It was a roller-coaster ride last week. On Monday, corporate credit spreads continued to widen as the risk-off mentality carried through from the prior week. In addition to pressure emanating from the emerging markets, U.S. markets fell due softer than expected auto sales, manufacturing data, trade data, and construction spending. However, by the middle of the week, markets bottomed out and the "buy the dip" crowd was out in force on Thursday, pushing credit spreads slightly tighter. On Friday, markets initially plunged lower after the Bureau of Labor Statistics reported a disappointing payroll headline. Non-farm payrolls grew a meager 113,000 in January, far below economists' estimates; in fact, it was even below the lowest estimate. While the headline number was certainly below expectations and the markets initially gapped downward, markets almost immediately began to retrace their losses and then rose throughout the rest of the day.
Even though the headline report was below expectations, the markets focused on positive momentum in private payroll growth underlying the headline figure. For example, within the construction and manufacturing sectors, jobs grew 69,000, one of the best single-month readings since the beginning of the recovery. This is certainly good news, as Morningstar's Bob Johnson highlighted that these are great paying, high hours type of jobs. However, he cautioned against reading too much into this report, as this job growth will be hard to match in months ahead, and may represent a bounce from weather-afflicted December data. Robert also drew attention to some sector issues that are troubling to him. The health care and education sectors continued to be soft, adding almost no jobs for the second month in a row after being the bulwark of job growth for a large part of the economic recovery. Given the report for productivity growth released earlier last week, the payrolls numbers are consistent with Robert's forecast of GDP growth this year between 2.0% and 2.5%.
There also was some discussion among market commentators that the payroll release may spur the Fed to ease off of its tapering program. We think that the Fed will continue to taper its asset purchase program, and that it would take a severe economic pullback for the Fed to change its current course. A large part of this belief is that if the Fed were to halt its tapering, it would signal to the markets that the Fed is projecting slower economic growth or even a recessionary environment--which may then become a self-fulfilling prophecy.
New Issuance Subdued, IBM and Oshkosh Bonds Look Cheap
The new issue market was relatively silent at the beginning of last week, but after the markets began to stabilize in the middle of the week, issuers took the opportunity to sell bonds before the payrolls number was released on Friday. Among those new issues, we thought International Business Machines' (IBM) (rating: AA-, wide moat) new 10-year bonds, which priced at +95, looked cheap as we think fair value on those bonds is closer to +80. Comparatively, similarly rated tech companies’ bonds such as Intel's (INTC) (rating: AA, wide moat) 2.70% senior notes due 2022 trade around +90, Oracle's (ORCL) (rating: AA, wide moat) 2.50% senior notes due 2022 were indicated at +82, and Apple's (AAPL) (rating: AA-, narrow moat) 2.40% senior notes due 2023 trade at +86. While IBM’s heavy share-repurchase activity is a negative from a credit viewpoint and leverage has inched higher to 1.2 times, we recognize that IBM carries about $11 billion in cash and could repay its entire debt load out of free cash flow in about four years, even after funding a $4.1 billion annual dividend payout. For investors with a greater risk appetite, we think there is upside in Oshkosh's (OSK) (rating: BB+, narrow moat) new 5.375% senior notes due 2022. This issue priced on Thursday at par, resulting in a +315 basis point spread over Treasuries; however, we think that fair value for the yield on these bonds is between 4.50% and 4.75%, some 63 to 88 basis points tighter than where the bonds were issued. Proceeds from the issue will be used to repay existing indebtedness and should leave the firm’s 1.3 times debt leverage unchanged compared to its targeted debt leverage, which is in the 1.5 times to 2 times range. Oshkosh recently announced a new share repurchase authorization of up to 10 million shares, which at the current stock price would equate to about $500 million. Considering we forecast that the company will generate about $200 million in free cash flow this year, we expect Oshkosh will stay within its leverage targets.
