Credit Spreads Remain Range-Bound
We are seeing an increase in idiosyncratic catalysts that are specific to an individual issuer as opposed to industry factors that affect an entire sector.
Credit spreads remain range-bound, as the average spread in the Morningstar Corporate Bond Index has only varied 4 basis points during the past three weeks, ending last week at +145 basis points. Interest rates have also been relatively range-bound, as the 10-year Treasury has traded between about 2.50% and 2.70% over the same period. The new issue market was relatively robust for the first week of August, with almost $18 billion worth of deals priced for issuers that Morningstar rates. Otherwise, average daily volume in the secondary market was very muted. We were just as surprised as buy-side investors by the strong volume of new issuance. Among those issuers to regularly frequent the market, new issue concessions were between slim and none, whereas more off-the-run issuers provided some new issue concession.
One issue that did perform well was issued by Hospira (HSP) (rating: BBB-, narrow moat). Both the new 7- and 10-year bonds were issued at a +325 spread to Treasuries and tightened up to around +300 by the end of the week, in line with where we estimated fair value in our new issue note published Wednesday morning. We rate Hospira BBB-, one notch higher than Moody's, which rates the company below investment grade. We suspect that the new issue market was front-loaded for the month as issuers and investment bankers decided to hit the markets before vacation season gets in full swing, which should provide a respite for the remainder of August.
Fundamental Credit Risk and Macroeconomic Risk Outlooks Benign, but Idiosyncratic Issuer Credit Risk Heating Up
Thus far in earnings season, most companies have been able to meet their second-quarter earnings expectations (albeit many estimates were lowered right before earnings reports) and our fundamental outlook remains benign. While we have seen recent patterns of decelerating consumer spending, recent economic metrics have been improving slightly, and our economic forecast continues to see GDP growing at 2% for the year. What has affected the corporate bond market is an increase in idiosyncratic risk, which has had a far greater impact on credit spreads than underlying financial performance. We are seeing an increase in issuers that have either raised leverage targets to fund share-buyback programs or acquiesced to activist shareholders prodding companies to take actions that reward shareholders at the expense of bondholders.
While changes in our outlook and industry themes continue to prompt rating changes, we are seeing an increase in idiosyncratic catalysts that are specific to an individual issuer as opposed to industry factors that affect an entire sector. Over the past few years, a significant amount of our rating changes were due to shifting themes that affected most of the issuers in a sector. However, over the past few months we have begun to see an increase in individual issuer credit risk for domestic issuers emanating from companies that look to financial engineering (i.e., spin-offs, mergers and acquisitions, and debt-funded share-buyback programs) to enhance shareholder value. Often, these events have been prompted by activist shareholders who have pressured the board of directors to take actions to reward shareholders to the detriment of credit quality.
In the second quarter, our upgrade/downgrade ratio was nearly even, but an increasing number of our rating actions were prompted by issuer-specific catalysts. For example, half of the downgrades occurred in the health-care sector after we performed an industry review that identified both sector-specific themes and issuer-specific catalysts. Stagnant organic growth across the entire industry and impending patent cliffs led several issuers to pursue debt-funded acquisitions in order to drive top-line growth. Other issuers funded large share-buyback programs with debt to increase earnings per share and significantly raised their debt leverage, leading to our downgrades.
While we maintain a positive view on Amgen (AMGN) (rating: A+, wide moat), higher ongoing leverage and the continued focus on shareholder returns at the expense of increased credit risk led us downgrade our credit rating by one notch in early April. For AstraZeneca (AZN) (rating: AA-, wide moat), we downgraded our rating by a notch due to weakening fundamentals and cash flow prospects, as the firm doesn't appear able to internally develop new products to replace products going off patent. Because of these weak fundamentals, we remain on the lookout for negative credit catalysts at AstraZeneca, including potentially large, debt-funded acquisitions. For Bristol-Myers Squibb (BMY) (rating: AA-, wide moat), a review of the pharmaceutical industry revealed that its net leverage had increased to levels that were too high relative to its peers to maintain its previous AA+ rating. We downgraded Hospira on the basis of declining cash flow prospects due to quality-control problems in its manufacturing operations and a tough intermediate-term debt maturity schedule, which could force the firm to tap its credit facility. We downgraded Merck (MRK) (rating: AA-, wide moat) a notch after the firm issued debt to fund a large new share-repurchase program. After Thermo Fisher Scientific (TMO) (rating: BBB, narrow moat) agreed to buy Life Technologies, we downgraded its rating from A+. Thermo intends to increase debt/EBITDA to about 4.5 times after the deal and then only reduce leverage to 2.5-3.0 times debt/EBITDA within two years of the transaction.
