Financial Markets Increasingly Complacent
With so many threats lurking and the ever-present risk that something strikes from left field, staying vigilant makes a lot of sense, warns Morningstar's Dave Sekera.
The average spread in Morningstar's Corporate Bond Index has traded in a very narrow range lately and ended last week 1 basis point tighter at +136. Since the beginning of the year, our index has traded within a 5-basis-point band, whereas on a monthly basis in 2012, the index on average traded within a 15-basis-point range. In the high-yield market, the realized volatility as measured by high-yield exchange-traded fund iShares iBoxx $ High Yield Corporate Bond (HYG) continues to decline.
The equity markets have been no exception to this complacency, as volatility as measured by the VIX has declined to its lowest levels since April 2007. Peripheral sovereign debt in Europe has settled into a relatively tight trading band, and the shapes of many countries' yield curves have steepened and normalized. For example, the yields on Spanish and Italian 10-year bonds ended the week at 5.18% and 4.38%, respectively. Both of these levels are near the middle of the range in which they have traded since the beginning of the year.
What could shake the markets' sanguine disposition? Europe's steadily weakening economy and increasing exchange rate of the euro could reignite the flames of the peripheral sovereign debt crisis sooner than later--we've long believed that the euro crisis is far from over--but nothing specific looms on the horizon. The March 1 sequestration deadline continues to stare at the U.S. Congress. But after the hype surrounding the fiscal cliff became a nonevent, investors have become inured to the potential risks from inept government policy, and few investors seem to have the inclination (or energy) to get worked up this time around. Currency wars are erupting as central banks are becoming increasingly more active in their attempts to manage foreign exchange rates in an effort to increase the attractiveness of their countries' exports.
In short, we don't know what will drive investors to action during the next several months. But consider this: During the past two decades, the VIX has never spent more than a two-month stretch at or below current levels and it's never spent more than about six months at a stretch below 15 (a blissful peaceful run in 1995). With so many threats lurking and the ever-present risk that something strikes from left field, staying vigilant (or fearful as others are greedy, as Warren Buffett would say) makes a lot of sense to us.
Acquisition Activity Continues to Pick Up Pace
Acquisition activity picked up last week with several large deals. First, H.J. Heinz (HNZ) (UR-/A-) announced it will be acquired by Berkshire Hathaway (BRK.A) (BRK.B) (NR) and 3G Capital in a $28 billion deal, valuing the company just north of 12 times our adjusted fiscal 2014 EBITDA estimate. We are placed our A- issuer credit rating under review, with the caveat that we expect to drop the rating once the acquisition is completed. We don't anticipate any roadblocks to the deal being completed. We've long regarded Heinz--the most global of the U.S.-based packaged food firms--as maintaining a breadth of competitive advantages, deriving from its expansive global scale and the brand strength inherent in its refocused product portfolio (resulting in our narrow economic moat rating). It appears that Warren Buffett shares our take. Our A- issuer credit rating was one to two notches higher than the rating agencies', with the differential probably due to our assessment that the firm has a narrow economic moat.
Comcast (CMCSA) (CMCSK) (A-) wrapped up a strong 2012 with solid fourth-quarter results and announced a deal to acquire the remainder of NBC Universal from General Electric (GE) (AA-) ahead of schedule. While consolidated leverage will increase sharply, we believe the firm's plans are in keeping with our decision to upgrade Comcast's credit rating last year. We view any weakness in the firm's bonds as a buying opportunity. The decision to buy GE out early doesn't come as a huge surprise. Comcast raised $2.95 billion in debt earlier this year despite the fact that it had already amassed a huge cash balance following the sale of its spectrum assets and NBC Universal's stake in A&E in 2012. Adjusted for the bond offering, the firm is now sitting on $13.1 billion in cash, with $2 billion in bond maturities hitting in the first half of 2013. Comcast will finance the $18.1 billion purchase price, split between $16.7 billion for GE's 49% stake in NBCU and $1.4 billion for two buildings, out of cash on hand, a $4 billion note from GE, $725 million of preferred stock issued to GE, and $2 billion of additional debt. The move will hurt Comcast's balance sheet, but the impact is within the parameters we contemplated when we upgraded our credit rating to A-.
New Issue Notes
Cardinal Health Plans to Buy AssuraMed; No Change Expected to our A- Credit Rating (Feb. 14)
On Thursday, Cardinal Health (CAH) (A-) announced plans to acquire AssuraMed for $2.1 billion with $1.3 billion in new senior unsecured notes and cash on hand. We do not anticipate changing our A- rating on the firm based on this deal announcement. We think debt investors should put Cardinal's new issuance on their radar screens, given the potential for it to represent an attractive relative value.
