Corporate Credit Spreads Unchanged on Weak Economic Data While Treasury Bonds Gain
The Morningstar Corporate Bond Index rose 0.67% last week, driven by a decrease in interest rates as opposed to tightening credit spreads. The yield on the 10-year Treasury declined 7 basis points to 2.66%, whereas the average credit spread in our corporate bond index only tightened 1 basis point to +116. Year to date, our corporate bond index has risen 2.84% as the yield on the 10-year Treasury has fallen a total of 37 basis points and credit spreads have tightened 4 basis points. In general, Treasury bond prices rose as the economic data remained as weak as it has been for the past few months. According to Robert Johnson, Morningstar's director of economic analysis, it is clear that the economic problems have stretched beyond the weather. For example, while durable goods orders (excluding transportation) on a month-to-month basis improved, the year-over-year data continues to fade. On a year-over-year basis, durable goods orders (ex transportation) have been declining since September. However, the month-over-month trend has been increasing over the past few months, which may portend that the worst of the slowdown in durables is near its end.
There was very little new information in Federal Reserve Chair Janet Yellen's testimony to the Senate banking committee. The only noteworthy change since her testimony to the House was that the Fed is attributing recent economic softness to the weather and not to other systemic issues. While Yellen reiterated that the Fed's policy is not on a predetermined course and is data dependent, most investors took her commentary to indicate that the Fed will continue to taper its quantitative easing program over the next few months.
The fourth-quarter real GDP growth rate was revised to 2.4% from 3.2%. In our Feb. 10 credit weekly, we warned that exports, government spending, and construction spending were overestimated in the fourth quarter and that GDP would fall to the mid-2% area. While each of these segments was significantly revised downward, business spending turned out to be better than expected, counteracting some of the downward revisions in consumer spending. Offsetting some of the weaker economic data released last week, the housing market showed improvement as new home sales jumped and pending sales of existing homes showed signs of stabilization.
After analyzing the recent economic data points and accounting for the weather, Johnson expects that the U.S. economy will bounce back this spring, but he still views it as a slow-moving ocean liner that should go along at a 2.0%-2.5% GDP growth rate for 2014. While we expect interest rates to increase in the long run as levels normalize toward historical norms, the sluggish rate of GDP growth and low inflation may allow interest rates to stay at lower levels for a little longer than we previously expected.
Next week will bring a flood of data, including vehicle sales, PMI Manufacturing Index, personal income and outlays, and the ISM indexes, but the most closely watched figure will be the payroll data in the Employment Situation report. Street consensus averages to 140,000 new jobs added, but Johnson cautions that there is more downside risk than upside risk to the February consensus. For greater detail regarding last week's economic news and Johnson's dissection of the data, please see his weekly Economic Insights.
New Issue Market Roars to Life; Several Offerings Provide Substantial Value for Investors
The new issue market roared back to life last week. Of the issuers we cover, more than $30 billion of bonds were brought to market, and several were priced at levels that we thought provided substantial value to investors. In our view, the cheapest deal was brought by Cloud Peak Energy CLD (rating: BB+, narrow moat), which issued $200 million of 6.375% senior notes due 2024. In his new issue note published before the deal was priced, basic materials analyst Dale Burrow opined that based on his view of the credit risk of the firm, fair value of the notes is 5.25%. The market agreed, and the notes immediately traded more than 50 basis points tighter in the secondary market. By the end of Friday, the bonds were trading hands at a yield of 5.80%. Cloud Peak's leverage is lower than most of its peers, and the firm ranks among the lowest-cost thermal coal producers in the United States. Dale expects that the firm's cost advantage, the primary basis for our narrow moat rating, will mitigate some of the ill effects of volatile coal prices. Another appealing characteristic of Cloud Peak relative to its peers is management's conservative financial policy and prudent approach to contracting, which has been especially supportive of its credit quality in the past few years. For example, Cloud Peak has committed more than 90% of its 2014 production at decent margins. With a healthy balance sheet, Cloud Peak is well positioned to benefit from improving coal prices. As such, we think the bonds have further to run and could provide another 4 points of upside for investors.
The largest deal last week was priced by Cisco CSCO (rating: AA, narrow moat), which issued $8 billion of bonds consisting of maturities ranging from 3 to 10 years. We had anticipated that Cisco would look to issue bonds early this year, given that it faces several maturities in 2014 and has let domestic cash steadily dwindle in recent quarters. While we think Cisco's competitive position will remain sound over the next 10 years, we recently downgraded the firm's moat to narrow from wide as the ongoing commodification of data networking equipment and increasing customer concentration have made us less confident in Cisco's ability to maintain excess returns on capital beyond that. However, we continue to view Cisco as one of the strongest competitors among enterprise and service provider infrastructure suppliers. Technology analyst Mike Hodel had pegged the fair value of the 5-, 7-, and 10-year notes at +40, +60, and +75, respectively. The notes were priced at +60, +75, and +90, leaving some upside for investors.