Rating changes in the energy sector that stemmed from idiosyncratic catalysts were primarily motivated by acquisitions and divestitures that occurred across the industry. In the midstream sector, we upgraded Plains All American Pipeline (PAA) (rating: BBB+, wide moat) based on our improved outlook for the company because of its acquisition of BP's natural gas liquids platform. The acquisition expanded the company's scope and scale as it now has a robust NGL footprint. Conversely, we downgraded Regency Energy Partners (RGP) (rating: BB-, no moat) because of its acquisition of Southern Union Gas Services. While the acquisition moves the firm toward a more integrated platform, we believe Regency paid a high price for the assets and we still view the company as having an undifferentiated product offering. In the exploration and production sector, we upgraded Noble (NE) (rating: BBB-, no moat) as we believe its excellent exploration history will enable the company to meet its target of doubling production within the next five years without a material increase in total debt. We lowered our rating on Apache (APA) (rating: A-, narrow moat) based on our review of the company, which was spurred by $6 billion of acquisitions during 2012. Although we maintain a positive view on the company in the long term, Apache meaningfully expanded its balance sheet, resulting in the near-term deterioration in credit metrics. By spinning off its downstream refining assets, Marathon Oil (MRO) (rating: BBB, no moat) removed the natural buffer to its E&P business and led to our downgrade of the credit. Without the refining business, our assessment of Marathon's credit risk increased because of the lofty price the company paid for its acquisitions in the Eagle Ford shale and our projection that operating cash flows will not cover capital expenditures.
Most recently, investment-grade Best Idea Washington Post (WPO) (rating: BBB+, narrow moat) announced it is selling the majority of its newspaper publishing assets to Jeff Bezos, the founder and CEO of Amazon, for $250 million in cash. We believe the transaction is an incremental positive for the Post, as the publishing division has reported significant circulation and advertising revenue declines over the past few years. Its papers have struggled to retain their local and national readership bases and have reported frequent operating losses despite the implementation of significant cost-reduction initiatives. While it is unclear what the firm's priorities for the cash will be, we expect Washington Post's balance sheet will remain conservative. The firm carries more cash than debt, and lease-adjusted leverage is just over 2 times. Washington Post's bonds have rallied over the past quarter, but at 227 basis points over Treasuries, they still trade much too wide for the rating, in our opinion.
For the remainder of the year, we expect that idiosyncratic catalysts will increase as a percentage of the drivers our rating actions. As organic top-line revenue growth will be tough to deliver to shareholders and with operating margins generally near their peak levels, management teams and shareholder activists alike will probably pursue greater financial engineering or mergers and acquisitions to reward shareholders.
New Issue Notes
Boston Scientific Refinancing 2014 and 2015 Notes With Fairly Valued New Issues (Aug. 8)
Boston Scientific (BSX) (rating: BBB-, narrow moat) is in the market issuing $1.05 billion in new 5-year and 10-year notes. This month, the firm also entered into a new $400 million term loan agreement due in 2018. Boston will use the proceeds from those new obligations to redeem existing notes due in 2014 ($600 million in principal) and 2015 ($850 million in principal). Initial price talk on the new notes looks about fair to us around 150-155 basis points over Treasuries for the 5-year and around 180-185 basis points over Treasuries for the 10-year. The projected spread on the new 10-year is tighter than the BBB- Morningstar Industrials Index, which is indicated around 239 basis points over Treasuries. However, our positive outlook on Boston's credit trajectory makes us consider the BBB+ (148 basis points over Treasuries) and BBB (195 basis points over Treasuries) categories of the Morningstar Industrials Index when analyzing the valuation of Boston's 10-year notes. Also, CareFusion (CFN) (rating: A-, narrow moat) is our best credit comparable for Boston in the medical device industry. We think Boston's new 10-year notes should price about 30 basis points wider than CareFusion's 2023s, which are indicated around 153 basis points over Treasuries.
