Demand for Corporate Bonds Stronger Than It Appears
Of the issues that we followed in the secondary market, each was trading higher last week.
The average credit spread within the Morningstar Corporate Bond Index only tightened by 2 basis points last week to 134 basis points above Treasuries. However, based on new issue market demand, we think the corporate bond market is stronger than indicated by the indexes.
For example, Avon Products (AVP) (BBB-) brought a new $1.5 billion deal to market with several different maturities. Initial whisper talk on the 10-year tranche of bonds was a spread over Treasuries in the mid-300s, which would equate to a 5.375%- 5.50% yield. Due to strong demand, the official price guidance was decreased to the low 300s basis points above Treasuries, and the bonds were priced at 313 basis points over Treasuries. We thought the bonds were very attractive for the credit risk at the whisper talk. Unfortunately, the underwriters priced out much of the upside to investors, so we consider fair value for the bonds to be near 300 basis points above Treasuries. While we are skeptical that the execution missteps that have plagued the company are fully resolved, we continue to think that the firm has the ability deliver excess returns over time. We view Avon as having a narrow economic moat based on a respected--but bruised--brand, extensive geographic reach, and an underlying business model that requires little invested capital.
Allergan's (AGN) (AA-) recent new issue also supports our contention that the current market is stronger than the indexes indicate. Allergan is a wide-moat aesthetic and ophthalmology medical products leader, which we rate 1-3 notches higher than the rating agencies. The market must agree with our view, because the initial whisper talk on the 10-year was in the low 90s, a level that much more closely dovetails with our rating. The notes were priced at 90 basis points above Treasuries and quickly traded up in the secondary market.
All in all, we saw a little over $16 billion of new corporate bonds priced last week, and of the issues that we followed in the secondary market, each was trading higher.
Strong Employment Gains Helping to Propel U.S. Economy
Regarding the employment number last week, Robert Johnson, our director of economic analysis, commented "This was an outstanding employment report on many fronts. First, the total employment gain of 236,000 was one of the larger in gains in the last 12 months. The gains were spread across a wide variety of industries with construction being a standout performer. The payroll tax increase seemed to have no impact on employment with even the restaurant sector showing gains. In addition to the large gain in jobs, the unemployment rate was down more than anyone was thinking. To make things better, wages were up and the number of hours worked were up, both often good indicators of gains in the months ahead."
The only concerns Johnson voiced were that February has been surprisingly strong for a few years and last year's February was even stronger than this report. There was a fairly large negative revision downward for January that wasn't totally offset by a large upward revision in December, and government lost 10,000 jobs again. The job losses in government are really stunning, especially as this reduction is before any major federal government budget cuts.
Fed's Stress Test Results a Nonevent
Last Thursday, the Fed released the results from the supervisory stress tests conducted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. As Jim Leonard--Morningstar's bank credit analyst--expected, 17 of the 18 banks passed the test. The banks that passed the tests maintained a minimum Tier 1 common ratio above the 5% level under the stress-case conditions. The only bank to not meet this hurdle was Ally Financial, a name we do not cover. The results are no surprise to us as they are generally in line with Morningstar's own Stress Test analysis. Next on the calendar for the Fed is the March 14 release of the results from the Comprehensive Capital Analysis and Review. The CCAR takes into account each company's capital plans, such as dividend payments, stock repurchases, or planned acquisitions. The Fed evaluates whether each bank would still pass the stress test even after planned capital releases.
European Sovereign Credit and Banking Fears Fading, but We Think the Risk Is Still There
The yield on both Italian and Spanish 10-year sovereign bonds continued to decline, ending last week at 4.60% and 4.76%, respectively. In fact, the yield on Spain's 10-year bond reached its lowest level since the PIIGS crisis began.
