Evergrande Real Estate Group Ltd: June 14

The fate of Evergrande’s bonds is resonating beyond the real estate sector. Being the largest seller of high-yield dollar bond in China and one of the most systemically important borrowers in the country grants a special status to the company, alongside China Huarong Asset Management, one of the large issuers of investment grade bonds also in trouble, with an equally large amount of bonds in the markets. Any default by an issuer as large as these would send waves across the Chinese offshore bond market, reducing the access of other issuers, as a result of investors repricing their appetite for Chinese issuers. The domestic economy is also highly dependent on the development of its real estate sector, which represents about 10% of the country’s GDP. Chinese leaders have always been most fearful of instability: a disorderly unravelling of the traded debt capital markets would look very bad indeed. The fate of Evergrande’s loans rests in the hands of state-owned banks, which can decide to roll over its debt at the discretion of central authorities. The political importance of the issue is not to be undermined: the next USD-denominated bond Evergrande will need to repay is coming due on 28th June and on 1st July, the Communist Party of China will raise its glass to toast its 100th anniversary. Evergrande’s large debt pile is mostly short-dated. It has committed to meeting a net debt/equity ratio below 100% by 30th June, one of the three ‘red lines’ imposed by the government, by reducing its interest-bearing debt to CNY590 billion, from CNY716.5 billion of total borrowings. The next commitment is to achieve a cash/short-term debt above 1x by December 2021. It had CNY181 billion of cash equivalents as of 31st December 2020. Meeting these objectives will demonstrate to Chinese authorities that the group is working on meeting government policies. There is clearly no incentive for the government to pull the rug under the company’s feet. Having announced a +6% increase in contracted sales in May and a corresponding growth in its aggregate cash collection for the first five months of the year, Evergrande’s first goal, at least, appears to be within reach. The EVERRE 8.75% 06/2025s are currently yielding 19.4% (z-spread: 1,881bps), up from 16.5% (z-spread: 1,586bps) twelve days ago. The shorter-dated 8.25% 03/2022s rose to a yield of 25.5% (z-spread: 2,538bps). There are $16.3 billion of bonds denominated in US Dollars, widely held by a large range of institutional portfolios around the world. The local currency bonds are also priced at levels implying a significant chance of default. We see the price action as mostly driven by fear of the next move by the authorities: they have no choice but be supportive. Change to OUTPERFORM.

PACCAR Financial Corp.: June 14

On a consolidated basis, first quarter net income was $470 million, up 31% year-over-year. Worldwide revenues were $5.9 billion, up from $5.2 billion, reflecting higher truck and part revenues. The company projects higher truck industry retail sales this year, although, as with the auto industry, truck manufacturing is being affected by the shortage of semiconductors. PACCAR said that the shortage, along with other supply chain disruptions, reduced its truck deliveries by 3,000 units in the first quarter. It is hopeful the situation will improve by the second half of this year. The balance sheet is prudently managed, with $4.7 billion in cash and marketable securities on hand in the manufacturing segment. There is a $390 million of available capacity under a share repurchase program, but there were no buybacks in the first quarter and only $42 million completed last year (buybacks were temporarily suspended because of the pandemic). Last year, PACCAR Financial Services financed 28% of Kenworth, Peterbilt and DAF trucks. Financial services revenues were $432 million in the first quarter, up from $384 million a year ago. The financial services business had $15.5 billion in assets and $10.6 billion in debt as of 3/31/21. Nearly half (48%) of assets are in the U.S. and Canada; Europe accounts for 26%; PacLease for 16%; and Australia/Mexico/Brazil the remaining 10%. Total debt includes $5.7 billion in medium-term notes and $1.3 billion of commercial paper issued out of PACCAR’s U.S. finance subsidiary, a separate SEC-filer. Subsidiaries in Europe, Mexico, and Australia are also debt-issuers. Total equity attributable to the financial services business was $3.6 billion at the end of March, with a conservative debt/equity ratio of 3.0x (4.0x on a stand-alone basis for U.S.-based Paccar Financial). PACCAR has $3.6 billion in line of credit arrangements, of which $3.24 billion was unused at the end of the first quarter. Included in this amount are $3.0 billion in committed facilities (untapped) supporting the CP program. There is no manufacturing debt. Credit quality is currently strong at the finance company—credit losses and repossessions could increase if the economy weakens materially, but this would be from a very low base (currently 0.4%). PACCAR estimates that average earning assets in the financial services business will increase 4-6% this year. Current trends are positive for the company’s customer base (high levels of freight tonnage, freight rates, and utilization). As in the market for used cars, there is currently increased demand for used trucks (and higher pricing), which reduces the risk of loss on repossession. Although the parent does not directly guarantee finance subsidiary debt, there is a support agreement between PACCAR and PACCAR Financial Corp. which requires that the parent to ensure that the finance company fixed charge coverage ratio is at least 1.25 to 1. The parent must also maintain ownership of all the finance company’s stock. PACCAR Financial issued $300 million of 1.1% medium term notes due 5/11/26 in early May. The yield is skimpy (mid-teens over the five-year Treasury), so we view the bonds as an underperform on a relative value basis but consider PACCAR Financial a core holding for buy-and-hold investors.

