Egan-Jones November Industry Review
Courtesy of Egan-Jones Ratings And Analytics
In the Matrix
The most perplexing issue in assessing credit quality for various industries over the next six to eighteen months is determining what is real, what is sustainable. As illustrated in the below graph, the monetary base has exploded over the past couple of years - a manifestation of the FED's effort to pump liquidity into the system to support the financial sector and prop up the broader economy. Other "props" are the step yield curve, FDIC backing for the bonds of the few and chosen, and the continued direct support of the particularly important (politically) and particularly wounded such as GMAC. Will we exit the matrix and if so, when? The short answer is that we will probably exit when we are able. Despite the massive cost of the bailout, the US has the will, and China and the multitude of other buyers of US Treasuries have the means, to continue to support the bailout. However, change is coming; some of it would come even without the great recession. The massive drivers of economic change in the US over the past 40 years, the baby boomers, are changing their ways and will not be making the expenditures they have previously. Forget the regular upgrading of housing (the more likely step is a reduction in housing needs), forget the three year upgrade of vehicles (most will last six years or more), and forget most other huge purchases. Rebuilding savings is likely to be the new norm for many baby boomers, and the other generations are not making enough yet to fill the void. A translation for fixed income investors is that the anointed financial service firms will thrive over the next couple of years as will most money managers. However, the consumer-based, capital intensive industries such as auto, home building, and retailing will lag, especially as the various stimulus programs wear off.
Review of industries
Below are our comments on various industries and companies
Health Care Services – Within the Standard Industrial Classification's list of six Health Care sectors to which we have made frequent reference in recent months, this will be our first venture into the Life Sciences Tools and Services segment for positive comment on one of the relatively few companies in this category rated by Egan-Jones. We have maintained, and recently reaffirmed, a BBB rating for Millipore Corp. (MIL) since June 2006. The company is a leader in membrane separation (microfiltration) technology, used for fluid analysis, identification, and purification. The vast majority of MIL's $1.6B annual revenue is related to customers engaged in life science research or biopharmaceutical production. Increasing stem cell research activity has been a visible factor in MIL's 5% revenue growth thus far this year. Operating income for the June quarter – the latest available at press time – was $75M in 2009 vs. $71.8M in 2008. Market cap is $3.8B compared to net debt of $850M. Further support for our positive view of MIL is its strong (14.9) Rating Change Anticipator ranking.
Consumer Staples – We now have earnings reports for the September quarter from Coca-Cola (KO) and PepsiCo (PEP), and while each of the giant soft-drink companies delivered a respectable operating performance, possibly the most interesting detail was a footnote to PEP's financial statements concerning an accounting change accompanying the parent's pending deal with its bottlers (please refer to our discussion of this transaction in this space in September). Assuming completion of the transaction in late 2009 or early 2010, revised depreciation schedules for Pepsi Bottling Group (PBG) and PepsiAmericas (PAS) bottlers will have the effect of increasing PEP's full-year 2010 earnings. Management expects a gain next year in the range of 11% - 13% (ex currency effects), but examination of the fine print reveals that five percentage points of that growth – approximately half of it - is attributed to the accounting change, and is of lower quality than underlying growth of a much more mundane 6% - 8%. PEP's operating income for the September quarter rose by 12% from $2.0B to $2.2B, with tight control of SG&A expenses leveraging a lesser 8% increase in division operating profit that was reduced further to 2% by currency effects. PEP's credit quality will be affected by the $7.8B it will lay out to acquire the balance of shares of PBG and PBS that it does not already own. Projected financials reflect $3B in additional borrowing raising current net debt to $7.5B vs. market cap of $95.5B. PEP's rating was recently affirmed at the A level.
Energy Service – As noted in this space last month, the industry's consolidation trend, stymied for much of the current year by weak energy prices after a high level of activity in 2007-08, is back in the headlines, with the latest installment being the pending acquisition of BJ Services (BJS) by Baker Hughes (BHI). Our focus this month will be the acquisition of Grant Prideco in April 2008 for cash ($2.9B) and stock ($4.3B) by National Oilwell Varco (NOV) and the transaction's subsequent impact on NOV's operating performance and credit quality. NOV's stock cratered during 2H08 but has since recovered smartly, nearly doubling in price from $24 in January 2009 to $45 currently, raising market cap to $18.3B vs. debt of just $881M and cash of $2.3B. Operating performance has been less impressive. Driven by sharply lower well drilling activity reflecting the steep drop in oil and gas prices, NOV's revenues declined 9.5% to $3.01B compared to $3.33 in the prior year, and operating profit of $589M excluding impairment, staff reduction and transaction costs was down by 22%. Egan-Jones recently affirmed NOV's A rating based primarily on the company's high degree (see above) of financial flexibility.
