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A return to rebuilding balance sheets

| December 7, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

As rates rise and funding becomes more expensive, balance sheet health is finally coming back into play for issuers in the consumer, retail and telecom-media-technology sectors.  Volatility has slowly crept back into the market as credits such as GE and PCG underscore the importance of liquidity and the ability to refinance.  With the added volatility and some long-awaited dislocations in the credit market, 2019 should mark a turn from broadly passive investing to relative value.  The strongest names will likely rely on organic growth, asset sales and other methods to rebuild balance sheets.

This new focus follows from a 2018 that can be summarized in a few words: heavy issuance and highly technical.  Mega M&A deals such as CVS’ purchase of AET and CMCSA’s purchase of the Sky assets led to two of the five largest corporate bonds deals in history.  While the packaged food/beverage space struggled to grow organically, they too looked to mergers to fuel growth and tapped the market to fund the deals.  Investment grade issuance, while trailing last year’s number year to date, is still expected to end the year around the $1.2 trillion compared to $1.37 trillion in 2017.

Back to the basics: balance sheets, credit profiles and relative value

Balance sheets and strong credit profiles should largely be a catalyst for the better performers in 2019.  After a few years of gorging on acquisitions or financing shareholder rewards with debt, balance sheets have become bloated.  With organic growth hard to come by, management teams have been willing to forgo ratings and use debt to fuel growth and support equity prices.  So much so, that the BBB ratings category has grown to over 50% of the index today, relative to 31% in 2010.  All of this happened in a low rate, low volatility environment as an influx of capital continued to pour into the market.  This inevitably produced very little spread dislocation among rating categories.  Only names that deemed to have fallen angel potential seemed to be the trading outliers.  With the added volatility in the market, the beginnings of spread differentiation are beginning to emerge, thereby bringing relative value back to credit picking.  As investors look for alpha in 2019 and try to avoid the potential for credit blow ups, balance sheet strength and strong credit profiles will likely be rewarded.

M&A should continue albeit at a slower pace

While M&A should continue in 2019, the pace of large-scale acquisitions should slow.  M&A has been used to fuel growth over the past few years as organic growth remained muted.  While organic growth doesn’t look likely to improve much in 2019, Best Buy and Verizon are prime examples where reinvestment in the business and innovation can successfully address growth and competition issues at a far lower price tag than M&A.  Both credits outperformed peers considerably this year from a sales perspective.  Without the additional debt from large acquisitions, BBY has positive ratings momentum while VZ remains rated one notch higher at Moody’s and S&P relative to AT&T.

From acquisitions to divestitures

Fears that the consumer pulls back and growth slows could pressure free cash flow forecasts and prolong debt reduction from acquisitions.  Furthermore, any fallout from GE regarding refinancing and delevering risk could put pressure on management teams to look for other levers to pull to reduce debt.  That said, the pace of divestitures could pick up in order to bring in proceeds for debt reduction.  NWL is in the process of raising $10 billion through asset sales as part of their Accelerated Transformation Plan after their acquisition of Jarden.  While CPB recently announced that it will be looking to shed its International and Fresh businesses with proceeds going to debt reduction after closing on the Snyder’s acquisition. AT&T noted at its analyst day that in addition to the $12 billion in free cash flow they expect to put to debt reduction in 2019, they are looking at roughly $6 billion to $8 billion in asset sale proceeds to help speed up debt reduction from the TWX acquisition.  This would bring leverage down roughly three ticks from the expected 2.8x net leverage at the end of 2018.

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