Overall, we believe Boston Scientific remains on the brink of a credit upgrade of one to two notches. During 2012, its debt/EBITDA stood around 3 times for most of the year, but increasing profits have helped Boston's debt/EBITDA decline to about 2.4 times by our estimates at the end of June. While Thursday's refinancing will make Boston continue to rely on increasing profits to deleverage in the near-term, we see room for further profit increases due to the ongoing transition to self-manufactured Promus stents (instead of sharing profitability with Abbott on previous-generation stents) and cost controls. With increasing profits, we believe Boston's debt/EBITDA could reach about 2.0 times by the end of 2014. We believe that leverage level would put its financial flexibility for making emerging technology acquisitions on a more even playing field with key operational peers Medtronic (MDT) (rating: AA, wide moat) and St. Jude Medical (STJ) (rating: AA-, wide moat). Both Medtronic and St. Jude typically operate with debt/EBITDA around 2 times; however, both hold significant cash positions as well, which will likely keep their financial flexibility higher than Boston Scientific for at least the next few years.
Price Talk on Norfolk Southern 30-Year Looks Modestly Attractive, but Unlikely to Hold (Aug. 8)
We're hearing that Norfolk Southern (NSC) (rating: BBB+, wide moat) is in the market with a $500 million 30-year offering and that the deal size will not grow. Initial price talk in the area of +130 sounds modestly attractive, but will likely tighten based on where we see existing NSC bonds. The NSC 3.95% due 2042 recently traded around a spread of 105 basis points over the Treasury curve, which we view as somewhat rich relative to rail comps. Eastern peer CSX (CSX) (rating: BBB+, wide moat) is the best comp. Our BBB+ rating for both names incorporates comparable business risk profiles, with both maintaining meaningful exposure to coal. Financial profiles are also similar, with TD/EBITDA around 2 times for both and operating ratios in the 70% area, although CSX now looks slightly better on this metric after trailing NSC for years. We recently saw the CSX 4.75% of 2042 indicated around a spread of 130 basis points over Treasuries, which looks mildly attractive to us. For further comps, the Union Pacific (UNP) (rating: A-, wide moat) 4.25% due 2043 were recently indicated around a spread of 101 basis points over Treasuries, which seems fair to us. We would place fair value for a new NSC 30-year in the area of +120.
Plains All American Pipeline to Issue $500 Million of 10-Year; Initial Price Talk Looks Fair (Aug. 8)
Plains All American Pipeline announced Thursday that it plans to issue $500 million of 10-year notes to repay borrowings outstanding under its credit facilities and for general corporate purposes. As of June 30, Plains had $300 million total outstanding on its two facilities. Initial price talk is 140 basis points over the 10-year Treasury. We place fair value on the new notes at +135.
Plains reported second-quarter results Monday that were in line with management guidance and our expectations. Although revenue increased 5.2% year over year, adjusted EBITDA margin declined to 4.8% from 5.3% in the second quarter of 2012. This decline was largely the result of lower profitability in the supply and logistics business because of less favorable crude price differentials this year. The facilities segment (which houses the liquids and gas storage, natural gas liquids fractionation, and rail unloading/loading businesses) saw the largest profit gain, with segment profit up 29%, thanks to its December 2012 rail acquisition and increased profitability in NGL fractionation. Plains generated $478 million of adjusted EBITDA compared with $522 million in the second quarter of 2012, dropping LTM EBITDA to $2.3 billion. Although LTM EBITDA continue to decline through the remainder of 2013 due to lower crude price differentials, we project that Plains will easily meet its 2013 target of $2.2 billion in adjusted EBITDA. We project year-end 2013 leverage of 3.8 times on total debt of $7.8 billion and debt to capitalization of 52%, which are under Plains' target credit metrics of 3.5-4.0 times adjusted leverage and 60% total debt to capitalization.