Information Technology – Our comments on IBM in the September issue of this report highlighted 1) a 12% increase for June quarter earnings despite a 13% y-o-y decline (down 7% ex-currency) in revenue; 2) sufficient confidence in the near-term outlook to prompt management to raise full-year EPS guidance from $9.20 to $9.70; and 3) an upgrade of IBM's rating from A+ to AA-. Fast forward to IBM's latest interim earnings report, and we find 1) a 14% increase for September quarter earnings despite a 7% y-o-y decline (down 5% ex-currency) in revenue; 2) sufficient confidence in the near-term outlook to prompt management to further raise full-year EPS guidance from $9.70 to "at least $9.85;" and 3) affirmation of the AA- rating. Driving this Street-surprising result was the dramatic margin improvement (18.6% pretax vs. 15.4% last year); management's strategic shift to emphasis on services and software and away from mainframes and other computer hardware has clearly proven itself. Finances and overall credit quality are very strong and flexible, with $11.5B cash, annual operating income of $15.9B vs. interest expense of $673M (30.1x coverage for four rolling quarters through September), a market cap of $160B, and net debt of $13.9B.
Banks – A loud and clear message from September quarter earnings reports from major banks is that at least temporarily, fixed-income trading revenue has supplanted conventional lending activity as the principal source of profitability. A return to prosperity in bond markets has been fueled jointly by the Fed's ultra-loose monetary policy and a rebound in bond-buyers' confidence, while banks' traditional lending business continues to be stymied by too many still-overleveraged, and therefore cautious, consumers. Goldman Sachs (GS) reported another strong quarter, its margins continuing to benefit hugely from management's decision to put more risk capital to work as markets revived, and from the absence of many former competitors in trading markets for credit and interest rate products as well as currencies. For its part, J. P. Morgan Chase (JPM) was easily able to absorb a $1.6B increase in its loan loss reserve during the quarter with strong investment-bank revenue. In this space in September we listed five top-tier banks whose ratings had all been recently upgraded by Egan-Jones (GS, JPM, Citi, B of A, and Morgan Stanley), to which list we can now add Wells Fargo & Co. (WFC), very recently upgraded from A to AA-. Our review cited reduced funding costs, $7.5B of new equity capital, and significant improvement y-o-y for September quarter operating income ($4.7B vs. $3.0B). Moreover, GS and JPM received further upgrades, from A+ to AA and A+ to AA- respectively.
Telecommunications – Once upon a time, AT&T was the nation's local service and long distance telephone company – until 1/1/84, when in order to settle a Department of Justice antitrust lawsuit "Ma Bell's" local service operations were split off into seven Regional Bell Operating Companies (RBOCs), while AT&T continued to operate all of its long-distance services in a fiercely competitive market. Today's AT&T consists primarily of four of the seven RBOCs recombined, remains a force in telecommunications as the leading domestic provider of wireline voice communication services, as well as the second largest (after Verizon) wireless carrier by both sales and subscriptions – and retains its single-letter ticker symbol. AT&T also presents a solid credit quality picture, with interest coverage consistently exceeding 6.5:1. For the June quarter, consolidated revenues were flat ($30.7B vs. $30.9B) although operating income slipped from $6.6B last year to $5.5B this year. Strong growth in wireless subscribers and data revenue (now two-thirds of total revenues) offset general economic pressures reflected in a 13.4% decline in wireline voice revenue. June quarter margins also absorbed launch costs of AT&T's new iPhone service. With market cap of $151B vs. net debt of $69.4B, AT&T has substantial financial flexibility. Egan-Jones recently affirmed the solid A rating.
Autos – Recent emphasis in this space on the trials and tribulations of General Motors has resulted in a virtual neglect of Ford (F) despite its precariously weak credit quality (Egan-Jones has maintained a D rating on the #2 domestic automaker since 11/7/08). Ford is perhaps best remembered for its thanks-but-no-thanks response to an offer of bailout money from the government (even though the sum of $5.9B was accepted for the specific purpose of support for suppliers). The company's program of buybacks and exchange offers to bondholders earlier this year amounted, in our view, to a de facto default since creditors were paid neither in full nor on time. Yet here was Ford back in the marketplace in mid-September with a new $1B bond issue priced to yield 9.125% – its third this year – hoping that investors have short memory spans. Whereas our ongoing comments on GM have included a steady drumbeat of declining retail market share, Ford is headed in the opposite direction with eleven increases in the past twelve year-over-year monthly comparisons. For September, the first monthly data since the end of the cash-for-clunkers program, Ford's market share rose to 15.3% vs. 13.5% in September 2008. Ford's cash position, moreover, showed the first sequential increase (from $21B to $24B) since late 2007 during the June quarter. Based on its financial position and market share trend relative to GM's, Egan-Jones recently upgraded Ford's rating from D to C.
