Even though the equity market is hitting all-time highs, this exuberance has not rubbed off on the corporate bond market. Since the beginning of September, when the 10-year Treasury peaked at almost 3%, the S&P 500 has risen 8.6% to a new high, whereas the average credit spread in our corporate bond index has only tightened 12 basis points to +135, which is still 6 basis points wider than the tightest level reached in May. After suffering from the sharp increase in interest rates and widening credit spreads this summer--due to the expectation that the Federal Reserve was going to begin tapering in the fall--investors are hesitant to pay tighter credit spreads for longer-dated corporate bonds.
Based on Fed vice chair Janet Yellen's testimony and responses to questioning at her confirmation hearing in the Senate, we don't expect the Fed to begin tapering its asset-purchase program anytime in the near future. With the Fed continuing to purchase mortgage-backed securities and long-term Treasury bonds, investors have increasingly fewer fixed-income assets from which to choose. This decrease in supply is becoming even more pronounced as the U.S. government's deficit is shrinking and requiring less new debt issuance. This has positively affected the demand for corporate bonds as the supply of available fixed-income securities constricts and the new Fed-provided liquidity looks for a home. So long as the Fed's asset-purchase program is running full speed ahead, it will provide a ceiling as to how much long-term rates can rise and will help push credit spreads tighter over time. As such, we expect that credit spreads will continue to grind tighter.
Are Wal-Mart's and Cisco's Earnings Reports Early Warning Signs of a Slowdown Ahead?
Even though recent economic indicators have indicated that the economy is expanding, Robert Johnson, Morningstar's director of economic research, is puzzled that consumer spending has not been accelerating. For example, September's consumption report increased only 0.1% on an inflation-adjusted basis, and weekly shopping center data has been mired at a 2% year-over-year growth rate. Due to lackluster consumer spending, Wal-Mart Stores (WMT) (rating: AA, wide moat) reported weak growth in the third quarter as comparable-store sales declined 0.3% and the firm guided for flat comparable-store sales in the United States this year. Kohl's (KSS) (rating: BBB+, narrow moat) reported that comparable-store sales declined 1.6% in the third quarter and expects comparable-store sales in the fourth quarter to decline between 2% and 4%.
However, Macy's (M) (rating: BBB, no moat), which caters to consumers with more discretionary income that Wal-Mart and Kohl's, reported third-quarter same-store growth of 3.5% and management said it believes momentum is building, suggesting a positive outlook for the upcoming holidays. Management saw improvements in the business throughout the quarter and was particularly pleased with October's results. In addition, the improvements were broad-based geographically, and the pickup in growth occurred across merchandise categories. During the past five years, consumer spending has relied on upper- and high-end consumers as lower-end consumers continue to be squeezed, and it appears this holiday season will be no different. Considering that 70% of our economy is driven by consumer spending, if declining consumer confidence begins to spread to higher-end consumers, and they in turn reduce their pace of spending this holiday season, the recent improvement in economic metrics could be short-lived.
In the technology sector, business spending on infrastructure hardware has slowed dramatically in China and the emerging markets. Cisco Systems (CSCO) (rating: AA, wide moat) reported weak results for the third quarter and significantly reduced its guidance for the fourth quarter. Management cited lower sales and a general reluctance in China, and the emerging markets in general, to spend on long-term infrastructure projects as the reason for the underperformance. A few weeks ago, International Business Machines (IBM) (rating: AA-, wide moat) also reported soft results for its third quarter due to lower sales in its hardware segment and highlighted lower sales in China. Thus far, most of the weakness in the technology sector has been concentrated on hardware infrastructure spending among the emerging markets, whereas, business spending in the U.S. has held up. For now, it appears that the weakness in the emerging markets appears to be cyclical in nature as opposed to idiosyncratic to specific companies.
