Payrolls Not Too Hot, Not Too Cold
It appears that the corporate-bond market believes Friday's jobs report was high enough to suggest an advancing economy, but not so strong as to prompt a Fed taper.
Corporate credit spreads tightened significantly after the employment report was released Friday. It appears that the corporate bond market believes the employment report was high enough to support the expectation that the economy is still moving forward, but not so strong as to prompt the Federal Reserve to taper its asset-purchase program. With the Fed continuing to purchase mortgage-backed securities and long-term Treasury bonds, investors have increasingly fewer fixed-income assets from which to choose. This decrease in supply is becoming even more pronounced as the U.S. government's deficit is shrinking and requiring less new debt issuance. This has positively affected the demand for corporate bonds as the supply of available fixed-income securities constricts and the new Fed-provided liquidity looks for a home.
The average spread in the Morningstar Corporate Bond Index tightened 4 basis points over the course of the week to +129, returning to its tightest level of the year. Interest rates, however, continued their march higher as the yield on the 10-year Treasury bond rose 14 basis points to 2.88%. In our fourth-quarter market outlook, published Sept. 25, we highlighted our expectation that over the long term interest rates will normalize toward historical metrics. Based on three of the metrics we watch (the spread between current inflation and interest rates, inflation expectations, and the steepness of the Treasury curve), we think the 10-year Treasury will rise to around 4% after the Fed begins to taper its asset purchases.
After grinding tighter for the past few months, corporate credit spreads have returned to their tightest levels of the year and in fact are at the tightest level since before the 2008-09 credit crisis. We also highlighted in the fourth-quarter market outlook our expectation that corporate credit spreads would be pushed toward the bottom of the trading range over the past year. Now that we are back at the tights, it appears that in the short term, the path of least resistance is tighter still. From a fundamental viewpoint, we think the preponderance of credit spread tightening has run its course. Across our coverage universe, our credit analysts generally have a balanced view that corporate credit risk will either remain stable or improve slightly, but that the tightening in credit spreads on those names is likely to be offset by an increase in idiosyncratic risk (debt fund M&A, increased shareholder activism, and so on). However, this could rapidly change if the Fed begins to reduce its asset-purchase program, which could lead to an increase in long-term interest rates. In that case, we would expect a repeat of the chain of events in May and June: Corporate credit spreads quickly widened out as portfolio managers looked to sell long-term bonds to reduce their portfolios' duration and dodge the brunt of losses from rising yields.
- source: Morningstar Analysts
From a longer-term perspective, credit spreads are 50 basis points wider than the lowest levels reached before the 2008-09 credit crisis. While credit spreads may continue to compress, we don't anticipate them returning to anywhere near those pre-crisis lows. At that time, credit spreads were lower than they should have been because of an overabundance of structured credit vehicles created to slice and dice credit risk into numerous tranches, artificially pushing credit spreads too low. Once the credit crisis emerged, investors found that many of these vehicles did not perform as advertised. While there have been some reports that a few investors are beginning to re-evaluate investing in collateralized debt obligations, we doubt that these structures will re-emerge anytime soon in any kind of meaningful size.
- source: Morningstar Analysts
Changes to S&P Rating Criteria Will Lead to Issuer Upgrades, Most of Which Will Move S&P's Ratings Toward, or Match, Our Existing Ratings
On Nov. 26, S&P placed its ratings of 57 issuers on CreditWatch with positive implications, as S&P believes it will probably raise these issuers' credit ratings. This action was attributable to changes recently made in S&P's corporate rating criteria. Of those 57 issuers, Morningstar assigns issuer-level credit ratings on 17. On Nov. 26, our credit rating was higher than S&P's on 11 issuers, the same on 5 issuers, and lower on 1 issuer. Since then, S&P has increased its credit rating on 4 issuers. We expect further rating upgrades to follow over the short term as S&P resolves the remaining outstanding positive CreditWatch ratings. Assuming that S&P upgrades the remaining 13 issuers on positive CreditWatch, 10 of those rating upgrades would either move toward, or match, our existing credit ratings.