Fourth-Quarter 2013 GDP Likely Overestimated and Will Be Revised Downward
Several economic metrics released last week have caused Morningstar's Johnson to estimate that fourth-quarter GDP will likely be revised substantially downward when the second estimate is released at the end of this month. Johnson pointed to exports, government spending, and construction spending as areas that were overestimated in fourth-quarter GDP. Unless there are other components that offset those detractors, the next GDP estimate could decrease to as low as mid-2% from the original estimate of 3.2%.
In addition to his expectation that fourth-quarter GDP is lower than currently estimated, several other economic indicators have him increasingly worried. For example, vehicle sales fell to a 15.2 million annual rate in January as compared to a 15.4 million annual rate in December, January’s PMI Manufacturing Index slipped to 53.7 from 55.0 in December, and the ISM Manufacturing Index dropped to 51.3 in January from 56.5 the prior month. However, not all of the releases indicate slowing economic growth rates. The ISM Non-Manufacturing Index rose to 54.0 from 53.0 last month and, considering services is a greater portion of economic activity than manufacturing, a pick up here should help to offset the stagnation in the manufacturing sectors.
Italian and Spanish Bonds Rally to Their Lowest Yields in Years
Turmoil in the emerging markets has not spread to the peripheral European sovereign bond markets. Both Spanish and Italian 10-year bonds continued to rally last week, pushing the yields down to levels not seen since 2005 and compressing spreads to levels not seen since before the credit crisis. At the end of last week, the yield on Spanish 10-year bonds dropped to 3.59% and its spread over German bonds was +192 basis points. Likewise, the yield on Italian 10-year bonds dropped to 3.69% and its spread over German bonds was +203 basis points. We caution that if contagion from the capital flight in the emerging markets and/or the foreign exchange markets begins to spread into the developed markets, then we expect that these two bonds would be the first to be hit by a wave of selling pressure and their bond prices would fall further and faster than other European sovereign or corporate bonds.
Click to see our summary of recent movements among credit risk indicators (http://im.mstar.com/im/newhomepage/bond_strat_credit_movement_02102014.png).
New Issue Notes
IBM Initial Talk Looks Attractive; Intel Likely Remains Our Favorite among Large-cap Tech (Feb 6)
IBM plans to issue 2- and 5-year floating rate notes and 5- and 10-year bonds. Initial price talk is around the mid +50s and +105 on the fixed-rate bonds, respectively. With the firm’s 3.375% notes due 2023 trading at +82 basis points over the nearest Treasury, we would expect pricing to tighten versus the initial talk. We would peg fair value on the new 10-year issue around +80 basis points over Treasuries, with the 5-year fair value at about +45 basis points. The AA tranche of the Morningstar Corporate Bond Index sits at +69 basis points over Treasuries, but high-quality tech names currently trade wide of this benchmark. In addition to IBM, Apple 2.4% notes due 2023 were recently indicated at +86 basis over the nearest Treasury. Oracle 2.5% notes due in 2022 and Intel 2.7% notes due in 2022 were indicated at +82 and +90 basis points, respectively. We wouldn’t be surprised to see the new IBM notes price at or slightly wider than fair value, but Intel will probably remain our favorite among large-cap tech bonds.
We believe IBM is well positioned competitively and worthy of a wide moat rating. The firm competes across multiple tech hardware, software, and services industries, using its broad expertise, global reach, research and development capabilities, and brand to maintain a leadership position in most of the markets it serves. 2013 was a challenging year for the firm, however, with sales dropping nearly 5% and free cash flow declining nearly 10%. IBM continues to reshape its business around its strongest segments, recently agreeing to sell its commodity x86-based server business to Lenovo. The biggest long-term risk to IBM, in our view, is a disruption in the mainframe business as cloud computing technology makes vast computing capacity available on demand. This threat is likely to take a long time to develop, however.
