Kernel Holding S.A. (KERPW): June 01

…Kernel’s free cash flow was positive $207 million in 3Q (-$356 million year-to-date) due to the increase in EBITDA and a decrease in working capital. Earlier this year, the company’s working capital increased due to the need to build larger inventories as the company entered into some contracts to hedge sunflower oil sales to lock in margins for future production. Its net leverage decreased from 4.9x in 2Q to 3.5x in 3Q and management stated that this ratio should decrease further in 4Q, towards 3.3x. Kernel has once more lowered its capital expenditure guidance for this year (from $300 million to $288 million) to preserve some cash. Consequently, the company raised next year’s capital expenditure guidance from $186 million to $234 million due to the postponement of some investments to next year. FY20/21 will be the last year of the “Strategy 2021” investment program, meaning that capital expenditure will fall towards maintenance capex levels of approximately $85 million in FY21/22. Kernel will keep its dividend payments at low levels until FY21/22. The company’s liquidity is adequate to cover short-term debt repayments and management said that they have started working on “several options” to address the refinancing of the $500 million Eurobond maturing in January 2022. Our most recent view on KERPW 6.5% 2024 bonds was “underperform” at a price of 103.875 and a z-spread of 470bps (on March 4, 2020). These bonds now trade at 96.3, a z-spread of 718bps and offer a yield-to-worst of 7.5%. Underlying sovereigns (rated Caa1/B) trade with a z-spread of 702bps and offer a yield-to-worst of 7.3%. At current trading levels, we think that KERPW 6.5% 2024 bonds are now attractive. Hence, we change our recommendation to “outperform”.

Bombardier: June 01

…The first quarter free cash flow shortfall (cash flow from operations less capital spending) increased $600 million to $1.6 billion, bringing LTM FCF to a $1.8 billion shortfall. The company ended the first quarter with $2.9 billion of liquidity, including a temporary $386 million equity infusion from Caisse de dépôt et placement du Québec to support working capital until the Transportation sale to Alstom is closed and $531 million of proceeds from exiting the A220 program joint venture with Airbus (additional $60 million to be paid through 2021). Pro forma liquidity increases to $3.5 billion adding in the $550 million of expected proceeds from the sale of the CRJ program scheduled to close on June 1. In addition, the $500 million sale of the aerostructure business remains on track to close in the coming months. The CRJ program and aerostructure business sale transactions complete the company’s exit from the commercial aerospace market and should provide sufficient liquidity until of pending sale of Transportation to Alstom can be completed in the first half of 2021, expecting to net BBD/B $4.2-4.5 billion which will be used towards lowering the company’s $9.3 billion of total debt. For the second quarter, revenues are likely to be down as much as 50% on production shutdowns with adjusted EBIT swinging to a loss from $206 million in the year ago period. Free cash flow usage will be comparable to the first quarter before gradually recovering in the second half towards breakeven. We look for leverage to remain at double digit levels until the Transportation sale to Alstom is completed next year and proceeds are used to reduce debt. The 7.875% senior notes due 2027 yield 18.6% ($59.25 dollar price). Significant risks remain. Reaffirm underperform.

AutoZone (AZO): June 01

…Recall that AutoZone typically does not classify current bond maturities or commercial paper as short-term debt on its balance sheet because of its intention to refinance maturing debt. At the end of the second quarter, commercial paper outstanding was nearly $1.3 billion, and there was a $500 million bond maturing in November and a $250 million bond maturing next April. All of this should be considered short term debt, especially in this market environment. We estimate free cash flow after share repurchases was about $400 million in the quarter–net debt fell by a similar amount. Gross debt was essentially unchanged, with the remainder used to bolster cash. This is what leads us to conclude the bond proceeds were used to refinance commercial paper.AutoZone estimates extraordinary costs related to COVID-19 of $75 million. This explains a 200 basis point decline in the operating margin to 17.7%, although gross margin held steady. It was still highly profitable, despite expense deleveraging. Rent-adjusted leverage per management’s calculation was 2.6x, even with last year. Our less liberal calculations show leverage of 2.9x, also steady. Our projections for the full year assume modest debt reduction using free cash flow and slightly lower leverage. The 2030 bonds have tightened immensely, but we still see value at T+186: Reiterate “outperform.”

