Fed Pushes Harder on a String
Low interest rates in and of themselves won't alleviate structural problems.
Corporate bond markets continued to rally last week as portfolio managers flush with cash scoured the market for bonds and drove corporate credit spreads tighter. The Morningstar Corporate Bond Index tightened 13 basis points to +218. The financial sector (which took the brunt of the credit spread widening last fall) significantly outperformed the industrial sector by a 3-to-1 ratio.
We first opined at the beginning of October that corporate bonds were cheap on a fundamental basis as credit spreads had widened out to recessionary-type levels. Last week we wrote that there was still room for credit spreads to tighten; however, as we reach the point where credit spreads bottomed out at the end of last October, we think further tightening will be limited until there is additional clarity on the situation in Europe.
For credit spreads to tighten further, we think investors will want to see meaningful progress being made in Europe's attempt to increase fiscal discipline. By mid- to late February, we expect to see an increase in the news flow on the negotiations among EU members regarding the framework to present at the March EU summit. In addition, over the same time frame, the negotiations concerning Greece's attempt to negotiate debt forgiveness will need to be concluded to allow the European Union and International Monetary Fund enough time to arrange another loan to fund Greece's March debt maturities.
The new issue market was especially quiet as corporate issuers were either in the midst of their earnings reports and conference calls or are in their quiet period before their earnings release. Part of the reason spreads have tightened so much over the past few weeks has been the lack of inventory on Wall Street trading desks and the dearth of new issues. Over the next few weeks as earnings season subsides, we expect corporate issuers will return to the market, which may provide enough supply to offset demand. The other reason we think credit spreads have tightened so dramatically over the past few weeks is the lull in negative headlines stemming from the sovereign debt crisis since the December EU summit. The lack of dire headlines from Europe has allowed investors to focus on fundamentals, and as we have seen this earnings season, corporate credit metrics are still positive.
The Federal Reserve announced that it intends to keep short-term rates near zero until the end of 2014. While the announcement provided positive sentiment to the Street, we aren't sure what, if any, effect the announcement will have on the broader real economy. It appears to us that there are structural issues at work in the economy which have led to continued deleveraging across the private sector. Low interest rates in and of themselves won't alleviate structural problems.
The Federal Reserve first embarked upon ZIRP--zero interest rate policy--in December 2008, during the heart of the credit crisis. If rates stay at essentially zero until the end of 2014, we will have had near-zero short-term rates for six years. Considering that the recession officially ended in June 2009 and the Federal Reserve is projecting 2.5% GDP growth this year with continued growth thereafter, it seems incongruous that the Fed would need to leave short-term rates near zero. Zero interest rates helped pull the financial system back from the brink of disaster during the depths of the U.S. credit crisis, but with GDP forecasts in the 2%-3% range, we don't see why the Fed would need to keep such extraordinary measures in place. Robert Johnson, Morningstar's director of economic analysis, had this to say about the Fed's announcement:
“Personally, I don't agree with the policy and more importantly, I don't see how it helps except maybe helping speculators finance their commodity purchases. And the low rate policy is really beginning to pinch savers and is hurting the personal income report in a meaningful way.”
We agree with Bob's assessment and think the Fed's announcement provides insight into just how tenuous the Fed considers this recovery to be.
European Sovereign Bonds Skyrocket
Corporate and sovereign credit spreads tightened across the board in Europe. European corporate credit spreads tightened about 14 basis points. The financial sector (which took the brunt of the widening last fall) outperformed the industrial sector by a 2-to-1 ratio. Whether it's the banks using proceeds from the European Central Bank's longer-term refinancing operations to purchase sovereign bonds or a shift in market sentiment regarding the credit risk of Spain and Italy, both of those countries' bonds continued to climb. Yields on Italian 10-year bonds dropped below 6%, to 5.90%, and Spain's 10-year bonds dropped below 5%, to 4.98%, the lowest level since last August. Credit default swaps for other countries tightened across the board as well. Portugal, again, was the only outlier as its bonds continued to fall. It appears that the market is pricing in an increased probability that the Portuguese government is watching how the voluntary haircut is playing out with Greece. If Greece is successful, the Portuguese may look for the same sort of treatment.