PepsiCo PEP (rating: AA-, wide moat) issued $2 billion of notes in 3- and 10-year maturities. Our AA- issuer credit rating is several notches higher than the rating agencies'. The rating differential is most likely based on our assessment that the firm has a wide economic moat and that it will continue to maintain very strong credit metrics. However, the valuation of the notes depends not on the current business profile and capital structure, but on whether PepsiCo accedes to activist investor Nelson Peltz's desire to split it up. Given our view that the firm will remain one entity and retain our credit rating, we opined that we saw fair value on the 10-year notes at a spread of 80 basis points over Treasuries. After the bond issue was priced, the company filed an 8-K with the Securities and Exchange Commission in which the board of directors roundly rejected Peltz's proposal to split the company into two. PepsiCo has conducted a strategic review of its business and has decided that it will increase its dividend and share buybacks, but will remain one entity. CEO Indra Nooyi has said numerous times that she believes the company garners significant synergies and benefits from the combined beverage and snack business (each account for roughly half of the firm's revenue). Given this strong boardroom endorsement of PepsiCo's Power of One strategy, we believe the company will operate as a single entity for the foreseeable future.
New Issue Notes
Mattel Plans to Tap Debt Markets for Acquisition; Bonds Undervalued (Feb. 28)
Mattel MAT (rating: A-, narrow moat) today announced the acquisition of Mega Brands for $460 million, which includes the assumption of debt it intends to repay at 105 of par (roughly $134 million). The acquisition price represents 1.1 times 2013 sales ($405 million) and 9.8 times trailing EBITDA ($47 million), a slightly higher multiple than Mattel paid for the Hit acquisition that closed in 2012. After transaction costs, this acquisition should be dilutive in 2014 and mildly accretive in 2015.
Management said it plans to fund the transaction through cash on hand and new debt. With more than $1 billion in cash at Dec. 31, 2013, Mattel certainly does not need to tap the debt markets. Still, management said it plans to issue $500 million in new debt. We estimate pro forma leverage, accounting for Mega's EBITDA contribution, would rise to roughly 2 times from 1.7 currently. However, we note that this excludes potential synergies. We believe this is within the current rating of A-.
We view Mattel's bonds as undervalued, as the 2023 notes were recently indicated at a spread of 113 basis points over the nearest Treasury. This is slightly wide of Morningstar's A- index, which is at 103. It is also well wide of similar-rated consumer cyclical names. Amazon's AMZN (rating: A-, wide moat) 2022 bonds and Starbucks' SBUX (rating: A-, wide moat) 2023 bonds trade around 85 basis over the nearest Treasury, and Nordstrom's JWN (rating: A-, narrow moat) 2021 bonds trade around 90 basis points over the nearest Treasury. While we believe Amazon and Starbucks should trade slightly tighter given their wide economic moats, we would place fair value on Mattel's bonds around 95 basis points--around where Nordstrom trades, but accounting for slightly longer maturity.
Mega owns well-known Mega Bloks and meaningful licensing agreements with brands like Halo, Power Rangers, SpongeBob, and Hello Kitty. Besides offering Mattel a broader entertainment presence, this deal lends the firm a wider presence in the key construction category, which NPD estimates to be a $4 billion opportunity in U.S., European, emerging, and developing markets, and we see it as strengthening Mattel's narrow economic moat. Mega captures $300 million in revenue in this category (out of $405 million total) and is the number-two player behind Lego. The remainder of the company's revenue is from the arts and crafts category. Regarding global expansion, Mega is present in only half of the markets Mattel is currently selling in, with nearly 70% of its sales in the U.S. and Canada, so we see a tremendous opportunity to expand this business internationally, in both developing and emerging markets, as it capitalizes on Mattel's existing international infrastructure.
Initial EBITDA margins are about half of Mattel's (10% versus 21%), but we think there is significant room for improvement at Mega as Mattel implements its operational efficiency initiatives at Mega's plants, which Mattel plans to maintain in Montreal and Tennessee, and improves utilization with the ability to add its brands to Mega's platform with no royalty costs (60% of Mega's revenue is from licensed products). Overall, we see this acquisition as both smart and timely, as it offers Mattel a strong footprint in the growing construction category through an established brand.
Williams Partners to Issue 10- and 30-Year Notes; Existing Bonds Fairly Valued (Feb. 27)
Williams Partners WPZ (rating: BBB, wide moat) announced that it is issuing new 10-year and 30-year notes. Williams intends to use the proceeds to repay amounts outstanding under its commercial paper program, to fund capital expenditures, and for general partnership purposes. As of Feb. 26, Williams had almost $875 million outstanding under its CP program. We remind investors that in November, Williams issued $1 billion of bonds ($600 million 10-year and $400 million 30-year). At that time, Williams also raised its 2014 and 2015 capital expenditure guidance by a total of $375 million, primarily driven by increased cost estimates to complete the Gulfstar project. Initial price talk is +175-180 basis points for the 10-year and +190-195 for the 30-year, which is roughly 20 basis points wide of existing Williams bonds. We view fair value at +155 for the 10-year and +175 for the 30-year.
Before today's announcement, Williams' recently issued 4.50% notes due 2023 traded at 156 basis points over the nearest Treasury, while its 5.80% notes due 2043 traded at 177 basis points over the nearest Treasury. We maintain a market weight recommendation on Williams and view its outstanding issues as fairly valued based on our projection for future improvement. ONEOK Partners OKS (rating: BBB, wide moat) is a fair comparable for Williams, although Williams' credit metrics are on a better trajectory, in our opinion. ONEOK's 5% notes due 2023 recently traded at 143 basis points and its 6.20% notes due 2043 traded at a spread of 170 basis points, both over the nearest Treasury. Given ONEOK's near-term challenges and softening credit metrics, we view both ONEOK issues as trading rich to fair value.