Strategically, we think this deal, which is expected to close in April, makes sense. AssuraMed is the industry leader in providing direct-to-home medical supplies, and it will push Cardinal more into home health care, which is a growing treatment option for the elderly and chronically ill populations. From a credit perspective, we estimate the transaction will increase Cardinal's debt/EBITDA to around 1.7 times at the deal's closing from about 1.4 times at the end of 2012 and interest coverage will drop from the low 20s to the mid- to high teens. At first glance, we do not believe that expected leverage increase and coverage decrease are enough to cut into our A- credit rating.
Also, we see Cardinal as a decent relative valuation play for debt investors. While we currently rate Cardinal one notch below its key drug distribution peers,
AmerisourceBergen (ABC) (A) and McKesson (MCK) (A), we see the potential for these ratings to converge over time due to their similar business risk profiles and credit metrics. Cardinal's notes typically are indicated at a wider spread and higher yield than its peers. For example, at the close yesterday, Cardinal's 2022s were indicated at a 3.08% yield compared with McKesson's 2.91% yield on its 2022s and AmerisourceBergen's 2.72% yield on its 2021s. Given its higher yields and the potential for credit ratings to converge in this niche over time, we prefer Cardinal's existing notes to the other drug distributors now, and if these pricing dynamics remain intact for the new notes, we'd probably find them relatively attractive, too.
We Recommend Citi's New 10-Year, if You Can Get It at the Price Talk (Feb. 14)
Citigroup (C) (A-) announced Thursday that it is issuing new 10-year senior notes. Initial price talk is a spread in the area of 150 basis points above the Treasury curve. In November, we removed Citi from our investment-grade Best Ideas list as we viewed the bonds as moving to a fairly valued range in relation to the other large U.S. banks. Citi's current 10-year is trading with a spread 135 basis points above the Treasury curve, so we view the 15 basis points of new issue concession as attractive and we would recommend the new 10-year offering all the way down to a spread of 135 basis points.
Morningstar's credit rating of A- for Citigroup reflects the company's future earnings power and overall capital position. Citigroup has placed its troubled assets associated with the housing bubble and financial market disruption into runoff mode. These troubled assets now represent less than 10% of total assets and are shrinking. The remaining assets are held at Citicorp and include global transaction services, a scaled-back investment bank, private banking, Citi credit cards, and its worldwide retail and commercial bank. We believe these remaining assets are strong, competitively advantaged businesses that provide Citigroup with a narrow economic moat. During the past two years, Citigroup has raised its Tier 1 common ratio more than 200 basis points to 12.7% on a Basel I basis. The company also has been able to reduce its nonperforming assets to less than 1% of total assets. Citigroup has reserves for loan losses of more than $25 billion, which represent approximately 4% of total loans and well over 200% of nonaccrual loans.
Initial Price Talk on Emerson New Issuance Seems Fair, but Will It Hold? (Feb. 14)
Emerson Electric (EMR) (A) is in the market, looking to raise $500 million of 10-year money. At the end of December, Emerson had short-term debt of $1.9 billion, including $500 million of senior notes maturing later this year, so proceeds may be used to refinance some of this debt. Our rating reflects Emerson's broad portfolio of industrial businesses coupled with a modestly leveraged balance sheet, with TD/EBITDA slightly above 1. Emerson has a solid management team and a diverse customer base. By being a large player in many markets, Emerson's customer and product risks are fairly limited and its main operating risks come from overall global economic activity. Emerson's dominant position in process automation contributes to its narrow economic moat, and the management team's ability to earn industry-leading incremental returns on capital gives us comfort that the firm can overcome the cyclicality of its end markets.
Initial price talk on the deal is in the area of 75 basis points over Treasuries, which we would put at the tight end of fair value. Although the company has a number of bonds outstanding, they tend to be smaller in size ($250 million-$400 million) and not very liquid. Looking at similar-rated diversified industrials, United Technologies (UTX) (A) has a 2022 maturity that was recently quoted around a spread of 80 basis points over Treasuries, which seems fair to us. Honeywell International (HON) (A) and Danaher (DHR) (A) each have slightly shorter 2021 bonds that are being quoted in the mid-70s, which also seems fair. The lack of outstanding benchmark bonds for Emerson could create strong demand for this deal; however, we wouldn't chase pricing much tighter than the initial talk.
