The Long and Short
Lessons learned in corporate credit in 2021 Part I
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. This material does not constitute research.
The last year had a few lessons to teach, including that credit fundamentals do not always win. With so much cash in corporate investors’ hands, spreads moved tighter for most of the year. That technical made it difficult to take a contrarian view. That was the biggest lesson of the year: do not to fight the market technical. Trade ideas based on fundamentals provided little reward unless the investor was long. Risk-off trading sessions were short-lived, with the snap back in spreads typically more aggressive than the widening.
#1 The market still rewards debt reduction
I put DELL credit in the spotlight multiple times last year, arguing that continued debt reduction and the possible sale of VMW could push spreads of DELL closer to AVGO, particularly in the back end of the curve. After DELL announced the spin of VMW on 4/14/21, DELL spreads moved 20 bp tighter. DELL noted that it would be targeting core leverage of 1.5x post spin, which was lower than its original target range of 2.0x to 3.0x. Furthermore, all three rating agencies placed DELL’s ratings on review for an upgrade. DELL is now fully investment grade on a senior unsecured basis, with mid ‘BBB’ ratings at S&P and Fitch. Furthermore, spreads have moved tighter to AVGO and now trade roughly 20 bp apart in the back end of the curve compared to more than 100 bp at the start of the year. DELL’s capital structure is now fully unsecured, excluding DFS debt. As of the company’s last earnings call, DELL has repaid a third of its debt balance from the last fiscal year end and $15.9 billion of core and margin loan debt.
#2 Equity performance can stave off higher leverage
At the start of 2021, shareholder remuneration looked likely to come back at the expense of the balance sheet. It seemed the equity market was not going to necessarily have the same move higher as we saw in 2020. Many management teams had suspended buybacks, and some even suspended the dividend during 2020 for liquidity purposes. As such, it seemed that most would return to shareholder rewards and would consider increasing leverage to support these rewards in an effort to improve their stock price. However, the equity market hit records this year, and while shareholder remuneration is back, management teams did not need to lever up to increase shareholder rewards for the sake of the equity price.
#3 Product and execution can play well
Back in April 2021, I published a piece arguing REGN was a good relative value play in pharmaceuticals. REGN’s capital structure was small, but that the 30-year bonds looked attractive trading roughly 10 bp behind TACHEM. It seemed that not only should REGN spreads collapse to TACHEM but should trade through its peer based on REGN’s much stronger credit and margin profile. REGN not only had strong execution in 2020, but we expected 2021 to be another solid year as the company was finding multiple applications for core drugs while also having entered into additional product launches this year. Furthermore, they maintain a broad and diverse pipeline with approximately 30 therapeutic candidates in clinical development. Now, not only has the trading differential collapsed between the two credits, but REGN now trades through TACHEM by roughly 4 bp in the 30-year part of the curve.
#4 Playing acquisitions is a tough game
In June, I looked at M&A risk among the packaged food names given that pantry stocking had seemed to be behind us, and we were heading for a new post-pandemic normal. Based on the analysis, CPB and MDLZ seemed the most likely candidates to be pursuing acquisitions. For CPB, it seemed the company would look to M&A given that organic growth was back in negative territory and its stock price was also down for the year. MDLZ was a candidate purely because it had completed four acquisitions since 2Q20 and management looked set to pursue something larger, especially since the company had been vocal about pursuing larger acquisitions in the snacking space to accelerate its overall growth rate. CPB not only did not pursue any acquisitions this year but continued to divest assets, having completed two small divestitures this year. MDLZ continued with its small tuck-in acquisition strategy with no announcement of any substantial acquisitions.
#5 Brick-and-mortar is not dead
Despite the shift to online buying during the pandemic, brick-and-mortar seem likely to get a new life as stores provide for the popular buy online/pick-up in store (BOPIS) experience while also acting as mini-warehouses for online fulfillment. Even as lockdown restrictions were lifted, BOPIS purchases continued and have become and increasing trend. While BOPIS was necessary during the pandemic, retailers are reporting that it has helped bring shoppers back into stores post lockdown. Furthermore, the overwhelming response for continuing to offer BOPIS as a shopping option is not to compete with Amazon, but to attract shoppers to the stores so that they will make additional purchases. Inventory tracking has become crucial for BOPIS and since many retailers had been making investments in real-time inventory prior to the start of the pandemic, they were able to capitalize on the trend. Stores without and online presence have seen a significant rebound traffic and sales. Most notably, ROST, is on track to post sales growth of 48% for the year, which would put revenues higher than where they were before the pandemic.
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