt load, which was taken on as part of the acquisition of National Semiconductor, is heavier than Intel's or Maxim's. Unlike both peers, TI carries more debt than cash.
Price Talk on Ford Motor Credit's 5-Year Bonds Looks Fair (March 5)
Ford Motor Credit (rating: BBB-) is offering 5-year senior notes with initial price talk of 100-105 basis points over Treasuries, which we view as fair. Competitors' captive finance subsidiary 5-year paper spreads to the nearest Treasury include Nissan Motor (NSANY) (rating: BBB+, no moat), whose recently issued notes are indicated at +80, which we see as fair; Daimler (DAI) (rating: BBB+, no moat), whose 2.25% notes due July 2019 are indicated at +61, which we view as rich; Volkswagen VOW (rating: A-, no moat), whose notes due in November 2018 are indicated at +59, which we view as fair; Honda Motor (HMC) (rating: A, no moat), whose notes due October 2018 are indicated at +45, which we view as roughly fair; and Toyota TM (rating: A, no moat), whose notes due in January 2019 are indicated at +44, which we view as fair.
We expect our rating on Ford Motor (F) (rating: BBB-, no moat) and Ford Credit to migrate to the mid-BBB area as Ford executes its global product plan as well as ongoing debt and pension liability reduction. Ford continues to make progress globally with its increasing use of common platforms, which will lead to economies of scale. Results out of Asia have been very strong, while the restructuring in Europe is on pace. South America is likely to remain challenging. Recent domestic monthly auto sales have been stable, despite difficult weather conditions this winter, but we expect modest growth over the course of the year. Importantly, incentives appear to remain in check for now. Ford's struggling Lincoln brand posted its fifth straight month of rising sales, an encouraging sign that supports our view.
Aetna Issuing New Debt to Redeem 2016 Notes; Maintaining Our Underweight Recommendation (March 4)
Aetna (AET) (rating: BBB, narrow moat) is in the market today issuing $750 million in new 5-year and 30-year notes. This issuance follows recently announced plans to redeem its 6% senior notes due in 2016, which have $750 million in principal outstanding and are callable at a make-whole premium plus 20 basis points. Aetna had been on our Potential New Issue Supply list due to that plan, and we will probably take it off that list after this issuance. Initial price talk looks about fair to us at 75 basis points over Treasuries for the 5-year and 120 basis points over Treasuries for the 30-year. However, given where existing notes are trading, we suspect spreads will tighten before launching, which will probably make these new issues somewhat rich for the risk, in our opinion.
Currently, we maintain an underweight recommendation on Aetna's existing bonds primarily because of its slim bond compensation relative to WellPoint (WLP) (rating: BBB+, narrow moat). We continue to believe the credit ratings on these two issuers will probably converge over time, as Aetna possesses a positive credit trajectory related to its deleveraging after the Coventry acquisition. However, Aetna's notes currently are indicated at much slimmer spreads than similar notes from WellPoint. For example, Aetna's 2017s, 2022s, and 2042s are indicated around 65, 104, and 102 basis points over the nearest Treasuries, respectively, while WellPoint's 2018s, 2023s, and 2043s are indicated around 84, 132, and 130 basis points over the nearest Treasuries. We view fair value for those issues in the middle of spreads from those two issuers, and overall, we maintain an overweight recommendation on WellPoint's notes and an underweight recommendation on Aetna's notes.
In February, Aetna reported fourth-quarter results that were in line with our expectations. The firm continued to feel the positive effects of the Coventry acquisition, which positively drove most metrics, including debt deleveraging to about 37% of capital. Year over year, operating revenue increased 47% (total revenue including float increased 33%), driven by a 2.5 million-person increase in membership and a 53% increase in health-care premiums. Encouragingly, operating margins increased 23 basis points to 3.77% (total operating margins excluding float increased 67 basis points to 5.21%), as the firm executed on its Coventry integration and cost-control efforts. Selling and administrative expenses as a percentage of operating revenue decreased 36 basis points to 19.02%. We believe this metric will continue to improve over the coming quarters as management seeks to reduce overhead and synergies continue to be realized from the Coventry integration. Ongoing improvement in profitability will be key for Aetna, as the entire managed-care organization industry will face significant headwinds over the next several quarters from gross profit caps, underwriting restrictions, and pressured pricing environment related to a reforming U.S. health-care system.
