Green Shoots Emerge in a Still Bleak M&A Landscape
We expect M&A trends to hold steady, despite the weakened fundamentals in Europe and China as well as mixed economic indicators in the U.S.
Acquisition activity has yet to pick up speed following a weak end to 2011, but the ingredients for M&A are still in place. Cash-rich balance sheets, an increased desire for a global presence, and the appeal of M&A as a source of growth sustain the M&A appetite for strategic buyers. In addition, private equity fundraising has picked up while exit activity remains robust, producing plenty of available capital.
Economic uncertainty and anemic credit markets remain as key challenges, but these are smaller hurdles for certain sectors. We do not anticipate an acceleration in deal activity for the remainder of 2012, but we expect M&A trends to hold steady, despite the weakened fundamentals in Europe and China as well as mixed economic indicators in the U.S.
U.S. banks have plenty of credit capacity available to provide commitment letters and fund strategic acquisitions; however, the syndicate desks continue to be stingy, providing the same capital for leveraged buyouts. This has limited private equity sponsors to fewer and smaller transactions thus far this year. European banks have pulled up their drawbridges and are hoarding whatever capital they have as they battle the sovereign debt crisis and look to raise additional capital to meet heightened capital metric requirements. While the European banks may still provide some funding for strategic acquisitions of investment-grade clients within Europe with whom they have long-standing relationships, we expect that those banks have very little to no appetite for lending outside of Europe.
U.S. domiciled investment-grade corporations will likely have an easier time sourcing capital for strategic acquisitions as the major U.S. banks are in a much better position to provide capital. However, even within the U.S., the capacity to provide commitment letters for leveraged buyouts will likely be limited. U.S. banks are wary of underwriting leveraged credit and certainly do not have the capacity to fund large deals, but are willing to support smaller to midsized buyouts. The collateralized loan obligation market has been attempting to stage a comeback as a few new deals have been completed; however, these deals have been limited to the largest managers and are relatively small by historical standards. Further recovery of the CLO market would help to provide the liquidity for LBOs, but the lack of buyers of the AAA layer of debt is currently holding back a wider recovery. Funding costs for leveraged buyouts, while expensive from a spread perspective, continues to be reasonable on an all-in basis as the decline in interest rates has left costs largely unchanged.
In the last half of 2012, we expect that individual issuer credit risk will most likely emanate from companies that look to financial engineering (that is, spin-offs, asset sales of non-core businesses, and debt-funded share buyback programs) to enhance shareholder value as opposed to leveraged buyouts. Depending on the structure and size of spin-offs, bondholders could be impaired as the remaining cash flow and assets may not provide as much coverage as the combined entity. Asset sales where the proceeds are used to repurchase stock, or pay a special equity dividend, will also likely result in credit deterioration for bond holders. We recommend that investors scrutinize covenant packages before they purchase bonds to understand if there are any limitations or restrictions on these types of financial engineering.
Corporate Bonds Still in High Demand
With new money pouring in the door and interest income needing reinvestment, demand for corporate bonds remains unrelenting. That demand and a light new issue calendar provided the background for tightening credit spreads last week.
In addition to the more traditional buyers of corporate bonds, corporate bond ETFs were also reportedly out in force, buying everything that they could get their hands on. Earnings season has begun and credit quality is holding steady thus far. While revenues appear to be generally coming in softer than expected, most companies have met their earnings guidance. Generally the theme this earnings season is that Europe continues to worsen (especially in the hardest hit of the peripheral countries) and foreign exchange headwinds are emerging.
A series of new issues from eBay (EBAY, rating: A+) provides a potent example of the strong demand for corporate bonds. Prior to the new deal announcement, eBay's existing 3.25% Senior Notes due 2020 were indicated at about +118 over Treasuries. From the initial whisper talk to where the bonds were trading on the break in the secondary market, the firms bonds tightened significantly with the 10-year bond wrapped around +100 (incidentally, we placed fair value at this level prior to issuance).