The average spread within the Morningstar Eurobond Corporate Bond Index more than reversed the prior week's losses after the Italian elections and tightened 5 basis points to 136 basis points above Treasuries, only 7 basis points from its tightest levels since the sovereign debt crisis began. Credit spreads in the European financial sector as represented by MarkIt's iTraxx Europe Senior Financials credit default swap index outperformed the general market and tightened 18 basis points. We have long held a skeptical view that the problems plaguing Europe have been solved for the long term. After market close on Friday, Fitch cut its credit rating on Italy 1 notch to BBB+. The ratings firm specifically pointed to the inconclusive results of the Italian parliamentary elections and adverse impact on the headline budget deficit due to the country's deep, ongoing recession. In addition, we think the continuing growth in nonperforming loans in Spain and Italy will most likely lead the markets to further question the stability of many European banks. We don't know what the exact catalyst will be that will cause the markets to recognize that the underlying problems are still festering, but we'll be keeping a close eye on the headlines out of Europe for forewarning.
New Issue Notes
Allergan Issuing New Notes After Map Acquisition (March 7)
Wide-moat aesthetic and ophthalmology medical products leader Allergan (AGN) (AA-) is in the market on Thursday to sell about $600 million in 5-year and 10-year notes. The proceeds will be used for general corporate purposes, and since the firm just acquired Map Pharmaceuticals (migraine medicine producer) for about $960 million including transaction fees, we believe this offering will be used to boost Allergan's recently reduced net cash position and repay some short-term borrowings related to the Map transaction. Based on our analysis of other drugmakers with similar ratings, we believe fair value on Allergan's new notes is around +60 basis points over Treasuries for the 5-year and around +85 basis points over Treasuries for the 10-year. The agencies rate Allergan A+/A3, and we see Baxter International (BAX) (A+)--rated A/A3 by the agencies--and GlaxoSmithKline (GSK) (AA-)--rated A+/A1 by the agencies--as good comparables to reach our fair value assessment for Allergan. For example, Baxter's 2017s were recently indicated around 59 basis points over Treasuries while its 2022s were indicated around 79 basis points over Treasuries. Glaxo's 2017s were indicated around 49 basis points over Treasuries while its 2022s were indicated around 83 basis points over Treasuries. We have yet to see initial price talk, but we would be eager buyers of Allergan's new notes if they are issued at wider spreads than our fair value assessment given the firm's attractive business characteristics and conservative financial practices.
Sealed Air Tapping the Market Again; Pricing Looks Attractive (March 7)
Sealed Air (SEE) (BB) announced that it is issuing $425 million of notes maturing in 2023. The company planned an $850 million issuance last November to tender for its outstanding 2013 and 2017 notes, but the high yield market was feeling rather leery to this credit and the company ended up placing half of what it had hoped. Those bonds due 12/1/20 were priced at 6.5% and have since traded up about 8 points to a yield of 5.2%. The proceeds of the new issue are targeted at retiring the $400 million of 7.875% notes due 2017, which are callable in June at $103.938. The high yield market may be more receptive to this credit after a satisfactory earnings release in February and considering where the 6.5% bonds trade. The EBITDA improvements in the fourth quarter underpinned the resolve of Sealed Air's new management team in healing the self-inflicted wound related to the Diversey acquisition.
Price talk on the new 10-year bonds is 5.375%, which is roughly in-line with where the 6.5% notes trade and still attractive, in our view. These levels compare favorably against BB-rated packaging companies such as Ball (BLL) (BB+),
Crown Holdings (CCK) (BB-) and Silgan Holdings (SLGN) (BB+), whose similar-maturity bonds trade at yields in the 3.0-4.5% range. In addition, the average yield on the Merrill Lynch BB Index is 4.6%, moderately lower than the yields on Sealed Air's existing bonds. As such, we see good upside in the bonds.
In addition, we think the downside of the new bond is hedged by the tight covenants in Sealed Air's existing bank facility. The tight covenant package in the bank loan dictates that Sealed Air has to reach a debt/EBITDA coverage ratio of 4.5 times by the end of 2013, which we think the company is fully capable of doing so. We estimate that Sealed Air will generate roughly $1.1 billion of EBITDA in 2013, which translates to a maximum of $4.5 billion of gross debt (SEE's total debt was $4.6 billion at FYE 2012). Indeed, Seal Air already used the $313 million net proceeds from the sale of Diversey's Japanese unit to accelerated debt reduction in the past quarter.
