...And What a Week That Was
Next FOMC meeting lining up to be especially contentious.
Global markets experienced a strong bout of volatility last week. For example, between its intraday high and low, over the course of the week the S&P500 varied by 6.7%. Similarly, the trading range of the 10-year U.S. Treasury bond varied by 30 basis points between its intraday high and low. In the investment-grade corporate bond markets, the average credit spread of the Morningstar Corporate Bond Index had widened as much as 8 basis points before recovering most of the widening and ended the week at +176, only 2 basis points wider. In the high-yield bond market, the average credit spread of the Bank of America Merrill Lynch High Yield Master Index had widened as much as 28 basis points before recovering and ending the week at +572, some 14 basis points tighter. Volatility was so great that the administrators of numerous mutual funds and ETFs were incapable of calculating the net asset values of some portfolios. As such, Morningstar was unable to calculate the weekly fund flows for high yield mutual funds and ETFs.
Last week, we noted that trading volumes in the secondary market were lower than usual as traders and portfolio managers take vacation time during the typical seasonal slowdown in August. With many investors on the sidelines, the trading action in the secondary market was what many traders call "gappy," meaning that there were many instances that after bonds traded, the next trade was conducted at a spread significantly wider (that is, gapped wider) than where the prior trade printed. This type of secondary market action exacerbates the downside as sell-side bond traders become extremely wary of taking down positions onto their own books and will act only as intermediaries as opposed to principals, thus reducing liquidity. This type of trading is indicative of a market where some investors are liquidating positions and are more concerned with selling bonds as opposed to maximizing value.
While the average credit spread in the high-yield index has tightened modestly from its recent highs, the credit spreads in both investment-grade and high-yield markets are near the widest levels both of these indexes have traded since 2012. The last time spreads were at these levels, the markets were recovering from the Greek debt crisis and related European bank solvency concerns. There does not appear to be any single factor that has instigated this recent bout of weakness, but appears to be a confluence of many factors. Investors are continuing to evaluate the impact of the Chinese devaluation of the yuan, softening Chinese economy (the second largest in the world), weak oil and commodity prices, capital flight from the emerging markets, disappointing earnings from global industrial firms, stagnant economic growth in eurozone, and the potential for Fed to begin raising short-term rates in the near term.
Investment grade bonds gave up their gains from the prior week and slipped back into the red for the year. The total return of our investment-grade corporate bond index year to date dropped to a negative (0.49%). However, as spreads tightened slightly in the high-yield market, the Bank of America Merrill Lynch High Yield Master Index regained some of its losses and is almost unchanged on the year as current loss has decreased to (0.05)%.
Next FOMC Meeting Lining Up to Be Especially Contentious
The next scheduled meeting of the Federal Open Markets Committee of the Federal Reserve is not until Sept. 16 and 17; however, based on the commentary that the Federal Reserve governors have made in their public speeches and interviews, this meeting is shaping up to be especially contentious between the hawks and the doves.
Those in favor of raising rates are pointing to the sharp acceleration of economic growth in the second quarter and contend that economic metrics are indicating that the economy has maintained its positive momentum thus far in the third quarter. Real GDP rose at a 3.7% annualized rate in the second quarter, which handily beat consensus estimates. Even though GDP only rose at a 0.6% annualized rate in the first quarter, the average for the first half of the year is a respectable 2%. In addition, employment has been steadily growing and the unemployment rate has fallen to 5.3%, which is the top end of the committee's estimate range of central tendency for unemployment in 2015 and only one tenth of a percent higher than their long-run estimate.
Those in favor of keeping short-term rates at 0% point to the deceleration of inflation, low employment participation, and middling economic growth. The core personal consumption index ex-food and energy moved away from the Fed's 2% inflation goal as it slowed to 1.2% last month from the prior reading of 1.3%. Employment participation has stagnated at a rate of slightly over 62% whereas it averaged 66% prior to the credit crisis. In addition, the recent market volatility and weakness in global economic growth may tip the scales in favor of those advocating waiting to raise rates.
There are several economic metrics to be released before the Fed's next meeting, but probably none as important as the August employment report due on Sept. 4. Current consensus estimates job growth of 223,000 jobs, which seems in line with recent economic indicators and alternate employment data; however, Morningstar Director of Economic Analysis Robert Johnson, CFA, cautions that the August report has been one of the hardest months to predict and is one of the most significantly revised reports when compared with every other month. Also compounding the committee's decision will be the impact of short-term market volatility. If the global markets remain highly volatile, the FOMC may decide that decelerating international growth and lower asset prices may weaken financial conditions, which by itself is similar to tightening monetary policy. Yet, after many months of preparing the markets to begin raising rates, many other governors may not want the FOMC to be viewed as being pushed around by the markets. One potential outcome would be for the Fed to raise rates in order to bolster its credibility, but make explicitly clear that the path of future interest rate increases will be much slower than in the past.