New Issue Market Mostly Fairly Valued, but We Recommend Avoiding Xerox's Bonds
The new issue market was especially busy as issuers looked to price bond deals before the market starts to run up against the holidays later this month. Of the issuers to which we assign credit ratings, more than $37 billion of new transactions were brought to market. For the most part, we thought most of the deals were priced at levels that fully reflected the underlying credit risk, with only a few transactions that we thought were cheap.
One deal that stood apart from the rest was Xerox's (XRX) (rating: BBB-, narrow moat) $300 million 2.75% senior notes due 2019, which priced at 138 basis points over Treasuries. We recommended that investors avoid Xerox's bonds as the credit spread is not nearly wide enough to compensate for the firm's relatively high leverage and the decline in the printer and copier business (which still accounts for about 40% of sales). Mike Hodel, our technology senior credit analyst, believes fair value for the bonds should be significantly wider, with fair value closer to +180, or 2.5 points below where the bonds are currently trading. Within the sector, we continue to prefer Hewlett-Packard (HPQ) (rating: BBB+, narrow moat), which has vastly improved its financial condition recently. HP's 3.75% notes due 2020 were recently indicated at +163 to the nearest Treasury, which we believe is far more attractive than the new Xerox notes.
New Issue Notes
Price Talk on BNP's 5-Year Is Attractive (Dec. 5)
BNP Paribas (BNP) (rating: A, narrow moat) is in the market with a benchmark-size offering of 3- and 5-year senior notes. Initial price talk on the 3-year notes is 75 basis points over Treasuries while price talk on the 5-year is +105, which we view as attractive. Price talk on the new 5-year notes would provide an attractive new issue premium to BNP's current 5-year dollar-denominated issue, the 2.7% due Aug. 20, 2018, which is indicated at +85 basis points to the nearest Treasury. Price talk is also attractive relative to lower-rated French banking peers Societe Generale GLE (rating: A-, narrow moat) and Credit Agricole ACA (rating: BBB-, narrow moat). Societe Generale is indicated at +103 basis points to the nearest Treasury in the 5-year area, which we view as fairly valued, while Credit Agricole is indicated at +105 basis points to Treasuries, which we view as overvalued. We see fair value on BNP's new 5-year note at +95.
BNP reported lackluster results for the third quarter. Pretax income of EUR 2.1 billion was 9% lower than the year-earlier period and 22% lower than the prior quarter. The bank continued to struggle with sluggish or falling loan demand across divisions, lower client activity, and the low interest rate environment. We were pleased, however, that the results weren't worse, considering the earnings reported by peers. BNP's corporate and investment banking pretax income fell "only" 24% compared with the year-ago quarter as fixed-income trading dropped 31% compared with the 40%-plus seen at other banks. The company has been effective reducing operating costs as its "Simple & Efficient" plan generated EUR 219 million of cost savings in the third quarter (3.3% of second-quarter operating costs), bringing 2013 cost savings achieved to EUR 549 million. Provisions fell 20% sequentially and 6% compared with the year-earlier period. BNP's loan losses overall are low and easily manageable--credit costs were just 55 basis points in the third quarter.
We were glad to see that BNP continued to build capital during the quarter and increased its fully loaded Basel III ratio 40 basis points during the third quarter to 10.8%, above average in its peer group.
Ameren Illinois to Issue $280 Million of 30-Year Notes; Initial Level Cheap (Dec. 5)
Ameren's (AEE) (rating: BBB-, narrow moat) regulated utility subsidiary, Ameren Illinois, announced today that it will issue $280 million of 30-year notes. Initial price talk on the new deal is in the area of the low 100 basis points over Treasuries, which we view as cheap. While we do not formally assign an issuer rating to Ameren Illinois, we view this entity to be of similar, although marginally stronger, credit risk to Delmarva Power & Light, a regulated utility of Pepco Holdings (rating: BBB, narrow moat). As highlighted in our November publication, "Regulated Utilities: A New Frontier in Credit Risk Analysis," Delmarva Power & Light's 4.0% senior secured notes due 2042 recently traded at 86 basis points over the nearest Treasury. Thus, we believe Ameren Illinois should trade just inside Delmarva Power & Light given our view of Ameren Illinois' slightly stronger relative credit fundamentals.