Navistar International: June 14

…Manufacturing revenues for the fiscal 2021 second quarter ended April 30, rose 13% to $2.1 billion reflecting higher sales in all manufacturing segments. Truck sales increased 7% to $1.5 billion on higher used truck volumes, GM branded units, and Mexico volumes. Parts sales were up 18% to $524 million as the economies in the U.S. and Canada recovered from the impact of COVID-19 in the year ago period. Global Operations sales jumped 171% to $138 million on higher engine, power generator, and parts volumes in South America. On a combined basis, the manufacturing EBITDA margin nearly doubled to 9.3% as increased overhead absorption was partly offset by higher compensation and TRATON merger expenses. Fiscal second quarter manufacturing EBITDA jumped 125% to $198 million, easily beating the $162 million consensus estimate. LTM manufacturing EBITDA of $583 million covered interest 2.8x and leverage was 6.0x (3.9x net), improvement from 2.1x and 8.3x (4.2x), respectively, in fiscal 2020. NAV ended the fiscal second quarter with $1.3 billion of liquidity and no debt maturities until 2025. Fiscal second quarter free cash flow (cash flow from operations less capitals pending) increased $362 million to $131 million on higher earnings, shrinking the six-month FCF shortfall to $350 million. Total manufacturing debt of $3.5 billion was mostly unchanged year over year and year to date. During the fiscal second quarter, the company called for the June 25 conditional redemption (the scheduled TRATON merger closing date) of its $600 million of 9.5% senior secured notes due 2025 and $225 million of 4.75% tax exempt bonds due 2040, leaving the $1.1 billion of 6.625% senior notes due 2026 outstanding (callable on November 1). We do know a subsidiary of TRATON will be merged into Navistar, making NAV the surviving entity. Given the transaction will be initially funded with an intercompany bridge loan from Volkswagen and with the 6.625% senior notes due 2026 callable in early November, we anticipated the new NAV will likely be in the market to refinance its Volkswagen bridge loan and higher coupon outstanding bond issue over the near term. The 6.625% senior notes due 2025 have tightened to 1.2% given their likelihood of being called in several months. Remain outperform with limited upside.

Tyson Foods: June 11

…Although sales growth was rather modest in fiscal 2020, which ended in September, we expect better results in fiscal 2021. Sales were stymied last year by the impact of the coronavirus, particularly in Asia. But Tyson posted an increase in sales of almost 4% in the second quarter, and we are projecting even stronger growth in the last two quarters. Full-service restaurants continue to expand their capacity as the pandemic eases. Schools and cafeterias are returning to more normal schedules, thereby boosting foodservice results. In terms of segments, Pork has led the way, reflecting strong demand that has lifted average sales prices. Beef has been expanding just moderately, attributable to constraints on live cattle processed because of some severe winter weather. Chicken has been the weakest, due recently to volume declines because of COVID-related production inefficiencies. Operating margins were up in the first half of fiscal 2021. The biggest improvement was in Prepared Foods, which benefited from lower commercial spending, a favorable mix, and the partial pass-through of raw material costs. Chicken profitability has been poor, attributable to winter storms that lowered production and forced the company to purchase meat from outside sources. We anticipate some overall margin pressure in the second half because of inflation across the supply chain. Tyson is experiencing increases in grain, labor, and freight expenses. Margins will be constrained by COVID-related costs that management estimates will run about $365 million for the year. Expenses associated with COVID totaled $540 million last year. Management expects to be able to offset some of the cost increases with price hikes. Tyson produced more than $2 billion of free cash flow in fiscal 2020, which was considerably higher than usual. The key factor was the benefit from working capital. We expect some of that to reverse this year. Therefore free cash flow should be roughly $1.1 billion, which is just slightly under the average for the preceding five years. Tyson has already slashed debt by just over $1 billion thus far in fiscal 2021. Given our estimate for slightly higher EBITDA, combined with the lower debt, we expect leverage to fall from 2.7x to 2.4x at year-end. If the $500 million of notes maturing in August are paid off with existing cash, leverage would drop to 2.3x. While Tyson has made several acquisitions over the years, and will probably consider more in the long term, our sense is that the focus is more on organic growth in the near term. Capital spending is likely to increase this year as the company expands capacity. Yet free cash flow should still be sufficient to reduce debt significantly. Share repurchases have been minimal over the last several quarters. We like the outlook for steady revenue gains, stable margins, outstanding free cash flow, and declining leverage. We maintain our buy recommendation, with the 2029 notes trading at a spread of +50.