Telecom Italia Downgraded to Below Investment Grade by S&P, Catching Up to the BB+ Rating That We Assigned in 2010
We have removed Telecom Italia (TI) (rating: BB+, narrow moat) from our Falling Angels list following S&P's decision to downgrade the firm's rating one notch to BB+, trailing Moody's downgrade to Ba1 a month earlier. We anticipated the decline in Telecom Italia's rating based on the firm's elevated leverage and poor geographic diversification. Telecom Italia ended the third quarter with reported net leverage at 2.6 times EBITDA, making it one of the most heavily leveraged incumbent telecom operators in Europe. The firm's Italian operations generate more than 60% of consolidated revenue and about 75% of consolidated EBITDA, with TIM Brazil and Telecom Argentina contributing the remainder. The firm's concentration in Italy looks even more striking, considering that it owns only 67% and 23% of its subsidiaries in Brazil and Argentina, respectively. Telecom Italia's bonds have traded like a non-investment-grade issues for some time. The firm's 7.175% U.S. dollar notes due 2019 widened only about 9 basis points on the S&P downgrade to trade at about 343 basis points over the nearest Treasury (a yield of about 5%). While this level is attractive, considering our rating on the firm and the relatively short duration on these notes, we would remain on the sideline, given the complexity of the challenges that Telecom Italia faces. Among similar-rated telecom firms, we would prefer CenturyLink's (CTL) (rating: BB+, narrow moat) 6.15% notes due 2019, which are currently indicated at a yield of 5.20%, or 350 basis points over the nearest Treasury.
Moody's Concludes Its Negative Watch on Major U.S. Banks; Downgrades Catching Up to Our Issuer Credit Ratings; Upside Still Left in Subordinated Bank Bonds
Moody's concluded its long-awaited review of the eight large systemically important U.S. banking groups by removing the government support previously embedded in its ratings and downgrading several banks. These downgrades bring many of Moody's ratings either closer to, or in line with, our issuer credit ratings. For instance, Moody's downgraded:
Bank of New York Mellon (BK) (rating: A, wide moat) to A1 as compared with our A rating Goldman Sachs Group (GS) (rating: BBB+, narrow moat) to Baa1 as compared with our BBB+ rating Morgan Stanley (MS) (rating: BBB, narrow moat) to Baa2 as compared with our BBB rating Moody's downgrades did not have an impact on the credit market as credit spreads in the financial sector were generally unchanged to slightly tighter after the report. As the market becomes more comfortable that Title II (orderly liquidation authority) of the Dodd-Frank legislation will impose losses on U.S. bank holding company creditors in order to support bank operating companies, we continue to see further upside in subordinated debt that has been issued at the bank operating level as compared with senior debt that has been issued at the holding company level. For greater detail, see our Feb. 11 report, "U.S. Banks: Senior Holdco Versus Operating Subordinated Debt."
Euro Area GDP Growth Slows in 3Q Compared With 2Q
The rate of gross domestic product growth in the euro area faltered in the third quarter as real GDP rose a meager 0.1%, compared with the 0.3% growth reported in the second quarter. The second quarter was first time the euro area had reported positive GDP growth since the third quarter of 2011. Germany's GDP growth rate fell to 0.3% in the third quarter of 2013 from 0.7% in the prior quarter, and France stumbled to a 0.1% decline for the quarter after having grown 0.5% in the second quarter. Offsetting some of the weakness in the larger economies, several of the southern peripheral economies showed improvement. Spanish GDP grew 0.1%, its first positive report since the second quarter of 2011. Italy continued to struggle as its GDP registered a 0.1% decline, but the rate of decline has now decreased sequentially for the past three quarters.
To support economic growth and assuage deflationary fears, the European Central Bank, in a surprise decision, cut its main short-term rate by 25 basis points on Nov. 7. The European Commission cut its forecast for 2014 GDP to 1.1% growth in the eurozone, marking its second forecast reduction this year (it cut its forecast in May to 1.2% from 1.4%). The EC also increased its unemployment estimate to 12.2% next year from 12.1%. Because of stagnant economic growth, S&P cut its credit rating for France by one notch to AA. S&P said lower economic growth is constraining the country's ability to shore up its credit quality. If the eurozone is unable to sustain positive economic growth, we are concerned that this downgrade may be the beginning of a reassessment of credit quality of other European countries, as well.
Peripheral European sovereign bonds have performed extremely well this year. Since the beginning of the year, the spread between Spanish and German bonds has tightened 160 basis points to a current spread of +235. The spread on Italian bonds over German bonds has also tightened substantially, having declined 81 basis points to +237. While investors are betting that the economies of those two countries have bottomed, the banking systems of both countries have continued to be under pressure as nonperforming loans grow. Intesa Sanpaolo (ISP) (rating: BB-, no moat) reported that in the third quarter gross nonperforming loans grew to 15.9% of total loans as compared with 12.7% in the year-ago period. UniCredit (UCG) (rating: BBB-, narrow moat) reported its nonperforming loans grew to 14% as compared with 12% last year. In Spain, doubtful loans have grown every month since the end of last year, while the total amount of loans outstanding has steadily decreased. At the end of August, doubtful loans were 12.1% of total loans outstanding as compared with 10.5% last year. While doubtful loans are growing in the country's banking system, the credit quality of the country continues to deteriorate as well. Last week, the Bank of Spain reported that debt/GDP continued to climb and reached 93.4%. The country expects debt to increase next year as well, taking debt/GDP up to 100%.