Gilead Issuing New Debt; Existing Notes Recommended at Market Weight (March 4)
Gilead Sciences is in the market issuing new 5-, 10-, and 30-year notes today; the proceeds will be used for general corporate purposes. Initial price talk of 70, 110, and 125 basis points over Treasuries, respectively, looks quite attractive. We view fair value on Gilead's new notes around 55, 85, and 95 basis points over Treasuries, respectively, which is based on where Gilead's existing notes and notes from other A+ rated pharmaceutical firms-- Baxter International (BAX) (rating: A+, wide moat) and GlaxoSmithKline (GSK) (rating: A+, wide moat)--are indicated. Currently, we maintain a market weight recommendation on Gilead's existing notes, including its 2021s and 2041s, which are indicated around 80 basis points and 100 basis points over the nearest Treasuries. Additionally, Baxter's 2018s, 2023s, and 2043s are indicated at 49, 88, and 88 basis points over the nearest Treasury, respectively. Glaxo's 2018s, 2023s, and 2043s are indicated at 48, 82, and 82 over the nearest Treasury, respectively.
We recently upgraded our credit rating on Gilead to A+ from A after the FDA approved its key hepatitis C product candidate, Sovaldi, and our rating is differentiated from the agencies at A-/Baa1. The approval of Sovaldi also boosted Gilead's moat to wide from narrow, in our opinion. Sovaldi appears to offer significant safety, efficacy, and convenience benefits to existing treatments, which we expect to change the treatment paradigm of hepatitis C. Gilead's previous narrow moat was based on its dominant position in the HIV therapy market with Truvada, Atripla, Complera, and Stribild. Diversification into hepatitis C, with a potential game-changer in that disease, widens Gilead's moat substantially. Now that Sovaldi is approved in the U.S., we think sales of Gilead's hepatitis C products will rise to about $11 billion of peak sales in 2015. Considering Gilead generated $11 billion of sales in 2013, this new franchise represents both a diversifying agent and significant growth driver. With profits also set to rise swiftly, we think Gilead's balance sheet has capacity for additional debt. At the end of December, debt/EBITDA stood around 1.4 times and net debt/EBITDA stood at 0.8 times on a trailing 12-month basis.
Viacom's New Issue Looks Mildly Attractive (March 4)
Viacom's (VIA) (rating: BBB+, narrow moat) is coming to market with new 5-, 10- and 30-year paper. It has also announced that it will redeem all of its $600 million outstanding 4.375% notes due September 2014 on their redemption date of April 3, 2014. Pro forma for the redemption, we estimate the firm could take on roughly $2.0 billion in debt and remain within its 3.0 times leverage target.
Initial price talk of 80-85, 145-150 and 175-180 basis points for the 5-, 10- and 30-year tranches, respectively, is slightly cheap to existing notes. Viacom's 4.35% notes due 2023 were most recently indicated at 131 basis points over the nearest Treasury, which we view as fairly valued. This is nearly 10 basis points wide of Morningstar's BBB+ Industrials Index, and more than 10 basis points wide of similar-rated media entertainment peer Time Warner (TWX) (rating: BBB+, wide moat). We think the extra spread is appropriate, given the bad taste the firm left in the bond market's mouth last year by increasing its leverage target to 2.75-3.0 times after reiterating quarter after quarter that the target was 2-2.25. We fear leverage could tick higher, at least temporarily.
Viacom reported strong fiscal first-quarter results earlier this year, which resulted in leverage of 2.7 times. For the quarter, the firm's cable networks showed particular strength as investment in new programming has driven improved ratings, while pricing increases from television distributors continue to add high-margin growth. Media network revenue increased 6.1% to $2.5 billion, driven by 4.4% higher advertising and 9.7% growth in affiliate fees in the quarter. Renewed momentum at the flagship Nickelodeon channel continued into the quarter, running its streak of consecutive year-over-year ratings growth to 12 months. Viacom also posted ratings gains across several other networks, including Comedy Central, Spike, VH1, and CMT. MTV struggled during the quarter, though management highlighted several bright spots at the channel that should improve results going forward. Viacom expects to see sequential domestic advertising growth in the current quarter, despite the diversion of viewer attention because of the Olympics and the shift of Easter into the June quarter. International advertising, which grew 16% during the December quarter, should also fuel continued growth.