PAO TMK: June 11

The company didn’t provide a clear timeline for the expected increase in pipe prices going forward, but we believe that the effect will only be visible in late 2021 because the spike in scrap steel prices remains unabated. Besides, in our opinion, the company won’t be able to fully pass through higher raw material prices onto its customers. Apart from this uncertainty on prices, the underlying demand for the company’s products is good. Management expects demand for TMK’s OCTG pipes to remain stable in 2021 supported by the continued development of Oil and Gas companies’ existing and new projects, as well as the increased complexity of hydrocarbon production in Russia. In Europe, the company expects a gradual recovery in demand for industrial pipes. The integration of ChelPipe is progressing as planned. The company even announced that it will most probably exceed the initial guidance of potential synergies from this transaction. Besides, the group’s capital expenditure won’t spike as TMK guided for annual capital expenditure of $200 million this year, which is at the low end of the tentative forecast of $200 million-$300 million announced in March. Considering that the ChelPipe results were consolidated for only two weeks, the company posted a net leverage of 7.3x in 1Q21, which reflects ChelPipe cost but not its annual earnings. While we previously expected the company’s net leverage to decrease towards 4x in 2021, we now expect a net leverage of 5x this year, as we have moderately reduced our EBITDA forecast on the back of soaring raw material costs. When we last wrote on TMK, on April 1st 2021, we changed our view from “outperform” to “underperform” on TRUBRU 4.3% 2027 notes on account of tight pricing levels and the company’s shift towards a more aggressive strategy with the acquisition of ChelPipe and a planned substantial increase in dividend payments this year. These bonds were trading with a spread of 281bps in April and they now trade with a z-spread of 310bps (price of 101.6 and yield-to-worst of 4%). We stick to our “underperform” stance for now as we believe that the pressure on EBITDA margins from soaring scrap steel prices will be even stronger in 2Q and we would like to have a better color on the integration of ChelPipe assets before changing our view.

Johnson & Johnson: June 11

…When JNJ reported its first quarter results, its COVID-19 vaccine had just received emergency use authorization in February, and the vaccine’s revenue contribution was an insignificant $100 million in the quarter out of total revenue of $22.3 billion. Adjusted operational sales rose 6%, led by international sales growth of 8.2%, while the U.S. was up only 3.9%. (Note: Unless otherwise specified, sales comparisons are adjusted operational, which means excluding M&A and currency.) Results by segment were mixed, with Consumer Health down 2.9%, hurt by a tough comparison with an 11% increase because of pantry loading last year and a soft cough, cold, and flu season this year because of social distancing. The Pharmaceutical segment posted sales growth of 7.4%, led by immunology and oncology sales. In the Medical Devices segment, sales rose 8.8%, but some products continued to suffer from deferred elective procedures, while surgery and and interventional solutions business picked up. Medical Devices, like apparel, should have a “reopening” surge soon from a backlog of elective procedures. The sales mix was highly beneficial to pretax margin, with Medical Devices leading the margin expansion with a 650 basis point improvement (in an easy comparison). Margins were about even in Pharmaceutical and higher in Consumer Health. The company’s pretax margin expanded by 210 basis points to 37.1%, driven by strong gross margin performance and overhead cost leverage somewhat offset by a higher R&D spending rate on new products and vaccine research. Adjusted earnings rose 13%, and JNJ reaffirmed the midpoint of its full year reported sales and E.P.S. guidance, which represent increases of 10% and 18%, respectively. Guidance implies the pretax margin could improve by more than 200 basis points this year. JNJ’s sterling credit profile continues unblemished. The company ended the quarter with debt in excess of cash plus marketable securities of only $9 billion, down slightly from December. Cash plus marketable securities was nearly $25 billion, providing strong liquidity for expected special payouts. Subsequent to the end of the quarter JNJ paid $1.2 billion in tax reform installments and estimated taxes and this month will pay the $2.5 billion for the (reduced) talc litigation award, which the U.S. Supreme Court recently refused to review. JNJ has also committed to paying $5 billion in the global opioid settlement framework, which continues to be negotiated. Free cash flow in the quarter rose to $700 million, which might seem low but reflects the company’s huge dividend payout. Its cash flow for the quarter was more than $4 billion. Although JNJ does not issue cash flow guidance, we are projecting free cash flow this year increasing to $13 billion. We expect free cash flow to be used primarily for share repurchases (which rose sequentially to $1.4 billion in the quarter) and modest tuck-in acquisitions. With debt/EBITDA projected to remain around 1x, JNJ does not need to reduce its debt. Its scale, diversification, cash generation, improving profitability, and conservative financial policies underpin its excellent credit profile. We reiterate our “outperform” (2030 notes at T+24).

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