Click to see our summary of recent movements among credit risk indicators (http://im.morningstar.com/im/newhomepage/bond_strat_credit_movement_11182013.png).
New Issue Notes
CenturyLink's 10-Year Issuance Likely to Price Attractively, On Par With Frontier (Nov. 14)
CenturyLink plans to issue $500 million of 10-year notes, with the proceeds to help fund the redemption of subsidiary Qwest Communications International's $800 million of 7.125% notes due in 2018. Earlier this year, CenturyLink threw in the towel on its investment-grade ratings from Moody's and Fitch by instituting a $2 billion share-repurchase program, while cutting its dividend, and raising its leverage ceiling to 3.0 times EBITDA versus a prior target range of 2.0-2.5 times (leverage at the end of 2012 stood at 2.7 times). Since instituting these changes, CenturyLink has repurchased nearly $1.3 billion of its shares, but the business has generated enough cash to fund the repurchases and the reduced dividend. As a result, net debt has actually declined slightly, holding net leverage at 2.7 times EBITDA on an LTM basis. The combination of the lower dividend rate and smaller share count has cut CenturyLink's annual dividend payout to $1.3 billion from $1.8 billion, giving management substantial flexibility in directing free cash flow in 2014.
CenturyLink's existing 5.8% notes due in 2022 have exhibited significant volatility recently, trading at a 6.7% yield at the end of September, rallying to 5.8% in late October, and then dropping off to 6.3% following the firm's third-quarter earnings release last week. Revenue was soft during the quarter, especially in the datacenter business, but our long-term view of the firm was unchanged. The spread on these notes currently sits at 378 basis points over the nearest Treasury, which we view as cheap to fair value. We believe fair value for the new 10-year notes is a yield of 5.7%, which would provide a spread of 300 basis points over the 10-year Treasury, slightly inside of the option-adjusted spread on the Merrill Lynch BB index (+318 basis points). Based on the spread on the 2022 notes, we would expect the new offing to price at about 6.6%, making the new notes a good value, in our view.
Frontier Communications (FTR) (rating: BB, narrow moat), CenturyLink's closest comparable, was recently on our high-yield Best Ideas list and is currently our top pick in the sector. Frontier's 7.125% notes due 2023 recently traded at a 7.0% yield, or a spread of +431 basis points to the nearest Treasury. At the current differential in spreads, we are indifferent between the two firms on a risk-adjusted basis. Frontier's management is committed to debt repayment, as demonstrated by its wiliness to cut the dividend last year and consistent reiteration of a 2.5 times EBITDA leverage target. CenturyLink management's intentions for the balance sheet are less clear, with room to add $1 billion-$2 billion of additional debt under its current 3.0 times leverage ceiling. However, Frontier is more heavily leveraged today (3.4 times EBITDA) and CenturyLink has built a stronger, more stable business. We expect CenturyLink will generate $1.7 billion in cash after dividend payments next year, equal to about 8.4% of net debt. On the other hand, we expect Frontier will generate enough cash in 2014 to reduce net debt only about 4.5%. As a result, we don't expect the gap in credit quality between the two firms will change much over the next year.
Initial Price Talk on State Street's 10-Year Notes Appears Too Tight (Nov. 14)
State Street (STT) (rating: A-, wide moat) is in the market today with benchmark-size 10-year notes at the holding company level. The proceeds are intended for general corporate purposes, but we suspect the offering will be used to retire a portion of the $500 million 4.30% notes due in 2014. Initial price talk on the new note is around 110 basis points over Treasuries. We think the whisper talk is slightly tight. Bank of New York Mellon's (BK) (rating: A, wide moat) 3.55% notes of 2021 are indicated at 105 over the nearest Treasury, implying an insufficient 5 basis points compensation for a one-notch lower rating. We therefore peg fair value closer to 120.