Ameren Illinois' credit considerations include (1) a below-average allowed ROE of roughly 9.00%, (2) a below-average Illinois regulatory environment, (3) average regulatory lag mechanisms, and (4) average management performance. As such, we rank Ameren Illinois in the lowest quartile of all regulated utility operating companies under our coverage. We view Ameren Illinois slightly more favorably than Delmarva Power & Light, which ranks similarly (albeit slightly weaker in the lowest quartile of all regulated utility operating companies under our coverage) to include (1) a slightly below-average allowed ROE of roughly 9.75%, (2) a below-average Delaware regulatory environment, (3) below-average regulatory lag mechanisms, and (4) average management performance.
CF Industries Announces Plan for New Debt in Early 2014; We Remain Underweight (Dec. 4)
CF Industries Holdings (CF) (rating: BBB-, no moat) today announced plans to issue $1.5 billion of new debt in early 2014 to fund additional share repurchases. In May, the company had issued a similar-size issue to also fund share repurchases. Along with today's announcement, management clarified its midcycle leverage target of 2-2.5 times and restated its goal to maintain an investment-grade rating. The company's current outstanding debt totals $3.1 billion, producing LTM leverage of 1.1 times. We believe the proposed debt issuance will raise the company's 2014 pro forma leverage to around 2 times.
Although we do not expect the proposed issuance to affect our current BBB- rating, we recognize that CF's recent sale of its phosphate business leaves it as a pure-play nitrogen producer subject to often volatile pricing in corn and natural gas markets. We expect the company's margins to decline as natural gas prices move toward our $5.40 per thousand cubic feet midcycle marginal cost estimate. We continue to believe that CF's current 2023 bonds indicated at +154 basis points to the nearest Treasury are rich relative to the Morningstar Industrials index level of +219 basis points and CF's agricultural input peers. We remain overweight Potash Corporation of Saskatchewan (POT) (rating: A-, wide moat), whose 2020 bonds are currently indicated at 127 basis point over the nearest Treasury. We also prefer market weight Mosaic (MOS) (rating: BBB+, no moat), whose recently issued 2023 bond is indicated at 151 over Treasuries.
Thermo Fisher Issuing Debt to Fund Life Acquisition; Initial Price Talk Rich (Dec. 4)
As previously highlighted in our Potential New Issue Supply report, Thermo Fisher Scientific (TMO) (rating: BBB, narrow moat) is issuing new notes to fund the acquisition of Life Technologies (rating: BBB, narrow moat), which is expected to close in early 2014. Thermo has stated in the past that it could issue about $3.5 billion-$4.0 billion in new notes to fund part of this acquisition. Initial price talk on the new notes looks rich, and we would underweight Thermo Fisher's bonds given the substantial debt leverage the firm plans to hold in the long run and the firm's ongoing appetite for acquisitions.
Initial price talk on Thermo's new notes is around 95, 125, 160, and 170 basis points over Treasuries, respectively, on its 3-year, 5-year, 10-year, and 30-year notes and already appears rich to us. Given the potential for spreads to tighten further from initial price talk, we suspect the final pricing on these notes will be quite rich for the risks in Thermo Fisher and relative to its life sciences peers. We place fair value on Thermo's new notes closer to 115, 145, 180, and 190 basis points over Treasuries, respectively. We think life sciences investors could obtain more compensation by investing in Agilent Technologies (A) (rating: A-, narrow moat), which we rate two notches higher than Thermo due to Agilent's lower debt leverage, and we maintain an overweight recommendation on Agilent's bonds. For example, Agilent's 2023s are indicated at 157 basis points over the nearest Treasury. With Agilent aiming for 2.0 times debt/EBITDA after it sells its cyclical electronic measurement business, which compares favorably with Thermo's long-term goal of 2.5-3.0 times debt/EBITDA, we think the credit risks at Agilent will remain lower than Thermo's in the long run. We would trade up in credit quality and potentially in bond compensation by investing in Agilent rather than Thermo.