Avon Comes Calling With New Bond Issues (March 7)
Avon Products (AVP) (BBB-) is reportedly bringing a new $1.5 billion bond deal to market this morning to refinance debt. We rate the firm at BBB-, which is one notch lower than Moody's and in line with S&P's rating. Fitch, however, rates Avon below investment grade with a rating of BB+. Considering S&P has a negative outlook on their rating, there is a real risk that the firm loses another one of its investment grade ratings and could slip out of some investment grade bond indexes. We recommend that only investors with the ability and willingness to hold bonds with below investment grade ratings should consider an investment in these bonds, lest they take the chance being a forced seller. We have heard that the company is going to issue 3-year, 7-year, and 10-year bonds. The new bonds reportedly have step-up language in which the coupon will increase by 25 basis points for each rating notch downgrade below investment grade per agency, up to 100 basis points per agency and capped up to 200 basis points in total. We think this step-up language is valuable and will be valued by the market between 25 to 50 basis points, covering investors up to one to two notches of downgrade potential and as such the new bonds should trade inside the existing bonds.
The whisper talk on the new bonds is high-200s (3% area) on the 3-year, high-300s (4.75% to 5%) on the seven year, and mid-300s (5.375% to 5.50%) on the ten-year. While at first blush the yield curve looks inverted between the 7s and 10s, we expect that the credit spread on the final pricing will be flat in that part of the curve. We have seen several examples of new issue pricing where the credit spread curve is very flat between 7s and 10s, such as Dr. Pepper Snapple DPS (rating: BBB+) which issued 7s and 10s at a spread differential of 5 basis points last November. If the 7s come much wider than the 10s, we think that would be an attractive spread pick up.
Currently, Avon's 4.20% senior notes due 2018 are trading around 3.45%, a +255 basis point spread over the closest comparable Treasury, the 5.75% senior notes due 2018 are trading around 3.85%, a +303 basis point spread over the closest comparable treasury, and the 6.50% senior notes due 2019 are trading around 4.19%, a +311 basis point spread over the closest comparable treasury. As a point of reference, the average BBB- spread within Morningstar's Industrials Corporate Bond Index is +216 and the average spread in Merrill Lynch's BB index is +356. Interpolating these two reference points leads a +286 spread for a BB+ bond. At the current whisper talk, we think the new bonds are attractive and the 7s and 10s could trade to +300 which we view as fairly valued. This issuance also provides investors an opportunity to swap out of the old bonds and into the new bonds, as either the new bonds should tighten to levels inside the existing due to the step-up, or the existing bonds should widen beyond the new issue spreads.
Avon Products recently closed the books on another tough year, plagued by execution missteps amid a competitive landscape. However, while the equity market welcomed management's commentary on seeing initial signs of stabilization, sending the shares up more than 15% after the earnings release, we remain more skeptical. Full-year results came in about where we expected, and while we intend to update our discounted cash flow model, we don't anticipate any material changes to our projections or credit rating. We still think the firm has the right ingredients to deliver excess returns over time, supporting our narrow moat rating (based on a respected --but bruised--brand, extensive geographic reach, and an underlying business model that appeals to entrepreneurial women). However, Avon remains in a tenuous position and will likely face further volatility over the near-term as execution missteps are negatively impacting the strength of its brand.
Attractive New Debt Offering Expected from CareFusion (March 6)
CareFusion (CFN) (A-) plans to issue $300 million in new senior notes in a 144a offering for general corporate purposes, which may include repaying its 2014 maturity ($450 million) or funding share repurchases. Initial price talk of +162.5 to +175 basis points over Treasuries looks attractive compared to our A- rating. In mid-February, another health-care firm that we rate A-, Cardinal Health (CAH) , priced its 10-year at +120 basis points over Treasuries, which we view as about fair for the rating. We would view fair value of CareFusion's new 10-year around +120 basis points over Treasuries as well, and if initial price talk holds, we'd see CareFusion's new issuance as highly attractive for long-term investors.
