Corporate Bonds Languish as Equity Markets Roar Ahead
Stronger-than-expected economic indicators prompted investors to rethink when the Federal Reserve may begin to taper its asset-purchase program.
In a week of mixed economic indicators, the average corporate credit spread in the Morningstar Corporate Bond Index held steady, ending the week at +137; however, long-term interest rates rose. The yield on the 10-year Treasury rose 13 basis points to 2.75%, with the preponderance occurring Friday.
For the week, rising interest rates pushed the Morningstar Corporate Bond Index down 0.74%. Stronger-than-expected economic indicators prompted investors to rethink when the Federal Reserve may begin to taper its asset-purchase program. While we doubt the Fed will begin to taper its asset purchases as soon as its December meeting, with these stronger reports the potential for the taper to begin sooner rather than later is certainly higher. After having suffered from the sharp sell-off in both interest rates and widening credit spreads this summer because of the expectation that the Fed was going to begin tapering in the fall, investors are once again hesitant to invest in longer-dated corporate bonds. While the equity markets have been roaring ahead over the past few months, credit spreads are languishing. Since the beginning of August, the S&P 500 has risen 5%, whereas the average credit spread in our corporate bond index has tightened only 5 basis points. In fact, since May 15, when our index hit its tightest level for the year at +129, the S&P 500 has risen 6.7%.
The payroll report released Friday blew away Wall Street's forecasts, rising 204,000, compared with the 120,000 consensus estimate. In addition to higher-than-expected payroll growth in October, the payroll report substantially revised its job growth estimates higher for August and September. In addition, the report for third-quarter GDP revealed that the economy grew a healthy 2.8%. The headline GDP growth rate was significantly higher than Wall Street estimates for 2.0%, but Robert Johnson, Morningstar's director of economic analysis, cautioned that the composition of that growth was far from optimal.
A significant portion of the 2.8% GDP growth was due to inventory accumulation as consumer spending and business spending on equipment deteriorated from the prior quarter. In Johnson's opinion, "Businesses seemed to ramp up production (which is what GDP measures), just in time to meet consumer reticence, causing inventories to expand. Unfortunately, businesses often trim production in the subsequent quarter to bring inventories more in line with demand. The pattern of inventory expansions and immediate contractions is relatively common at this stage of a recovery." If consumer spending does not pick up, this could portend weaker-than-expected revenue and margins for the retail sector this holiday season. Given a shorter sales period before the holidays and weaker consumer sentiment, R.J. Hottovy, director of Morningstar's consumer product research team, had already predicted that holiday sales growth will be less robust than last year. If retailers are not able to sell their merchandise early in the holiday period, they may be forced to resort to sales earlier in the holiday period and at greater discounts, lest they be stuck with too much inventory after the holidays.
While headline indicators in the United States are indicating that the U.S. economy is growing ahead of expectations, the European economy continues to struggle. In a surprise decision, the European Central Bank cut its main short-term rate 25 basis points in order to support economic growth and assuage deflationary fears. In addition, S&P cut its credit rating for France by one notch to AA as lower economic growth is constraining the country's ability to shore up its credit quality. The European Commission cut its forecast for 2014 GDP to 1.1% growth in the eurozone. This is the second forecast reduction the EC has made this year; it cut its forecast in May to 1.2% from 1.4%. The EC also increased its unemployment estimate to 12.2% next year from 12.1%.
Notable Earnings Announcements and Recommendation Changes
Toll Brothers (TOL) (rating: BBB-, no moat) announced the acquisition of Shapell, which will be mostly funded by debt. Pro forma for the deal, we estimate that net debt/capital would increase to 46% from 33%. While this is elevated for our rating, the company has committed to rapidly paying down a meaningful portion of the new debt. Based on the amount of cash expected to be generated from working capital reductions and land sales, net debt/capital will decrease to 40%. While this remains higher than historical levels, management appears committed to reducing this further over time. As such, we are maintaining our BBB- rating although we note the firm is weakly positioned in the rating category. With our modestly weaker credit view, we shift our recommendation back to market weight from overweight. We expect Toll to be back in the market to fund the deal, which is expected to close by March 31, 2014. Toll also has a $268 million bond maturing in March. Thus, we could see a range of $1.25 billion-$1.50 billion of new bonds to fund the deal and this maturity.