We instead prefer Eaton Vance's (EV) (rating: A, wide moat) 3.63% notes due in 2023. The Eaton Vance bonds provide investors with roughly the same spread (+119) for a one-notch higher credit rating. Moving down the credit quality in the asset manager universe are Ameriprise Financial's (AMP) (rating: BBB+, no moat) 4% notes due in 2023, which are currently indicated at 116 to the nearest Treasury. We remain cautious on this name given its legacy insurance exposure, which is around 40% of revenue.
State Street reported decent third-quarter results last month despite a challenging environment. The firm reported a respectable 10.7% return on equity (13.3% last year) as cost efficiencies were offset by a decline in net interest income and continued pressure on noninterest revenue. Despite this degradation, we continue to see State Street's capital position as strong. The bank's pro forma Basel III under the tougher standard approach ratio increased 20 basis points to 10.2% and its Tier 1 common ratio was 15.5%. State Street's fortunes remained strongly tied to its clients' assets, so the sequential increase in assets under custody and assets under management of 4.4% and 1.1%, respectively, help allay our concerns about slow sequential fee growth.
Maxim's 5-Year Issuance Looks Very Attractive (Nov. 14)
Maxim Integrated Products (MXIM) (rating: A+, wide moat) plans to issue $500 million of 5-year notes, replacing the cash used to fund the $450 million acquisition of Volterra Semiconductor. The issuance was expected, as we've had the firm on our Potential New Issue Supply list. Initial price talk is in the low 140 basis points range over Treasuries, which we believe presents an excellent value. Maxim's existing 10-year notes, issued last March, also look very attractive, with a large block moving in late October at 170 basis points over the nearest Treasury. The existing notes also trade at a discount and, like the planned offering, have change-of-control protection.
We have a significantly more favorable view of Maxim than the major agencies, owing in large part to our wide moat rating on the firm. Maxim is a premier provider of highly differentiated analog chips for various electronic devices that carry long product life cycles. The firm has pushed into higher-volume segments of the chip market, notably phones and tablets, where competition is stronger and it has developed a heavy concentration of sales at Samsung. However, we believe the firm's large base of industrial customers that use its proprietary analog chip designs provide stability to offset volatility in sales into the phone market. With the planned debt issuance, Maxim will carry $1 billion in debt, equal to about 1.3 times trailing EBITDA (slightly lower including Volterra's results). Against this debt load, the firm will hold about $1.1 billion in cash, most of which will be available domestically.
We believe Maxim's bonds are attractive relative to the broader corporate market and its semiconductor peers. At 140 basis points over Treasuries, the new issue would trade similarly to the BBB+ tranche of the Morningstar Industrials Index (+148 basis points), but with a much lower duration (the average maturity in the index is about 10 years). Also, Broadcom's (BRCM) (rating: A, narrow moat) 2.7% notes due in 2018 are currently indicated at 74 basis points over the nearest Treasury and Texas Instruments' (TXN) (rating: A+, narrow moat) 1.65% notes due in 2019 are indicated at about 64 basis points over the nearest Treasury. While Maxim is significantly smaller than these two peers, we believe that it enjoys a stronger competitive position.
Macy's Leverage Still Below Target After Another Solid Quarter; We Expect More Debt Issuance (Nov. 13)
Macy's reported another solid quarter of operational improvements and steady execution, which continue to propel the company in what is still a tepid economic environment. Macy's increased same-store sales 3.5% in the third quarter, and management believes momentum is building, suggesting a positive outlook for the upcoming holidays. We still rate the company as having no moat given the competitive nature of the department store sector and call out that same-store sales improvement and other efficiency gains are the only avenues for the company to grow. Given that backdrop, the focus on operating the business under the existing structure has brought 15 straight quarters of earnings growth, 14 quarters of improving same-store sales, and operating margins that have expanded each year since 2009. Gross margin in the quarter contracted 40 basis points to 39.2%, primarily because of free shipping from omnichannel growth. While the department store environment remains promotional, management expressed that there wasn't anything unusual driving promotions or markdowns. Selling, general, and administrative expenses rose only 1% in the quarter to $2.1 billion, providing 80 basis points of leverage to 33.4% of sales.