Even though the markets are improving, we think there is a heightened probability that sovereign interest rates and corporate credit spreads could widen toward the end of February. By then we expect the market's attention will be shifted back to the EU's ability to agree upon the actual mechanics of the framework to ensure budgetary discipline. We expect either a resolution of the Greek debt forgiveness negotiations or default around the same time. Fortunately, the ECB is planning another three-year LTRO at the end of February. If the markets do weaken and the European banks are unable to access the public debt markets to refinance near-term maturities, those banks will be able to secure financing through the LTRO to prefund maturing debt. While the LTRO by itself does not solve the underlying solvency and capital adequacy issues plaguing the European banks, it does alleviate the near-term liquidity pressures that spooked that markets last fall.
New Issue Commentary
Ford's Soft 4Q Results Do Not Change Our Favorable Long-Term Thesis (Jan. 27)
Ford Motor Company (ticker: F, rating: BBB-) reported fourth-quarter results Friday that missed consensus expectations. Nonetheless, the firm continued to make improvements to its balance sheet, and we are maintaining our favorable long-term view of the credit. Ford's manufacturing operations ended the year with $22.9 billion of cash, up $2.1 billion in the quarter, while debt increased $0.4 billion to $13.1 billion as the firm utilized Department of Energy loans. Thus, Ford's net cash position continues to grow, and we expect more of the same in 2012, supporting our investment-grade rating. We continue to like the long-term credit fundamentals of Ford, although its bonds are now trading in line with weak BBBs. The Ford Motor Credit 5% due in 2018, reissued earlier this month at 5%, is now trading at about 4.2%, with spreads close to 300 basis points over Treasuries. Challenges in international markets and high commodity costs could damp short-term momentum and push rating upgrades out a few quarters. As such, we don't envision meaningful short-term spread tightening.
Pro forma results for the quarter were $0.20 per diluted share, which missed consensus expectations of $0.25. GAAP earnings per share came in at $3.40 because of a nearly $12.5 billion noncash gain from the reversal of the deferred tax asset valuation allowance. Importantly, cash taxes will remain low for many years. Excluding special items, consolidated fourth-quarter pretax income was $1.1 billion, down 14.6% from the prior year's fourth quarter. Automotive pretax income declined 20.9% to $586 million, primarily because of higher commodity and freight costs as well as higher North American compensation due to the payment of the United Auto Workers ratification bonus. Geographically, only North America posted an increase in automotive pretax operating profit, while Europe and Asia posted losses. The Thai flooding cost Ford 34,000 units of lost production, affecting Asia results. Management expects 2012 commodity costs to increase, but not materially, which would be a welcome relief from the pressure Ford experienced in 2011.
Revenue comfortably beat consensus by coming in at $34.6 billion (up 6.5%) compared with consensus of $32.1 billion. We remain very optimistic about Ford's future; the company has terrific products and much-improved pricing power from a few years ago, and we expect significant improvement in U.S. light-vehicle sales over the coming years. The competition is certainly fierce, but we think Ford will remain a global auto manufacturing leader.
Ford guided to flat operating cash flow metrics in 2012 but higher capital spending in the area of about $1.5 billion, so net cash does not appear likely to improve as much as it did in 2011. Still, Ford is aggressively targeting $3.5 billion in pension funding, which, along with modest cash improvement, should lead to improving overall credit metrics.