We take a differentiated view of narrow-moat CareFusion's credit rating than the agencies, which only rate it Baa3/BBB. The agencies appear unduly focused, in our opinion, on the firm's status as a spin-off with a limited financial history and relatively modest size. Our higher rating reflects our positive view of its competitive position and easily manageable debt position. CareFusion operates in an oligopoly as a top-tier player in the infusion pump market; CareFusion, Baxter (2022s spread around +81), Hospira (HSP) (BBB+), and B. Braun control an estimated 70% of the U.S. infusion pump market. New or smaller entrants have a hard time succeeding in this market because of these established players' scale, breadth of product offerings, and product familiarity to users. Also, these devices are being integrated into hospitals' IT infrastructures, which should help lower administrative costs and improve patient safety at hospitals while also increasing the barriers to entry in this niche. In terms of its financial health, we see CareFusion's management team as solid stewards of its resources. Currently, the firm holds a net cash position, and even after this new debt issuance, the firm's debt to EBITDA level will only hit about 1.7 times from 1.4 times at the end of 2012. Debt investors should be aware that CareFusion's net cash position likely won't grow during the next three years though, as the firm intends to use around $2 billion during the period (or most of its expected free cash flow) for share repurchases and acquisitions. Management plans to be disciplined with its purchases though, and we don't expect the team to jeopardize CareFusion's ability to repay debtholders with these activities.
John Deere Capital Back in the Market; Existing Bonds Look Fair (March 6)
John Deere Capital (A) is back in the market in a two-tranche deal, looking to raise two-year floating and five-year fixed money. Proceeds will likely go towards the refinancing of maturing debt. Our credit rating on Deere Capital is directly linked to our rating of Deere (DE) (A) based on the strong interrelationships between the two entities. Deere dominates the North American agricultural equipment market, with a market share near 50%. This leadership position, combined with its strong dealer network, reputation for high quality products, and conservative financial policies have helped the company generate impressive economic profitability, carving a narrow economic moat.
Based on comps, we would place fair value for a new Deere Capital five-year in the area of 50 basis points over Treasuries. The company's existing 1.2% notes due October 2017 recently traded around a spread of 47 basis points over Treasuries, which we generally view as fair within the sector. Caterpillar Finance, which we rate one notch lower at A-, has a 2018 maturity that recently traded around a spread of 54 basis points over Treasuries, which we view as slightly rich. Both names have bonds in the ten year part of the curve that were recently quoted around 80 basis points over Treasuries. At those levels, we would prefer to own Deere.
MetroPCS Looks to Issue Debt to Support the T-Mobile Deal (March 5)
MetroPCS Communications (PCS) (BB-) is offering two benchmark-size tranches of senior notes through a private placement: eight-year notes callable after four years and 10-year notes callable after five years. We see fair value around 6.25% for the eight-year and around 6.5% for the 10-year notes. The offering is part of Metro's plan to merge with Deutsche Telekom's (DTEGY) (BBB-) T-Mobile USA unit. As part of the deal, Metro needs to issue $3.5 billion of new notes, with a portion used to refinance $2.4 billion of borrowings under its secured credit facility. Metro shareholders will vote on the T-Mobile merger next month, and some large investors have already voiced opposition to the current deal terms. In particular, shareholders seem concerned that DT is pulling too much value out of the deal via the $15 billion of senior notes from the combined firm that it will hold in addition to its equity stake. The notes enable DT to receive a steady stream of cash from the new company while ensuring that DT receives value in a distress scenario.
We agree that the deal structure will leave the new company in a relatively weak financial condition, exacerbating its weak competitive position. Both T-Mobile and MetroPCS have been shedding market share over the past several quarters. T-Mobile lost more than 2 million traditional postpaid customers during 2012, or nearly 10% of its customer base heading into the year. The firm's postpaid customer base is now a quarter the size of Verizon Wireless' and less than a third the size of
AT&T's (T) (A-). Even Sprint Nextel (S) (BB-) is 50% bigger. Given the importance of scale in the telecom industry, and especially in the postpaid business, T-Mobile's position is weak and getting weaker. MetroPCS hasn't fared much better in the prepaid market. The firm lost 460,000 customers during 2012, pulling its share of the prepaid market among firms we cover down to 12.4% from 14.0%.