Year to date, share repurchases have totaled $1.2 billion (versus $1.0 billion in the prior-year period). With only $438 million in free cash flow generation over the same time frame, cash on hand, along with a $400 million debt, issuance funded the remainder. Still at 2.3 times lease-adjusted leverage, Macy's is below its targeted range of 2.4-2.7 times, which management reiterated on the call. Therefore, with earnings improving, we estimate there is $1 billion-$2 billion in incremental debt capacity. We had noted on the firm's debt issuance in September that we were surprised the amount wasn't larger, particularly given a $450 million debt maturity in the first half of 2014.
We currently view Macy's bonds as fairly valued to slightly rich with its 2023 notes at 162 basis points over the nearest Treasury, or just over 20 basis points inside Morningstar's Industrials index. The preponderance of consumer cyclical credits that we view as fairly valued trade around 20 basis points inside the Index. Other BBB retailers that have less cyclical business models--the auto-parts retailers, AutoZone (AZO) (rating: BBB, narrow moat) and O'Reilly Automotive (ORLY) (rating: BBB, no moat), trade inside Macy's, which we believe is appropriate. We believe Macy's should trade wider than both auto-parts retailers given its cyclicality.
Lastly, of interest to investors, Macy's expressed confidence in the momentum of the business going into the important holiday quarter. Management saw improvements in the business throughout the quarter and was particularly pleased with October results. In addition, the improvements were broad-based geographically, and the pickup in growth occurred across merchandise categories as well. Other reasons for optimism include early strength in categories that tend to be gift driven, such as home goods, or jewelry, and also improvements in some categories that had been tougher in previous months. Finally, marketing adjustments made to better communicate value after the second quarter's slight dip in same-store sales appeared to be working and will be leveraged into the holidays.
Macy's has continually posted solid results, as its operating strategies produce incremental results. We believe comparable-store sales improvements can continue for at least the next few seasons, as many of the merchandising initiatives and employee training initiatives are still taking effect. In 2013, the firm increased its share-repurchase program by $1.5 billion, bringing the new authorization to $2.6 billion and the dividend from $0.20 per share to $0.25 per share. Still, management stated that it continues to target lease-adjusted leverage in the 2.4-2.7 times range, and the firm has well-spread-out maturities and a Cash Flow Cushion above 1 times.
Corning's 10-Year Issuance Looks Fully Valued (Nov. 13)
Corning (GLW) (rating: A-, narrow moat) is in the market looking to raise $250 million of 10-year notes. Initial price talk is around 115 basis points over Treasuries, which we view as fair value. Price talk is in line with the A- bucket in the Morningstar Industrials Index, which trades at about 116 basis points above Treasuries. Corning's existing notes don't provide much guidance given the high dollar price on its existing notes around the 10-year maturity mark. For example, its 7.53% notes due 2023 have traded recently, in very small size, at about 124, or 166 basis points versus the nearest Treasury. Its 4.25% notes due 2020 trade closer to par (around 107) with a spread indicated at about 105 basis points over the nearest Treasury. Corning doesn't have any close comparable firms within the technology sector, but Broadcom 2.50% notes due 2022 have been indicated in the range of 116 basis points over the nearest Treasury.
Corning recently announced plans to acquire full ownership of Samsung Corning Precision, a move we viewed as a positive for creditors. Corning will issue Samsung $2.3 billion of 4.25% perpetual preferred shares that are convertible at $20 per share seven years after issuance in exchange for Samsung's 43% stake in SCP and $400 million. Corning will also pay $300 million to buy out other minority SCP shareholders. Corning will gain direct access to the $1.2 billion in cash held on SCP's balance sheet, bringing the net cash added to Corning's balance sheet to $1.3 billion. Partially offsetting this benefit to the balance sheet, Corning is increasing its existing $1.5 billion share repurchase program by $2 billion, bringing the total authorization to $3.5 billion, with expected completion over the next couple of years.
Corning ended the second quarter with $5.5 billion in cash, putting net cash at $2.6 billion. The SCP deal boosts gross cash to $6.8 billion. Treating the convertible preferred as equity while treating the present value of future interest obligations as debt puts net cash at $3.4 billion. With Corning generating healthy cash flow currently ($1.5 billion over the past year) and management expecting to gain access to $2 billion in incremental SCP cash flow over the next four years, the firm is in good shape to handle the $3.5 billion buyback while maintaining a healthy cash balance. We expect management to continue to maintain a cash position, net of debt, of at least $2 billion and utilize excess cash generation for dividend increase and share repurchases during the next several years.