Pepco Holdings (POM) (rating: BBB, narrow moat), which is on our Best Ideas list, reported strong third-quarter earnings. Improved earnings were primarily driven by improved operating and maintenance expenses, lower fuel and purchased energy costs, and higher electric distribution revenue. For a regulated BBB utility, we believe Pepco's 7.45% senior bonds due 2032 provide very attractive risk-adjusted spreads as the bonds trade about 50-75 basis points wide of similar-duration notes issued by comparable, albeit slightly higher-rated, regulated utility peers. In addition to providing attractive carry, we believe the notes could tighten 25-50 basis points relative to peers.
High-yield Best Idea Cimarex Energy (XEC) (rating: BBB-, narrow moat) announced third-quarter results. For the quarter, on a sequential basis, natural gas production increased 1.6%, crude production increased 6.5%, and natural gas liquids increased 8%. We continued to be pleased with Cimarex's production gains, as we see higher production volume as a key requirement for the ratings agencies to upgrade Cimarex to investment grade. Cimarex's credit metrics were flat with the second quarter as gross leverage remained at 0.7 times and debt/proved reserves was flat sequentially at a very healthy at $0.40 per thousand cubic feet equivalent. We estimate Cimarex's funding gap between operating cash flows and capital expenditures will range from $100 million to $300 million for the full year. Assuming Cimarex borrows a total of $300 million this year, we project that year-end leverage will be 0.8 times and debt per Mcfe would be $0.35, both still very conservative metrics. As such, we continue to have an overweight recommendation on Best Idea Cimarex and anticipate Moody's will upgrade the company to investment grade in late 2014 or early 2015.
Weatherford International (WFT) (rating: BB+, no moat) reported decent third-quarter results, which were overshadowed by the appointment of a new CFO, an update on the firm's divestiture plan, and the announcement of definitive agreements being reached regarding the Foreign Corrupt Practices Act and oil-for-food matters. Both last-12-months EBITDA and total debt were unchanged sequentially, resulting in gross leverage of 3.3 times and interest coverage of 5.4 times. Debt/capitalization was also unchanged sequentially at 52%. Management set an aggressive target for debt reduction to lower debt/capitalization to 25%-35% from 52%. Weatherford stated that debt reduction is its first priority and that a combination of free cash flow, divestment proceeds, and rig contract IPO proceeds will be used to achieve its goal. Based on management's failure to deliver on its previous targets, we believe that the market is putting too much faith in these goals and that spreads on Weatherford's bonds currently reflect a best-case outcome. We remain skeptical of management's ability to execute on its plan and prefer to wait for actual confirmation of asset sales. While we have removed Weatherford from our Bonds to Avoid list, we recommend an underweight in the bonds due to our concerns about free cash flow and debt reduction.
R.R. Donnelley & Sons (RRD) (rating: BB, no moat) reported sequential improvement in its third-quarter results. Management raised its fiscal 2013 revenue guidance but slightly lowered its adjusted EBITDA margin forecast. Pricing remains under pressure, but most of the transaction counts are finally improving, which could alleviate some of the industry's excess capacity. R.R. Donnelley reiterated its commitment to its leverage goal of 2.25-2.75 times. The firm has generated solid free cash flow amid its industry headwinds by prudently downsizing its cost structure. This has allowed the firm to continually reduce debt in an attempt to achieve its leverage goal. Debt/EBITDA currently stands around 3 times. Bonds continue to grind tighter, with the 2019 notes yielding close to 5%, but we believe management's more conservative approach to the balance sheet and copious free cash flow generation will allow bonds to outperform further.