Credit Rating Actions
Credit Rating Downgrade: EBay
We are downgrading eBay's EBAY (rating: BBB+, narrow moat) issuer credit rating by three notches to BBB+ following the firm's recapitalization and the spinout of PayPal, which was finalized in June. In October 2014, we placed eBay's issuer credit rating under review with negative implications in response to the proposal to split the PayPal and eBay Marketplaces/Enterprises businesses into separate publicly traded entities. Previously, management had been reluctant to separate the businesses, citing that eBay's Marketplaces provided PayPal a low-cost customer acquisition tool, data-sharing synergies, and growth capital. However, a rapidly evolving commerce and payment environment and PayPal's decreasing dependence on Marketplaces (less than 30% of total payment volume today and potentially less than 15% within three years, per company estimates) has convinced management that this is the appropriate time to unwind the businesses to better capitalize on their respective growth opportunities, albeit through a number of arm's-length shared services/synergies agreements.
EBay’s new capital structure is more highly leveraged, with $7.5 billion in debt remaining at the remaining company, while post-spin EBITDA is 25% lower, declining to $3.7 billion. Accordingly, stand-alone debt/EBITDA is 2.0 times, compared with 1.5 times for the combined entity. Our new rating also considers a shift to a narrow economic moat/negative moat trend rating, compared with wide moat/positive trend for the combined entity, higher uncertainty, lower revenue and EBITDA (to $9 billion and $4 billion, respectively, compared with $18 billion and $5 billion previously), and weaker free cash flow generation (to $2 billion from nearly $6 billion previously).
We also anticipate the company will add to its debt leverage, based on recent comments by management that it believes it has additional debt capacity from current levels and plans to target leverage in the range of 2.5-3.0 times. We expect any additional debt will be prioritized to fund investments, increased M&A activity such as technology- or geographic-related acquisitions, and additional share repurchases. The company added $1 billion to its share-repurchase program in July, bringing total authorization to $3 billion. We also believe there is the possibility that the company will initiate a dividend in the next few years.
Credit Rating Downgrade: Expedia
We are downgrading Expedia's EXPE (narrow moat) issuer credit rating by one notch to BBB- on the additional debt leverage taken on for the pending acquisition of Orbitz. In February, Expedia announced the acquisition of Orbitz for $1.6 billion in cash. Both boards have approved the transaction, but the Department of Justice has yet approve it. We anticipate the transaction will go through as planned and have modeled in the closing as of the start of 2016. In June, Expedia added roughly $725 million in debt for general corporate purposes that we believe will help finance the acquisition or be used to repurchase shares. Pro forma for the acquisition, this new debt as well as over $400 million in debt at Orbitz, we estimate that debt/EBITDA will rise to 2.0 times from 1.7. However, we think more debt leverage may be added to fund other acquisitions, investments, or share repurchases, as management said it is comfortable with leverage in the 2-3 times range, despite the fact that it has remained below 2 times for the past few years. Expedia has recently been active on the acquisition and partnership front, highlighted by its partnership with Decolor.com, majority stake taken in AirAsia.com, acquisition of Travelocity, divestiture of Chinese online travel agent eLong and collaboration with Chinese OTA CTrip, and proposed acquisition with Orbitz. Given the many areas of growth in the online travel industry that we see (vacation rentals, in-destination, emerging markets) we would not be surprised that Expedia and other leading players like Priceline continue to acquire assets in order to position themselves for further network advantage. Year-to-date share repurchases have totaled only $45 million, but we expect them to accelerate once the Orbitz acquisition closes, as Expedia has repurchased over $500 million in shares for the past two years. Management has cited its continued commitment to repurchasing shares.
Credit Rating Upgrade: Hologic
We are upgrading our credit rating on Hologic to BB+ from BB-, reflecting recent deleveraging after the Gen-Probe acquisition along with its competitive advantages in women's healthcare. Since new management has taken the helm at Hologic, we have been impressed with its deleveraging progress. At the end of June, the firm owed $4 billion in debt and held $889 million in cash, resulting in net debt/EBITDA of 3.2 times. By our estimates, the firm looks capable of reaching its net debt/EBITDA goal of 2.5 times within the next year, and our upgrade reflects its recent deleveraging through debt repayment, cash generation, and profit growth. If the firm continues to deleverage through its current goal, we may consider another rating upgrade.
