Commodity Issuers' Slumping Bond Prices Make the Headlines, but Media Sector Quietly Underperforms Even More

Friday's employment report was generally upbeat and in line with expectations, with 215,000 jobs added during July. The report also indicated that full-time jobs as a percentage of total employment rose to 81.7%, the highest reported level since November 2008, while the unemployment rate held at 5.3% last month. Job growth was led by the retail and business service sectors as well as health care and hospitality. However, the energy and mining sectors continued to shed workers, and the labor participation rate remained mired at 62.6%. Meanwhile, the Institute for Supply Management Purchasing Managers Index ticked lower in July to 52.7 from 53.5 in June. A reading above 50 indicates economic expansion, whereas below 50 indicates contraction. The ISM attributed the softness to uncertainty around international markets as well as the ongoing weakness in energy and commodities.

Commodities' recent price rout continued last week as oil retested its lows from earlier this year and copper traded down to prices not seen since 2009. In the Morningstar Corporate Bond Index, the average spread in the basic industries sector widened out 7 basis points to +243 and the energy sector widened out 9 basis points to +226. Overall, the average spread of our investment-grade index widened 4 basis points to +164. This is the widest level the index has reached over the past two years.

While most eyes have been anxiously watching the recent action in commodity-sensitive sectors, the media sector has quietly been the worst performer year to date. Since the end of last year, the average spread in media sector has widened 66 basis points, easily surpassing the 49-basis-point widening in the basic industries sector. Leading the sell-off was Time Warner Cable TWC (rating: SUS/BBB-, wide moat), which saw its bonds widen an average of 150 bps wider in the first quarter following its failed merger with Comcast CMCSA (rating: A-, wide moat). Subsequently, however, new suitor Charter Communications CHTR (not covered) announced its own plans to acquire TWC. Since Charter's announcement, Time Warner Cable's spreads have recovered about 20-25 bps but remain significantly wider year to date. Meanwhile, both covered advertising names--Interpublic Group of Companies IPG (rating: BBB-, narrow moat) and Omnicom Group OMC (rating: BBB+, narrow moat)--have been trending wider, though OMC has been slightly outperforming IPG. This is consistent with our view that while both companies have been outspending their cash flow on repurchases, we view leverage at OMC as likely to remain more stable and is a stronger credit.

Media and entertainment names Disney DIS (rating: A+, wide moat), Time Warner TWX (rating: BBB+, wide moat), Viacom VIA (rating: BBB+, narrow moat), Discovery DISCA (rating: BBB, wide moat), and CBS CBS (rating: BBB, narrow moat) have also been active this year. The trend toward cord-cutting, and most recently the recent research reports on ESPN's subscriber losses and subsequent discussion by management at Disney, generated downward pressure on media companies' bonds, and all have widened since the end of last year.

Following second-quarter earnings results, though, we assert that all this is consistent with management's forecasts. We continue to expect the companies, with the exception of Viacom, will maintain their current capital structures. Viacom is the only name in the group that concerns us from a credit perspective, as it has been operating with leverage (3.1 times EBITDA versus management's 3.0 times target). In our view, management has not seemed concerned about this. While Viacom has refrained from share repurchases during the last quarter, it plans to resume them in October. We may consider a downgrade if leverage persists at the top end of the company's target or begins to move higher. We prefer wide-moat-rated names such as Best Idea Time Warner, Disney, and Discovery.

We acknowledge that streaming service and skinny bundles will disturb the traditional pay television bundle in the near term. However, the timing of the disruption remains unclear. We believe the legality of Verizon's skinny bundles will ultimately be decided in court as Disney, Time Warner, and Fox all appear unwilling to concede on the issue. The media companies believe that their current carriage agreements obligate pay TV distributors such as Verizon to place certain channels such as ESPN, TBS, or FX in the basic bundle offering and that the skinny bundle offered by Verizon without those channels violates the agreement. Verizon's public position is that the agreements allow for its specific version of the skinny bundle. The cases covering these agreements may drag on for years, thus possibly halting other major distributors from selling a similar offering. We believe Verizon's attempt is a reflection of the weaker position of distributors, which are being squeezed by declining video subscribers on one side and rising affiliate fees on the other.

On the streaming side, we note that Disney, Time Warner, CBS, and Fox all either run their own SVOD service (HBO Now for Time Warner and CBS All Access) or own part of one (Hulu for Disney and Fox). We believe that in a shift to an over-the-top world, the media companies with both deep content libraries and must-watch live programming (sports and news) will be able to create a compelling SVOD service. The service for channels like TNT or FX could look like CBS All Access, with a combination of linear programming and a deep library of on-demand content including new shows available sometime after airing (with full season stacking). ESPN's service could mimic its WatchESPN/ESPN3 service with multiple live streams and archived events. One advantage of moving to an OTT world for media companies would be deep and meaningful data concerning viewer watching habits and demographics, similar to the data that Netflix currently obtains. This data would be used to not only better understand what programs to greenlight and to renew, but also to better target advertising and measure its efficacy.

Against this backdrop, we believe that the wide-moat firms (Disney, Time Warner, and Discovery) with the best production studios, deep content libraries, and live programming rights will have the best chance to navigate any of these potential changes in the space.

Content contributed by Michael Dimler, Joscelyn MacKay, and Neil Macker.

Strategic M&A Activity in Health-Care Sector Remains Robust While the recent decline in commodity prices has taken its toll across all of the issuers in commodity-sensitive sectors, idiosyncratic risk has been a consistent, ongoing theme in the health-care sector for the past several years. This risk has been brought about by changes in the business dynamics of the sector as well as political and regulatory changes. Management teams have looked to strategic mergers and acquisitions as well as financial engineering to enhance shareholder value. This company-specific idiosyncratic risk, which often leads to downgrades, has been the biggest risk to bondholders over the past few years. The health-care industry has been one of the most active sectors engaging in M&A, and that trend does not appear to be abating anytime soon. Julie Stralow, Morningstar's health-care credit analyst, first pointed out this emerging theme in her third-quarter 2012 outlook and further detailed the potential for a long-term trend toward strategic acquisitions in her report "Spread-Widening Events Possible in Big Pharma Niche" published in August 2012.

Most recently, Shire SHPG (not rated, narrow moat) publicized a bid to acquire Baxalta BXLT (rating: BBB+, narrow moat) in an all-equity transaction. We maintain our credit rating on Baxalta for now; however, we would note that although the combination will be made with equity, Shire's team intends to repurchase about $10 billion in shares during the next two years, which will be funded with a combination of new debt and cash on hand. If the acquisition were to proceed, we would re-evaluate our credit rating based on the pro forma cash flow dynamics and capital structure of the combined entity at that time. The basis for the acquisition appears to be based on both the business benefits that could result from combining the rare-disease focus of both companies as well as the potential tax synergies from Shire's Irish tax domicile.