IBM's heavy share-repurchase activity is a negative, as the firm has directed most of its free cash flow to buy back stock over the past several years. Leverage has inched higher over the past year, with total debt hitting $40 billion, or 1.6 times EBITDA, at the end of 2013, up from $33 billion, or 1.2 times, the year before. However, IBM could repay its entire debt load out of free cash flow in about four years, even after funding a $4.1 billion annual dividend payout. The firm also carries about $11 billion in cash and short-term investments, providing exceptional liquidity. IBM's financing operation holds about $30 billion in customer financing receivables, providing support for about 70% of its debt load.
Initial Price Talk on Deutsche Bank’s New Issue Is Fair (Feb 6)
Deutsche Bank (DB) (rating: A, narrow moat) is in the market with benchmark–sized 3-year fixed and floating rate as well as 5-year senior holding company bonds. Initial price talk on the 5-year bonds is in the low-100 basis point area while the 3-year is in the mid-80 basis point. Price talk on both issues is near our fair value of +100 bps on the 5-year and +75 bps on the 3-year. Deutsche Bank's 6% senior notes due 2017 are indicated at +82 bps over the nearest Treasury, which we consider fair for the maturity. After a string of weak earnings--dragged down by legal and regulatory charges and poor trading results--we consider Deutsche Bank weakly positioned in its rating category. European peer BNP Paribas' (BNP) (rating: A, narrow moat) 2.40% notes due 2018, which were recently issued, are indicated at +93 bps to the nearest Treasury, which we consider fair value. Barclays (BARC) (rating: A-, no moat) 6.75% senior holding company notes due 2019 are indicated at +90 to the nearest Treasury. This is rich to our fair value of +100 bps. Among U.S. universal bank peers, Citigroup (C) (rating: A-, narrow moat) 2.5% senior holding company notes due 2018 are indicated at +97 bps above the nearest Treasury, which we consider fair.
On Jan. 19, 2014, Deutsche Bank released fourth-quarter results early, reporting dismal results for the period. For the fourth quarter, Deutsche Bank lost EUR 965 million and reported earnings for the year of just EUR 1.1 billion. Although these results were an improvement from the EUR 2.5 billion loss during the same quarter a year ago and earnings of just EUR 315 million for 2012, they represent the second consecutive year of weak earnings. Results in the most recent quarter included a litigation expense of EUR 528 million, a 16.4% decrease in group net revenues (lead by a 27% decrease in Deutsche Bank's corporate banking and securities division due to weak fixed income trading), a 43% increase in restructuring costs, and a striking 59% increase in provisions for credit losses, all relative to the year earlier period. For the year, the bank reported a lackluster return on average equity of 1.9% and a weak efficiency ratio of 87%. Deutsche Bank has also been mentioned prominently in recent press reports as a focus of a multiregulator probe into foreign exchange trading.
Deutsche Bank’s Basel III Tier 1 regulatory capital--which compares favorably with most global peers--remained unchanged from the sequential quarter at 9.7% due to a decrease in risk-weighted assets; however, a broader concern to us regarding DB is their high asset leverage. By their own calculation, third-quarter leverage was 19 times as compared to an average of 15 times for large U.S. banks. While Deutsche Bank’s results are not an immediate cause for concern, they do cause us to question their credit risk on a relative basis compared to their global peers.
Oshkosh Refinancing Debt With New Bonds (Feb 6)
Not unexpectedly, Oshkosh announced it is calling its $250 million 8.25% senior notes due 2017 and offering new 8NC3 144a senior notes of the same size. We peg fair value of the new bonds at about 4.50%. We note that defense peer Alliant Techsystems (ATK) (rating: BB+, narrow moat) issued similar bonds in October which are now indicated at about 5.20% which we view as about 50 basis points cheap. ATK's pro forma total leverage is 2.7 times and 2.0 times through its senior unsecured notes, but we expect steady deleveraging. Oshkosh's total leverage is 1.3 times, but we view this as low versus the firm's leverage targets. Looking down in quality, industrial peer Terex (TEX) (rating: BB-, narrow moat) has 2021 maturity notes also indicated at 5.20% which we view as fair. Each of these bonds is also structurally subordinated to senior secured bank debt. We also note that the Merrill Lynch BB index offers a yield-to-worst of 4.63%. Oshkosh also has 8.50% senior notes which are callable in a year and indicated at about 3.00% to that call date. We have maintained a market weight opinion on Oshkosh bonds given the short call protection.