Discover's New 5-Year Notes Look Attractive (Feb. 13)
Discover Financial Services (DFS) (BBB+) announced Wednesday that it is issuing new benchmark 5-year notes out of its banking subsidiary, Discover Bank. Although we do not rate Discover Bank, we view it as a similar credit risk to its holding company, Discover Financial Services. Initial price talk is a spread in the area of 125 basis points above the Treasury curve, which we view as attractive. We have recently released an industry credit piece in which we contend that subordinated debt at a U.S. bank's operating subsidiary should trade tighter than, or at the very least the same as, senior debt of the holding company. While we do not yet know whether the new bonds are senior or subordinated, we would view them as attractive at the proposed terms even if they are subordinated. Of course they become even more attractive if they are senior in the capital structure. Currently, senior holding company debt for names like Fifth Third Bancorp (FITB) (A-) or BB&T (BBT) (A-) trade in the area of 80 basis points above the Treasury curve at the 5-year point. We think that 45 basis points of pickup for just one notch lower in rating (rating of the parent holding company) is good value for investors, and we would recommend the Discover notes all the way down to a spread of 110 basis points.
Morningstar's BBB+ credit rating for Discover Financial Services reflects the company's relatively healthy business, hampered by its reliance on noncore funding methods. Strong underwriting standards have resulted in better-than-average credit quality when compared with other credit card issuers. Once inferior to its peers, Discover's credit card network is catching up as merchant acceptance levels in the U.S. approach those of Visa (V) (NR)and MasterCard (MA) (NR). Discover, however, relies largely on the securitization market as a source of funding. About 25% of assets are funded through securitizations. While the securitization market has performed well in recent years, the complete freezing of it in 2008 demonstrates the dangers of overreliance on this source of funding. Discover's sound capital levels, however, should aid the company in achieving other forms of financing should the securitization market become unavailable. Discover's ratio of tangible common equity/tangible assets stands at more than 11%.
Praxair Back in the Market, but Spreads Still Rich (Feb. 13)
Praxair (PX) (A) is in the market looking to raise $750 million, split between 3-year and 10-maturities. The company has two bonds totaling $850 million coming due in June and recently announced a $1.1 billion debt-financed acquisition, so the deal could be upsized and we could also see it back in the market in the not-too-distant future. The industrial gas sector continues to trade tight, with price talk on this deal no exception. Initial indications on the 10-year tranche are mid- to high 70s over Treasuries, which seems somewhat rich relative to our rating and could tighten given that the company's existing 2022 bonds recently traded around a spread of 65 basis points over Treasuries, almost 30 basis points inside the A rated bucket of the Morningstar Industrial Index. Looking at comps in the sector, competitor Air Products & Chemicals (APD) (A-) has a 2021 bond that recently traded around a spread of 82 basis points over Treasuries, which also seems rich. Across the spectrum of higher-rated industrials, spreads are generally tight as well but look slightly more attractive than Praxair. For example, United Technologies (UTX) (A) has a 2022 bond that recently traded around a spread of 81 basis points over Treasuries, which generally seems fair to us. We are certainly comfortable owning the bonds of Praxair and would expect this new deal to be met with strong demand, but would place fair value for the new 10-year closer to 80 basis points over Treasuries.
Praxair is a global leader in the industrial gas industry, where the top four players hold nearly 80% of the market. Praxair's wide moat rating stems from its on-site business model and long term contracts, typically lasting 15-20 years, which gives the company tremendous pricing power. Although the recently announced acquisition of NuCO2 for $1.1 billion will take leverage up to 2.4 times on a pro forma basis, we expect leverage to move down closer to 2 times over the medium term, more appropriate for our A rating. NuCO2 is a leading provider of beverage carbonation systems to the U.S. restaurant industry and generates stable and growing free cash flow, consistent with Praxair's existing businesses. The deal is expected to close by the end of the first quarter.
American Honda Finance to Issue 5-Year Bonds; Price Talk Is Attractive (Feb. 12)
Honda Motor's (HMC) (A) subsidiary American Honda Finance is in the market with an offering of $500 million of 5-year notes. We view the finance subsidiary as being a similar credit risk as the parent. Initial price talk is around +80 basis points, which we view as about 10 basis points cheap. Finance subs of peers Toyota Motor (TM) (A) and
Daimler (DAI) (BBB+) priced 5-year deals last month at +60 and +115 basis points over Treasuries, respectively, and these are now trading at +51 and +102, respectively. We view the Toyotas as rich and the Daimlers roughly fairly valued. Volkswagen's (VOW3) (A-) finance subsidiary's 5-year bonds issued in November recently were indicated at about 86 basis points above Treasuries, which we view as fair.