New Issue Notes
Mosaic's Long-Anticipated Senior Note Issue Is Attractive (Nov. 7)
Mosaic (MOS) (rating: BBB+, no moat) is issuing debt to fund its well-advertised plan to return capital to shareholders, which had been highlighted in Morningstar's recent Potential New Issue Supply report. The company plans to issue new 10-, 20- and 30-year senior notes to fund a stock buyback program. Initial price talk for the benchmark 10-year notes is +187 basis points, which we view as attractive. We believe fair value for the risk is in the range of +160-165 basis points. By comparison, the company's current 2021 bonds recently traded at 172 basis points over the nearest Treasury and the BBB+ tranche of Morningstar Industrial Index's is 147 over Treasuries. Furthermore, we note that lower-rated Agrium (AGU) (rating: BBB, no moat) 2023 bonds recently traded at 146 over the Treasury curve. Initial price talk for the 20-year and 30-year notes is around 192 basis points and +207 basis points over Treasuries. We also think the 30-year tranche appears attractive by comparison with Agrium's 2041 bonds, which recently traded at 171 basis points over the nearest Treasury.
To date, the company has been prevented from conducting a general market purchase of its outstanding shares due to restrictions included in the 2004 merger agreement, which formed Mosaic. Since that time strong cash flows have helped the company build a large cash position that is currently 3 times the amount of outstanding debt. Management has been clear regarding its intention to use its balance sheet capacity once buyback restrictions are lifted. Our BBB+ rating had factored the issuance of up to $3 billion of new borrowing to fund a share-repurchase program. Mosaic also recently announced plans to its increase phosphate operations through acquisition of CF Industries' U.S.-based mines and processing facilities. Mosaic will pay $1.2 billion of cash and assume $200 million of CF's asset retirement obligation escrow for these assets. We believe this purchase is a smart way for Mosaic to expand its phosphate business. The proximity of Mosaic's and CF's assets should lead to operating synergies and savings on capital spending, since Mosaic will not need to construct a beneficiation plant at its future Ona mine.
Management estimates that this will save $1 billion in future capital expenditures. Further, the company has scrapped plans to build a $1.1 billion Louisiana ammonia plant to meet its needs (ammonia is a primary input in phosphate fertilizers). Instead, Mosaic will enter a long-term supply agreement with CF for ammonia supply beginning in 2017. With the announced deal, Mosaic will be able to expand its phosphate operations without the execution risk and higher capital costs that come with developing new mines and plants. Based on historical gross profits per ton and the proximity of the assets, we believe Mosaic's and CF's phosphate assets are on a similar position on the industry cost curve.
Ameriprise Issuing More 4% 2023 Notes; We Prefer Pure Play Eaton Vance's Notes Instead (Nov. 7)
Ameriprise Financial (AMP) (rating: BBB+, no moat) is selling more of its 4% notes due 2023 that it issued in September to retire debt and extend its maturity profile. The firm expects to use the proceeds for general corporate purposes. Initial price talk is 120 basis points above Treasuries, which we think is too expensive given comparable trading levels for other asset managers and AMP's exposure to general insurance (roughly 40% of overall revenue). We peg fair value at a spread of 140 basis points over Treasuries. We instead direct investors looking for a pure-play asset manager to Eaton Vance's (EV) (rating: A, wide moat) 3.63% notes due 2023. The EV bonds provide investors with roughly the same spread (+122), a two-notch-higher credit rating, and no insurance exposure.
Generally, we aren't fans of the insurance industry and our issuer credit ratings are two to three notches below the rating agencies'. We believe the inherent risk of issuing policies based on future expected costs is more likely to result in greater losses than projected, especially in the realm of catastrophe losses. This will result a greater strain on capital levels as insurance firms pay out claims, resulting in lower solvency scores, all things equal. As such, we think the insurance sector generally trades very rich.