From DT's fourth-quarter earnings release last week, we'd seen the weakness in T-Mobile's customer growth translated into its financial results. Service revenue declined 10% year over year during the quarter, while the lost revenue and a jump in customer acquisition costs pulled the EBITDA margin down to 24% of service revenue, an eight-year low. For the full year, T-Mobile reported an 8% drop in EBITDA. Metro has done a nice job of boosting revenue per customer to offset customer losses, but services revenue still declined 3% versus a year ago during the fourth quarter. While Metro grew EBITDA 14% during 2012, the decline in service revenue and increasing customer acquisition costs caused a 15% drop during the fourth quarter. On a combined basis, the firms produced a 4% drop in EBITDA during 2012, including a 25% drop during the fourth quarter. Both T-Mobile and MetroPCS clearly have a lot of work ahead in turning these businesses around in the face of tough competition from far larger competitors.
As of the end of 2012, the combined firm's pro forma gross debt would have totaled $21 billion, excluding $2.5 billion of tower financing obligations related to T-Mobile's recent tower sale. That puts gross leverage at 3.3 times 2012 EBITDA (3.7 times including the tower obligations). With $2.3 billion in pro forma cash, net leverage would have been 2.9 times EBITDA (3.3 times with the tower obligations). We believe these metrics remain consistent with our current MetroPCS credit rating, but given the trajectory of the two businesses, we see room for deterioration if the firms' turnaround plans don't gain traction relatively quickly.
Metro's existing 6.625% notes due in 2020 currently yield 5.7% to a par call date in 2018, or an option-adjusted spread of about 450 basis points. These notes are callable as early as November 2015. We view these notes as fairly valued. For comparison, Windstream (rating: BB-) 6.375% notes due in 2023 and callable after 2018 currently trade below par and yield 6.68% to maturity. We believe Windstream bonds are slightly rich given our rating on the firm and the fact that the firm carries a sizable chunk of secured bank debt (1.2 times EBITDA) in front of bondholders. Sprint's 6.0% notes due in 2022, which aren't callable, trade at a yield of 5.88%, or a spread of about 400 basis points over Treasuries. We believe that Sprint bonds are near fair value at current levels. Based on these comparable levels, we would put fair value on the new Metro 10-year notes at 6.5%, a spread to 10-year Treasuries of about 460 basis points. We believe that a higher yield relative to the Sprint notes is warranted given our view that Sprint has more potential for credit improvement over the next couple years than Metro.
Markel's New Notes Look Attractive (March 5)
Markel (MKL) (BBB) announced Tuesday that it plans to issue new 10- and 30-year fixed-rate notes. Initial price talk is a spread in the area of 210 basis points above the Treasury curve for the 10-year and 235 basis points for the 30-year. The new 10-year pricing is approximately the same as the company's existing 10-year notes, so it appears there is no new issue concession. Even without a new issue concession, we think these bonds are attractive in comparison to other insurers.
Allstate (ALL) (BBB) trades almost 100 basis points tighter for the same rating and MetLife (MET) (BBB-) trades 80 basis points tighter for a one-notch lower rating. We acknowledge that one must account for the difference in business models and overall size of the three companies, but we don't think such a sizable spread differential is justified. We would recommend the 10-year notes all the way down to a spread of +150.
From a credit perspective, we like Markel's excellent risk management in specialty insurance, hampered by its aggressive investment portfolio. By confining its operations to the specialty insurance markets, Markel is able to dodge both competition and regulation. Specialty insurance, primarily excess and surplus lines, is characterized by policies that are complicated to price or are not accepted in the regulated insurance market. This form of insurance is sometimes perceived to carry higher risk, but Markel has proved that it is able to manage this risk efficiently over the long term. The company consistently seeks to write insurance that it believes will be profitable, often sacrificing top-line growth to achieve this end. While the company has managed claims to a relatively low level, the expenses incurred in the underwriting process are higher than peers and this has prevented Markel from producing strong underwriting profits. As such, we don't believe Markel possesses an economic moat.