In our January 28 earnings note we highlighted that Oshkosh's LTM debt/EBITDA is 1.3 times, comfortably below management's target range of 1.5 to 2.0 times. Subsequently, Oshkosh announced a new share repurchase authorization of up to 10 million shares, which at the current stock price would equate to about $500 million. The new bond refinancing will leave Oshkosh's total debt at about $939 million, but we note the firm also sits on cash of $559 million. This, along with expected free cash flow this year of $200 million gives the firm ample ammunition to continue to buy back stock or pursue acquisitions while staying within leverage targets.
Regency Energy Issues $900 Million of Senior Notes at 5.875%; Bonds Look Rich (Feb 5)
On Wednesday, Regency Energy Partners (RGP) (rating: BB-, no moat) issued $900 million of senior notes due 2022 to repay borrowing under its revolving credit facility and for general corporate purposes. The issuance was upsized from an initial amount of $600 million. The new notes are subordinated to the company's $1.2 billion revolving credit facility, which had an outstanding balance of $780 million as of Jan. 31. Regency Energy Finance Corp., a wholly owned direct subsidiary of Regency, will serve as the co-issuer of the notes.
Regency has been on a buying spree over the past year, executing two large acquisitions and several smaller tuck-in purchases. In December, we affirmed our issuer credit rating of Regency Energy Partners at BB- following our review of Regency's acquisition of midstream pipeline company PVR Partners. The $5.6 billion acquisition, including the assumption of net debt of $1.8 billion, is a stock-for-stock deal that leaves Regency's credit metrics roughly unchanged on a pro forma basis. PVR's asset base in the Appalachia and Mid-Continent region appears to be very complementary to Regency's existing assets in the Permian Basin, South Texas, and North Louisiana. Regency is particularly interested in expanding its presence in the Marcellus, Utica, and Granite Wash plays, which largely come with attractive fee-based contracts. The merger did not affect our no moat rating for Regency, though we do acknowledge that PVR's Marcellus gathering and trunkline assets will be a boon to the company. We think the most compelling logic for the merger is size and scale. Our biggest question is whether Regency will now consider itself big enough to finally direct its focus on low-multiple organic growth. If so, this deal could be a long-term winner for the firm, given the depth of investment opportunities afforded by PVR's Marcellus and Mid-Continent footprints.
Regency’s new 5.875% notes were priced to yield 6.12%. We believe this level is slightly rich compared to midstream company MarkWest Energy Partners (MWE) (rating: BB, narrow moat), which we also rate underweight. MarkWest's 4.5% notes due 2023 recently traded at a yield-to-worst of 5.33%. Our more favorable view of MarkWest's credit is based on the company's organic growth opportunities in the prolific Marcellus shale, which should drive improvement in MarkWest's metrics. Based on the lack of future improvement in Regency's credit metrics and the substantial integration risk as well as the structural subordination of the new notes, we place fair value on the new notes in the area of 6.25%.