That said, Ameriprise did report better-than-expected third-quarter results due to robust inflows, increased client activity, and higher-than-expected management fee income. The firm's diversification strategy during the past five years beyond traditional insurance and into asset management continues to help improve the firm's credit profile. Ameriprise remains well capitalized with a capital solvency ratio of over 460%.
Pepco's Delmarva Power & Light to Issue $300 Million of 10-Year Notes at Slightly Rich Initial Level (Nov. 7)
Pepco Holdings' (POM) (rating: BBB, narrow moat) regulated utility subsidiary, Delmarva Power & Light, announced today that it will issue $300 million of 10-year senior bonds. Initial price talk on the new deal is 95 basis points over Treasuries. We view Delmarva Power & Light's new issue to be valued slightly rich if issued at 95 basis points. While we do not formally assign an issuer rating to Delmarva Power & Light, in our September publication, "Regulated Utilities: A New Frontier in Credit Risk Analysis," we view this entity to be of similar, although marginally weaker, credit risk to Connecticut Light & Power, a regulated utility of Northeast Utilities (NU) (rating: BBB, narrow moat). We note that Connecticut Light & Power's 2.50% first mortgage bonds due 2023 trade at 74 basis points over the nearest Treasury. Given that Connecticut Light & Power's 2023 bonds provide security, we believe roughly 20 basis points of additional spread at Delmarva Power is warranted for the lack of security. Thus, because we view Delmarva to be of slightly weaker credit quality, we believe fair value for the new issue is in the 100-105 basis points range.
Delmarva Power's credit qualities include slightly below-average allowed ROE of roughly 9.80%, below-average regulatory environments in Maryland and Delaware, below-average regulatory lag mechanisms (albeit improving), and average management performance. As such, we rank Delmarva Power's credit strength in the lower quartile of all regulated utility operating companies under our coverage. Moreover, we believe Connecticut Light & Power's credit strength ranks similarly (albeit slightly better within the lower quartile) to include above-average allowed ROE of roughly 10.70%, below-average regulatory environment in Connecticut, below-average regulatory lag mechanisms, and below-average management performance.
Delmarva Power's (Maryland) distribution rate case was approved in August. Key settlement terms include a 9.81% allowed ROE (versus a requested ROE of 10.25%) including support for a grid resiliency charge (priority feeder program), as well as $14 million of amortization expenses resulting from storm cost recovery. New rates became effective Sept. 15, 2013. Additionally, Pepco's Delmarva Power (Delaware Gas) distribution rate case was also approved in October. Key settlement terms include a 9.75% allowed ROE (versus a requested ROE of 10.25%) including regulatory lag measures (interface management unit assets--50% at May 1, 2014, with the remainder of assets to be included in rates March 1, 2015). New rates become effective Nov. 11, 2013.
Buckeye Partners to Issue 5-Year and 30-Year Notes; 30-Year Looks Attractive (Nov. 6)
Buckeye Partners (BPL) (rating: BBB, wide moat) announced that it plans to issue 5- and 30-year notes in benchmark size. Initial price talk is a spread in the mid-100s for the 5-year and very low 200s for the 30-year. We peg fair value at +145-150 basis points for the 5-year and +185-190 basis points for the 30-year. Buckeye intends to use the proceeds to finance a portion of the $850 million acquisition of Hess' terminal assets and for general corporate purposes, including prepayment of amounts due under its credit facility. To help fund the acquisition, Buckeye issued $500 million of new equity capital in early October. We note that as of Sept. 30, Buckeye had almost $590 million drawn on its $1.25 billion unsecured revolving credit facility.