Municipal Update: Report Highlights Pressure on States
Contributed by Elizabeth Foos, Municipal Credit Analyst
There is little doubt that many U.S. states face extraordinary challenges in the aftermath of the global fiscal crisis. Volatile revenue streams and increasing costs have pressured operations for several years, and little relief is in sight. The State Budget Crisis Task Force released a report on July 17 analyzing these issues and concluded that the current trajectory of spending, taxation, and administrative practices for states is not sustainable.
We believe that the current overall credit quality of most U.S. states is still sound, yet we agree that without action, the challenges many states face today will test their fiscal stability and ability to fulfill basic obligations to customers and creditors over the longer term.
Led by former Federal Reserve Chairman Paul Volcker and former New York Lieutenant Governor Richard Ravitch, the State Budget Crisis Task Force analyzed the current fiscal situation of six states: California, Illinois, New Jersey, New York, Texas, and Virginia. The report notes that certain key costs are growing faster than revenues, creating a basic structural imbalance in annual budgets. The task force reports that spending for Medicaid is growing quickly due to skyrocketing health-care costs and increasing enrollments. Local and state municipal pension funds are underfunded by approximately a trillion dollars according to their actuaries, the report says, and unfunded liabilities for local and state retiree health-care benefits amount to at least another trillion dollars. At the same time, states face eroding sales tax bases, volatile income tax revenue collections, and federal aid reductions. Opaque budget practices, untimely reporting and essentially no multiyear planning compound the difficulty of seriously addressing these issues, and the task force concludes that the existing trends are not maintainable. The report stresses that without meaningful corrective action, states' ability to fund basic governmental functions and obligations to their residents and public employees is threatened.
We agree that the challenges for U.S. states are large and unprecedented. We believe that their overall credit quality is currently still sound, and it should remain so in the near term. Favorably, states have considerable ability to raise revenues and contain spending, unlike many other government units. Through moderate adjustments to taxing laws and practices, such as modest income tax hikes, states often can generate considerable increases in revenue while local entities operating under various revenue-raising constraints are much more limited. States can also decrease spending through service cuts and program transfers to local units and by lowering direct aid payments to underlying municipal governments to balance their budgets swiftly. State governments also can't declare bankruptcy as many locals can, which also aids protection for bondholders.
At the same time, we recognize that a state's political environment can and often has served as a practical limit on this inherent operating flexibility. Although they can make significant changes, many legislators lack the political will to further increase taxes and/or slash spending as necessary to balance budgets today. When faced with mounting pressures like those detailed in the task force's report, this can stress credit quality over the longer term. Many have already spent the last several years trimming programs, compensation, and staff sizes, and making politically unpopular revenue increases. Although more structural action needs to be taken, some states have opted to deplete financial reserves or increased borrowing to fund operations instead, which also hinders flexibility and credit quality.
Investors and residents alike should carefully note the current fiscal and operating pressures highlighted by the State Budget Crisis Task Force. As mentioned, states are stressed and, although the national economy is slowly improving, pressure on state operations is expected to continue for the foreseeable future. Without action to addresses these challenges, credit quality can suffer.
New Issue Notes
DISH Looks to Raise More Cash, but We're Not Sure Why (Published July 19)
We're still not exactly sure what DISH Network (DISH, rating BBB-) is up to. Subsidiary DISH DBS has announced plans to offer additional senior notes, reportedly adding $500 million to the $1.9 billion debt offering closed last May. The firm didn't have an obvious need for the cash raised in May. At the end of the first quarter of 2012, cash on hand stood at $2.7 billion, including $1.6 billion at DISH DBS. The firm generated $690 million of free cash flow during the first quarter alone. The next major debt maturity doesn't hit until late 2013 and is modest at $500 million. Another $1 billion comes due in late 2014.
Spreads on DISH debt widened following the May issuance and have widened further, along with the market, since. The firm's 6.75% 2021 notes were trading at a spread of about 366 basis points above Treasuries before the May issuance was announced and have traded at about 410 recently. The 5.875% notes due 2022 were issued in May at 406 basis points above Treasuries and currently trade at about 420. But with interest rates overall lower today--the 2022 notes are trading at a premium--DISH may be looking to add additional debt at low cost. The firm also pre-announced nice year-over-year improvement in its customer metrics for the second quarter, which could fuel demand for its notes.