Owens-Illinois (OI): May 29

The second quarter is expected to be worse because shipment volumes were off 17- 18% in April, and COVID-19 disruption is ongoing. OI withdrew its 2020 estimates (its prior guidance was cash from operations of $650 million), but management suggested a likely fall in revenue of down 5-10% and lower capex at under $300 million. Free cash flow also will be benefited by no asbestos payments. Earlier this year OI dealt with its asbestos liabilities by moving them to a separate deconsolidated subsidiary called Paddock Enterprises that filed chapter 11 in January. The company still estimates its claims liability at over $450 million, but court resolution could cut down on cash outflow and litigation expenses that have required 40% of OI’s free cash flow in the last ten years. Our guesstimate of free cash flow (EBITDA less capex, pension payments, restructuring costs, interest and cash taxes) leads to an increase in leverage to the mid to high 5x range. Even so, OI may not need a covenant waiver under the credit agreement given addbacks. Capital markets remain open for OI as indicated by the recent upsized new issue of 6.625% senior notes due 2027 (issued by subsidiary Owens Brockway). Proceeds were used to repay Euro notes due next year ($130 million) and outstandings on the revolver. We previously recommended the 2022 notes but now view the new notes trading at a y.t.w. of almost 6% as more attractive despite credit uncertainties. Buy on weakness at a y.t.w. of 6.5% or more.

LATAM Airlines Group S.A. (LTMCI): May 29

LATAM Airlines Group S.A. (LTMCI) has also filed for voluntary protection under the Chapter 11 in New York this week, which includes its affiliates in Chile, Peru, Colombia, Ecuador and the United States. LATAM Brazil is not included in the chapter 11 filing, as negotiations with local banks are continuing, but the company will seek the recognition by Chilean, Colombian and Peruvian courts of its filing in New York. In April, its passenger traffic was down by 97% year-on-year and its load factor had fallen to 50% and it had already announced that it would maintain a 95% reduction in traffic during May 2020. Yet, it had also announced last week that it would operate at 18% of capacity by July, increasing gradually its operations from 5% of pre-crisis capacity. Some of LATAM’s largest shareholders, Qatar Airways (10% shareholder) and two wealthy families close to the airline, are committing $900 million of new financing, in addition to the $1.3 billion in cash held by the company and the $600 million the company had available at the end of 2019 from 12 financial institutions, which has probably been utilized to fight the crisis, to support the reorganization process and continue the operations of the airline. However, we expect that this will be insufficient to restore the value for the bondholders. As of the end of 2019, the airline had $1.9 billion of current liabilities, mostly from interest bearing notes and loans and leases. Yet, the company is reaffirming its commitment to remain in operation, honor the tickets sold to its customers and pay both employees, suppliers and commercial partners. We had rated the LTMCI 6.875 04/24s at “underperform” in March. Their value has now plummeted to $18 for both USD-denominated bonds. We terminate coverage.

Hewlett-Packard Enterprise: May 29

…Free cash flow was negative in the first half of the year. That is not so unusual, but the amount was larger than it typically has been. The cash conversion cycle shrunk from minus 17 days last year to minus 5 days this year, requiring significantly more working capital. Given our outlook for weaker revenue, we project that free cash flow will be considerably negative in fiscal 2021. The company has suspended share repurchases, but has left the dividend intact. HPE issued $2.25 billion of notes in April to bolster its liquidity. Part of those proceeds will be used to redeem the notes due in October. Given our outlook for lower revenue and weak margins, we expect a huge decline in EBITDA this year. HPE may be able to achieve meaningful cost cuts, but margins may deteriorate nonetheless. Combined with the higher debt levels, we estimate that leverage will soar to more than 5x by year-end. Core leverage is still under 2x. Leverage could go even higher with some acquisitions, but we think M&A activity will be limited over the near term. Nevertheless, we think event risk is considerable based on the company’s history and the eroding revenue base. We maintain our sell recommendation, with the 2025 issue trading at a spread of +193 to the 5-year Treasury.

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