In mid-October, Buckeye announced it had agreed to acquire Hess' terminal assets spanning the East Coast and Caribbean for $850 million. The addition of 39 million barrels of storage increases Buckeye's storage capacity by more than 50% to 112 million barrels and complements the partnership's existing wide-moat footprint very well, in our view. In particular, Buckeye will gain 15 million barrels of capacity in the New York Harbor area and 10 million barrels of capacity at St. Lucia in the Caribbean, which are positioned near Buckeye's pipeline and terminal assets in New York and New Jersey, and BORCO marine terminal in the Bahamas, respectively. Additionally, Hess is set to be an anchor tenant with four-year storage and throughput contracts and minimum revenue commitments.
Buckeye's 5.50% notes due 2019 recently traded at a spread of 172 basis points above the nearest Treasury. Magellan Midstream Partners (MMP) (rating: BBB+, wide moat) and Plains All American Pipeline (PAA) (rating: BBB+, wide moat) are comparable to Buckeye. Magellan's 6.40% notes due 2018 are quoted at 82 basis points over the nearest Treasury, while Plains' 6.50% notes due 2018 recently traded at 95 basis points over the nearest Treasury. We view both of these levels close to fair value. In the 30-year tenure, Magellan's 5.15% notes due 2043 traded at 136 basis points over the 30-year Treasury, while Plains' 4.30% notes due 2043 recently traded at 137 basis points over the 30-year. Again, we view these as near fair value. Based on these trading levels, the difference in credit ratings, and Buckeye's improving operational outlook, we believe that fair value for the new 5-year is +145-150 basis points and +185-190 for the new 30-year.
PPL's Kentucky Utilities to Issue $250 Million of 30-Year FMBs at Slightly Rich Guidance Level (Nov. 6)
PPL's (PPL) (rating: BBB, narrow moat) regulated utility subsidiary, Kentucky Utilities, announced today that it will issue $250 million of 30-year first mortgage bonds. Guidance on the new deal is 90-95 basis points over nearest Treasury. We view Kentucky Utilities' new issue to be valued slightly rich if issued in the 90-95 range. While we do not formally rate Kentucky Utilities, in our utility operating company scoring system, we view this entity to be of similar credit risk to Nstar Electric, a regulated utility of Northeast Utilities. We note that Nstar Electric's 5.5% senior notes due 2040 trade at 112 basis points over the nearest Treasury.
Kentucky Utilities credit qualities include slightly above-average allowed ROE of roughly 10.25%, an average Kentucky regulatory environment, above-average regulatory lag mechanisms, and average management performance. As such, we rank Kentucky Utilities in the upper half of all regulated utility operating companies under our coverage. We believe Nstar Electric ranks very similarly, including slightly above-average allowed ROE of roughly 10.50%, an average Massachusetts regulatory environment, above-average regulatory lag mechanisms, and slightly above-average management performance.
We Expect High-Yield Best Idea R.R. Donnelley's New Issue to Price Attractively (Nov. 6)
R.R. Donnelley is coming to market with $350 million in 10-year notes today. As we highlighted in our Potential New Issue Supply sheet, we had expected the firm to tap the debt markets to fund the recently announced acquisition of Consolidated Graphics, which we estimate will involve a $400 million cash outlay. R.R. Donnelley reiterated its commitment to its leverage goal of 2.25-2.75 times; we estimate that leverage will rise to roughly 3.3 times from around 3.0 times currently pro forma for the new deal. We believe that the firm can reach its leverage target over the next year or so.
We expect the new notes to price attractively as we view R.R. Donnelley's existing bonds as undervalued. While the firm continues to post soft results as its customers make the transition to digital media from paper-related products, R.R. Donnelley has generated solid free cash flow amid these headwinds by prudently downsizing its cost structure. This has allowed the firm to reduce debt in an attempt to achieve its aforementioned leverage goal.