AutoNation Reports Record 4Q Results; Plans to Issue $250 Million of Senior Unsecured Notes (Jan. 27)
AutoNation (ticker: AN, rating: BBB-) wasted no time after reporting its best quarterly results ever last week to announce a new bond offering. The eight-year (noncall for life) $250 million senior unsecured note will be pari passu with the rest of the firm's bonds and bank debt, with proceeds being used to retire bank debt. The firm ended the year with non-floorplan total debt of about $1.6 billion, including almost $500 million drawn on the recently negotiated $1.2 billion revolver. We estimate total debt/adjusted EBITDA (to include floorplan interest as a cost of sales) of 2.7 times for the year, increasing to 3.1 times adjusting for rents. Note that the bank calculation for the funded debt/adjusted EBITDA covenant came in at 2.6 times versus a covenant of 3.75 times.
AutoNation's 6.75% of 2018 is currently indicated at about 5.3%, representing a spread of 420 basis points over Treasuries. Given that the bulk of the firm's assets are used to secure floorplan debt, we view a modest premium to the rating-implied spread as appropriate. That said, we view the existing levels as slightly cheap given the Merrill BB index at 5.7% and weak BBBs per the Morningstar index at about 310 basis points above Treasuries. We view fair value on the new bonds at about 5.5%. While the fundamental trends are decidedly positive, the firm is clearly managing itself to maintain stable credit quality by increasing debt typically in line with EBITDA growth. As such, we believe the firm's bonds will retain below-investment-grade status at the rating agencies. On the other hand, despite massive share repurchases over the years, we take comfort in management's comments on the call that it is committed to maintaining a strong balance sheet.
AutoNation reported all-time record quarterly and year-end results Thursday. For the fourth quarter, AutoNation posted adjusted diluted earnings per share from continuing operations of $0.51 compared with the consensus expectation of $0.49. Revenue increased 13.3% year over year to nearly $3.7 billion, ahead of consensus of $3.5 billion. All categories posted an increase from the fourth quarter of 2010, and same-store revenue increased 10.7%, including a healthy 14.4% increase in new vehicles. The higher revenue helped drive selling, general, and administrative expense as a percentage of gross profit down 80 basis points from a year ago to 71.3%. Gross margins on new vehicles, used vehicles, and parts and service all declined from the fourth quarter of 2010 to result in a 20-basis-point operating margin decline to 3.9%. The consolidated gross margin fell 110 basis points to 15.7%, with most of this decline attributable to used vehicles and parts and service. Used-vehicle margins are probably continuing to be squeezed by extremely high procurement costs, while service was hit by a 17% decline in warranty revenue because of a tough 2010 comp from all the recall work done that year. It is also worth noting that even though the quarter was strong from a volume point of view, Toyota's (ticker: TM, rating: A+) and Honda's (ticker: HMC, rating: A+) inventories still are not at full strength. Management expects Toyota to normalize by the end of the first quarter, while Honda's recovery is still uncertain and will take longer than Toyota's. Honda was nearly 11% of new-vehicle retail unit sales in 2011 while Toyota was more than 18%. For the quarter, domestic brand new unit retail sales increased 21% from year-ago quarter, imports rose 3%, and premium luxury increased 28%.
AutoNation continues to buy back tremendous amounts of its own shares. In 2011, the company repurchased 17.1 million shares at an average price of $34.12. It has purchased 395 million shares since 1999 at an average price of $16.44. The company announced Thursday that the board approved a new $250 million repurchase plan and has total authorization of $278 million remaining. Management estimates the actual shares outstanding as of Jan. 25 to be about 132 million, and it has repurchased 3.5 million shares this month. The firm's liquidity remains strong with $810 million available at year-end. Capital expenditure for 2012 is guided to be $145 million.
Eaton Remains Solid Core Holding Despite Softer-Than-Expected 4Q and 2012 Outlook (Jan. 26)
Eaton's (ticker: ETN, rating: A) fourth-quarter earnings per share of $1.07 fell slightly short of consensus estimates as well as the midpoint of the firm's guidance. This was the first time in several quarters that the firm disappointed, reflecting the greater uncertainty in the global economy. Sales also fell below estimates, as a weaker European economy and restrictions on credit in China muted demand. Still, EPS grew about 30% quarter over quarter and sales were up 10%. EBITDA for the year was about $2.3 billion, with debt/EBITDA at about 1.6 times.