Overall, though, Thermo Fisher remains advantaged as the largest supplier of research instruments and consumables in the world. Its one-stop-shop business model and sizable recurring revenue stream should make it attractive for customers and investors alike. However, Thermo plans to fund its $13.6 billion purchase of Life with about $10 billion in debt and the balance in equity; Thermo also will assume $2.2 billion in Life's debt. Once this merger closes in early 2014, we estimate the combined entity will hold debt/adjusted EBITDA around 4.5 times, up from 2.7 times on a trailing 12-month basis at the end of September. Before the Life acquisition announcement, we had assumed Thermo would continue to deleverage to debt/EBITDA around 2.0 times after integrating other recent acquisitions. Now we believe management is comfortable with its relatively high leverage position for the long run. Thermo's management aims to reach debt/EBITDA of 2.5-3.0 times within two years of the transaction's closing. That substantial leverage position and Thermo's ongoing appetite for acquisitions will probably constrain our view of its credit profile going forward.
Nordstrom's New 30-Year Debt Issue Looks Attractive (Dec. 3)
Nordstrom (JWN) (rating: A-, narrow moat) is tapping the debt market for the first time in a number of years with $400 million in 30-year paper. Initial price talk in the area of 140 basis points over Treasuries looks attractive relative to where other retailers' 30-year bonds trade. Home Depot's (HD) (rating: A, wide moat) 2044 and Lowe's Companies (LOW) (rating: A, wide moat) 2043 bonds were most recently indicated at 97 and 109 basis points over the nearest Treasury; respectively. We would place fair value for Nordstrom around 20 basis points wider than these names given the notch differential in credit quality, or 120-125 basis points over Treasuries.
We are quite favorable on Nordstrom from a credit perspective because of not only its steady revenue growth, operating margins, and leverage but its disciplined approach to dividends and share repurchases. During 2009-10, the firm reduced its cash outlays to shareholders as a percentage of free cash flow. We are not concerned about the increase since then to more than 100% of free cash flow, given the company's consistent lease-adjusted leverage at just over 2 times.
While Nordstrom recently reported tepid third-quarter results of flat same-store sales and only modest margin expansion, we have a constructive long-term view of the firm and believe it merits a narrow economic moat. The firm has high sales per square foot (around $400, despite large stores), fast inventory turns (more than 5 times), a focus on great fashion and customer service, structural advantages of favorable locations, and consistently high returns on capital.
Price Talk on Xerox Notes Is Too Rich; We Prefer HP (Dec. 3)
Xerox plans to issue $300 million of long 5-year notes (due March 2019) with initial price talk around +160 basis points. Xerox is on our Bonds to Avoid list, based primarily on valuation, relatively high leverage, and the decline in the printer and copier business, which still accounts for about 40% of sales. The firm's 4.50% notes due 2021 were recently indicated at +191 basis points to the nearest Treasury, which we view as about 20 basis points rich. Based on this view, we would peg fair value on the new Xerox issuance at roughly +180 basis points, leaving the initial talk on these notes also about 20 basis points rich.
Xerox has reduced gross debt during the past year to $7.5 billion from $9.4 billion, largely in response to the decision to shrink its financing business. Finance receivables and equipment on lease have declined to $5.2 billion from $6.2 billion a year ago. While Xerox uses debt to support its lease book, it still looks heavily leveraged on a consolidated basis. Gross leverage stood at 2.5 times EBITDA at the end of the third quarter and pension obligations add another 0.5 turn of leverage. Management does not expect to further shrink the receivables book in 2014 or make any incremental debt reductions, instead allocating capital to dividends, increased share repurchases, and acquisitions.
In the sector, we continue to prefer Hewlett-Packard, which has vastly improved its financial condition recently, driving gross leverage down to 0.8 times EBITDA. HP management continues to target a mid-A credit rating over the long term. HP's 3.75% notes due 2020 were recently indicated at +163 to the nearest Treasury, which we believe is far more attractive than the new Xerox notes.