Juniper's 10-Year Offering Looks Cheap (Feb. 27)
Juniper Networks JNPR (rating: A, narrow moat) is looking to issue $350 million of new 10-year notes, following up on its announcement last week that it will return excess cash to shareholders via repurchases and a newly introduced dividend. With initial price talk in the low 200 basis points range over Treasuries, we believe the new notes are very attractive. The planned offering will take Juniper's gross debt load to $1.35 billion, or 1.7 times trailing 12-month EBITDA. The firm ended 2013 with $4.1 billion in cash and investments after generating $609 million of free cash flow during the year. Management intends to return $3 billion to shareholders over the next three years, including $1.2 billion through an accelerated share-repurchase program. To put the current shareholder return plans in perspective, Juniper has returned $1.8 billion to shareholders over the past three years, with net cash on hand growing nearly $300 million during this period. Juniper has generated positive free cash flow every year since 2002 despite the cyclicality of the business and margin pressure seen in recent years.
We expect Juniper will remain an important supplier of carrier-grade routers for the foreseeable future. The firm's routers are technically complex and mission-critical, and carriers may spend months evaluating new equipment before making a purchase commitment. As a result, barriers to entry are high, and only Juniper and Cisco CSCO (rating: AA, narrow moat) have demonstrated consistent profitability and relatively stable market share over the past decade. While Juniper faces increasing competition from Alcatel-Lucent and Huawei, we think its entrenched position in the core of service providers' networks will allow it to maintain a strong market position.
Cisco, Juniper's closest peer, issued 10-year notes earlier this week at 90 basis points over Treasuries. Cisco is clearly in a superior financial position relative to Juniper, as it is 10 times the size of Juniper and holds far more cash relative to its debt load. However, we believe the difference in spread between the two firms' bonds should only be about 50 basis points. We pegged fair value on the new Cisco 10-year bonds at +75 basis points, which would imply a fair value on the Juniper issue of +125 basis points, roughly in line with the BBB+ portion of the Morningstar Industrials Index. Technology firms generally trade wide of the index relative to our rating, and we view Juniper as weakly positioned within its rating category. While not a direct competitor, NetApp NTAP (rating: A+, narrow moat) also provides a useful comparison as a smaller, cash-rich technology firm that is also in the process of ramping up shareholder returns. NetApp's 3.25% notes due in 2022 were recently indicated at 171 basis points over the nearest Treasury, which we view as attractive as well.
Importantly, the new Juniper bonds will include change-of-control protection. While Juniper's plans to return capital to shareholders and streamline operations seem to have placated activist shareholders for now, this provision offers protection in the event that shareholders become more aggressive over time.
Price Talk on BB&T's New Issues Is Attractive (Feb. 27)
BB&T BBT (rating: A-, narrow moat) is in the market today with a $750 million deal split between a 3- and 7-year senior bank-level offering. Initial price talk for the 3-year notes is a spread in the low 50s over Treasuries and the high 80s for the 7-year. We view price talk on both tranches as attractive, but believe the 3-year notes will likely launch at +45 basis points to Treasuries, while the 7-year will probably launch around +80, both of which we view as fair.
BB&T's most recent 3-year bank note, the 1.05% due in 2016, is indicated at +40 over the nearest Treasury, which we consider fair. Regional peer Fifth Third Bancorp's FITB (rating: A-, narrow moat) holding company notes, the 1.15% due 2016, are indicated at 52 over the nearest Treasury, which we also view as fair, as we would expect holding company debt to trade about 5 basis points wide of bank-level debt in the 3-year area. We consider Fifth Third and BB&T to represent similar credit risk.
BB&T's most recent 5-year bank-level debt, the 2.3% due 2018, are indicated at 60 over Treasuries, which we consider fair. We would expect roughly 20 basis points of spread when moving from the 5- to 7-year maturity. As a result, we view fair value at +80 for the 7-year note. Fifth Third's holding company notes, the 1.45% due 2018, are indicated at 67 basis points over Treasuries. Given our assumed 5- to 10-basis-point spread between holding company and bank-level debt, we would consider this issue as fair value and in line with the BB&T 5-year issue.
BB&T emerged from the financial crisis in better shape than many of its peers and has continued to report solid returns in recent periods. Although lower net interest income weighed on 2013 results relative to the prior year, the bank reported a still respectable 7.7% return on equity and 1% return on assets. Asset quality is solid with 0.8% nonperforming loans/total loans, down from 1.2% in the year-earlier period, while net charge-offs for 2013 were a respectable 0.67%, down from 1.14% in 2012. The bank also managed to raise capital during the year, with its Tier 1 ratio finishing the year at 11.8%, up 80 basis points over the prior year and in line with its well-performing regional peers. Net interest margin for 2013 was an impressive 3.68%. We see the bank well positioned to continue producing solid returns.