Eaton guided to 2012 sales up 4%, compared with our 5% estimate, and a midpoint EPS of $4.25 per share, also marginally below our forecast (which is below consensus estimates). Nonetheless, management was confident in eventually hitting its peak segment operating margin target of 16% (slightly higher than our peak estimate) after reaching 14.2% on this measure in 2011 and targeting 14.5%-15.0% for 2012. We now estimate 2012 EBITDA will come in at about $2.6 billion.
The firm expects end market growth in all six of its operating divisions, along with higher segment operating margins (with the exception of flat margins in its auto segment). Management is more optimistic in the U.S. market (with expected end market growth of 6%) than in foreign markets (4% end market growth) as Europe remains weak and developing economies weaker than expected. In the electrical segments, management is seeing favorable developments in both residential and nonresidential construction domestically. In aerospace, the commercial market is expected to improve 15% while the defense market is expected to decline 6%-7%. The domestic heavy-truck market remains robust, with Class 8 volume expected to reach 300,000 units. All in all, it appears that the European economy could be the swing factor driving 2012 results, as expectations for a recovery in the second half of the year could be too optimistic if weakness continues. Still, management's expectations of global GDP of about 2% for 2012 do not seem out of line.
Eaton retains a healthy balance sheet with cash of almost $1.2 billion and total debt of $3.7 billion. It has a $300 million maturity in 2012, which we expect to get retired with cash. The firm also said it made a $300 million pension contribution in January. Including its increased dividend, we expect free cash flow to be de minimus. Nonetheless, management indicated it will continue to focus on modest-size acquisitions rather than share repurchases and retain a stable capital structure, which suggests that the balance sheet and leverage will be maintained in the context of our rating.
We view Eaton's bonds as fairly valued, with the 2019 maturity indicated at about 140 basis points over Treasuries. This represents a spread pickup of about 30 basis points versus similar maturities of other diversified industrials such as Honeywell (ticker: HON, rating: A) and Danaher (ticker: DHR, rating: A-), both of which we would underweight.
Pension Expense Weighs on Boeing's Impressive 4Q Results and Outlook; Remain Underweight on Bonds (Jan. 25)
We are maintaining our underweight rating on Boeing (ticker: BA, rating: A-) bonds despite relatively good fourth-quarter results, based on valuation. Boeing's 2020 maturity bonds are indicated at the tightest levels among our coverage universe, with spreads at about 85 basis points over Treasuries. We continue to find better value in similar-rated Lockheed Martin (ticker: LMT) and Northrop (ticker: NOC), which are indicated about 60 basis points wider for similar maturities. However, Boeing's results and outlook are directionally superior to most of the other names in the group, as growth in its commercial business outweighs the softening defense segment.
Boeing's commercial aircraft business continues to hum along, driving overall backlog to a record $356 billion. The launch of the 787 and 747-8 in 2011 sets the table for steadily improving growth in deliveries over the next several years. Management guided to revenue growth of more than 30% in this segment for 2012. Boeing's defense business also held up reasonably well, with a modest uptick in sales in the quarter leading to flat sales overall for the year. However, management guided to revenue declines of about 6% in 2012 as U.S. defense spending declines. Interestingly, management indicated it expects its percentage of sales to foreign customers to steadily grow over the next few years. Cash flow performance for the quarter was strong, as free cash flow of more than $2 billion strengthened the balance sheet. We estimate the manufacturing operations ended the year with about $10 billion of cash versus $9 billion of debt. We estimate total debt/manufacturing EBITDA of 1.2 times.
The primary dark spot in the results was management's guidance for significantly higher pension expense in 2012, leading to EPS guidance far below consensus estimates. In addition, Boeing expects to contribute $1.5 billion to its pension plans in 2012, which will have a negative impact on operating cash flow. This is higher than we expected and leads to free cash flow guidance of about $3 billion, somewhat lower than our expectations.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.