Initial Price Talk on Microsoft New Issuance Looks Very Attractive (Dec. 3)
Microsoft (MSFT) (rating: AAA, wide moat) is planning to issue 5-, 10-, and 30-year notes in its second such issuance of the year. The firm is probably looking to boost domestic cash on hand, which dropped to about $4.7 billion at the end of its fiscal first quarter from $7.4 billion at the end of fiscal 2013. Increased share repurchases and a debt maturity drew on domestic cash during the quarter. Calls on domestic cash will continue as the firm recently increased its dividend 22% to about $9.3 billion annually from $7.7 billion and instituted a new $40 billion share-repurchase authorization.
Given our view of Microsoft's credit strength, we believe spreads on the firm's existing bonds are attractive. For example, the 2.375% notes issued earlier this year are indicated at about 81 basis points over the nearest Treasury. Equal-rated Johnson & Johnson (JNJ) (rating: AAA, wide moat) issued 10-year notes yesterday at +58 basis points. In the tech sector, Google's (GOOG) (rating: AA, wide moat) 3.625% notes due in 2021 are indicated at +73 basis points and Apple's (AAPL) (rating: AA-, narrow moat) 2.4% notes due 2023 trade at 85 basis points over the nearest Treasury, roughly in line with Microsoft despite a slightly weaker credit rating. Initial talk on the new notes, at 45, 100, and 110 basis points over Treasuries, respectively, looks very attractive relative to Microsoft's existing notes and its comparables. At those spreads, Microsoft would be trading more like the typical weak A rated credit in the Morningstar Industrials Index.
While its domestic cash has dwindled, the firm's overall liquidity position is solid. It held more than $80 billion of cash and investments at the end of September after generating nearly $7 billion in free cash flow during the fiscal first quarter. Compared with its cash holdings and prodigious cash flow, the firm's debt load looks very modest. Weak global PC sales have weighed on Microsoft recently, but the firm has still managed to produce stable results thanks to the strength of its enterprise businesses.
Johnson & Johnson Issuing New Notes; Price Guidance Looks Rich (Dec. 2)
Johnson & Johnson is in the market issuing new 3-year (fixed- and floating-rate), 5-year, 10-year, 20-year, and 30-year notes. The proceeds will be used to repay commercial paper ($3.0 billion outstanding) and for general corporate purposes. We expect final pricing on the new issuance to be rich for the lowest risk issuer in the health-care industry.
Price guidance of 20, 30, 60, 60, and 70 basis points over Treasuries, respectively, for the new 3-year, 5-year, 10-year, 20-year, and 30-year notes looks modestly rich. We see fair value on J&J's new issues around 30, 45, 75, 75, and 80 basis points over Treasuries, respectively. We compare J&J's bonds primarily with other very low-risk pharmaceutical issuers, primarily rated in the AA category. We currently place fair value in the AA category in the 5-year, 10-year, and 30-year maturity buckets around 55, 85, and 90 basis points over Treasuries, respectively, and believe J&J's notes should offer slightly less compensation than its AA rated peers. However, we note that the credit risks at AA rated health-care companies remain very low, and investors may be able to obtain more compensation than J&J's notes by stepping out slightly on the risk continuum. For example, we maintain market weight recommendations on several other large pharmaceutical firms, including Novartis (NVS) (rating: AA+, wide moat), Allergan (rating: AA-, wide moat), Bristol-Myers Squibb (BMY) (rating: AA-, wide moat), Merck (MRK) (rating: AA-, wide moat), Roche (RHHBY) (rating: AA-, wide moat), and Sanofi (SNY) (rating: AA-, wide moat). Those issuers typically offer about 20-25 basis points more compensation than pricing guidance on J&J's 10-year maturity bucket while still representing very low credit risks.