Hologic operates with a narrow moat, too, with its foundations in breast health and diagnostics. The breast health segment, where Hologic built its name, has sizable barriers to entry in the form of research and development and regulatory hurdles. Additionally, customer switching costs are high on a direct and indirect basis. Hologic's machines are typically expensive, big-ticket purchases for hospitals and clinics, which often guarantee that a customer will choose to upgrade a current system rather than buy a competing one. That dynamic creates dependable revenue and customer loyalty for the company. Furthermore, the acquisition of Gen-Probe added its chlamydia/gonorrhea, HPV, and trichomonas products to Hologic's in-house ThinPrep offering, creating a powerful and extensive diagnostic platform catering to women's health. The strength of these innovative products, which run on proprietary instruments, gives Hologic control over the entire work flow and locks in customers for long-term contracts. High switching costs related to swapping expensive platforms and retraining lab technicians add to the moat in this niche.
Credit Rating Upgrade: Southwest Airlines
We are increasing our corporate credit rating on no-moat Southwest Airlines one notch to BBB from BBB- on improved credit metrics since our previous rating. Southwest operates with a best-in-class financial health, as evidenced by our investment-grade credit rating, and the recent industry consolidation has further bolstered its profile. Industry capacity discipline has resulted in pricing power, while falling oil prices have enabled EBITDA to grow from $1.4 billion in 2011 to a projected $5 billion in 2015, nearly tripling EBITDA margins to 26% while boosting returns on invested capital to a projected 20% in 2015 from 5.5%. These two factors have strengthened the firm’s Solvency Score. Southwest has used the resulting free cash flow windfall to reduce outstanding debt by nearly $1.5 billion, halving its rent-adjusted debt/EBITDAR falling to 1.5 times. Our Cash Flow Cushion is negatively affected by average debt maturities of $500 million and capital spending of nearly $1.5 billion per year over the next five years. In addition, we also project the firm to repurchase $1.5 billion of shares this year. Liquidity remains strong, in our opinion, with cash and short-term investments of $3.1 billion, with full availability on the firm’s $1 billion revolver.
Credit Rating Upgrade: United Continental Holdings
We are increasing our corporate credit rating on no-moat United Continental Holdings one notch to B+ from B on improved credit metrics since our previous rating. The recent industry consolidation has enabled United Continental to improve its financial health, although integration issues related to its 2010 merger, including two technology glitches this summer alone, have been a slight drag. Even still, United has benefited from capacity discipline and the resulting pricing power, in addition to falling oil prices. EBITDA has grown from $3.3 billion in 2011 to a projected $7 billion in 2015 as result, nearly quadrupling EBITDA margins to 21% while boosting returns on invested capital to a projected 18% in 2015 from 5.0%. This strong performance has strengthened the firm’s Solvency Score. Moreover, the industry’s revival resulted in a lowering of the firm’s uncertainty rating to very high, aiding its Business Risk score. During this time, United has reduced outstanding debt by nearly $3 billion, causing rent-adjusted debt/EBITDAR to fall to 4.4 times in 2014 from 5.2 times in 2011. The firm’s weak Cash Flow Cushion score reflects average debt maturities of $1.3 billion and capital spending of nearly $3 billion per year over the next five years. The firm recently authorized a $3 billion share repurchase plan in addition to its previous $1 billion authorization, and we forecast upwards of $2 billion to occur by year end. We think liquidity is adequate, with cash and short-term investments of $5.0 billion, in addition to $1.4 billion availability on its revolver.
Credit Rating Affirmation: Terex
We have affirmed our BB- credit rating on Terex TEX (rating: BB-, no moat) after the firm announced an all-stock merger with Konecranes. The deal is targeted to close in the first half of 2016. While the deal appears to be a credit positive, given the all-stock nature and Konecranes' modest debt levels, the company also intends to buy back $1.5 billion in stock over the succeeding two years. Given this potentially aggressive financial policy, we do not see a rating upgrade as appropriate at this time. A new CEO will need to be named to lead the merged entity, and we intend to revisit our view once that individual has formulated any update in the strategy. The company is targeting $2.8 billion in free cash flow over 2016–18, but our forecast is substantially lower. Management targets net debt/EBITDA of 2.3 times one year after the close, which would include the impact of $500 million in share repurchases. We estimate pro forma net leverage is already near those levels, given pro forma cash of $524 million and pro forma adjusted 2014 EBITDA of $845 million haircut by softer 2015 results. The targeted net leverage ratio compares with last-12-months' leverage of about 2.7 times for stand-alone Terex as of June 30.
The deal brings together complementary businesses and will strengthen Terex's product offerings in the industrial lifting/material handling and port solutions segments. While geographic diversity remains similar, revenue generated by more stable services business improves from 18% at stand-alone Terex to 24% pro forma. Pro forma 2014 sales are about $10 billion, with more than 70% coming from Terex. Pro forma operating margins of 6% are targeted to increase to over 10% in three to four years because of market penetration and synergies. We have not modeled in margins at these levels, but successful integration of the companies combined with financial discipline could put upward pressure on the rating.