Lowe's Plans to Issue Debt in 2014 to Manage Leverage to Target; Bonds Fairly Valued (Feb. 26)
Lowe's LOW (rating: A, wide moat) ended the year with lease-adjusted leverage just inside its target of 2.25 times. However, with higher expected earnings and projected share repurchases of $3.4 billion, and dividends of $700 million exceeding estimated 2014 free cash flow of $2.9 billion, we would expect Lowe's to tap the debt markets. We currently view Lowe's bonds as fairly valued, as the 2023 notes were recently indicated at a spread of 81 basis points over the nearest Treasury. This is roughly in line with other A rated retailers such as Home Depot HD (rating: A, wide moat), Target TGT (rating: A, no moat), and TJX Companies TJX (rating: A, narrow moat).
Lowe's continues to focus on improving its in-store and multichannel experience for consumers, which we believe helps strengthen its position in the home-improvement market and supports its wide moat rating. Experience remains the differentiating factor for Lowe's, which can be conveyed in a limited way to consumers, primarily through spot-on merchandising and associate expertise. In our opinion, Lowe's has kept finding new ways to expand the operational efficiency of its business, which should spur top- and bottom-line growth for the business in years ahead, but probably at a slower pace than in recent years.
The fourth quarter offered the conclusion of Lowe's first round of value-improvement initiatives, where the company targets lower costs on high-velocity items alongside an improved merchandising strategy (using consumer insights to be more relevant by market). While this is expected to be a perpetual process, we anticipate it will have annual resets at a slower cadence in the past and will be able to focus largely on underperforming categories. More important, now that the initial phase of this key initiative is complete, Lowe's is not resting on its laurels. Management said there will be three priorities to drive top-line growth in 2014: improved merchandising that focuses on micro seasons by market, wider product and service offerings for pros, and expanded customer experience capabilities based on the occasion. The continuous evolution of the business is key in driving foot traffic and sales productivity, which should incrementally help operating margins.
Despite sales falling shy of internal expectations by $100 million because of extreme January temperatures (Home Depot estimated a similar impact yesterday), Lowe's fourth-quarter sales rose 6%, to $11.7 billion, helped by same-store sales growth of 3.9%. All three months comped positively, with November delivering 3.3% growth, December experiencing 6.3% growth, and January offering 1.4% growth. Average ticket at comparable stores grew 2.4% while transactions ticked up 1.4%, and higher-ticket (greater than $500) sales grew faster at 8.9% than lower-ticket (less than $50) sales, which rose 1.2%. Gross margins rose 40 basis points, to 34.7%, helped by value improvement, mix, and lower shrink, but were affected by markdowns to clear seasonal inventory. The selling, general, and administrative expense ratio deleveraged 70 basis points, to 26.1%, hindered by asset impairments, risk insurance, and foreign exchange, among other small items.
Lowe's offered its initial outlook for 2014, which included 5% revenue growth, a 4% comp-store sales increase, 20 total new locations, a 65-basis-point improvement in operating margin, and earnings per share of $2.60. This implies more than 20% bottom-line growth, driven primarily by gross margin improvement, SG&A leverage, and share repurchases, which we deem impressive for a mature business with little growth in its overall footprint.
We Expect Macy's to Add Debt to Balance Sheet as Solid Performance Continues (Feb. 26)
In the competitive retail environment, Macy's M (rating: BBB, no moat) is running on all cylinders. For the fourth quarter, holiday comparable-store sales of 4.3% gave up some ground to finish the full quarter at just 2.3% after adjusting for the extra week in the period last year and the change of athletic footwear to a licensed business this year. Operating income on a reported basis was 14.7% of sales in the fourth quarter, producing $1.349 billion, compared with 14.9% of sales last year; but excluding $88 million of restructuring and asset-impairment charges this year (roughly half of which were noncash), operating income would have been 15.6% of sales, a 70-basis-point rise.
We believe there is still some improvement to go from the company's operating initiatives. Macy's also appears to be the winner of the ongoing battle for what has been a rather thin middle-class wallet, filling a niche between luxury and discount department stores. Our view of Macy's having no economic moat is unchanged because of the competitive nature of retail. For once, though, access to prime locations in a period when retail square footage expansion is quite slow gives some advantage to an incumbent.
The firm ended the quarter at 2.3 times leverage, slightly lower than its targeted range of 2.4-2.7. With continued solid operating performance, we would expect the firm to add debt to its balance sheet to remain in this range. While management said it would refinance its $453 million maturity this year, it would not confirm or deny that it would take on more than that refinancing amount, depending on market conditions.
We currently view Macy's bonds as slightly rich, with its 2023 notes at 133 basis points over the nearest Treasury, or just over 20 basis points inside Morningstar's Industrials index. The preponderance of consumer cyclical credits that we view as fairly valued trade around 20 basis points inside the index. Other BBB retailers with less cyclical business models--auto-parts retailers AutoZone AZO (rating: BBB, narrow moat) and O'Reilly ORLY (rating: BBB, no moat)--trade roughly in line with Macy's. We believe Macy's should trade wider than both auto-parts retailers, given its cyclicality.
