The Long and Short
Lessons learned in corporate credit in 2022, Part II
Meredith Contente | December 16, 2022
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.
Credit spreads proved to be much more volatile than expected this year given rate increases and an inverted Treasury curve, and that helped to paralyze the market somewhat. Additionally, large swings in the equity market helped fuel a spotty new issue market, as risk-off days spooked potential issuers. New issue concessions came back into play, forcing repricing of secondary positions. As we progressed through the year, enough cash came off the sidelines to tighten spreads in the fourth quarter. While technicals dominated for most of the year given significant ETF and algorithm trading, fundamentals did come back into play by year-end. Recession fears have some accounts looking for credits with balance sheet strength and strong cash flow profiles.
A couple of the hits and misses of 2022:
#1 Hit: Broadcom Inc. (AVGO) balance sheet improvement with new deal
In this particular piece dated in April, I highlighted how AVGO was taking advantage of the relatively low-rate environment at the time to make further capital structure improvements, which I viewed positively. I felt that AVGO’s strong margin improvement coupled with its stronger cash flow generation set the stage for stronger credit metrics and could lead to ratings improvement over the next 12-24 months. I also highlighted that acquisitions would still be a source of growth and were comforted by management’s track record in rapidly delevering post acquisition. I noted that its growing cash balance provides for flexibility in the ratings when pursuing acquisitions and that management could suspend buybacks to reduce leverage quickly should it pursue a larger acquisition. Post publication, AVGO announced its intent to purchase VM Ware (5/26/22) for a total transaction value of roughly $70bn (including assumed debt). While leverage is expected to climb to approximately 3.5x at close, management noted that they plan to bring leverage below 2.5x within two years post close. Post-acquisition announcement, AVGO was placed on review for an upgrade by S&P. Should the acquisition close with no material changes to original terms, I expect S&P will upgrade to BBB.
#2 Hit: Dick’s Sporting Goods Inc. (DKS) deep discount and steepest curve provides attractive entry point
In the DKS piece written in September of this year, I highlighted that DKS remained the widest trading credit in the BBB retail space (excluding department stores), despite having margin and credit profiles similar to or better than peers. DKS had just posted quarterly results that beat consensus estimates while raising full year guidance. Additionally, DKS was now at a point where its net sales and EBIT levels were considerably higher than pre-pandemic levels. I noted that bonds issued in January 2022 were trading at a deep discount and that DKS had the steepest 10s/30s curve, providing for an attractive entry point. Since publication, DKS’ curve has collapsed the most relative to peers. In fact, some peers have actually widened. I highlight the difference in the curves of DKS and its peers in Exhibit 1. I have included the spread curves from original publication date (9/16/22) as well as where they stand today.
Exhibit 1. BBB Retail Spread Comparison
#3 Miss: Target Corporation (TGT) inventory woes hit profit but full-year guidance affirmed
In August, I highlighted that any spread widening in TGT’s bonds on the heels of is profit warning, should be considered a better buying opportunity. TGT’s results had come in worse than anticipated, as bloated inventory levels forced management to aggressively “clear” excess merchandise. The actions led to a nearly 90% decline in EPS for the quarter. However, management was confident that the profit decline experienced in 2Q was ephemeral as it affirmed full year guidance. I noted that the balance sheet remained in order and any hit to EBITDA would not impact leverage enough to warrant a ratings event.
While ratings and outlooks have remained intact since publication, I did not anticipate TGT would reduce full year guidance on its next earnings call. TGT’s inventory issues continued to plague the credit and increased inflation and rising interest rates impacted shopping behavior which had 3Q results come in well below expectations. Furthermore, management decreased full year guidance and provided a broad range of outcomes centered around much lower sales and profit expectations. As such, TGT spreads continued to leak wider for the rest of the year. I highlight in Exhibit 2, the curve differential between original publication date and now.
Exhibit 2. TGT Spread Curve (8/19/22 versus now)