News and Notes
Best Idea Amgen Receives Key Product Approval; Bonds Remain Cheap On Aug. 27, the Food and Drug Administration approved Amgen's AMGN (rating: A, wide moat) high cholesterol therapy Repatha for marketing. If this product succeeds in the marketplace, including in Europe—where it was approved in July—this new product launch could help to stabilize Amgen's currently negative moat trend, as profits should rise on Repatha's commercialization. These rising profits should also help Amgen service its debt obligations, which creditors should appreciate. We look forward to seeing whether this positive fundamental catalyst will lead to spread-tightening in Amgen's bonds, which remain on our Credit Best Ideas list.
In our opinion, Amgen's bonds continue to offer attractive compensation for investors relative to similarly rated peers. For example, Amgen's notes due 2025 recently traded at +170 basis points over the nearest Treasury. We see about 20 basis points of tightening potential toward our fair value estimate of +150 basis points, which includes a margin of safety for Amgen's relatively risky capital allocation practices for debtholders. However, we note that Bayer's BAYRY (rating: A-minus/UR+, narrow moat) notes due 2024 recently traded at +127 basis points, which is roughly in line with the Morningstar Industrials A Index of +133 basis points. Since we see about one notch of upgrade potential in Bayer's credit rating, we think Amgen and Bayer represent similar credits. Overall, Bayer's notes represent the positive capital allocation scenario for Amgen's bonds, and we maintain an overweight recommendation on Amgen and a market weight recommendation on Bayer.
Schlumberger Announces Agreement to Acquire Cameron; No Credit Rating Change for Schlumberger
On Aug. 26, Schlumberger Limited SLB (rating: A-plus, wide moat) and Cameron CAM (rating: A-minus, narrow moat) jointly announced a definitive merger agreement, in which the companies will combine in a stock and cash transaction. The agreement was unanimously approved by the boards of directors of both companies. Cameron shareholders will receive 0.716 shares of Schlumberger common stock and a cash payment of $14.44 ($2.8 billion) in exchange for each Cameron share. Based on the closing stock prices of both companies on Aug. 25, the agreement places a value on Cameron of $66.36/share, a 56% premium to Cameron's prior-day closing stock price of $42.47/share. The transaction is expected to close in the first quarter of 2016. We do not anticipate any change to our Schlumberger rating as a result of the deal, but we are suspending our Cameron rating, as we expect to drop coverage once the deal closes. It is still not clear whether Schlumberger will guaranty the Cameron bonds, but implied or full support from Schlumberger is a positive for Cameron bondholders.
For several reasons, we believe the merger makes strategic sense. First, the transaction combines two complementary technology portfolios—Schlumberger's down-the-hole technology, instrumentation, and software capabilities and Cameron's wellhead and surface hardware offerings—to create a "pore-to-pipeline" products and service offering to the global oil and gas industry. The two companies are well- known to each other, having formed the OneSubsea joint venture in 2013 (a venture to which Cameron contributed 60% and Schlumberger 40%), which has helped reinforce Cameron's strong offshore position. With little to no product overlap, we expect approval of the merger regarding antitrust.
Second, the current sharp cyclical downturn in energy pricing calls for the acceleration of low-cost solutions, especially for deep-water exploration and production. By combining the research and development expertise of both companies, the time to market for new technology and service offerings from OneSubsea should be shortened. More broadly, the performance attributes of all Cameron hardware offerings should benefit from incorporation of Schlumberger's software and instrumentation technology, enhancing the value proposition to customers.
Third, the merger will allow broader geographic distribution of Cameron products and services, benefiting from Schlumberger's global reach. With these points in mind, we expect the merged entity to retain Schlumberger's existing wide economic moat, which supports our Business Risk ratings.
From Schlumberger's financial perspective, the company will issue 137.5 million new shares ($10.0 billion equivalent), utilize $2.8 billion of cash and acquire Cameron's $2.8 billion of debt and $1.1 billion of cash. Schlumberger's hoard of nearly $7.3 billion in cash and short-term investments is helping to ease the company's purchase of Cameron. Therefore, we anticipate that Schlumberger's ratio of net debt/(net debt plus equity) will increase modestly, from 14% at the June quarter to 17% pro forma. Schlumberger's ratio of gross debt/trailing 12-month EBITDA will remain largely flat at slightly over 1 times pro forma for the merger and excluding any synergies. Net leverage will increase slightly, but will remain comfortably below 1 times.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.