Cloud Peak Offers 10-Year Senior Notes to Refinance High-Coupon Debt; We View Fair Value at 5.25% (Feb. 26)
Cloud Peak Energy CLD (rating: BB+, narrow moat) announced plans to issue $200 million 10-year (noncallable for 5 years) senior unsecured notes, which along with available cash will help fund a tender offer for the company's outstanding $300 million 8.25% senior notes due 2017. These bonds became callable in December and have been highlighted as a source for new issuance on our Potential New Issue Supply list. Cloud Peak is offering to tender bonds at $101.65 plus a consent fee of $30 per bond, for a total price of $104.65. If fully subscribed, this funding will total $314 million. Cloud Peak's $300 million 8.5% senior notes due 2019, which are callable December 2014, are currently indicated a 4.36% yield to the short call. We place fair value for the new 10-year notes, which rank equally with the 2019 notes, at 5.25%. Similar-rated Peabody Energy's BTU (rating: BB+, narrow moat) 6.25% senior notes due 2021 are currently indicated at a 5.76% yield, which we believe is fair value. Although larger and more diversified than Cloud Peak, Peabody is weakly rated in the category because of its higher leverage. Similar-rated Steel Dynamics' STLD (rating: BB+, narrow moat) outstanding 5.25% notes due 2023 are indicated at 4.96%, which we view as modestly rich.
Although smaller than Peabody, we view Cloud Peak more favorably due to its significantly lower leverage and its pure-play exposure to the lower-cost Powder River Basin. Cloud Peak ranks among the lowest-cost thermal coal producers in the U.S. We expect this geologically derived cost advantage, the primary basis of our narrow moat rating, will serve to mitigate some of the ill effects of volatile coal prices. Another appealing characteristic of Cloud Peak relative to peers is management's conservative financial policy and prudent approach to contracting. However, a lengthy period of very low PRB coal prices would still place considerable stress on Cloud Peak's financial health.
We think the company's prudent contracting policy has been especially supportive of its credit quality in the past few years, and we do not think Cloud Peak's financial health will face a similar amount of pressure compared with its coal miner peers, as it has committed more than 90% of its 2014 production at decent margins. At the close of 2013, Cloud Peak reported $597 million in debt (consisting of its two bonds) and $313 million in cash, putting net leverage at 1.3 times, low compared with Peabody's nearly 5 times. We also view favorably Cloud Peak's recently renegotiated $500 million revolver facility, which has extended the maturity (5 years), relaxed covenants, and increased total liquidity. Furthermore, unlike most of its peers, Cloud Peak benefits from carrying no pension liabilities. With a healthy balance sheet, Cloud Peak is well positioned to benefit from improving coal prices which we expect over the next few years as PRB coal becomes a more competitive option to natural gas for generating electricity when natural gas prices are above $2.50-$2.75 per mmBTU, which compares with our midcycle forecast of $5.40 per mmBTU.
PepsiCo Attractive If It Remains Whole, Expensive If Peltz Breaks It Up (Feb. 25)
PepsiCo PEP (rating: AA-, wide moat) is in the market this morning with 3-year floating and fixed-rate notes and 10-year notes. Initial price talk places the 3-year fixed-rate notes in the low +40s and the 10-year note at +105. Pepsi's outstanding 1.25% senior notes due 2017 recently traded at about 30 basis points over the nearest Treasury and its 2.75% senior notes due 2023 are currently indicated at 87 basis points over the nearest Treasury. Beverage peer Coca-Cola KO (rating: AA-, wide moat) 1.65% senior notes due 2018 trade in the mid-20s and the 3.20% senior notes due 2023 recently traded 73 basis points over the nearest Treasury, which we view as fairly valued. Based on the liquidity of the company's existing debt, Pepsi's brand recognition, and our AA- issuer credit rating, the large new issue concession is not warranted; we expect official price talk will be reduced to near where the existing bonds are trading. Given our view that Pepsi will remain a combined entity and retain our credit rating, we think fair value for the 3-year notes is +35, near the current trading level, but the new 10-year notes should be tighter than existing levels at about +80 basis points.
Our issuer credit rating on PepsiCo is one to two notches higher than the rating agencies. The rating differential is most likely based on our assessment that the firm has a wide economic moat and our projections that the firm will continue to maintain very strong credit metrics. The firm's wide economic moat is derived from its direct-store delivery system, global scale, and strong brands that dominate the snack business. However, the valuation of the notes depends not on the company's current business profile and capital structure, but on whether PepsiCo accedes to activist investor Nelson Peltz's desire to force the company to split up. In April 2013, Peltz's investment vehicle, Trian Fund, announced that it had taken a position in PepsiCo's equity and the company acknowledged it discussed alternatives with Peltz to increase shareholder value. Given Trian's holdings of both Pepsi and Mondelez MDLZ (rating: BBB, wide moat), rumors circulated that Pepsi may acquire Mondelez. That rumor died down after Peltz's push failed to gain traction (however, he did gain control of a board seat at Mondelez). Since the initial discussions, PepsiCo has conducted a strategic review of its business and has decided that it would increase its dividend and share buybacks, but will remain as one entity. CEO Indra Nooyi has stated numerous times that she believes the company garners significant synergies and benefits from the combined beverage and snack business (each account for roughly half of the firm's revenue). In our opinion, she has been so emphatic that the company creates greater shareholder value as a combined entity that so long as she is CEO, the company will remain intact. However, if she resigns (either willingly or forced out by the board of directors) over the next few years, we think that would be a sign that the company will be broken up. In that case, in our downside scenario for bondholders, we estimate the credit rating would fall at least several notches to mid- to low single A.