The filmed entertainment segment turned in soft results, with sales down 30% year over year to the lowest level in at least eight years. New theatrical releases during the quarter underperformed, notably Anchorman 2, and there were no home entertainment releases during the period. The firm will need its slate of summer movies to produce solid results to meet our expectations for this segment.
Initial Price Talk on Citigroup's New 3-Year Is Attractive (March 4)
Citigroup (C) (rating: A-, narrow moat) is in the market with a benchmark-size 3-year senior holding company offering split between fixed- and floating-rate notes. Initial price talk on the fixed-rate notes is mid- to high 70 basis points over Treasuries. We see fair value at 70 basis points over Treasuries. Citigroup's most recent 3-year issue, the 1.3% notes due in November 2016, are indicated at around 77 basis points to the nearest Treasury, which we view as attractive. The most recent 3-year note, the 1.35% due in February 2017, from global peer JPMorgan Chase (JPM) (rating: A-, narrow moat), which we now rate in line with Citigroup, is indicated at 58 basis points to the nearest Treasury, which we view as slightly rich relative to a fair value around +65 basis points. Bank of America's (BAC) (rating: BBB, narrow moat) 1.25% notes due in 2016 are indicated at 70 basis points to the nearest Treasury, which we view as slightly rich relative to a fair value around +80 basis points.
Citigroup reported impressive results in 2013, with net income up 84% from 2012 and a return on equity of 7.1%, well ahead of last year's paltry 1.0%. Similarly, return on assets was a respectable 0.74%, ranking near the high end of the range for global banks. The bank also improved its asset quality by reducing nonperforming loans 42 basis points to 1.34% of loans and charge-offs to 1.57% of loans. Loan loss coverage continues to be impressive at well over 200%. Capital levels compare favorably relative to many global peers with tangible common equity of 9.1%, Tier 1 capital of 13.6%, and Basel III Tier 1 common equity of 10.5%, all as of the fourth quarter.
Citigroup recently announced that it is reducing its previously reported 2013 earnings by $235 million after discovering a large fraudulent transaction in its Mexican subsidiary. After a detailed review of its books, Citigroup's Banamex subsidiary found that about $400 million of accounts receivable obtained in connection with the financing of an oil services company were nonexistent. The charge does amplify the difficulties that large financial institutions like Citigroup have managing diverse and far-flung geographic operations. While this charge is a setback for Citigroup, we believe that over the long term Citigroup's exposure to developing markets should provide a strong growth tailwind, in contrast to banks in heavily indebted developed countries. Citigroup's Asian and Latin American loans have both grown impressively during the past year. We continue to believe that secular growth trends will eventually benefit Citigroup relative to other U.S. banks, but investors should expect to see negative headlines along the way.
Northeast Utilities' NSTAR to Issue 30-year Notes at Cheap Initial Levels (March 4)
Northeast Utilities' (NU) (rating: BBB, narrow moat) regulated electric utility subsidiary, NSTAR Electric, announced today it will issue $300 million of 30-year notes. Initial price talk on the 30-year notes is in the +95 basis points area. We believe NSTAR's 30-year new issue appears about 15-20 basis points cheap. While we do not formally assign an issuer rating to NSTAR, we view this entity to be of similar credit risk to Alliant Energy's (LNT) (rating: BBB+, narrow moat) regulated utility, Interstate Power & Light. As highlighted in our November publication, "Regulated Utilities: A New Frontier in Credit Risk Analysis," NSTAR's 5.5% bonds due 2040 recently traded at 83 basis points over the nearest Treasury. Furthermore, Interstate Power & Light's 4.7% bonds due 2043 trade at 70 basis points over the nearest Treasury. Thus, we believe fair value on NSTAR's 30-year new issue is in the neighborhood of 75-80 basis points.
NSTAR's credit qualities include slightly above-average allowed ROE of roughly 10.5%, an average Northeastern regulatory environment, above-average regulatory lag mechanisms, and above-average management performance. As such, we rank NSTAR as a slightly above-average regulated utility operating company under our coverage. We believe Interstate Power & Light ranks very similarly, with an average allowed ROE of roughly 10.0%, an average Midwestern regulatory environment, above-average regulatory lag mechanisms, and average management performance.