Enterprise Products Partners to Issue 10- and 31-Year Bonds; Initial Price Talk Looks Attractive (Feb 5)
Midstream energy company Enterprise Products Partners (EPD) (rating: BBB+, wide moat) announced that it plans to issue debt in two parts, 10-year and 31-year bonds, through its wholly-owned operating subsidiary Enterprise Products Operating. Enterprise Products Partners conducts substantially all of its business through Enterprise Products Operating and guarantees the debt issued by Enterprise Products Operating. Proceeds will be used to repay amounts outstanding under the company's commercial paper program and its revolving credit facility, which were drawn against to fund principal repayments of maturing notes, and for general corporate purposes. As of Feb. 4, $530 million of commercial paper was outstanding and $15 million was outstanding on the revolving credit facility. Initial price talk is +135 basis points for the 10-year and +155 basis points for 30-year; we view fair value for the new issues at +120bps and +140 bps respectively.
Our credit rating on Enterprise, which we award a wide economic moat, is driven by its industry-leading size and the integration of its asset base across the midstream value chain. Enterprise gathers natural gas from wellheads, operates gas processing plants, transports both natural gas and natural gas liquids on dedicated pipelines to market hubs, provides storage and fractionation for NGLs, and markets natural gas and NGLs to the petrochemical industry. The majority of cash flows are fee-based, accounting for approximately 80% of the firm's revenue. This revenue is driven by throughput and only indirectly affected by commodity prices. With significant new projects, such as the ATEX Express and looping Seaway pipeline, underway, we project EBITDA to increase by 13% in 2014 despite depressed prices for NGLs, keeping leverage below 4.0 times despite a slate of debt-funded growth projects.
We view Williams Partners (WPZ) (rating: BBB, wide moat) and Kinder Morgan Energy Partners (KMP) (rating: BBB+, wide moat) as fair comparables for Enterprise. Williams' 4.5% notes due 2023 recently traded at a spread of +163 bps while its 5.80% bonds due 2043 traded at a spread of +181 bps, both over the nearest Treasury; we view both issues as close to fair value. Kinder Morgan’s 4.15% notes due 2024 traded at a spread of +165 bps over the nearest Treasury, and its 5.00% bonds due 2043 traded at +174 bps. Despite recent operational issues surrounding several recent acquisitions, we believe Kinder's debt is cheap to fair value. Enterprise’s outstanding 3.35% notes due 2023 traded at a spread of +112 bps and its 4.85% bonds due 2044 traded at a spread of +134 bps, both over the nearest Treasury. Given our moat and credit ratings of Enterprise’s comparables, spread levels on Enterprise’s outstanding debt and our projection for debt-funded growth projects, we believe fair value on the new issue 30-year bonds is approximately +140 bps. Based upon the average spread differential across these companies, we believe Enterprise’s 10-year and 30-year debt should be approximately 20 bps apart, pegging fair value on the new issue 10-year at +120 bps.
BP to Issue 5- and 10-Year Debt; Initial Price Talk Looks Cheap (Feb 5)
BP (BP) (rating: A, narrow moat) plans to issue 5-year fixed and floating rate notes, and 10-year notes in benchmark size. Initial price talk is a spread in the area of +85 basis points for the 5-year, and the +125 area for the 10-year. We peg fair value for the new notes at +55 bps for the 5-year and +100 bps for the 10-year.
Within our coverage universe of supermajor integrated companies, BP is unique because of the liabilities remaining from the Gulf of Mexico oil spill, but Total (TOT) (rating: A-, narrow moat) and Statoil (STO) (rating: A-, narrow moat) are comparable in terms of issuer credit rating, albeit one notch lower. Total's 2.125% notes due 2019 recently traded at a spread of +45 bps above the nearest Treasury, while its 3.70% notes due 2024 traded at a spread of +90 bps. Statoil’s 1.95% notes due 2018 recently traded at +49 basis points and its 3.70% notes due 2024 traded at a spread of +90 bps, both over the nearest Treasury. We rate both companies underweight. We note that Statoil has been a frequent issuer of late as the company has issued debt to fill the funding gap between its operating cash flow and its dividend and capital spending program. Also for comparison, BP’s outstanding 2.241% notes due 2018 traded at +50 bps above the nearest Treasury and its 3.994% notes due 2023 traded at +107 bps.