Building Materials – n recent months (specifically, February through August) the government's construction spending reports have included six consecutive (four up, two down) minuscule changes for total spending, so that it would not be too far-fetched to describe the current overall sequential trend as flat even though the numbers continue to run well below the comparable months last year. Total construction spending for August, for example, increased 0.8% from July, but trailed August 2008 by 11.6%. Among the component sectors, residential spending rose 4.2% from July while declining 26.0% from August 2008. Total private construction spending, moreover, grew 1.8% sequentially, while public construction was down 1.1%, and private manufacturing spending posted an encouraging 5.4% gain. As to the various sectors of the industry and their leading companies, we have commented in recent months on suppliers of rock and stone building materials (Vulcan Materials; Martin Marietta) and lumber products (Louisiana Pacific; Weyerhaeuser). Our focus this month is wallboard and USG Corporation (USG), the largest manufacturer of gypsum products in North America and the largest domestic distributor of wallboard. Citing the year-over-year declines in residential and commercial construction noted above, USG management reported a 34% drop in revenue for the June '09 quarter, and an operating loss of $21M before restructuring and asset impairment charges vs. $18M before similar charges last year. A higher level of borrowings resulted in increased interest expense and a weaker coverage margin, with market cap of $1.66B barely matching total debt of $1.67 as of 6/30 (USG's shares are down from $40 two years ago to $16.65). Egan-Jones's recent review of USG concluded that a downgrade from B+ to B was warranted.
Non-Ferrous Metals – The aluminum industry, and Alcoa in particular, has received the lion's share of comments in this space so far this year. Recently, however, the spectacular market price performance of Freeport-McMoRan Copper & Gold (FCX), the world's second largest copper producer (Codelco, owned by the Chilean government, ranks #1), has caught our eye as it has nearly quadrupled its year-end 2008 price despite significant sales and earnings declines through the June quarter that mainly reflect the effect of the global economic slowdown on copper's commodity price. The geography of FCX's copper reserves is especially well suited to supply the now-burgeoning demand from Chinese industry, which should translate into much-improved operating performance for FCX over the next 12 – 18 months. With market cap having risen to $32.4B vs. debt of $7.2B and cash of $1.0B, FCX's financial flexibility has been further strengthened by two capital transactions. One, an issue of 5 Â½ % Convertible Perpetual Preferred Stock has been called in, with all but a $1M balance converted into 17.9M shares of common stock, thereby eliminating an annual dividend of $46M; and two, the entire $340M issue of 6 7/8% Senior Notes has been redeemed, saving $23M.of annual interest. An overall pattern of strong credit quality metrics has warranted three rating upgrades thus far this year, first from BB to BBB-, then to BBB, and very recently, to BBB+.
Energy – Although weak oil and gas pricing was the principal driver of Big Oil's steep 2Q09 earnings declines (ExxonMobil (XOM) down 66% y-o-y, Chevron (CVX) down 71%, ConocoPhillips (COP) down 76%), the picture was somewhat brighter during the September quarter. Neither XOM nor CVX had released its numbers by press time, but CVX did provide an Interim Update on October 8 stating unequivocally that September earnings would exceed the June quarter's (operating income comparisons: 2Q09 $3.4B, 3Q08 $14.4B), and that upstream operations benefited from "significantly higher oil prices", bolstered by asset sale and tax items. Domestic upstream realized $62.47/barrel during July-August vs. $53.21 for the entire June quarter. Downstream earnings, on the other hand, were relatively flat, and the overall impact of currency adjustments was unfavorable. Presumably, XOM's experience was qualitatively similar. CVX could easily retire debt if it chose to do so, with $7.3B in cash, $12.1B of debt, and market cap of $154B. XOM has been and remains a credit quality powerhouse, with cash of $15.2B, debt of $9.3B, and market cap of $352B. CVX's AA rating, and XOM's AA+, have each in place since 2003 and recently reviewed, and in our view remain fully justified.
Machinery – Although Deere's 3QF2009 (ended July 31) earnings report revealed a steepening sales decline (-24% overall vs. -17%, -21% for agricultural equipment vs. -4%, both sequentially), management reiterated its guidance to full fiscal year (ending October 31) net income of $1.1B, unchanged from the August figure. However, subsequent announcement of a $300M after-tax charge during 4QF2009 for impairment of goodwill related to reduction of the value of Deere's Landscapes reporting unit; the charge is not included in the $1.1B number. In our recent review of Deere's A- rating, we suggested that "an issue likely to be tested is the continued access to credit at reasonable rates." Our concern turns out to be short-lived, having been effectively addressed by the even more recent sale of $1.25B of new debt in two tranches, $750M of 10-year 4.375% notes (priced to yield 110 basis points over Treasurys) and $$500M of 20-year 5.375% bonds (120 basis points over Treasurys). Accordingly, and – as they say at the stadium – upon further review, the negative modifier has been dropped from Deere's affirmed A- rating.