CVS Caremark Funding Coram Acquisition; Underweight Bonds (Dec. 2)
CVS Caremark (CVS) (rating: BBB+, wide moat) is in the debt market today, issuing 3-year, 5-year, 10-year, and 30-year notes. The proceeds will be used to repay outstanding commercial paper borrowings ($1.2 billion) and fund the planned acquisition of Coram, the specialty infusion services and enteral nutrition business unit of Apria Healthcare, for approximately $2.1 billion. Based on initial price talk, we believe better options are available in the drug supply chain, and we recommend investors continue to underweight CVS' bonds.
We place fair value on CVS' new notes around 90, 115, 145, and 170 basis points over Treasuries for the new 3-year, 5-year, 10-year, and 30-year notes, respectively. Therefore, initial price talk around 80, 105, 135, and 160 basis points over Treasuries appears slightly rich to us, despite being wide of spreads on CVS' existing notes. For example, CVS' 2022s are indicated around 104 basis points over the nearest Treasury. We maintain an underweight recommendation on CVS' notes, as those spreads remain tighter than the average BBB+ issuer; the BBB+ Morningstar Industrial Index, which is comparable in maturity to CVS' 10-year notes, is indicated around 145 basis points over Treasuries. Also, notes from key pharmacy benefit management competitor Express Scripts (rating: A-, wide moat), which we rate a notch higher than CVS, are indicated at wider spreads than CVS' notes. For example, Express Scripts' 2017s, 2022s, 2041s are indicated at 83, 144, and 145 basis points over the nearest Treasury, respectively. We think Express Scripts notes typically offer better relative values than CVS' notes.
However, we recognize that CVS may represent the lesser of two evils in the retail pharmacy business. Walgreen (WAG) (rating: BBB/UR, no moat) remains on our Bonds to Avoid list with 2015s, 2017s, 2022s, and 2042s indicated at 50, 75, 129, and 129 basis points over the nearest Treasury, respectively. With its higher credit rating, CVS' notes may offer similar compensation for less risk than Walgreen's bonds, although in general we don't think either issuer's bonds offer enough compensation for the risk.
Starbucks Layering in Shorter-Dated Debt; Price Talk Is Fair (Dec. 2)
Starbucks (SBUX) (rating: A-, wide moat) is coming to market with $750 million in 3- and 5-year notes today. Initial price talk of 50 and 75 basis points over Treasuries for the respective tranches appears fair. We currently view Starbucks' 2023 notes as fair at around 100-105 basis points over the nearest Treasury. This is roughly on top of where similar-rated Nordstrom's 2021 notes trade and +20 wide of where TJX Companies' (TJX) (rating: A, narrow moat) 2023 notes trade, which we think is appropriate given the notch higher rating. We expect 5-year paper to price roughly +30 basis points inside the 10-year and 3-year notes to price around +25 basis points inside the 5-year. This would place fair valued on Starbucks' new 3- and 5-year around +45-50 and +70-75 basis points, respectively.
We remain positive on Starbucks from a credit perspective. The firm has continued to deliver impressive comp gains at a time when most restaurant and retailers are struggling to stimulate transaction growth, and we believe this highlights the global strength of its brand. We expect the additional debt will fund shareholder returns. For fiscal 2013, dividends and share repurchases were robust at $1.2 billion, but we note that this is less than free cash flow generated of nearly $1.8 billion. Accordingly, we weren't surprised that management recently raised its dividend payout range to 45% from 35%, which implies an annual dividend of just under $1.20 per share. While this represents a yield of just 1.5%, we are confident that the dividend will grow in line with the company's earnings over the next several years. Still, lease-adjusted leverage is moderate at just over 2.0 times and management specifically noted that it is happy with its current credit rating of A- from S&P.
Schlumberger to Issue 10-Year Debt; Initial Price Talk Looks Attractive (Nov. 25)
Schlumberger (SLB) (rating: A+, wide moat) announced that it plans to issue 10-year notes in benchmark size. The notes, which are issued by Schlumberger Investment SA, are fully and unconditionally guaranteed by Schlumberger Limited, the ultimate parent of the company. The use of proceeds is stated as general corporate purposes. As we previously noted in our Potential New Issue Supply publication, we believe the use of proceeds will be to refinance all or a portion of Schlumberger's $1.3 billion maturity due in March 2014 and $300 million maturity due in September 2014. Initial price talk on the new notes is +105-110 basis points. We place fair value on the new 10-year notes at +90 basis points.
