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Full-year guidance gets withdrawn as earnings roll in

| April 24, 2020

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.

Earnings season is well underway, and more companies are pulling full year guidance given the uncertainty surrounding the pandemic. The lack of visibility is forcing management teams to rethink sales and profit targets that were set pre-COVID-19, and provided investors with a new perspective for assessing relative value. Opportunities among companies that have pulled guidance include Kimberly Clark (KMB), which has benefited greatly from consumers stockpiling paper goods; and Quest Diagnostics (DGX), which just started COVID-19 antibody testing, but has yet to offset the loss of revenues related to routine medical and employment testing.

Kimberly Clark (KMB – A2/A)

KMB witnessed organic sales growth of 11% during the quarter as volumes increased more than 8%. The growth largely came from the Consumer Tissue Segment which saw sales and volume growth of 13% and 14%, respectively, driven by toilet paper stockpiling. Adjusted operating profit was up a strong 24% to $997 milion, reflecting cost savings from restructuring programs coupled with lower pulp input costs. This led to a 250 bp year-over-year expansion of the adjusted operating profit margin (to 19.9%). Additionally, cash from operations was $704 million, up from $317 million in the year ago period.

Even with strong results, KMB continues to prudently manage its balance sheet and further strengthen liquidity.  KMB executed two debt deals during the quarter for a total of $1.25 billion, with proceeds being used to pre-fund its August maturities ($500 million) as well as for cash on hand to reduce its commercial paper needs. At quarter end, liquidity was a solid $3.73 billion, as KMB’s two credit facilities totaling $2.75 billion remain untapped and the company had $979 million of cash on hand. KMB also announced that it would temporarily suspend its share repurchase program (effective 4/24/20) to provide additional liquidity, underscoring its commitment to maintain its single-A credit ratings.

Relative Value : While KMB should be considered a core hold during the pandemic, their on the run bonds seem to be somewhat fairly valued for the mid-single A ratings. Spreads look comfortable across the curve, with the most value seen in the KMB 2037 and 2041 bonds. Although these particular bonds are hard to source, they provide an attractive pick in yield whether investors are looking to add or shorten duration.

Exhibit 1: Single-A Consumer Products Curve

Source: Bloomberg TRACE

Concessions Get Squeezed  

Quest Diagnostics (Baa2/BBB+/BBB)

DGX got off to a good start in the quarter with management noting that January and February results were consistent with full year guidance.  However, they witnessed a material decline in March as volumes dropped over 40% in the last two weeks of the month. That said, revenues were down 3.8% year-over-year, to $1.82 billion, however they still beat consensus estimates of $1.75 billion.  Furthermore adjusted EPS of $0.94 beat street estimates of $0.86. Adjusted operating income fell over 21% (to $225 million) with the margin contracting 280 bp (to 12.3%). Management noted that the year-over-year operating margin decline was entirely due to the revenue decline in March. Prior to March, DGX had witnessed a meaningful improvement to the operating margin driven by strong volumes and revenue growth.

Liquidity is good as DGX ended the quarter with $342 million of cash on hand and borrowing capacity under its unsecured revolver and secured receivables facility of $1.3 billion. DGX did note that in April it drew down $100 million on each facility. While the company remains in compliance with covenants under the facilities, including a 3.5x maximum leverage covenant, they are in advanced talks with their lead lender to amend the covenant as they believe it would be breached by the end of 2Q. Management is confident that the covenant will be amended before quarter end. They also noted that their IG ratings help to provide them access to alternate sources of financing should it become necessary. In an effort to shore up liquidity, DGX has suspended its share repurchase program for the rest of the year.

Exhibit 2: BBB Healthcare/CVS/ DGX Curves

Source: Bloomberg TRACE

Relative Value: While the ramp up in antibody testing should help DGX to offset some lost revenues and volume declines, the potential for higher leverage for the remainder of the year is a risk. Additionally the sheer drop in revenues at the end of March is alarming, and spreads could drift wider in here particularly if they come with a deal to further enhance liquidity. While DGX’s spread curve closely matches that of its BBB peers, investors should be more comfortable owning the CVS Health credit (CVS – Baa2/BBB), as CVS has already tapped the market. CVS bonds largely trade though DGX across the curve, but the relationship between the two credits is reversed in the 30-year sector.

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