John Deere Capital Is in Market With Multitranche Offering; We Remain Market Weight (Feb. 25)
John Deere Capital (rating: A) is in the market with a multitranche deal. The firm is looking to raise 2-year floating-rate notes and 5- and 7-year fixed-rate bonds in benchmark size. Parent Deere DE (rating: A, narrow moat) dominates the North American agricultural equipment market, with a share north of 50%. This leadership position, combined with its strong dealer network, reputation for high-quality products, and conservative financial policies, has helped the firm generate impressive economic profitability, resulting in a narrow economic moat.
Based on comps, we would place fair value for the new Deere Capital 5- and 7-year notes in the area of 45 and 65 basis points over Treasuries, respectively. The company's existing 1.95% notes due in December 2018 are indicated at a spread of 45 basis points over the nearest Treasury, which we generally view as fair within the sector. John Deere Capital's existing 2.8% notes due in 2023 are indicated at a spread of 81 basis points over the nearest Treasury. Caterpillar Finance's (rating A-, wide moat) 1.9% notes due in 2019 were recently indicated with a spread of 59 basis points over Treasuries, while its 3.9% notes due in 2021 are indicated at a spread of +77. We view both Caterpillar issues as slightly rich, given our weaker credit rating, and we prefer Deere at existing levels.
TransCanada to Issue 20-Year Debt; Initial Price Talk Looks Attractive (Feb. 25)
TransCanada TRP (rating: BBB+, narrow moat) announced it is issuing 20-year notes in benchmark size out of its wholly owned subsidiary, TransCanada PipeLines, which we do not separately rate. While we award TransCanada a narrow economic moat, we view TransCanada PipeLines as a wide-moat business based on its stable cash flows and the regulated nature of its pipelines. As a result of our wide-moat view, we have a similar opinion as the rating agencies that TransCanada PipeLines' credit rating is higher than that of its parent corporation. TransCanada PipeLines intends to use the proceeds for general corporate purposes and to reduce short-term borrowings, which were incurred to fund the company's capital spending program. As of Dec. 31, TransCanada PipeLines had CAD 2.8 billion of notes payable and long-term debt classified as current.
Initial price talk on the new notes is +125 basis points. We view this level as attractive to both existing levels and comparable companies' bonds. Before today's announcement, TransCanada PipeLines' existing 3.75% notes due 2023 traded at 100 basis points, while its 5% bonds due 2043 traded at 116 basis points, both over the nearest Treasury. TransCanada PipeLines' existing 5.85% notes due 2036, which have a similar maturity to the new notes, recently traded at 125 basis points over the nearest Treasury. The 5.85% notes have a relatively high 114 dollar price, which implies that a par-priced bond with a similar maturity should trade at a spread roughly 10 basis points tighter. For comparison, Kinder Morgan Energy Partners KMP (rating: BBB+, wide moat) 4.15% notes due 2024 trade at a spread of +161, and its 5% bonds due 2043 trade at a spread of +172. We view both Kinder Morgan issues as roughly 10-15 basis points cheap to fair value. Kinder Morgan is a master limited partnership, not a wholly owned subsidiary, so a higher percentage of its free cash flow is distributed to unitholders in the partnership. Given the difference in cash flow distribution between TransCanada PipeLines and Kinder Morgan, and our assumed ratings differential, we peg fair value on TransCanada PipeLines' new notes at +115 basis points.
Magellan Midstream to Tap 5.15% Bonds Due 2043; Initial Price Talk Is Fair (Feb. 25)
Magellan Midstream Partners MMP (rating: BBB+, wide moat) announced it is issuing an additional $250 million of 5.15% bonds due 2043; the issue size will not grow. Magellan initially offered $300 million of 5.15% bonds in October 2013 at a spread of +148 basis points. Magellan intends to use the proceeds to repay borrowings outstanding under its revolving credit facility and for general partnership purposes, which may include capital expenditures. As of Feb. 21, Magellan had $138 million outstanding under its $1 billion senior unsecured revolving credit facility. As included in our Potential New Issue Supply publication, we anticipated that Magellan would issue additional debt in 2014, in part to help fund its $250 million bond maturity in June 2014.
Initial price talk for today's tap of the 5.15% bonds is in the mid-130s. We view this level as fair compared with existing levels, comparable companies' bonds, and our fair value. Before today's announcement, Magellan's existing 5.15% bonds were quoted at spread of 131 basis points over the nearest Treasury. For comparison, Plains All American Pipeline PAA (rating: BBB+, wide moat) 4.30% bonds due 2043 are indicated at 128 basis points above the nearest Treasury, which we view as rich to fair value. Based on our estimates of 2014 EBITDA, we project Magellan's year-end leverage to be 3.6 times and Plains' to be 4.1 times. This compares with LTM leverage of 3.1 times for Magellan and 3.4 times for Plains. Given our positive view of Magellan's growth prospects partially offset by our projection for near-term deterioration in its credit metrics, we peg fair value on Magellan's 5.15% bonds at +135 basis points.