Spreads on the 2022 notes compare favorably with the BBB- bucket within the Morningstar Corporate Bond Index, which currently offers a spread of about 290 basis points above Treasuries. As such, we believe these notes are still priced at attractive levels. However, we'd continue to wait for DISH debt to trade wider from here before making an investment, especially given the uncertainty around the firm's uses of cash and its wireless strategy. The firm has a $1 billion share repurchase authorization that runs through the end of the year and it likely wants to maintain a chunk of capital in reserve as it moves forward in the wireless business.
Spreads on the firm's 2021 and 2022 notes have been around 500 basis points above Treasuries (nearly 200 basis points wide of our BBB- index) as recently as June. We would be much more interested at those types of levels.
Morgan Stanley Announces New 30-Year Debt on the Heels of Weak Earnings (Published July 19)
Morgan Stanley (MS, rating: BBB) announced Thursday that it plans to issue new benchmark 30-year notes. No information has been given on price guidance yet. Given that Citigroup's (C, rating: A-) 30-year trades with a spread of 220 basis points above the Treasury curve, and Goldman Sachs' (GS, rating: BBB+) 30-year trades with a spread of 330 basis points above the Treasury curve, we would expect Morgan Stanley's new 30-year to come with a spread of approximately 400 basis points after considering a new-issue concession. We would view the bonds favorably at that level, and would recommend them all the way down to a spread of 350 basis points.
Our recommendation factors in Morgan Stanley's poor earnings announcement Thursday morning. Revenues were down 24% from last year and basically flat from last quarter, as the company experienced trading revenue declines in both fixed income and equities, as well as investment banking declines. Net income was down 50% from last year including the DVA adjustments and down more when excluding DVA adjustments.
From a credit standpoint, however, the news is not all bad. Morgan Stanley increased its Tier 1 common capital ratio to 13.5%, compared with 13.3% last quarter and 11.4% last year. More importantly, Morgan Stanley increased its ratio of tangible common equity to tangible assets to 7.3%, as compared with 7.0% last quarter and 6.2% last year, as we calculate it.
Given the continued increases in capital, and that the company was able to produce positive earnings in a tough economic environment, we still like the Morgan Stanley name from a credit perspective.
If New Bonds Price on Top of Existing, We Would View EBay's Bond Deal as Attractive (Published July 19)
Despite $6 billion in cash, eBay (EBAY, rating A+) is coming to market with its second-ever bond deal. The firm priced $1.5 billion of bonds in late 2010, concurrent with a $2 billion share repurchase authorization. The firm plans to issue three-, five-, 10-, and 30-year notes. While the exact amount has not been released, we would not be surprised to see another $1.5 billion deal (or more), given another $2 billion share repurchase announcement in June.
We're hearing whisper prices of 55, 95, 125, and 160 basis points above Treasuries for the three-, five-, 10-, and 30-year bonds, respectively, or slightly wide of the existing bonds. EBay's 3.25% notes due 2020 are trading around 120 basis points above Treasuries. Still, given the amount of cash that needs to be put to work, we'd expect the new deal to price at least on top of the existing. We'd find the bonds very attractive at this level and down to just below 100 basis points above Treasuries (the level of our 10-year A+ index) for the 10-year.
EBay is not a common name in the bond market, but we'd urge investors to take a second look given its wide economic moat and conservative capital structure. Even with the assumption of an additional $2 billion in debt, leverage would remain below 1 times and net leverage would still be negative. The firm generates copious free cash flow, yielding a Cash Flow Cushion of nearly 8 times our five-year base-case expense and obligation forecast. We have no concerns for the firm's liquidity.
The firm reported strong second-quarter results Thursday, supporting our favorable long-term view. PayPal continues to evolve into a more diversified facilitator of commerce through new offline transaction processing capabilities, but in our view, consumers' increasing comfort with mobile shopping and the halo effect it is having on other aspects of eBay's business were the clear highlights from the quarter. With an expansive network of buyers and sellers and leading payment processing innovations, we've long held the position that eBay was well positioned to capitalize consumers' gravitation toward mobile shopping and merchants' increasing acceptance of mobile payment processing.