Chemical – We focused on Monsanto (MON) last month, using and commenting on several numbers from the pre-announcement of 4QF2009 earnings and projections for key product lines for F2010-2012. MON's most important strategic problem going forward will be management of the transition from glyphosate-based herbicide products (Roundup) that are now threatened by generic competition, especially from China, to the company's seeds and genomics business as the principal driver of its future earnings growth. For the near term, MON is guiding to a range of reported EPS of $2.85 - $3.11 vs. $3.80 for F2009 ended August 31. Major components of an overall $600M - $700M decrement in forecasted gross profit are Roundup lower by $1.1B - $1.2B, partly offset by seeds and genomics higher by $600M - $700M. Management's longer term strategic plan runs to 2012, with a target for overall gross profit of $8.6B - $8.8B. S&G contributes $7.3B - $7.5B, while volume growth, new capacity and cost reductions bump Roundup back up to $1B. Finances remain a strong point for MON; market cap is currently $40.6B vs. debt of only $1.8B and cash of $2.0B. Egan-Jones recently reaffirmed MON's A+ rating, which has stood since 1/3/08.
Auto Suppliers – Recently in this space we described a two-part arrangement whereby GM, its principal customer, would provide funds to American Axle & Manufacturing (AXL) that could help the supplier of axles and driveshafts stave off bankruptcy. The entire deal was contingent upon AXL receiving approval from its lenders of a debt restructuring plan. That has now been accomplished, step #1 has been completed, and step #2 will now likely move forward. AXL has received a $110M payment from GM related to contracts predating the automaker's Chapter 11 filing on June 1 in consideration for warrants that entitle GM to buy 4.1M shares (7.4%) of AXL stock at $2.76 each. Step #2 is a $100M loan facility that will also include an option for a further 12.5% of AXL stock, depending on how much of the facility is used and giving GM a potential holding of 19.9% of this key parts supplier. Revised loan covenants include maintenance of a daily average of $85M in liquidity until 6/10/2010, plus limitations on payment of dividends, additional borrowing, and purchase or sale of assets. Egan-Jones's review of these developments resulted in an upgrade of AXL from D to CC; continuity of GM support going forward was cited as a key issue. We see it as likely as long as GM remains under government control.
Retail – News of the retail industry's first overall year-over-year increase (+0.6%) in same-store sales (comps) in thirteen months was greeted more with caution than with elation, inasmuch as September's results are traditionally viewed as a harbinger of the coming holiday season and the critical fourth quarter as a whole. The source of the caution in this instance was the industry's weak performance in September of 2008 which, even though it provided an easy target for this year's numbers to beat, they barely did so. Two store chains about which we commented last month, however, extended their positive trends. Kohl's reported an increase for the third month in a row (+0.2% for July, +0.4% for August, +5.5% for September). Encouraged by a 7% increase for September same store sales, following a 4% sales increase for 2QF2010 (ended August 1) and a 5% y-o-y sales gain for August, management of TJX Companies, Inc. (TJX) has raised its forecast for both comps and EPS for 3QF AND 4QF2010. Finances are strong: cash exceeds debt and market cap has risen to $16.2B In upgrading TJX from A to A+/positive in August, Egan-Jones listed "large share repurchases" as a potential threat to credit quality. We mention this in view of the recently announced new $1B buyback program which will become effective upon completion of the current authorization, of which $367M remains.
Insurance – We paid close attention to the monolines sector of this industry during 2008 as Ambac (ABK) and MBIA (MBI) paid the price for diversification into the structured credit field that was intended to expand the limited growth opportunities afforded by municipal bond insurance. A recurring theme of our frequent Rating Analysis Reports last year was the urgent need for additional capital to support guarantees of subprime mortgages and CDOs, without which the credit default swap prices of ABK and MBI went through the roof. A further credit quality issue was the separation, allowed by New York State's insurance regulatory authority, of MBI's municipal bond business from its other operations. The separation was accompanied by movement of some $5B of MBI's capital to the new entity, action which promptly triggered lawsuits by 18 banks, including BAC and JPM, with exposure to MBI. A recent review of MBI by Egan-Jones concluded that the company needs to go into a rehabilitation process, but that doing so will place pressure on cash because of triggers. Our review resulted in affirmation of MBI's C rating.