Initial Price Talk on SEB's 5-Year Note Offering Looks Attractive (Nov. 13)
Skandinaviska Enskilda Banken (SEB A) (rating: A, no moat) is in the market with its second benchmark-size 5-year senior bank note offering of the year. The bank issued 5-year notes in March at a spread of 100 basis points over Treasuries. These notes are now indicated at 90 basis points over the nearest Treasury, which we view as fair and appropriate for the new 5-years. Initial price talk on the new notes is 105 basis points over Treasuries. Scandinavian peers Svenska Handelsbanken (SHB A) (rating: A+, narrow moat) and Nordea Bank (NDA) (rating: A, narrow moat) are both indicated at 83 basis points to the nearest Treasury in the 5-year area. We view Nordea as overvalued and Svenska as fairly valued at these spreads. Moving down a notch in ratings, French bank Societe Generale (GLE) (rating: A-, narrow moat) is indicated at +109 basis points to the nearest Treasury in the 5-year area, which we view as fairly valued.
SEB reported net income of SEK 3.7 billion for the third quarter, 32% higher than SEK 2.8 billion in the year earlier period. Return on equity for the period was 13.4%. Overall net interest income improved as interest expense declined with lower funding costs and the improvement in lending volume. Much of the lending growth is occurring outside of Sweden and in SEB's other European markets in the other Nordic countries, Germany, and the Baltics. Meanwhile, expenses decreased to SEK 5.5 billion on a sequential quarterly basis as staff costs were lower due to a 5% smaller head count. Total revenue decreased modestly to SEK 10.3 billion for the third quarter, compared with SEK 10.6 billion for the second quarter. Nonperforming loans continue to improve to SEK 10.1 billion or 0.72% of total loans compared with 0.88% last quarter. Furthermore, SEB reported lower credit losses of SEK 267 million, or 0.08% of loans, compared with SEK 291 million at the end of second quarter. We are comfortable with this low level of credit losses and expect them to remain within this range for the remainder of 2013.
From a capital standpoint, we are pleased with SEB's common Tier 1 equity ratio under fully implemented Basel III equaling 15.0% as of the third quarter.
Volkswagen Finance Offering 3-Year and 5-Year Notes With Price Talk Marginally Attractive (Nov. 13)
Volkswagen (VOW) (rating: A-, no moat) finance subsidiary Volkswagen International Finance, whose debt is guaranteed by the parent, is in the market with an offering of 3-year floaters and 3- and 5-year fixed-rate notes. Initial price talk is +65 on the 3-years and +85-90 on the 5-years. We view these levels as slightly cheap, with fair value about 5 basis points tighter. October issuers in the 5-year part of the curve include the finance subsidiaries of Toyota Motor (TM) (rating: A, no moat), whose 5-year notes are currently indicated at 61 basis points above Treasuries, and Honda Motor (HMC) (rating: A, no moat), at +66. We view the Toyota's as fair and the Honda's as about 5 basis points rich given Toyota's stronger position in the rating category. The finance subsidiary of Daimler (DAI) (rating: BBB+, no moat) issued 5-year bonds in July that are now indicated at +103 versus the nearest Treasury. We view this as about 5 basis points cheap.
We continue to have a favorable intermediate-term view of Volkswagen as it navigates near-term weakness in the European and other markets. Volkswagen benefits from product offerings across all price points, with its Audi brand showing particular strength in the luxury market. Volkswagen's international diversification, including a leading position in China, also offsets its European exposure. Volkswagen recently reported third-quarter earnings per share of EUR 3.79, down EUR 1.43 (before special items) versus the same period last year. The lower EPS resulted primarily from lower revenue on the strength of the euro and significantly lower unit volume in North America and Latin America. However, management reiterated its full-year guidance for revenue to exceed the previous year and for operating profit to be flat (both on a consolidated basis) with the previous year's level. We continue to expect Volkswagen to benefit from the scale of its global operations, the roll-out of a manufacturing system that enables greater cost savings, and an eventual recovery in Europe. This leads to our low-single digit top-line growth forecast with EBITDA growing slightly faster as we see margin expansion over time. We expect gross debt/EBITDA to remain well below 1 times and the firm to maintain a healthy net cash position for its manufacturing operations.