Plains' 2.85% notes due in 2023 traded at a spread of 120 basis points over the Treasury curve before the earnings release. Due the pressures in the supply and logistics business segment, we have an underweight recommendation on Plains as we believe the 2023 notes are trading about 10 basis points rich to fair value. For comparison, Enterprise Products Partners' (EPD) (rating: BBB+, wide moat) 3.35% notes due in 2023 traded at 124 basis points over the Treasury curve, which we view as cheap to fair value. While Plains' has similar credit metrics to EPD, we prefer EPD due to its improving competitive position versus the headwinds Plains faces in its supply and logistics business.
Procter & Gamble Issuing New 10-Year Bonds, Whisper Talk Will Tighten (Aug. 8)
Procter & Gamble (PG) (rating: AA, wide moat) announced it is issuing 10-year bonds this morning in benchmark size. We have heard whisper price talk on P&G's new 10-year note is 65 over Treasuries, which is a sizable concession to where P&G's current bonds are indicated. P&G's 2.30% senior notes due 2022 are currently bid at 50 over the nearest Treasury, which we think is good value as our credit rating is one notch higher than the rating agencies. We expect that once official price talk is released, it will tighten 10-15 basis points and the new issue will likely price very near where the existing 2022 bonds are indicated.
P&G recently reported its fourth-quarter results, which was the first chance recently returned CEO A.G. Lafley had to provide his take on opportunities and challenges facing the firm. The clear message from management was that, despite recent struggles (at home in general and globally within the beauty space) there is a renewed emphasis on driving productivity while also creating value for customers. From our view, these initiatives will likely play out over the next few years rather than a couple of months. So while we think these actions will better position P&G for the long term, we don't expect a material acceleration in sales growth or margin expansion in short order. We still regard P&G as a wide-moat giant that enjoys the benefits of scale and unprecedented brand reach, but a healthy dose of reinvestment (in research and development and marketing) will be needed to truly turn the corner. Management also issued fiscal 2014 guidance that calls for 3%-4% organic sales growth and 5%-7% earnings per share growth.
The best sector comparisons are Colgate-Palmolive's (CL) (rating: AA, wide moat) 2.10% senior notes due 2023 which are priced at +55 and Coca-Cola's (KO) (rating AA-, wide moat) 2.50% senior notes due 2023 which recently traded at +47. Another highly rated comparable is Wal-Mart Stores' (WMT) (rating: AA, wide moat) 2.55% senior notes due 2023 which trade around 70 over Treasuries. In addition, yesterday Royal Dutch Shell (RDS.A) (rating: AA-, narrow moat) issued 10-year bonds at +83, which are now trading a few basis points tighter. We prefer the longer-dated credit risk of P&G compared to Shell. Shell, along with its supermajor integrated peers, is finding it increasingly difficult to expand production and add reserves as many of the remaining pools of cheap, easily accessible resources large enough to interest the supermajors reside in the hands of governments and national oil companies.
Iron Mountain to Issue New Senior Unsecured Notes (Aug. 8)
Iron Mountain (IRM) (rating: BB, narrow moat) is in the market with a dual-currency transaction, looking to raise $450 million and CAD 300 million of 10NC5 senior unsecured notes. Proceeds will be primarily used to tender for some existing senior subordinated notes, with any remaining amounts earmarked to pay down borrowings under the senior secured revolver. Specifically, the company is tendering for all of the 8% senior sub notes due 2018 ($50 million outstanding), the 8% senior sub notes due 2020 ($300 million), and the 7.5% senior sub notes due 2017 (CAD 175 million), and up to $138 million of the 8.375% senior sub notes due 2021 ($550 million total). We estimate total borrowings under the secured revolver of about $640 million after management utilized some capacity on the newly upsized $1.5 billion facility to pay off the $450 million term loan balance. If all of the tenders were successful, and the deal is not upsized, we estimate total secured bank debt of roughly $600 million, total senior unsecured debt around $750 million, and total subordinated debt of $2.4 billion.