Honda announced fiscal 2013 third-quarter results in late January that showed continued year-over-year improvement due to the easy comparable following the Thailand flooding. Honda posted a 25% year-over-year revenue increase to JPY 2.4 trillion, a nearly 200% rise in operating income and a 63% increase in net income. Earnings per share came in at JPY 42.97 compared with JPY 26.45 in third quarter of fiscal 2012. A 32% increase in automotive revenue was the biggest factor thanks to a 24% increase in Honda's North American sales volume, profitable operations in Japan, and higher volume in Asia due to strong sales of the Fit, Civic, and City in Thailand as well as the CR-V crossover in Indonesia. Automotive operating margin improved to 3.7% from a negative 1.2% in the prior-year quarter. At the consolidated level, cost-reduction efforts nearly completely offset higher selling, general, and administrative expense due to increased advertising spending, allowing a JPY 81.2 billion contribution from better volume to flow to the bottom line. We expect Honda's fiscal 2014 results to benefit from our expectation of continued auto sales increases in Honda's critical U.S. market. We expect calendar 2013 U.S. industry new light-vehicle sales of 15.2 million-15.5 million units. We expect this increase, along with a steady stream of new products such as the new Accord, to continue to help drive Honda's EBITDA steadily higher in fiscal 2014 and 2015.
Arrow Issuance Looks Attractive but We Prefer Avnet (Feb. 12)
Arrow Electronics (ARW) (BBB) is looking to issue 5- and 10-year notes with initial price talk around +237.5 basis points and +275 basis points over Treasuries, respectively. These levels look very attractive given our rating, though we prefer peer Avnet's (AVT) (BBB+) recently issued 10-year note: Avnet's 4.875% notes due in 2022 currently trade at about +267 basis points over Treasuries. Both distributors trade well wide of the typical BBB- issuer in the Morningstar Industrials Index (+223 basis points with an average of about 10 years to maturity), but we believe Avnet's credit rating is more securely entrenched in investment-grade territory. While we wouldn't mind owning either firm's bonds, we would rather trade 8 basis points of spread for the additional security Avnet offers. In addition, the average spread differential between BBB+ and BBB issuers in the Morningstar Industrials Index typically runs closer to 40 basis points.
We don't believe either Arrow or Avnet has carved out a strong competitive position, despite the scale advantages both enjoy. Strong bargaining power of suppliers and low barriers to entry have pushed margins lower over the past 15 years. However, both firms have been friendly to debtholders over the years, limiting shareholder returns and instead using cash flow to expand. Both firms have grown substantially over the years while their debt loads have held fairly constant. Avent has consistently employed less leverage, though, with net debt currently at 1.3 times EBITDA versus 1.7 times at Arrow. Spreads on Arrow and Avnet bonds have widened considerably over the past several months, probably on concerns about the cyclicality of the distribution business. Both firms have posted mid-single-digit revenue declines over the past year, which has pressured margins. However, we'd note that cash flow is typically countercyclical as working capital needs contract in a downturn. As such, we would expect both firms to maintain financial flexibility if the current downturn worsens.
DuPont's New Debt Offerings May Price Too Tight (Feb. 12)
E.I. du Pont de Nemours (DD) (BBB+) is tapping the bond market this morning for a 10-year and a 30-year bond offering. We expect the bulk of the proceeds to be used to retire DuPont's 2013 and 2014 debt maturities. The company has a heavy refinancing need in the next two years. At the end of 2012, the company reported $1.3 billion of debt due in 2013 and $3.12 billion due in 2014 and 2015.
If DuPont's bonds are launched at initial whisper levels, we would recommend passing. The whisper talk of the new 2023 issue is around 90 basis points over Treasuries, and the whisper talk for the new 2043 is in the low 100s. These levels are right in line with DuPont's existing 10-year and 30-year bonds, so this price talk does not offer much new issue concession. Also, our Morningstar Industrial Index on BBB+ carries a spread of 140 basis points over Treasuries this morning. While DuPont traditionally trades well inside of that (we think 20 basis points inside the index is fair), the initial price talk of 50 basis points inside the index on DuPont's 2023 issue is too rich, in our opinion, considering DuPont's underlying credit quality. If investors would like to gain exposure to the chemical or agriculture industry, we would highly favor Potash Corp. of Saskatchewan (POT) (A) 2020 bond that is indicated at 146 basis points over Treasuries.
We like DuPont's agriculture business, which has become a formidable competitor against industry titan Monsanto (MON) (A+). However, we think DuPont's traditional chemical business will continue to exhibit heavy cyclicality, which requires the company to pay special attention to its balance sheet health. Over the years, DuPont has accumulated a significant amount of debt on its balance sheet, weakening its credit metrics along the way. While its gross leverage appears healthy at roughly 2.5 times for 2012, we estimate total adjusted leverage at more than 4.7 times after adding $9.78 billion of underfunded pension and $3.5 billion of underfunded health care and other benefit to its debt load. We think the leverage ratio will remain stretched for its rating for the next two to three years, and we think DuPont has to deleverage significantly in the coming few years to maintain its credit rating.