We recently changed our recommendation on BP to overweight from underweight following significant spread widening in January and based on our improving outlook for the company. Although it was a multi-year effort for BP to shore up its balance sheet in the wake of the Macondo oil spill, it is now clear that operationally 2014 is going to be the first year of the company posting material cash flow growth since 2010. Well over a year ago, CEO Robert Dudley began to promise that as asset sales slowed, Gulf of Mexico production would rebound, and new projects coming online would increase operating cash flow to $30-$31 billion in 2014 (assuming Brent oil prices of $100 per barrel). As we’ve stated several times during the last few quarters, this cash flow target is turning out to be achievable; after updating our forecasts, we are forecasting 2014 operating cash flow to be $30.5 billion, net of $900 million of Macondo cash outflows. As a result, we find the initial price talk on the new issue attractive.
VEPCO to Issue $500 Million of 10- and 30-Year Notes at Slightly Cheap to Fair Initial Price Talk Levels (Feb. 4)
Dominion Resources' (D) (rating: BBB+, narrow moat) regulated electric utility subsidiary, Virginia Electric & Power, announced today this it will issue $500 million split between 10 and 30-year senior notes. Initial price talk on the 10 year is in the high 95 range while initial price talk on the 30 year is in the low 100 range. We believe Virginia Electric & Power’s new issue appears about 5-10 basis points cheap on the 10 year and about fairly valued on the 30 year. While we do not formally assign an issuer rating to Virginia Electric & Power, we view this entity to be of similar, although marginally lower credit risk to Southern Company's (SO) (rating: A-, narrow moat) regulated utility Georgia Power. As highlighted in our November publication, “Regulated Utilities: A New Frontier in Credit Risk Analysis,” Georgia Power’s 2.85% bonds due 2022 recently traded at 85 basis points over the nearest Treasury while its 4.3% bonds due 2042 also recently traded at 99 basis points over the nearest Treasury.
Furthermore, Southern Co.’s slightly higher ranked regulated utility (versus Virginia Electric & Power), Alabama Power’s 3.55% bonds due 2023 traded at 77 basis points over the nearest Treasury while its 3.85% bonds due 2042 also traded at 77 basis points over the nearest Treasury. We believe both Virginia Electric & Power’s 10 and 30 year new issues appear moderately cheap versus Alabama Power.
Virginia Electric & Power primary credit qualities include: relatively high allowed ROE of roughly 11.0%, very favorable southeastern regulatory environment, strong regulatory lag mechanisms, and above average management performance. As such, we rank Virginia Electric & Power as one of the strongest regulated utility operating companies under our coverage. Moreover, we believe Georgia Power’ ranks very similarly: high allowed ROE of roughly 12.2%, very favorable southeastern regulatory environment, slightly weaker regulatory lag mechanisms, and outstanding management performance. On the other hand, Alabama Power is the highest ranked regulated utility under our coverage. Specifically, we believe Alabama Power benefits from one of the best allowed ROE’s (roughly 13.8%, exceptionally efficient regulatory lag mechanisms, and outstanding management performance.
Moreover, on a consolidated basis, Dominion Resources reported strong adjusted full-year 2013 EBITDA of $4.8 billion, up 5.2% year over year, primarily attributable to electric service territory growth, higher rate adjustment clause revenue, higher revenue related to its gas transmission growth projects, and lower operating and maintenance expenses. Negative factors offsetting these benefits include milder-than-normal weather and lower contributions from unregulated retail marketing operations and producer services (business exited). Specifically, Dominion Virginia Electric & Power reported full-year 2013 operating EBIT of $945 million, down 5.5% (versus mid-point guidance of $975 million-$1,025 million) due to milder than normal weather.
Click here to see more new bond issuance for the week ended Feb. 7, 2014 (http://im.mstar.com/im/newhomepage/bond_strat_new_issue_table_02102014.png).
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