With the new notes being issued on a senior unsecured basis, there remains significant debt below the notes in the capital structure and only a modest amount of secured debt ahead of them. We estimate less than 1 times leverage through the secured revolver on a pro forma basis, leverage of close to 2 times through the senior notes, and total leverage of 4.7 times. Total enterprise value/EBITDA is 10.8 times. As such, we would place fair value on the new notes more in line with our BB rating, or around a yield of 5.875%-6.125%. This equates to a spread in the range of 325-350 basis points over Treasuries, slightly inside the spread on the Merrill Lynch BB Index. For comparison, the company's 5.75% senior subordinated notes due 2024 were recently indicated around a yield of 6.7% and a spread of +400, which we view as fair to slightly rich given the level of subordination.
Our BB rating on Iron Mountain reflects the firm's leading position in the document management industry and its highly-visible, recurring revenue business model offset by a relatively elevated debt load. As the country's largest document management firm, Iron Mountain operates within a highly fragmented industry that exhibits high switching costs and considerable economies of scale. These latter two traits translate to a narrow economic moat for the company. The company's potential transition to a REIT has been delayed while management awaits a definitive IRS ruling. The ultimate impact to credit quality from a REIT conversion is somewhat uncertain. Under the REIT initiative, leverage has increased to more than 4 times, straining our rating, as the company increased its debt load over the near term to help fund the profit and earnings distribution as well as ongoing conversion costs. However, management was in the middle of a $2.2 billion initiative to return capital to shareholders through share repurchases and special dividends and this program has been suspended. Longer term, management indicated a preference to utilize equity financing for growth initiatives due to the loss of tax advantages related to interest expense under a REIT structure. If the situation plays out this way, leverage would likely decline over the longer term, potentially enhancing credit quality. With the company still in the early stages of pursuing the conversion, we will monitor the situation closely and adjust our rating as necessary.
Hospira Alleviates Liquidity Concerns With New Issuance; Initial Price Talk Looks Cheap (Aug. 7)
Hospira is issuing new 7-year and 10-year notes. The proceeds from these new notes will be used to redeem existing maturities due in 2014 ($400 million in principal at MW+20) and in 2015 ($250 million at MW+50). Initial price talk on the new notes is in the low to mid-300s, which looks wider than fair in our opinion. We see fair value on these new notes closer to 300 basis points over Treasuries, which recognizes Hospira's status on the border of investment-grade and non-investment-grade territory. For reference, the option-adjusted spread of the BBB- Morningstar Industrials Index is +245 basis points while the option-adjusted spread on the Merrill Lynch BB Index is +347 basis points.
While we recognize the ongoing manufacturing problems at Hospira, we believe this new issuance will go a long way in resolving any potential liquidity problems that could arise in the intermediate term. Our worst-case scenario suggests a potential liquidity need around $300 million within the next few years due to those ongoing problems and an unforgiving debt maturity schedule. Those financial resources could have been obtained by pulling on Hospira's credit facility ($690 million available at the end of June), but we appreciate that Hospira is alleviating potential liquidity concerns in advance and even giving itself a little cushion to relieve the prospective pressure associated with its ongoing manufacturing problems. Should those problems dissipate, we believe Hospira's notes eventually could tighten further towards the mid-200s, which is in line with the BBB- index and where pharmaceutical firm Mallinckrodt's (MNK) (rating: BBB-, no moat) 10-year notes (around 265 basis points over Treasuries) are indicated.