Initial Price Talk Attractive as McKesson Taps Debt Market, but Cardinal Still Best Relative Value (March 5)
Following Cardinal Health's (CAH) (A-) new issuance in mid-February, its drug distribution peer McKesson (MCK) (A) is in the market Tuesday to raise $900 million in 5-year and 10-year notes that will be used to refinance a bridge loan that funded the purchase of PSS World Medical. As we stated in our note on Cardinal's issuance a few weeks ago, we believe Cardinal's notes represent the best relative value in the drug distribution niche, including relative to McKesson's notes. Initial price talk puts McKesson's new 5-year and 10-year at 75 and 105 basis points over Treasuries respectively. Given where McKesson's existing notes are indicated (2016s at 43 basis points over Treasuries and 2022s at 91 basis points over Treasuries), we wouldn't be surprised to see McKesson's new notes price tighter than initial price talk, and we see fair value for McKesson's new 5-year and 10-year notes around 65 and 95 basis points over Treasuries, respectively. Even if these new notes are priced around fair levels, we think long-term investors could be better served by investing in Cardinal's notes. In mid-February, Cardinal's 5-year and 10-year notes were priced at 85 and 125 basis points over Treasuries, respectively; the new 5-year and 10-year notes were recently indicated at 80 and 110 over Treasuries, respectively. While we believe these spreads are close to fair value based on Cardinal's current credit profile, we could see credit ratings on the top-tier drug distributors, including Cardinal and McKesson, converge in the long run due to their similar business risk profiles and credit metrics. Therefore in the long run, investors may see better performance from Cardinal bonds than McKesson bonds due to their higher yields.
We continue to believe the top-tier, narrow moat drug distributors--
AmerisourceBergen (ABC) (A), Cardinal, and McKesson--occupy admirable positions in an attractive sector of the health-care industry, especially for debtholders. Unlike other health care firms, drug distributors face limited product concentration risks, and demand for their services primarily depends on continued demand for branded drugs, which, in our opinion, is a very likely scenario given U.S. demographic and medical treatment trends. While we see long-term risks to being a middleman in any industry, we think significant barriers to entry in drug distribution, such as scale advantages, warehouse investments, logistic networks, and customer relationships, will continue to protect cash flows in this niche for many years to come. Given these admirable business characteristics and manageable debt loads (debt to EBITDA ratios are typically below 1.5 and net debt/EBITDA ratios are typically below 0.5), we think the drug distributors represent low risk credits.
Bank of New York's Wide Moat Business makes its 5-Year Price Talk Cheap (March 4)
Bank of New York Mellon (BK) (A) announced Monday that it plans to issue new 3-year fixed and/or floating-rate notes and 5-year fixed-rate notes. Initial price talk is a spread in the area of 50 basis points above the Treasury curve for the 3-year and 72 basis points for the 5-year. We love Bank of New York's business model and think this price talk is cheap, especially compared to existing bonds. The company's current 5-year trades in the low 50s area, which actually looks slightly rich to us. We doubt the price talk will hold and recommend the new 5-year bonds all the way down to a spread in the low 60's.
Morningstar's A credit rating for Bank of New York Mellon reflects the company's global leading position as a provider of services for the management of financial assets, which allows the firm to enjoy a wide economic moat. The bank has approximately $25 trillion in assets under custody and administration, $1 trillion in assets under management, and services $12 trillion in outstanding debt. The global custody business is concentrated in the hands of six firms, which administer more than 75% of all financial assets. The custody and asset-servicing business is a commodified business in which scale and operating efficiency are essential for success. Relationships in this business can span decades because switching costs prevent asset managers from changing their custodians frequently. As a result, the top three providers in this business, with BNY Mellon being the largest, benefit from wide economic moats.