Before today's announcement, Schlumberger's 2.4% notes due 2022 were quoted at a spread of 71 basis points above the 10-year Treasury. We view these notes as fairly valued and recommend a market weight position. For comparison, National Oilwell Varco's (NOV) (rating: A+, wide moat) 2.6% notes due 2022 recently traded at 74 basis points above the 10-year. We also view National Oilwell as fairly valued and recommend a market weight position. NOV has similar scale, diversity, and acquisition acumen to Schlumberger, as well as nearly identical credit metrics. Based on our assumption for the use of proceeds and the additional year to maturity, we peg fair value on the new issue at +90 basis points.
In October, Schlumberger reported solid third-quarter results as revenue increased 4% sequentially and 10% from year-ago levels. North American revenue was up 7% sequentially to $3.6 billion, a new high for the company, thanks to strong levels of offshore activity, a seasonal rebound in western Canada, and an excellent performance in U.S. land. International results were largely consistent with prior quarters, with the Middle East region performing the best. Middle Eastern revenue growth was 19% year over year, while Latin American and European revenue growth was 4% and 6%, respectively. Overall international margins expanded about 130 basis points sequentially to 23.3%, which are the strongest margins Schlumberger has reported since late 2008. We expect these positive trends to continue.
Compared with the second quarter, Schlumberger's credit metrics were unchanged as the $500 million increase in total debt during the third quarter was offset by a $500 million increase in last-12-months EBITDA. Gross leverage of 1.0 times and net leverage of 0.5 times were both flat sequentially, as was debt/capitalization of 25%. Interest coverage and the ratio of EBITDA less capital expenditures/cash interest expense were both also essentially unchanged at 30 times and 20 times, respectively. Over our forecast period, we project that gross leverage, interest coverage, and debt/capitalization will remain roughly unchanged.
Advance Auto Parts to Issue Debt to Help Finance Acquisition; Price Talk Is Fair (Nov. 25)
As we highlighted in our Potential New Issue Supply report, Advance Auto Parts (AAP) (rating: BBB-, no moat) is coming to market with $450 million in 10-year notes to help finance the $2 billion acquisition of General Parts, announced in October. Management had stated it would finance the acquisition with a combination of bonds and bank debt. We estimate this note issuance will bring lease-adjusted leverage to around 3 times. Advance Auto had stated that it expects to bring leverage to 3.2 times after the transaction, but that it expects to swiftly repay debt to bring leverage back to below 2.5 times (its target). Accordingly, we expect shorter-dated bank debt to make up the balance of debt.
Initial price talk in the low 200s looks fair as Advance Auto's 2022 bonds were most recently indicated at 196 basis points over the nearest Treasury. Morningstar's BBB- Industrials Index is at +223 basis points, and the preponderance of consumer cyclical names that we view as fairly valued trade around 20 basis points inside the index. Given Advance Auto's more countercyclical nature due to operating in an industry with more stable demand, balanced by the planned increase in leverage for the acquisition, we believe fair value for the new 10-year is around +200-210 basis points.
Advance Auto's third-quarter earnings, reported earlier this month were soft, due to the weak do-it-yourself market and decelerating do-it-for-me growth. Management expects comps will remain choppy in the near term, declining to low negative single digits in the fourth quarter, blaming the slowdown on the industry's sluggishness, with especially weak results in the DIY segment. However, it also attributed weakness to competitors opening many of their new stores (80%, by management's estimates) in Advance Auto's territory. O'Reilly, for instance, will accelerate its expansion in Florida, currently one of Advance Auto's strongholds, and has reported solid comps during this process. Over the long run, we believe the mom-and-pop shops will be most affected by this increased competition, but it is clear that Advance Auto should proactively invest in improving its delivery and service capabilities to minimize potential share losses.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.