Royal Dutch Shell to Issue 5-, 10-, and 30-Year Debt; Initial Price Talk Looks Modestly Cheap (Aug. 7)
Royal Dutch Shell announced Wednesday that it plans to issue 5-year, 10-year and 30-year debt in benchmark size through its 100%-owned subsidiary Shell International Finance, which is guaranteed by Royal Dutch Shell PLC. Proceeds are earmarked for general corporate purposes. Initial price talk is a spread of low +60s basis points for the 5-year, +90 for the 10-year, and +100 for the 30-year. We peg fair value for the new notes about 5 basis points tight to initial price talk. We note that Shell's existing bonds trade well inside the price talk on the new notes. For example, the 1.125% notes due 2017 recently traded at a spread of +45 basis points, the 2.375% notes due 2022 traded at a spread of +76 basis points, the 3.625% notes due 2042 traded at a spread of +66 basis points, all over the Treasury curve; we view these levels as rich.
Shell, along with its supermajor integrated peers, is finding it increasingly difficult to expand production and add reserves as many of the remaining pools of cheap, easily accessible resources large enough to interest the supermajors reside in the hands of governments and national oil companies. In an effort to increase reserves, Shell previously spent $30 billion in the U.S. and Canada on shale plays. As very poor second-quarter results show, Shell's big bet in North America now appears to be a bust. Although the poor performance in North American shale has been a drag on results for some time, the company booked an unexpected impairment of $2.1 billion based on poor production results in some of its liquids-rich shale acreage. In response, management announced that it is moving to trim its shale portfolio in coming quarters. Despite these issues, operating cash flows are well on their way to record levels in the coming years as recent megaprojects, such as Pearl GTL and Qatargas 4, come on line. As such, we expect Shell's credit metrics to remain in line with our AA- issuer credit rating, although we lowered our recommendation on Shell to underweight following second-quarter earnings.
Within our coverage universe of supermajor integrated companies, Chevron (CVX) (rating: AA, narrow moat) and Statoil (STO) (rating: A-, narrow moat) are comparable to Shell based on their operational profiles and the challenges they face. In June, Chevron issued 5-year and 10-year notes. Chevron's 1.718% notes due 2018 recently traded at a spread of +46 basis points, and its 3.191% notes due 2023 traded at +78 basis points, respectively, over the Treasury curve. We view Chevron as trading close to fair value. In May, Statoil issued its 3.95% bonds due 2043. These bonds are quoted at 94 basis points over the Treasury curve, which we view as very rich given the long-term production decline issues Statoil faces in its core Norwegian fields. Based on our rating differentials, Shell's strong balance sheet and cash flow generation offset by the company's near-term challenges in North America, we place fair value on the new notes at +55 basis points for the 5-year, +85 basis points for the 10-year, and +95 basis points for the 30-year.
Best Ideas SABMiller Issuing New 5-Year Bonds; We See Strong Value (Aug. 6)
SABMiller (SBMRY) (rating: A, wide moat) announced it is issuing debt this morning consisting of 5-year fixed- and floating-rate notes, in benchmark size. We have long opined that the trading levels for SAB are cheap for our issuer credit rating and relative to Anheuser-Busch Inbev (BUD) (rating: A-, wide moat). While A-B Inbev has recently increased its debt leverage to fund its combination of Modelo, SAB continues to be in a deleveraging mode following its acquisition of Foster's in December 2011. As SAB's debt leverage continues to decline, we expect SAB's credit spreads will tighten toward A-B Inbev's credit spreads over time.
We have heard that the whisper price talk on SAB's new 5-year note is +105. We expect the new 5-year fixed-rate bond will price closer to the existing 2.45% senior notes due 2017, which are currently indicated at 91 basis points over the closest Treasury (+30 to the benchmark). SAB's 3.75% senior notes due 2022 are indicated at 113 over the closest Treasury (+90 to the benchmark). As a comparison, A-B Inbev's 1.25% senior notes due 2018 are indicated at +51 to the nearest Treasury (+32 to the benchmark) and A-B Inbev's 2.625% senior notes due 2023 are indicated at +77 basis points to the nearest Treasury (+73 to the benchmark). At these levels, we consider A-B Inbev's bonds to be fully valued.