On a consolidated basis, all of Northeast Utilities' businesses increased core earnings in 2013. Rate increases, lower operating costs, and favorable weather resulted in a 24% increase in earnings at the electric distribution and generation segment. The transmission business also continued its rapid growth, adding $37 million of earnings in 2013, up 15%. The transmission business now represents 40% of consolidated earnings and we think will continue to increase its share of consolidated earnings in the next few years. The natural gas distribution utilities nearly doubled earnings from 2012 primarily due to weather but also record customer growth. Although Yankee Gas and NSTAR Gas remain small relative to Northeast Utilities' electric distribution and transmission businesses, low gas prices and government policies should continue driving strong customer and earnings growth.
Spirit in Market With 8NC3 Senior Notes to Refinance Existing Bonds; We See Fair Value at 5.25% (March 4)
Spirit AeroSystems Holdings (SPR) (rating: BB, no moat) is in the market with a $300 million senior note offering of an 8-year maturity, noncallable for 3 years. Proceeds will be used to tender for its existing 7.50% senior notes due 2017, which are currently callable at 103.75. We view fair value on the new notes at 5.25%. Spirit's 6.75% senior notes due 2020 are currently indicated at 4.50% to the next call in December 2015. We have maintained our market weight view on those bonds. Elsewhere in the sector, Alliant Techsystems (ATK) (rating: BB+, narrow moat) issued 5.25% 8NC3 senior notes in October which are indicated at 4.86%, about 35 basis points cheap in our view. Oshkosh (OSK) (rating: BB+, narrow moat) issued 5.375% 8NC3 senior notes last month that are now indicated at 5.00%, about 50 basis points cheap in our view. Both ATK and Oshkosh bonds are subordinated to some senior secured bank debt, as are the Spirit senior notes. Bombardier's (BBD.A) (rating: BB-, narrow moat) 5.75% senior notes due 2022 are indicated at 5.60%, which we view as fair given the challenges that company faces.
Spirit ended the year with total debt of $1.2 billion, including a $540 million senior secured term loan due 2019 and the two $300 million senior unsecured bonds. We expect cash flows to be a bit choppy over our forecast horizon although generally positive, with adjusted debt/EBITDA remaining below 2 times. As a result of a series of charges the company has taken to address challenges in some of its developmental programs, the financial covenants on the bank facilities (including senior secured leverage, total leverage, and interest coverage tests) have been suspended through 2014 as part of an amendment to the credit agreement. Spirit's liquidity, including cash of more than $400 million, remains good. For the fourth quarter, Spirit announced program-level charges on the Boeing 787 and Gulfstream programs that reveal the firm still does not have a handle on costs. It also wrote down tax assets of $381 million because of a lack of sustained income over prior years. CEO Larry Lawson is approaching one year in his position. His evaluation of the business is still in process, though he has reduced the number of salaried employees by more than 500. We estimate this could save nearly 1% of operating costs, which will benefit operating margins in 2014 and beyond. Spirit has received strong interest from various parties for its Tulsa, Okla., operations. The facilities represent about 12% of sales, or more than $700 million in annual revenue. This includes the troubled Gulfstream business and Boeing's 787 program. A sale could facilitate greater focus on core operations and add to liquidity. We continue to maintain that Spirit knows how to execute on mature programs. The firm's production of critical parts for multiple key Boeing and Airbus platforms remains a key theme to our credit rating.
Tesoro to Issue $300 million of 10-Year Senior Notes; Fair Value at 5% (March 4)
Refiner Tesoro (TSO) (rating: BBB-, narrow moat) announced plans to issue $300 million of senior notes due 2024 to help fund the redemption of its 9.75% notes due 2019, which become callable in June 2014. The call price on the $300 million 2019 issue is 104.875. The new notes will be subordinate to the company's $3 billion revolving credit facility, which was undrawn as of Dec. 31, and its term loan, which had $398 million outstanding. At year-end, leverage through the secured debt was 0.3 times, while total leverage was 1.4 times. Over our forecast period, we continue to expect credit metrics to improve, with gross leverage approaching 1.2 times.
Tesoro's outstanding 5.375% notes due 2022 recently traded at yield to worst of 4.75%, or a spread to worst of 277 basis points, which we view as fair value. At this level, the 5.375% notes are trading about flat on a spread basis with the Merrill Lynch BB index. While we have a BBB- issuer credit rating on Tesoro, we believe the comparison with the BB index is appropriate because of Tesoro's secured debt that is superior to the 5.375% notes and today's new issue. As Tesoro integrates the Carson refinery acquisition, improves its position in the California market, and reduces secured debt, we believe a comparison with BBB- rated issues will become more appropriate. However, including the Carson refinery, Tesoro has only three large-scale refineries, which makes its performance vulnerable to an outage or accident at one of these three key refineries. As such, while we await improved results following Tesoro's soft fourth quarter, we peg fair value on the new issue at 5%.