Toll Gets Jump on Funding Shapell Acquisition With New 5- and 10-Year Notes; Price Talk Cheap (Nov. 12)
Toll Brothers (TOL) (rating: BBB-, no moat) is offering new 5-year bonds with price talk in the 4.375% area and long 10-years talked in the 5.625% area to help fund its acquisition of Shapell for $1.6 billion in cash (see our Nov. 7 note). Toll's 4.375% notes due 2023 recently traded at 5.40%, providing a spread of +264 basis points to the nearest Treasury, which we view as fair in the crossover area. We note that Moody's rates the credit Ba1 while S&P is at BB+ and Fitch at BBB-. All ratings were affirmed after the Shapell deal was announced. The Morningstar Industrials BBB- index is currently +224 while the Merrill Lynch BB Index option-adjusted spread is +313. Toll's new 5-years offer a spread of +294, which looks particularly cheap considering their position ahead of several bonds maturing in 2019 or later. We view fair value closer to 3.625%, or a spread of +220 to the 5-year. We note that D.R. Horton's (DHI) (rating: BB+, no moat) 3.625% notes due 2018 trade at about 3.30% and a spread of +225 to the nearest Treasury, which we view as somewhat rich. The spread on Toll's new 10-year of +285 looks moderately cheap and we view fair value at about 5.375%. Horton's 4.75% notes due 2023 trade at 5.56% in comparison, offering a spread of +288 to the nearest Treasury, which looks fair.
Williams Partners to Issue 10- and 30-Year Notes; Initial Price Talk Looks Fair (Nov. 12)
Williams Partners (WPZ) (rating: BBB, wide moat) announced that it is issuing new 10-year and 30-year notes. Williams intends to use the proceeds to repay amounts outstanding under its commercial paper program, to fund capital expenditures and for general partnership purposes. As of Nov. 7, Williams had almost $1.1 billion outstanding under its CP program. In addition, Williams recently raised its 2014 and 2015 capital expenditure guidance by a total of $375 million, primarily driven by increased cost estimates to complete the Gulfstar project. Initial price talk is +187 basis points for the 10-year and +205 basis points for the 30-year. We view fair value at +185 basis points for the 10-year and +205 basis points for the 30-year.
Prior to today's announcement, Williams' outstanding 3.35% notes due 2022 traded at 181 basis points over the nearest Treasury, while its 6.30% notes due 2040 at 208 basis points over the nearest Treasury. We maintain a market weight recommendation on Williams and view its outstanding issues as slightly cheap to fair value based on our lookout for future improvement at Williams. ONEOK Partners (OKS) (rating: BBB, wide moat) is a fair comparable for Williams, although Williams' credit metrics are on a better trajectory, in our opinion. ONEOK's recently issued 5% notes due 2023 recently traded at +175 basis points and its 6.20% notes due 2043 traded at a spread of +200 basis points, both over the nearest Treasury. Given ONEOK's near-term challenges and softening credit metrics, we view both ONEOK issues as trading rich to fair value.
Williams recently announced respectable third-quarter results, which were softer relative to last year due to lower ethane prices and the impact of the Geismar olefin plant fire, which occurred over the summer. Williams received $15 million of business interruption insurance payments related to the Geismar outage and expects an expanded Geismar facility to be operational by mid-2014. Our core thesis on the company remains intact; Marcellus shale growth will lift cash flows for Williams' fee-based business and drive future growth. We continue to believe Williams Partners is among the best-positioned midstream firms to capitalize on Marcellus production growth and encourage investors to look past the partnership's distribution coverage deficit. On an LTM basis, gross leverage is 3.7 times and interest coverage is 5.0 times. Debt/capitalization stands at 44%, close to the 50% level which is typical for master limited partnerships. Based on our estimates for 2014, we project year-end leverage and interest coverage will be at similar levels, although we anticipate that debt/capitalization could increase slightly, to around the 50% area.
Royal Dutch Shell to Issue Multiple Short-Dated Tranches; 5-Year Initial Price Talk Looks Attractive (Nov. 12)
Royal Dutch Shell (RDS.A) (rating: AA-, narrow moat) announced that it plans to issue 2-year floating, 3-year fixed and floating, and 5-year fixed debt in benchmark size through its 100%-owned subsidiary Shell International Finance, which is guaranteed by Royal Dutch Shell. Proceeds are earmarked for general corporate purposes, although we believe a portion of the proceeds will be used to refinance debt maturities. Initial price talk is attractive in our view at a spread in the low 60s for the 5-year. We peg fair value for the new 5-year notes at +55 basis points. We note that Shell's existing 5-year trades well inside the price talk on the new notes. Shell's 1.90% notes due 2018, which were issued in August, have been trading recently at spreads in the mid-40s; we view these levels as rich and recommend an underweight in Shell.