R.R. Donnelley's 2022 notes were recently indicated at a yield of 6.23%, well wide of the yield on the average BB issuer in the Merrill Lynch index of 4.81% (just under a 5-year duration). We believe management's more conservative approach to the balance sheet and copious free cash flow generation will allow the bonds to outperform. We would view fair value for the new 10-year notes at around 5.4% given where other consumer cyclical names in the BB area trade. Gannett (GCI) (rating: BB/UR, narrow moat) has 2023 notes recently indicated at a yield of 5.57%, which we view as fair given the recent uptick in leverage for the Belo acquisition. Royal Caribbean Cruises (RCL) (rating: BB-, narrow moat) has 2022 notes that we view as very rich at 5.27%, and would place fair value closer to 6%.
Perrigo Funding Elan Acquisition (Nov. 5)
Perrigo (PRGO) (rating: BBB+, narrow moat) is in the market, as we highlighted in our recent Potential New Issue Supply publication, to fund its acquisition of Elan (ELN) (not rated, no moat), which is expected to close by the end of 2013. Perrigo aims to issue about $2.3 billion in new 3-, 5-, 10-, and 30-year notes; we see fair value on these new issues around 90, 110, 145, and 155 basis points over Treasuries, respectively. We use bonds from Actavis (ACT) (rating: BBB+, narrow moat), which we recommend at market weight, as our guide for Perrigo's fair value. For example, Actavis' 2017s, 2022s, 2042s are indicated around 95, 140, and 145 basis points over the nearest Treasury, respectively. Initial price talk on Perrigo's new issuance looks attractive even at the low end of the range (3-, 5-, 10-, and 30-year at 100, 125, 162.5, and 177.5 basis points over Treasuries, respectively).
In late July, Perrigo announced plans to purchase Elan in an approximate $8.6 billion stock and cash deal, or $6.7 billion net of Elan's cash. To fund this acquisition, Perrigo anticipated increasing its debt to about $3.25 billion upon the deal's close, or around 3 times EBITDA on a pro forma basis, from about $2 billion at the end of June, or 2.3 times trailing 12-month EBITDA. The firm's goal is to reduce debt leverage back to 2.2 times EBITDA within 18-24 months of the transaction's close, which we view as supportive of our BBB+ rating.
Noble Energy to Issue 30-Year Debt; Initial Price Talk Looks Attractive (Nov. 5)
Noble Energy (NBL) (rating: BBB+, narrow moat) announced that it plans to issue 30-year notes in benchmark size. The company intends to use $900 million of the net proceeds to repay borrowing under its revolving credit facility and the balance for general corporate purposes. The borrowing was incurred this year to fund the free cash flow shortfall between operating cash flow and the company's capital expenditure program. We note that Noble has a $200 million bond that comes due in April 2014. Initial price talk on the new notes is +150-55 basis points. We place fair value on the new 30-year notes at +135-140 basis points.
Noble recently reported solid third-quarter earnings that featured over 20% production growth year over year. Although LTM credit metrics were slightly softer due to higher total debt, we continue to have a favorable view of the company and its long-term credit profile. Bolstering our opinion, Noble received very favorable news regarding its large holdings in Israel. The Israeli high court issued a ruling which supports the government's plans to allow more than 40% of its natural gas production to be exported. This was critical for Noble and its partners, as the gas resources discovered off the shores of Israel are far too large to develop for just the Israeli domestic market. Most importantly, this allows for the development of the Leviathan field (recoverable resources are estimated at 18 trillion cubic feet) to move forward. This is one of the largest gas fields discovered in the last decade, and its development has been on hold for the past couple years as the Israeli government heatedly debated the pros and cons of allowing exports. The high court's ruling makes it appear possible that the first phases of development could be sanctioned within the next few quarters.
Prior to the new issue announcement, Noble's 6% notes due 2041 traded at 131 basis points above the 30-year Treasury. We view this level as near fair value based on the positive news from Israel. For comparison, Devon Energy's (DVN) (rating: BBB+, narrow moat) 4.75% notes due 2042 recently traded at 144 basis points over the 30-year. We view Devon as trading slightly rich to fair value as its credit metrics have deteriorated in recent quarters. Apache's (APA) (rating: A-, narrow moat) 4.25% notes due 2044 traded at 116 basis points over the 30-year, which we view as fair value. Based on our positive long-term view of Noble and the developments in Israel, we place fair value on the new 30-year notes at +135-140 basis points.