Grifols Issuing New Notes (March 3)
Grifols (GRFS) (rating: BB+, narrow moat) is in the market issuing $1 billion in new 8-year notes, which are noncallable for 3 years. Previously, we had highlighted Grifols on our Potential New Issue Supply list, and we may take it off the list after this new issuance. We believe the proceeds from this issuance will probably be used to redeem currently callable 8.25% notes due in 2018, which have $1.1 billion in outstanding principal. We also believe new bank debt may be enough to permanently finance the recent acquisition of Novartis' (NVS) (rating: AA+, wide moat) transfusion diagnostics unit.
We view fair value on Grifols' new notes at a yield around 4.875%, or a spread around 250 basis points over the nearest Treasury. This valuation appears in line with notes due in January 2022 from Fresenius Medical Care (FMS) (rating: BB+, narrow moat), which are indicated at a yield of 4.82% and a spread over the nearest Treasury of 246 basis points. We maintain a market weight recommendation on Fresenius. Additionally, we believe fair value on Grifols' notes should be inside of Endo International' (ENDP) (rating: BB, narrow moat) notes. For example, Endo's 5.75% notes due in 2022 are indicated at a yield to worst (call date in 2020) of 5.13%, or a spread to worst of 332 basis points over the nearest Treasury.
From a business risk perspective, we like Grifols' strong position in the global plasma protein oligopoly, and we assign it a narrow moat based on that market's high barriers to entry. Grifols, Baxter, and CSL together hold roughly 60% of the global plasma market, with shares split relatively equally. We see Grifols as a low-cost provider of plasma-derived therapies and attribute the high barriers to entry in this market to the capital-intensive nature of plasma fractionation, the long lead time (five to seven years) for new capacity to be approved, and the experience level of all of the firms in this oligopoly (which contributes to high manufacturing yields and strong brands). Also, we estimate leverage will increase by less than half a turn due to the Novartis diagnostic division acquisition, and Grifols' management aims to reach predeal leverage levels (around 2.6 times on a trailing 12-month basis at the end of September) shortly, which informs our BB+ credit rating. The agencies rate Grifols BB/Ba2.
HCA Refinancing Senior Secured Notes; Existing Secured Notes Look Fairly Valued (March 3)
HCA has announced plans to issue $3 billion in new senior secured notes due in 2019 ($1 billion) and 2024 ($2 billion). The proceeds from this offering are earmarked toward redeeming high-coupon secured notes, including 8.50% notes due in 2019 ($1.5 billion in principal), which are callable in April at 104.25, and 7.875% notes due in 2020 ($1.25 billion in principal), which are callable in August at 103.938. Our underweight recommendation on HCA's notes generally refers to its unsecured offerings, which typically are indicated at rich levels compared with similar notes from other high-yield health-care firms. However, based on existing secured note pricing, investors should watch for a potentially fair offering from HCA relative to its peers.
We have not seen initial price talk yet, but we suspect HCA's new notes may price similarly to its existing senior secured notes, including its 2020s (6.50% coupon) and 2023s (4.75% coupon), which are indicated around 4.06% and 4.73%, respectively. Pricing on those HCA secured notes looks about fair when compared with Tenet Healthcare's THC (rating: B, no moat) 4.375% secured notes due in 2021, which are indicated at a yield of 4.51%. However, if HCA's new notes price significantly inside where its existing secured notes are indicated, we would find them unattractive, much like HCA's unsecured notes. For example, HCA's unsecured notes due in 2023 (no hard call) are indicated at a yield of just 5.10%. When adjusted for duration, that yield appears in line with notes from higher-rated dialysis services provider Fresenius FMS (rating: BB+, narrow moat), which has senior unsecured notes due in 2022s (no hard call) indicated at a yield of 4.82%. We believe investors should market weight Fresenius' notes. Tenet remains our Sector Pick in high-yield services; its senior unsecured notes due in 2022s (no hard call) are indicated at a yield of 6.25%.
