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Credit Insights

Takeovers: Rumors and Candidates

Investors should pay attention to bond covenants as buyout activity heats up.

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Early last week, rumors surfaced that  Sara Lee (ticker: (SLE), rating: BBB) had been approached by KKR with a takeover offer that was rebuffed. This rumor led to a hunt across the rest of the consumer product sector to identify other leveraged buyout targets. Pretty much anything with a market capitalization below $10 billion is now considered as potentially being in play. Names like  Clorox (ticker: (CLX), rating: A-),  ConAgra (ticker: (CAG), rating: A-),  Fortune Brands (ticker: (FO), not rated), and  Newell Rubbermaid (ticker: (NWL), rating: BBB-) all experienced significant bids in their credit default swaps. As the week wore on, the market expanded its search for LBO candidates to the retail sector, where  Limited Brands (ticker: (LTD), rating: BB+) was discussed as a candidate. With private equity firms sitting on more than $400 billion in uncommitted capital available for takeovers, we expect an uptick in LBO deals in the near term, particularly while interest rates are low and before capital commitments must be released to investors.

We are not surprised that Sara Lee may have become an LBO target, given its respectable free cash flow characteristics (it generates a free cash flow yield in the midsingle digits) and debt/EBITDA of less than 2 times. In addition, the firm has been in limbo since the departure of CEO Brenda Barnes for health reasons in August, and KKR may consider this a window of opportunity. On the basis of our preliminary LBO model analysis, which considers $4.6 billion-$5.1 billion in added leverage (4.0-4.5 times our projected fiscal 2010 EBITDA), an exit multiple of 8 times, and a required internal rate of return of 15%-18%, we view $13-$15 per share as a reasonable takeout range.

Sara Lee's credit default swaps widened 50 basis points on the news. However, the 4.10% notes 2010, which were trading at 102 before the news, widened only 15 basis points, resulting in the bonds trading down to 101. This is an important lesson for investors to pay attention to bond covenants. These notes have a change of control clause stipulating that if the firm is bought out, investors have the right to put the bonds back to the company at 101% of par, thus limiting the downside in an LBO scenario. The 6.125% notes 2032 bonds do not have a change of control clause. The only relevant covenant is a restriction on secured debt that precludes the company from securing an interest in principal domestic property or shares of a domestic subsidiary if it would exceed 10% of consolidated stockholders' equity without securing the bonds equally. We believe a private equity sponsor would most likely be able to structure a transaction around this covenant without triggering it. As a result, these bonds would probably be layered by a significant amount of new debt, which would greatly increase the credit risk and cause these bonds to trade at a much wider spread. The 6.125% notes widened 50 basis points as the price dropped from 108.4 to 102.

Morningstar equity analysts are scouring their respective sectors to identify potential LBO targets. In the retail sector, we have identified  Saks (ticker: (SKS), rating: B) and Limited as potential targets. In the restaurant sector, we have identified  Wendy's/Arby's (ticker: (WEN), rating: BB) and  Brinker (ticker: (EAT), rating: BBB) as potential LBO targets. For additional information, please see Scanning the Value Menu for Investment Ideas.

Besides renewed merger and acquisition activity, shareholder activism is rising to the forefront.  J.C. Penney's (ticker: (JCP), rating: BBB-) bonds took a hit after it was disclosed that Pershing Square Capital Management, a hedge fund run by shareholder activist Bill Ackman, has accumulated nearly 17% of the firm. Given Pershing's record of activism, we believe there is a high potential for financial engineering that would benefit shareholders, most likely to the detriment of bondholders. As an indication of the credit market's suspicion, CDS levels widened 25 basis points after the announcement. Upon our first review of the bond indentures, we have found few covenants that would protect bondholders from the type of activism that Pershing has advocated in the past.

Week in Review
Credit spreads tightened last week as the Morningstar Corporate Bond Index tightened 4 basis points to +160. Financials tightened 6 basis points, outperforming industrials, which tightened only 2 basis points. U.S. Treasury bonds strengthened toward historically low yields, as the two- and five-year ended the week at 0.38% and 1.16%, respectively. The 10-year Treasury yield tightened to 2.41%, approaching the historical low of 2.06% reached in December 2008, when the credit crisis was in full bloom and the equity market was still rapidly declining. The dollar took it on the chin as the dollar index fell, having declined 1.8% just since the beginning of the month.

European corporate credit spreads mirrored the tightening in the United States, with financials outperforming industrials. Sovereign concerns continued to abate as sovereign credit default swaps were generally tighter across the board. Even a report that Greece would once again have to restate its deficit wider could not stop Greek CDS from tightening another 25 basis points to +750.

As earnings season has begun, the new issue market has begun to slow its torrid pace.  CBS (ticker: (CBS), rating: BB+) issued two bonds that we consider to be overvalued from both absolute and relative value perspectives. Our issuer rating for CBS is BB+, one notch below both rating agencies. The 10-year bonds priced at +185, significantly tighter than Morningstar's BBB- Corporate Bond Index, which ended last week at +239. Entergy Arkansas (a subsidiary of  Entergy (ETR)) issued first mortgage bonds at +200, in line with our BBB issuer rating and Morningstar's BBB Corporate Bond Index level of +187; the rating agencies rate the bonds three notches higher.  Navios Maritime (ticker: (NM), rating: B+) issued senior secured notes at +591, which we believe is more in line with our B+ issuer rating; both rating agencies rate the bonds one notch higher.

In addition to the public markets, issuers are finding a warm welcome in the private placement market. For example,  Molson Coors (ticker: (TAP), rating: A) priced a seven-year, CAD 500 million private placement issue at CAD+183. This pricing looks cheap compared with Morningstar's single A index of +109.

Click here to see more new bond issuance for the week ended Oct. 8, 2010.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.