We Expect Best Idea Mattel's New Bond Deal to Price Attractively (March 4)
Investment Grade Credit Best Idea Mattel (MAT) (A-) is coming to market with $500 million in 5- and 10-year notes, split in equal tranches. The firm will likely use the proceeds to refinance a $350 million March 2013 maturity and a $50 million November 2013 maturity. Price talk of around 100 basis points over Treasuries and 135 basis points over Treasuries for the 5- and 10-year tranches, respectively, appears very attractive to us. This level is tight of Mattel's off the run existing notes due 2020, which are indicated at +182 basis points over Treasuries. However, it is well wide of Morningstar's 10-year A- Industrials Index at +111 basis points and where narrow moat and similarly levered retailer Nordstrom's (JWN) (A-) 2021 maturity bonds are indicated, at a spread to maturity of around +100 basis points. Given resilient consumer spending in the toy category, we see no reason Nordstrom should trade that much tighter than Mattel. Accordingly, we would view fair value on the 10-year tranche around +100-110 basis points, and fair value on the 5-year tranche roughly 25-35 basis points inside this level, given the differential of where recent 5- and 10-year tranches have priced for similarly rated credits.
With such large scale and iconic brands such as Barbie, Hot Wheels, Fisher Price and American Girl, we believe Mattel has carved a narrow economic moat. It is the leader in the $21 billion domestic toy market, capturing 17% market share. To us, this ensures some pricing power as larger retailers do not want to lose out on sales from Mattel toys, which are the most widely demanded brands across the toy universe. Additionally, while the firm has taken on more than $800 million of debt over the past five years to help fund share repurchase activity, it has managed to keep lease-adjusted leverage at or under 2 times. Management has stated it intends to maintain A-range credit metrics.
Range Resources to Issue $500 Million of Senior Subordinated Debt; Fair Value at 4.75% (March 4)
Range Resources (RRC) (BBB-), which we award a narrow moat based on its Marcellus Shale assets, announced Monday that it plans to issue $500 million of senior subordinated debt due 2023. We estimate fair value to be 4.75%. This new debt will be non-callable for the first five years. We note that our BBB- credit rating is an issuer level rating. Thus, based on the structural subordination to Range's bank credit facility, we believe our credit rating on Range's new issue and its outstanding $2.1 billion senior subordinated debt would be one notch lower than our issuer level rating. As with its debt issuance last year, Range plans to use the proceeds to repay borrowings under its bank credit facility. As of Dec. 31, there was $739 million outstanding under this facility. Based on our projections and Range's estimates, we anticipate that Range's capital expenditure budget will outstrip cash flow from operations by roughly $300 million in 2013; we anticipate that Range will follow its historical pattern of borrowing against its credit facility to fill this funding gap.
Range reported fourth-quarter results last week. Volumes came in at 844 MMcfe/d, up 7% sequentially and 35% year over year. Range expects production to grow 20%-25% in 2013, led by its Marcellus and Mississippi Lime positions, where the company continues to post some of the best results in the play. Range's 2013 hedge book is solid, with 70% of natural gas hedged at around $4.20 per Mcf, 80% of crude hedged at around $95 per barrel, and more than 50% of NGLs hedged near current market prices. Credit metrics improved compared with the third quarter, as LTM leverage declined to 3.3 times, from 3.8 times in the third quarter. Year over year, debt per mcfe increased to $0.44 from $0.39, as total debt grew 45% while proved reserves increased 29%. We expect that Range will generate $275 million in proceeds from the sale of its Permian assets, which will be applied to debt pay down. We project that by 2014 leverage will decline to 2.8 times and debt per mcfe will decline to $0.42.
Range's 5% notes due 2022 recently traded at a yield to worst of 4.49%. We believe this level is close to fair value based on Range's substantial production gains and its solid hedge book for 2013. As today's issuance is to term out structurally superior borrowings and does not impact credit metrics, we believe that fair value for the new issue is 4.75% on a yield to maturity basis, allowing for a slight new issue concession and the later maturity date. Although it does not offer similar production gains, has about half the equity market capitalization of Range and controls proved reserves which are 35% of the size of Range's, we prefer the conservative approach of Cimarex Energy (XEC) (BBB-, narrow moat). Cimarex is also borrowing to fund its drilling program, but the company has a more balanced production mix and markedly better credit metrics. As of year-end 2012, Cimarex's leverage was 0.7 times and debt per mcfe was $0.33. Cimarex 5.875% notes due 2022, which are on our high yield best idea list, are quoted at a yield to worst of 4.80%.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.