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M&A and leverage back in play in investment grade debt

| December 13, 2019

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.

A generally constructive outlook for investment grade corporate credit still involves a few potential wrinkles. In looking for ways to reinvigorate net sales growth and drive continued equity outperformance, packaged food companies may once again look to M&A.  A record $771 billion in currently unspent private equity cash allocated for North American buyouts may lead to the return of the investment grade LBO.  And a higher cost of debt in the leveraged loan market may push LBOs toward secured financings as a way to access investment grade debt. Each of those likely developments would drive relative value opportunities in 2020.

Volume declines push the M&A card in packaged food

An acquisition-heavy 2018 in North America packaged foods, a reach for top line revenue growth, stretched balance sheets and resulted in downgrades.  But management turned to deleveraging in 2019.  Management teams have largely been on track with debt reduction and moving closer to their leverage targets.  However, after annualizing the acquisitions, organic net sales are failing to materialize.  Pricing power appears to be limited. Increasing prices to offset higher raw material costs has largely been met with volume declines.  In some instances, volumes have continued to decline even in the face of lowered prices, suggesting weak consumer demand.

General Mills Inc. (GIS – Baa2/BBB/BBB (n)), for example, which closed on its Blue Buffalo acquisition on 4/25/18, saw a 1% decline in organic net sales in fiscal 1Q20.  Volumes fell 4%, offsetting the 3% growth in price/mix.  Additionally, The JM Smucker Company (SJM – Baa2/BBB), which closed on its acquisition of Ainsworth Pet Nutrition on 5/18/18, posted an organic net sales decline in both fiscal 1Q20 and 2Q20 of -4% and -1%, respectively.   SJM’s improved pricing has failed to drive volume growth and forced management to revise full year net sales guidance twice.  SJM is now expecting FY20 net sales to be down 3%, from initial guidance of 1%-2% growth.  Lastly Conagra Brands Inc. (CAG – Baa3/BBB-/BBB-), which closed on its acquisition of Pinnacle Brands on 10/26/18, saw organic net sales in fiscal  1Q20 slide 1.7%.  Management noted that volume declines of 2.5% more than offset price/mix growth of 0.8%.

The equity market has seemingly overlooked the net sales underperformance of both GIS and CAG as they have outperformed the SPX year to date.  Only when SJM revised full year guidance downward did it start to underperform the SPX. SJM’s stock rebounded after fiscal 1Q20, and looked set to outpace the SPX until it revised guidance for second time.

Exhibit 1. CAG, GIS and SJM Equity performance Relative to SPX

Source: Bloomberg; APS

In looking for ways to reinvigorate net sales growth and drive continued equity outperformance, packaged food companies may once again look to M&A.  Despite not having achieved explicit leverage targets yet, management teams could argue that they have been making good on their promise to delever. Furthermore, investment grade supply demand remains strong and rates continue to be low, providing an opportunity to pursue a deal and fund with additional debt on the promise to once again delever.   In a pinch, management teams could use inflated equity prices as currency to partially fund deals. This could help stave off downgrades given that the rating agencies value any equity funding and view it as management’s commitment to the current ratings.

A return of the investment grade LBO

Headlines emerged in late 2019 that Walgreen’s Boots Alliance Inc. (WBA – Baa2/BBB) was exploring a deal to take the company private with KKR & Co. (KKR).  While the merits of what would be the largest LBO in history came into question and the ability to place that much debt in the high yield market were argued, it highlighted the massive amounts of cash that private equity firms are currently sitting on.  According to data provider Preqin, unspent cash allocated for North American buyouts has reached a record $771.5 billion. This is up 24% from year-end 2018 and stands at more than double the amount at year-end 2014.

With all this cash on the sidelines, the WBA headlines suggest that private equity firms may start thinking outside the box when looking for takeover targets.  Given lofty equity valuations, private equity firms may be forced to become more aggressive in their takeovers, looking at larger deals while considering higher leverage levels.  According to LCD, the amount of deals getting done where leverage is 6.0x or higher has been on a steady rise since 2009.

Source: LCD, a division of S&P Global Market Intelligence; FT

Secured financing becomes an attractive funding solution

After binging on LBO debt for the past 10 years and as the fear of downgrades rises, the credit in the levered loan and CLO markets has tightened lately, making it more difficult for private equity to finance LBOs.  Increased borrowing costs and high equity valuations are translating to decreased return expectations.  With the IG market still very much in demand, secured financing may be the answer to the funding problem.   We have seen the use of secured financing by strategic buyers such as Charter and Dell in an effort to access cheaper financing in the IG market.  Private equity buyers could replicate a similar funding strategy in an effort to get deals done and improve return expectations given the lower borrowing costs associated with accessing the IG market.

The underlying consensus

US investment grade spreads appear poised for a continued march tighter in 2020 as investors search for yield amidst a rise in global negative yields.  Supply, while coming in slightly below 2018 levels, proved to be easily digested as 2019 progressed, bringing less frequent issuers to market.  Investment grade investors seemed to shrug off headlines associated with the trade war in China, despite the likelihood of increased prices for consumers.  Furthermore, a focus on deleveraging after a slew of M&A activity, particularly in the consumer and TMT sectors, helped investors to grow more comfortable buying higher levered ‘BBB’ risk.  While the US election seems to be the biggest wild card with respect to 2020 and is likely to inject periods of volatility during the year, a return to M&A could put pressure on spreads and increase supply prospects and leverage.

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