Nissan Offering Short-Term Bonds; Existing 5-Years Are Cheap (Feb. 25)
Nissan Motor's NSANY (rating: BBB+, no moat) finance subsidiary is in the market with 3-year floaters and 5-year fixed-rate notes. We view the finance sub as a similar credit to the parent. We view fair value on the 5-year notes at a spread of 85 basis points over Treasuries. Nissan's recent 5-year bond issued in October is indicated at 97 basis points over the nearest Treasury, which we view as cheap. Several auto OEM finance subs issued 5-year paper in the October-November period. Current indicated levels, spread to the nearest Treasury, include Toyota TM (rating: A, no moat) at +44 basis points, which we view as fair; Honda HMC (rating: A, no moat) at +47 basis points, which we view as slightly rich; Volkswagen VOW (rating: A-, no moat) at +62 basis points, which we view as fair; and Ford F (rating: BBB-, no moat) at +96, which we view as somewhat rich. Daimler's DAI (rating: BBB+, no moat) finance sub bonds maturing in August 2018 are indicated at 69 basis points over the nearest Treasury, which we view as rich.
Nissan's solid third-quarter results were primarily driven by a hefty vehicle launch schedule that includes several new models in Europe, Asia, and North America. In Japan, the DAYZ minicar launched in the first half of fiscal 2013, and strong demand for the Note propelled volume to a 21% increase. The new Altima, Pathfinder, and Rogue models contributed to a 13% volume increase in North America. However, we were disappointed that margins for the quarter did not expand more versus the same period last year. With most launches out of the way for the year, a new factory in Mexico now producing vehicles, and the Japanese yen skidding 24% and 30% versus the U.S. dollar and euro, respectively, compared with last year's third quarter, we are expecting solid fourth-quarter results. Even so, with volume declining 14% in Asia and rest of world regions (which exclude China), we were impressed that management maintained its full-year volume target of 5.2 million units, operating profit of JPY 490 billion, and net income of JPY 355 billion.
Nissan has been investing heavily in new capacity in several regions. There are nine capacity projects underway, dropping to two facility projects next year. As part of the company's Power 88 initiative (8% global market share, 8% sustainable operating margin including China on a consolidated basis), management has committed to launching at least one new model on average every six weeks over the six-year plan that began in 2011. The model plan was more heavily weighted for larger global volume and hence larger investment plus launch costs during the first half of the plan. Given the increase in global volume, lower capacity investment, reduced launch costs, and the historical high EBITDA margin of 12.4%, we are confident in our five-year discounted cash flow forecast that includes EBITDA margin expansion from 7.2% in fiscal 2013 to midcycle EBITDA margin of 10.4% in fiscal 2017. Strong EBITDA growth could push gross leverage, typically around 1 times, lower while the company maintains a comfortable net cash position.
Fifth Third Bancorp's New 5-Year Initial Price Talk Appears Attractive (Feb. 25)
Fifth Third FITB (rating: A-, narrow moat) is in the market today with a new $500 million senior holding company issue. Initial price talk on the notes is in the low 90s over Treasuries, which we consider attractive; we consider fair value on the notes around 70 over Treasuries. Regional peer BB&T's BBT (rating: A-, narrow moat) 2.25% notes due in 2019 are indicated at 65 over the nearest Treasury, which we consider slightly expensive to a fair value of +70. PNC Financial's PNC (rating: A-, narrow moat) senior holding company 6.70% notes due in 2019 are indicated at +68 to the nearest Treasury, which we consider fair, while lower-rated KeyCorp's KEY (rating: BBB+, narrow moat) 2.3% due 2018 is indicated at +83 to the nearest Treasury, which we also consider fair.
Fifth Third posted an impressive 2013, increasing net income 16.2%. Growth was led by an 18.3% increase in noninterest income and lower loan loss provisions. Net interest income slipped a modest 1%, leading net interest margin to decline 23 basis points on the year to a still healthy 3.32%. The bank was successful in controlling costs as illustrated by an impressive 360-basis-point improvement in their efficiency ratio to 58.4%, well ahead of many of their peers. Asset quality also showed marked improvement as nonperforming loans decreased to approximately 1% of loans from 3.9% in the year-earlier period. Similarly, net charge-offs improved 27 basis points to 56 basis points of average loans for the year. Finally, Tier 1 capital finished the year the year at a solid 10.4%, down modestly from 10.6% in the year-earlier period.
Cisco Bond Issuance Provides an Attractive Opportunity in Large-Cap Tech (Feb. 24)
Cisco CSCO (rating: AA, narrow moat) is coming to market with a seven-part bond offering that includes 1.5-, 3- and 5-year floating-rate notes and 3-, 5-, 7-, and 10-year fixed-rate bonds. We had anticipated that Cisco would look to issue bonds early this year, given that it faces several maturities in 2014 and has let domestic cash dwindle steadily in recent quarters. Initial price talk on the notes looks very attractive, in our view, though we would expect pricing will tighten significantly. Cisco's 4.45% notes due in 2020 have traded recently at 52 basis points over the nearest Treasury. This level compares to initial talk of +70 basis points and +95 basis points on the new 5- and 7-year bonds, respectively. We wouldn't be surprised if actual pricing was perhaps 15 basis points tighter across the board. We would place fair value on Cisco's new 5- and 7-year notes at +40 and +60 basis points, respectively.