KeyCorp's New 5-Year Bond Looks Fair at Price Talk (Nov. 5)
KeyCorp (KEY) (rating: BBB+, narrow moat) is in the market with $500 million 5-year notes, its first offering this year of senior holding company debt. Price talk on the notes is 95 basis points over Treasuries, which we view as fair value. Key Bank, KeyCorp's primary operating subsidiary, issued $1 billion of 5-year notes on Jan. 30, 2013, at 80 basis points over Treasuries. This issue is currently trading at 84 basis points over the nearest Treasury. We view these notes as structurally senior to the new holding company notes in a Title II liquidation and should therefore trade at a tighter spread than the new issue. At the senior holding company level, KEY's peers trade in a very narrow range in the 5-year area: BB&T (BBT) (rating: A-, narrow moat) and Fifth Third Bancorp (FITB) (rating: A-, narrow moat) both are indicated at approximately 85 basis points over the nearest Treasury. Moving up two notches in credit, U.S. Bancorp (USB) (rating: A+, narrow moat) issued $1 billion of 5-year notes at a spread of 62.5 basis points over Treasuries yesterday. Although this is the tightest spread relative to the peers, we see the issue as fairly valued for the rating. We see better value moving down in quality to Regions Financial's (RF) (rating: BBB, no moat) 5-year senior holding company notes, which are indicated at a spread of 138 basis points over the nearest Treasury, or the Regions Bank (bank level, subordinated debt) 2018s at 182 basis points to the nearest Treasury which we have on our investment-grade Best Ideas list.
Key's performance has been solid recently with third-quarter earnings up 8.5% from the year-earlier period. Noninterest income grew 7% while interest income was roughly unchanged from the year earlier period at $584 million. Net interest margins declined, falling 12 basis points to a still respectable 3.11% as earning asset yields fell faster than cost of funds.
Credit quality again improved as charge-offs fell to just 0.28% of average total loans. The nonperforming loan ratio also improved falling to 1.01% of period-end loans from 1.23% in the previous quarter. The allowance to nonperforming loan ratio improved to 160% from 134%. The reported tangible common equity ratio remained healthy at slightly under 10%, slightly ahead of its peers.
Statoil to Issue Multitranche Senior Notes; Intermediate Maturities Look Fair, 30-Year Looks Rich (Nov. 5)
Statoil (STO) (rating: A-, narrow moat) announced Tuesday that it plans to issue 5-year fixed- and floating-rate notes, 7-year notes, 10-year notes, and 30-year bonds in benchmark size. Price guidance is +65 for the 5-year note, +90 for the 7-year note, +110 for the 10-year note, and +110 for the 30-year bond. We believe fair value on Statoil's new issues are +65 basis points for the 5-year, +85 for the 7-year, +105 for the 10-year, and +125-130 for the 30-year. The use of proceeds is stated as general corporate purposes including debt repayment, working capital, or acquisitions. Based on our projections, we expect that the proceeds from this issuance will be used to help fill the funding gap between operating cash flow and the company's dividend and capital spending program. We note that in May of this year, Statoil issued $3 billion of new debt with the same stated use of proceeds and that Statoil's CFO Torgrim Reitan has said that the company strives for a "predictable, growing dividend".
Within our coverage universe we view Apache as comparable to Statoil as Apache has a balanced portfolio of onshore and offshore oil and gas properties throughout the world comprising mature assets and a solid assortment of exploratory and developmental projects. Apache's 2.625% notes due 2023 recently traded at +98 over the 10-year, and its 4.25% bonds due 2044 traded at +116 above the 30-year. We view these levels as fair based on Apache's recent asset sales and its use of the proceeds to reduce debt. Based on the near-term outlook for Statoil's production levels, operating cash flow, capital spending, and the use of debt to fund dividends, we see fair value on Statoil's new 10-year note at +105.