Within our coverage universe of supermajor integrated companies, Chevron (CVX) (rating: AA, narrow moat) and Statoil (STL) (rating: A-, narrow moat) are comparable to Shell based on their operational profiles and the challenges they face. In June, Chevron issued 5-year notes and in November, Statoil issued 5-year notes. Chevron's 1.718% notes due 2018 recently traded at a spread of 45 basis points over the nearest Treasury, which we view as about 5 basis points rich to fair value, but we maintain our market weight recommendation based on our relatively stronger outlook for Chevron compared with peers. Statoil's 1.95% notes due 2018 recently traded at 49 basis points over the nearest Treasury. We have an underweight recommendation on Statoil as we view it as trading roughly 15 basis points rich to fair value based on the long-term production decline issues Statoil faces in its core Norwegian fields and the fact that Statoil has been increasing debt to fund the gap between operating cash flow and the company's dividend and capital spending program. Our credit rating for Statoil is more than three notches below that from Moody's and S&P. Based on our rating differentials, Shell's strong balance sheet and cash flow generation offset by the company's near-term challenges in North America, we place fair value on Shell's new notes at +55 basis points for the 5-year.
Shell, along with its supermajor integrated peers, is finding it increasingly difficult to expand production and add reserves as many of the remaining pools of cheap, easily accessible resources large enough to interest the supermajors reside in the hands of governments and national oil companies. In an effort to grow reserves, Shell previously spent $30 billion in the U.S. and Canada on shale plays. As disappointing third-quarter results again show, Shell's big bet in North America appears to be a bust. Although the poor performance in North American shale has been a drag on results for some time, actions are just now being taken to address the issues. We believe the best-run large-cap oil companies would have recognized these operational weaknesses far earlier than Shell and acted much more rapidly to address them. Despite these issues, operating cash flows are well on their way to record levels in the coming years as recent megaprojects, such as Pearl GTL and Qatargas 4, come on line in 2016-17. As such, we expect Shell's credit metrics to remain in line with our AA- issuer credit rating.
Despite Higher Share Repurchases, Disney's Leverage Lower at Year-End; We Expect Debt Issuance (Nov. 11)
Walt Disney (DIS) (rating: A+, wide moat) reported posted solid sales growth and profitability in the fiscal fourth quarter, along with an increase in share-repurchase activity. Overall sales increased 7% and the segment operating margin of 21.5% was essentially flat with the year-ago quarter. Share repurchases for the quarter were $1.4 billion, bringing the annual total to $4.1 billion, compared with just $3.0 billion in fiscal 2012. Management also stated that it intends to repurchase $6 billion-$8 billion in shares during fiscal 2014.
Even with the uptick in share repurchases, we continue to be pleased with management's comments that it does not intend to sacrifice its rating to return cash to shareholders. However, we do believe a debt issuance is on the horizon to help fund the share repurchases. Disney ended the year at 1.2 times debt/EBITDA, slightly lower than last year (1.3 times). We estimate that an additional $3.5 billion of debt will bring the firm's leverage to around 1.5 times, which we believe is still indicative of Morningstar's A+ credit rating. Disney has maintained leverage around the mid-1 times range for the past few years, and we don't foresee a change in this strategy. Disney is a frequent debt issuer, as we believe management targets a specific credit profile, increasing overall debt levels with EBITDA.
Currently, Disney is trading fairly to slightly cheap, with the 2022 notes recently indicated at 74 basis points over the nearest Treasury. Other consumer cyclical companies that we rate one notch lower and that we view as fairly valued, such as TJX Companies (TJX) (rating: A, narrow moat), and Target (TGT) (rating: A, no moat), trade around 80-85 basis points over Treasuries for the similar-dated maturities. Accordingly, we would view fair value on a new 10-year issuance from Disney around 70 basis points over the nearest Treasury, given its higher credit rating and robust free cash flow.
Click here to see more new bond issuance for the week ended Nov. 15, 2013 (http://im.morningstar.com/im/newhomepage/bond_strat_new_issue_table_11182013.png).