Initial talk on the new 10-year bonds is in the +105 basis points area. We would peg fair value on this issue at around +75 basis points, leaving the notes attractive even if pricing comes in closer to the +90 basis points level. The AA tranche of the Morningstar Industrials Index currently sits at +66 basis points. The Index was at the same level last week when Google GOOG (rating: AA; wide moat) priced a 10-year note offering at +62.5 basis points, 12.5 basis points inside initial price talk. The new Google issue has held at around +65 basis points in the secondary market. We had placed fair value on the Google issue at +70 basis points. We would look for modestly wider spreads on Cisco's bonds, owing to our recent decision to cut our moat rating to narrow from wide.
While we think Cisco's competitive position will remain sound over the next 10 years, the ongoing commodification of data networking equipment and increasing customer concentration have made us less confident in Cisco's ability to maintain excess returns on capital beyond that. Importantly, we continue to view Cisco as one of the strongest competitors among enterprise and service provider infrastructure suppliers. Also important, we believe Cisco will continue to use debt primarily as a tax management tool, with overseas cash serving effectively as collateral.
At the time of Google's bond issuance, we indicated that Oracle ORCL (rating: AA, wide moat) was our favorite among large-cap, cash-rich technology firms. Oracle's 3.7% notes due in 2023 were recently indicated at 86 basis points over the nearest Treasury. We would view the new Cisco 10-year as equally attractive should it price at the +90 basis points level.
PG&E to Issue $350 Million of 5-Year Bonds; Initial Price Talk Appears Cheap (Feb. 24)
Pacific Gas & Electric PCG (rating: UR-/A-, narrow moat) announced today that it will issue $350 million of 5-year bonds. Initial price talk is +110 basis points. When compared with peers including Duke Energy's DUK (rating: BBB+, narrow moat) 5.05% due 2019 trading at 73 basis points over the nearest Treasury and CMS Energy's CMS (rating: BBB-, narrow moat) 8.75% due 2019 trading at +109 basis points, initial price talk on Pacific Gas & Electric's 5-year appears cheap. We believe fair value on Pacific Gas & Electric's 5-year is roughly +95-100 basis points. We also note that PG&E's on-the-run 3.75% due 2024 issued last week at +105 basis points (now trading at 102 basis points over the nearest Treasury). The 3.5% notes due 2020 recently traded at 77 basis points over the nearest Treasury, which we view as rich.
Pacific Gas & Electric remains exposed to approximately $1.3 billion of additional unrecoverable costs in 2014 and beyond, absent any punitive damages resulting from ongoing regulatory reviews, related to the San Bruno pipeline explosion ($2.7 billion of already incurred or committed costs as of 2013 year-end). Thus, we previously placed Pacific Gas & Electric's A- rating under review with negative implications. However, we believe the company operates in a generally constructive regulatory environment with an above-average allowed ROE of 10.5%. Pacific Gas & Electric continues to expand its stable regulated electric rate base, as it projects roughly $2.0 billion (midpoint) of electric distribution infrastructure buildout in 2014. We expect the firm to raise roughly $900 million of additional equity to partially offset its San Bruno expenses in 2014, which do not include future potential penalties.
Best Idea Delphi Taps Investment-Grade Market for First Time (Feb. 24)
Not surprisingly, Delphi Automotive DLPH (rating: BBB, narrow moat) is in the market with its first investment-grade bond after a recent upgrade from high yield. The firm is offering $500 million 10-year senior notes; initial price talk is 175 basis points over Treasuries. Based on the comps listed below and the Morningstar BBB Industrials Index at +155, we place fair value at about +150 basis points. We previously highlighted the potential for new supply out of Delphi, given the callability in May of its $500 million 5.875% notes due 2019. Indeed, the new offering is expected to fund that redemption. Delphi reached investment-grade status in December at S&P, joining Fitch at BBB-. Moody's followed Feb. 5 by upgrading the firm one notch to Baa3. We established our BBB rating in late 2012. For auto supplier comps, we point to TRW's TRW (rating: BBB-, no moat) 2023 maturity notes, which are indicated at +200 basis points to the nearest Treasury. We view TRW as slightly cheap, trading in line with the Morningstar Industrials BBB- Index. We also point to Best Idea BorgWarner's BWA (rating: A-, narrow moat) 2020 maturity notes indicated at a very cheap 147 basis points over the nearest Treasury. Johnson Controls' JCI (rating: BBB+, narrow moat) 2021 maturities are indicated at about 105 basis points over the nearest Treasury, which we view as fair to slightly rich, given its more diversified business profile.
We think Delphi will benefit from automakers' increasing use of electronic devices, safety equipment, and the auto companies' legislated need to improve fuel efficiency and lower engine emissions. Our narrow moat rating stems from the firm's ability to regularly develop innovative technologies, its customers' high switching costs, and the cost advantages of Delphi's global presence. We estimate average annual revenue growth of 6% over our five-year forecast. We also expect gross leverage to remain near 1 times. When management announced at the North American International Show a sharp dividend increase and enhanced share-repurchase program, it also reiterated several times its commitment to investment-grade ratings and a strong balance sheet.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.