The spread curve between Statoil's outstanding 5-year and 10-year notes is similar to initial price talk at about +40 basis points, which we view as fair compared to Apache's 40-basis-point 5-10s curve. Thus we peg fair value on the new 5-year at +65 basis points and +85 for the new 7-year.
The spread curve between Statoil's outstanding 10-year note and 30-year bond is also similar to initial price talk, but is only +5. This stands in contrast to Apache's 10-30s curve, which is +20. Statoil faces declining oil production in its key production area in the North Sea on the Norwegian Continental Shelf, which contributes 80% of its production. In an effort to boost production, Statoil is moving away from its areas of expertise. The company has made several international acquisitions and is undertaking more exploratory projects that come with a higher level of risk than the company has historically carried. Therefore the 10-30s curve should begin to resemble that of an exploration and production company. As such, we believe that a +5 10-30s curve fails to reward 30-year bondholders for the risk inherent in Statoil's long-term growth plans and that the appropriate 10-30s curve is approximately +20-25 basis points. This places fair value on the new 30-year at +125-130.
We award Statoil a narrow economic moat because of its experience operating in deep water, one of the few remaining opportunities available to international oil companies. Our credit rating is 3.5 notches below the average NRSRO rating due in part to the fact that 80% of Statoil's production is from core fields which have been in production decline since 2001. As a result, Statoil's capital spending program is a strain on the company's ability to generate free cash flow. Statoil has announced large discoveries in its core areas of operation that should help stabilize declining production, although 2014 will be a challenging year as production will be stagnant or declining production due to asset sales, reduced activity onshore U.S., and reduced Omen Lange ownership. The company will rely on international assets to grow production over the next decade. Production should start growing in 2015-16, which could accelerate growth to 3%-4% per year. While we maintain a positive long-term view of the company and its balance sheet, we note that the company is taking advantage of the strong credit markets to fund dividend growth at a time when production is declining and Brent crude oil prices are below the level which generates operating cash flow in excess of dividends and capital spending.
Monsanto Issues Senior Notes to Fund Recent Acquisition; Initial Talk Reflects Fair Value (Nov. 4)
Monsanto (MON) (rating: A+, wide moat) today announced plans to issue $1 billion of senior notes in a multitranche offering including 3-year floating-rate notes and, 5-year and 30-year fixed-rate notes to fund its recent acquisition of Climate Corporation. Initial price talk for the 5-year and 30-year notes is 60 and 95 basis points over Treasuries, respectively. We view these as fairly valued and note that they are in line with existing levels on the company's 5.125% senior notes due 2018 and 3.6% notes due 2042. Among other chemical names, Praxair's (PX) (rating A, wide moat) 5-year bonds are trading at a spread of 63 basis points to Treasuries while its 2042 maturity notes are indicated at 88 to the nearest Treasury. We view these levels as slightly rich. We note that the sector generally trades tight to the Morningstar Industrials Index with both names trading about +15 basis points tight of the A index in the 10-year part of the curve.
Monsanto's credit rating continues to be well supported by its strong balance sheet, which consistently holds more cash than debt. We expect pro form total debt/EBITDA will remain below 1 time and interest coverage will remain above 20 times. The company's significant and well-defended position in the global seed market gives it a wide moat and helps produce stable cash flows that easily support its debt obligations and important R&D activities. Monsanto's focus on developing new technologies to maximize crop yields globally has served to diversify its geographic mix and expand opportunities into higher growth markets. We believe the recent acquisition of Climate Corporation for $930 million will boost Monsanto's long-term growth prospects. Climate Corporation is a technology company that develops predictive tools to aid Monsanto's customers in fine-tuning planting decisions which will maximize crop yields and farm profitability.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.