Delphi Issuing Senior Notes to Take Out Term Loans; Pricing Likely to Be Attractive (Feb. 11)
Delphi Automotive (DLPH) (BBB) is offering $800 million of 10-year senior notes that are callable in five years. Proceeds are targeted for the reduction of senior secured term loans. Delphi has $567 million of Term Loan A's due 2016 and $772 million of Term Loan B's due 2017. This refinancing will both extend maturities and reduce the amount of secured debt outstanding, both positives for the two existing senior notes due 2019 and 2021. Both of those notes are trading to the respective first call dates and indicated at spreads of about 350 basis points above Treasuries. We view this as very cheap relative to our favorable view of the credit and see fair value closer to +200. As such, we see fair value on the new 10-year bonds at around 4.0%. We note that both Moody's and S&P rate Delphi as a junk credit and thus investors may not realize our price targets until at least one of them upgrades the company to investment grade (Fitch has a BBB- rating on the firm). From a valuation perspective, we note that Ford Motor Credit's (BBB-) latest 10-year bond is trading just north of +200, which we view as moderately attractive. Auto supplier BorgWarner's (BWA) (BBB+) 2020 maturities are indicated at +190, which we view as cheap. Looking at the junk comps, Tenneco (TEN) (BB) has 2020 maturity bonds indicated at about 4.5% and a spread of +400, which we also view as slightly attractive given positive fundamentals.
Existing Spreads on Airgas Seem Rich, but Initial Price Talk on New 7-Year Sounds Fair (Feb. 11)
We're hearing that Airgas (ARG) (BBB) is in the market looking to raise $500 million, targeting 5- and 7-year maturities. Proceeds may be used in part to pay down debt. The company has a $300 million note coming due in October. We recently upgraded our issuer rating on Airgas to BBB as we now believe the company has garnered a narrow economic moat, resulting in an improved Business Risk score. With nearly a 25% share of the $13 billion U.S. packaged gas and welding hardgoods market, Airgas is double the size of its closest competitor and nearly equivalent to the size of its top four competitors combined. The company sells to 1 million unique customers--its largest one amounts to just 0.5% of annual sales--which enables Airgas to command bargaining power over each respective purchaser. Airgas has also leveraged its size into more favorable terms with suppliers relative to its regional competitors.
As we've written before, the industrial gas sector has historically traded tight, given the stable cash flows associated with the business. In line with this thinking, the Airgas 2.9% of 2022 were recently quoted around a spread of 125 basis points over Treasuries, which looks a little rich to us. However, initial price talk on the 7-year tranche is the +130 area, which sounds fair if it holds. We would place fair value for the 5-year tranche around +120. Within the sector, higher rated peers Praxair (PX) (A) and Air Products & Chemicals (APD) (A-) also look rich, with Praxair's 2022 bonds quoted around a spread of +64 and Air Products 2023 bonds quoted around a spread of +80. Looking at other stable cash flow businesses, rail Canadian Pacific Railway (CP) (BBB) has as 2022 bond that recently traded around a spread of +150, which we view as fair.
Vodafone's New Issue Looks Rich (Feb. 11)
Vodafone Group (VOD) (BBB+) is offering floating 3-year notes and fixed-rate 3-, 5-, 10-, and 30-year notes. Initial talk on the fixed-rate notes is at 60, 80, 110, and 135 basis points over Treasuries, respectively. The initial price talk appears to offer a decent new issued concession, as Vodafone's 2.5% notes due in 2022, issued last fall, have traded in the +90 basis points area recently. Still, we view initial price talk on the planned 10-year offering as rich at +110 basis points. Both the A- bucket within the Morningstar Industrial Index and AT&T's (T) (A-) recently issued 2.625% notes due in 2022 currently trade around +110 basis points. We view Vodafone as a strong BBB+ credit given its access to the massive cash flow coming out of Verizon Wireless, its broad geographic diversification, and its prescient sale of assets before the worst of the European financial crisis. However, the firm is still heavily exposed to weak markets in Europe, including Italy and Spain, and it has placed a heavy emphasis on dividend growth and share repurchases in recent years, which has limited debt reduction. As a result, we would prefer to see Vodafone's bonds move closer to the BBB+ bucket in the Morningstar Industrials Index, which currently trades at about +140 basis points over comparably dated Treasuries (around 10 years to maturity).
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.