Lennar to Tap the High-Yield Market with a $300 Million Senior Note Offering (Published July 17)
Lennar (LEN, rating: BB) is in the market with a $300 million five-year 144a senior note with proceeds used to tender for a $268 million 5.95% bond due in early 2013 at a price of 103. Lennar's 12.25% senior note due 2017 is currently offering a yield of about 5.3% and a spread of 470 over Treasuries, which we view as fairly valued. We would expect the new issue to price on top of this, as the firm's 6.95% senior notes due 2018 trade at a similar spread and a yield of about 5.5%.
We view Lennar as a solid core holding in an industry with gradually improving fundamentals despite macro headwinds. As one of the best operators in the homebuilding industry, we recommend that investors gain exposure to this name. From a relative value perspective, we note that D.R. Horton's (DHI, rating: BB+) recently issued five-year bond is trading at about 3.8% and a spread of about 322 basis points over Treasuries. Toll Brothers' (TOL, rating: BBB-) 2017 maturity bond is trading in line with DHI. We prefer both Toll and Lennar to Horton based on valuation, and we view Lennar and Toll as fairly valued relative to each other. Both trade slightly wide to their respective ratings benchmarks, and thus we recommend each as a solid core holding.
Lennar's next "maturity" is its 2.0% converts, which are putable and callable in December 2013. With the stock now trading above the strike price, this $276 million bond could get converted to stock or just stay outstanding (it has a 2020 final maturity). Notably, Lennar's longest maturity (including the first put/call dates on the firm's three outstanding converts) is the 2018 bond. As such, we would expect Lennar to continue to periodically tap the market to refinance bonds and extend maturities, as it has done in the past.
We have maintained our credit rating since we initiated on the name in May 2010, despite ongoing weakness in the housing market, as we continue to view Lennar as one of the best operators in the homebuilding universe, with multiple quarters of profitability and industry-leading gross margins consistently above 20%. Net homebuilding leverage in the mid-40% range is a bit of a concern, although this metric has been stable for several quarters. Liquidity has been enhanced by the recent establishment of a $525 million credit facility, and thus the somewhat low cash balance of $667 million at the end of the second quarter is not a concern.
Toyota Motor Credit To Issue Benchmark Three-Year Bonds; Existing Levels Are Rich (Published July 16)
Serial-issuer Toyota Motor (TM, rating: A) subsidiary Toyota Motor Credit is in the market again with a "benchmark" offering of three-year bonds. We view Toyota Credit similarly to Toyota. Toyota Credit's 3.2% bonds due in 2015 are now indicated at about 60 basis points above Treasuries and price talk on the new deal is in the 65 area. We view these levels as moderately rich and reiterate our underweight recommendation on the bonds, based on valuation. We would place fair value on the bonds about 20 basis points wide of existing levels, noting that Honda (HMC, rating: A) subsidiary American Honda Finance has 2015 maturities indicated around 105 basis points above Treasuries, which we view as cheap. Volkswagen's (VOW, rating: A-) finance sub U.S. dollar-denominated bonds due 2015 recently were indicated at about 110 basis points above Treasuries, which we also view as fairly valued. Daimler's (DAI, rating: BBB+) finance sub U.S. dollar-denominated three-year bonds are indicated at about 118 basis points above Treasuries, which we also view as rich.
We remain very optimistic on Toyota's fiscal 2013 prospects thanks to the large rebound in vehicle volume that we expect, especially in the profitable U.S. market. Management expects the company to sell 8.7 million vehicles in fiscal 2013, up 18.3% from fiscal 2012. Toyota expects its North American unit sales to increase 25.5%, while Japanese sales are expected to increase 6.2%. We see these large deltas as reasonable given how severe vehicle shortages were last year following the Japan earthquake and flooding in Thailand. We see the dollar/yen exchange rate as a wild card for Toyota in fiscal 2013. Toyota produces about half of its vehicles sold globally in Japan, which is far more than its competition. We expect this sensitivity will decline in the coming years as more hybrid and possibly Lexus production gets moved to North America around calendar 2015.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.