Daimler Finance Issuing 3- and 7-Year Fixed Rate Notes; Existing Levels Are Fair (March 3)
Daimler's North American finance subsidiary is in the market today with a benchmark offering of 3-year fixed- and floating- and 7-year fixed-rate bonds. We view the credit quality of the finance subsidiary as similar to the parent's because of the inextricable linkage in the businesses and parental guarantees. We view fair value on the 7-year notes at a spread of 95 basis points over Treasuries, roughly in line with where Daimler's existing 3.875% notes due 2021 are indicated. We see fair value on the 3-year fixed-rate notes at about +60 basis points. Both are roughly in line with initial price talk.
Several other auto OEM finance subs have bonds maturing in 2021. Current indicated levels, spread to the nearest Treasury, include Toyota Motor (TM) (rating: A, no moat) at +72 basis points, which we view as fair; Honda at +75, which we view as fair; and Ford at +135, which we view as fair. The latter are high-dollar-price bonds and we note the spread is on top of the 4.375% notes due 2023, which we view as rich. Volkswagen's (VOW) (rating: A-, no moat) 4.00% notes due 2020 are indicated at +77, which we view as fair.
Daimler reported strong fourth-quarter results earlier, as well as guidance for 2014 that should unfold with first-half accelerating performance relative to the first half of 2013 and the second half slightly improving year over year. Our 2014 estimates are for revenue from industrial activities of EUR 109 billion, up 6% from EUR 103 billion reported for 2013. Mercedes-Benz Cars is expecting to achieve record unit volume owing to the launches of the GLA and CLA in 2014, as well as the recently launched redesigned E-Class and the all-new S-Class in the second half of 2013. Daimler expects "significantly higher" unit volume in heavy trucks on a full year of availability from new, recently launched vehicles, and new business in Asia. We are somewhat skeptical of management's assessment of the global heavy truck market, with U.S. demand still soft from fleet cost-saving measures and weak European economic conditions.
Duke's Progress Energy to Issue 30-Year First-Mortgage Notes at Cheap Initial Levels (March 3)
Duke Energy's (DUK) (rating: BBB+, narrow moat) regulated electric utility subsidiary, Progress Energy (also known as Carolina Power & Light), announced today it will issue $650 million of notes split between 3-year floating-rate and 30-year first-mortgage-backed notes. Initial price talk on the 30-year first-mortgage-backed notes is in the +90 basis points area. We believe Progress Energy's 30-year new issue appears about 20-25 basis points cheap. While we do not formally assign an issuer rating to Progress Energy/Carolina Power & Light, we view this entity to be of similar credit risk to Xcel Energy's (XEL) (rating: BBB+, narrow moat) regulated utility Northern States Power. As highlighted in our November publication, "Regulated Utilities: A New Frontier in Credit Risk Analysis," Progress Energy/Carolina Power & Light's 4.1% first mortgage bonds due 2042 recently traded at 69 basis points over the nearest Treasury. Northern States Power's 3.4% first-mortgage bonds due 2042 trade at 62 basis points over the nearest Treasury. Thus, we believe fair value on Progress Energy's 30-year new issue is in the neighborhood of 65-70 basis points.
Progress Energy/Carolina Power & Light's credit qualities include relatively average allowed ROE of roughly 10.2%, an average Southeastern regulatory environment, average regulatory lag mechanisms, and average management performance. As such, we rank Progress Energy/Carolina Power & Light as a slightly below-average regulated utility operating company under our coverage. We believe Northern States Power ranks very similarly, including average allowed ROE of roughly 10.2%, an average Midwestern regulatory environment, and average regulatory lag mechanisms, although slightly below-average management performance.
On a consolidated basis, Duke Energy reported improved adjusted 2013 EBITDA of $8.6 billion, up 30.1% year over year (versus $6.6 billion at 2012 year-end). The increase was due primarily to a full-year contribution from Progress Energy (July 2012 merger). EBITDA also benefited from increased pricing and riders resulting from revised customer rates, lower operating and maintenance costs due to energy efficiency programs, increased retail volume, and increased wholesale margins. Partially offsetting improved EBITDA results was a decrease in the allowance for funds used during construction equity, primarily because of the completion of certain major capital projects. As a result, Duke's 2013 year-end total debt/adjusted EBITDA declined to 4.8 times versus 6.1 times at 2012 year-end. Duke said it is on track to exceed its initial targeted nonfuel operating and maintenance merger savings of 5%-7% through total cost savings of $550 million or roughly 9% by 2014.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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