Total to Issue 3-Year, 5-Year, and 10.5-Year Debt; Initial Price Talk Looks Modestly Cheap (Aug. 5)
Total (TOT) (rating: A-, narrow moat) announced Monday that it plans to issue 3-year fixed, 5-year fixed and/or floating rate, and 10.5-year notes in benchmark size. The proceeds will be used for general corporate purposes, including the repayment of existing borrowings. Initial price talk is a spread of +55 basis points for the 3-year, +80 basis points for the 5-year fixed-rate, and +115-120 for the 10.5-year. We currently rate Total market weight and peg fair value for the new notes at +40-45 basis points for the 3-year, +70 basis points for the 5-year fixed-rate, and +100 basis points for the 10.5-year.
Within our coverage universe of supermajor integrated companies, Royal Dutch Shell and Chevron are comparable to Total because they both face similar challenges to Total in regards to finding sufficient new resources to replace current production. Shell's 1.125% notes due 2017 recently traded at a spread of 47 basis points above the Treasury curve, while its 2.375% notes due 2022 traded at a spread of 70 basis points over the Treasury curve. We view Shell as rich to fair value. In June, Chevron issued 3-year, 5-year and 10-year notes. Chevron's 0.889% notes due 2016 recently traded at a spread of 14 basis points, its 1.718% notes due 2018 traded at a spread of 45 basis points, and its 3.191% notes due 2023 traded at 74 basis points over the Treasury curve. We view Chevron as trading close to fair value. Based on the ratings differentials and Total's relatively weaker credit metrics, offset by Total's proven ability to operate in resource-rich countries that are perceived as risky, we place fair value on the new issues of +40-45 basis points for the 3-year, +70 basis points for the 5-year fixed-rate, and +100 basis points for the 10.5-year.
Total's second-quarter earnings were largely in line with our expectations, although the company continues to face longer-term challenges. Total, along with its supermajor integrated peers, is finding it increasingly difficult to expand production and add reserves as many of the remaining pools of cheap, easily accessible resources large enough to interest the supermajors reside in the hands of governments and national oil companies. As such, Total has turned towards natural gas, becoming the second largest player in liquefied natural gas behind Shell. In coming years, Total's return on investment for each incremental addition to its production is likely to be lower than past levels due to the higher costs associated with new production. In the downstream and chemicals segments, we expect recent trends will continue going forward, with mediocre results from Total's European-heavy refinery footprint and decent returns from its chemicals assets. We note that Moody's Aa1 rating is on outlook negative as a result of these issues.
Discover's New 10-Year Offering Looks Attractive Given Its Improving Competitive Position (Aug. 5)
Discover Financial Services (DFS) (rating: BBB+, narrow moat) announced Monday that it is issuing a new benchmark 10-year note out of its banking subsidiary, Discover Bank. We do not rate Discover Bank separately, but consider it a similar credit risk to the holding company Discover Financial Services. Initial price talk is a spread in the area of 180 basis points above the Treasury curve, which we view as attractive. Based on our curve, we think fair value is closer to 160 basis points,. Currently, senior bank debt for names like Fifth Third Bancorp (FITB) (rating: A-, narrow moat) trade in the range of 80-90 basis points above the Treasury curve at the 5-year point. Discover Bank's 5-year senior notes priced in February are now indicated at +140, which we view as about 20 basis points cheap to comps given a one-notch lower rating at the holding company level. Extending to a 10-year, we view fair value on the new notes at about 160 basis points over Treasuries. Our current positive moat trend rating suggests an improving fundamental position, bolstering our viewpoint.
Morningstar's credit rating of BBB+ 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) and MasterCard (MA) . Discover in recent years has lowered its reliance on funding through the securitization market and has increased its deposit base. The company, however, still funds approximately 20% of its assets through securitizations and only 50% through deposits. While these numbers have improved, we would still like the improvement to continue. 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 over 11%.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.