Johnson & Johnson: July 26

…Meanwhile the company reported tremendous second quarter results, benefiting from an easy comparison with its weakest quarter last year, when COVID-19 negatively impacted most of its businesses. Sales on an adjusted operational basis (i.e., excluding currency, acquisitions, and divestitures) soared by 23.8% versus an 8.8% decline in the prior year period. (Note: Sales comparisons are on an adjusted operational basis.) The hardest hit segment last year, Medical Devices, swung from a 32.5% sales decline to a 58.7% increase. Within this segment, every line of business posted sales growth of at least 50%, and all but Orthopaedics (the market that has been the slowest to recovery due to the elective nature of many of its procedures) and Vision are well above the 2019 period sales. In Consumer Health, the most dramatic recovery came in skin health/beauty, with 12.9% growth, and segment sales rose 10%. Pharmaceutical posted 14.1% sales growth, above the market, as the base business (i.e., excluding the COVID-19 vaccine) grew a respectable 12.6%, with most core categories back to pre-COVID-19 levels. This sales mix (in addition to pension asset performance) was highly beneficial to pretax margin, which expanded by 430 basis points to 33.4%, still well below pre-pandemic margins. The most striking margin improvement came in Medical Devices, where the pretax margin climbed from 1.2% to 28.7%. As impressive as this comeback is, the segment’s margin remains about half of pre-pandemic levels. Somewhat offsetting this was a decline in the Pharmaceutical segment margin, attributed to portfolio life cycles and investment in innovation. The COVID-19 vaccine contributed only $164 million in sales and was dilutive to margins. JNJ projects full year vaccine sales of $2.5 billion, mostly in the fourth quarter, with an immaterial earnings contribution. Adjusted earnings were up by nearly 50%, and JNJ raised its full year guidance for sales and earnings. We have only the skimpiest balance sheet and cash flow information, but cash and marketable securities were just $8 billion less than debt, and free cash flow before dividends was a robust $8 billion. Market recovery, innovation, diversification, and cash generation continue to support a sterling credit profile (debt/EBITDA steady at 1x), despite some legal overhang. We reiterate our “outperform” (2030 notes at T+22).

Ecopetrol S.A.: July 23

Ecopetrol has announced that it was aiming for ‘net-zero carbon emissions’ by 2050. This will include a reduction of its direct emissions of 25%, relative to 2019, by 2030, and of its direct and indirect emissions of 50%, also relative to 2019, by 2050. This will include some major investments in renewable energy and energy efficiency, as well as carbon capture and sequestration technologies. This is likely to add to the capital expenditures that will be necessary to increase Ecopetrol’s assets. The current forecast is to increase the number of wells and reach 700 million barrels per day by 2021, up from 676 million, as well as develop the gas portfolio. Some investments are also needed in the midstream operations, with 8 projects of pipeline expansion. The total investment plan for the year amounts to $3.5-4 billion, with a ramp up throughout the year. 1Q21 has already recorded the largest execution of the last 5 years. The road to recovery is benefiting Ecopetrol. The EBITDA margin remains at high levels, driven by gains in the midstream and upstream segments, even though volumes are lower than a year ago. ISA has also recorded some strong results, with an EBITDA margin of 63.8% in 1Q21 and a net debt/EBITDA ratio of 3.2x. The combination of both companies will have only a small impact on the credit profile of a combined group, given the support from the Colombian government and the debt ratios of both entities. ECOPET 5.375% 2026 bonds yield 3.05% (z-spread: 233bps), against 2.26% (z-spread: 165bps) last February. This compares to 2.23% on COLOM 4.5% 2026 (z-spread: 156bps), a similar pick-up over the sovereign, compared to our last update. Petrobras bonds 8.75% due 2026 yield 2.5% (z-spread: 175bps), or 37bps higher than the BRAZIL 6% 04/2026s. Change to OUTPERFORM.

KeyCorp: July 23

…Relatively weaker growth is more of a concern for shareholders than for bondholders provided that a bank does not decide to materially weaken its credit standards to book more loans (which does not appear to be the case at KeyCorp). There were also positive offsets to the C&I declines in the second quarter, notably the investment banking and debt placement fees, which rose to $217 million in the second quarter, versus $162 million and $156 million in the linked-quarter and prior-year periods, respectively. Some clients who might have borrowed directly from the bank are tapping the capital markets instead. Also, while total average loans were down 7% year-over-year, consumer loans were up 9%, fueled by strength in consumer mortgages and at Laurel Road, the company’s new digital bank for medical professionals. KeyCorp has not made a large bank acquisition since it acquired First Niagara Financial Group for $3.7 billion in 2016. But it is investing in digital technologies, and on March 30, it launched Laurel Road for Doctors, a national digital platform aimed at physicians and dentists. On its earning call, the company said it has already added over 2,500 new clients. Marketing costs were up by $5 million sequentially in the second quarter, reflecting the roll-out of the new business. Medical professionals are generally high-quality credit risks, although the segment is competitive. Fifth Third said last month that it was acquiring Provide, a digital platform for healthcare practices. At KEY, the growth in mortgages and at Laurel Road is more than offsetting the runoff of the indirect auto lending business, which the company exited last year. As a regional bank with less than $250 billion in assets, KeyCorp was not required to participate in the Federal Reserve’s Dodd-Frank stress test exercise this year, and like most of its peers, it opted out. It already was assigned the minimum stress capital buffer (2.5%), based on last year’s results. Share buybacks totaled $300 million in the second quarter, leaving the CET1 ratio at 9.9% as of June 30, unchanged from the first quarter level, and well above the 7.0% regulatory minimum. In July, the board of directors approved a new one-year $1.5 billion share repurchase authorization. The company said it will consider an increase in the quarterly common stock dividend (currently $0.185) in the fourth quarter. Our credit score is stable: we expect KeyCorp to maintain a stable risk profile and a prudent capital structure. The 2.25% medium-term notes due 4/06/27 are seen at T5+71. Opinion: buy.

OJSC Novolipetsk Steel: July 23

The rally in steel and iron ore prices has slowed down in the first three weeks of July. Concerns about the spread of the Delta variant and Chinese pressure on commodities to curb its inflation data may temporarily weigh on prices but underlying global demand levels remain strong meaning that we expect steel prices to remain high in the back half of this year. On a more negative note, starting from August 1st, 2021, a 15% duty will be levied on Russian steel exports. The goal is to have more steel sold locally and, consequently, lower prices as the country is not immune to the risk of higher inflation. Considering that this export tax is currently expected to stand until the end of this year, the impact for NLMK and other Russian steelmakers isn’t overly worrisome, but we wouldn’t be surprised if the Russian government ultimately decides to extend the expiry of this tax. Overall, we have raised our EBITDA forecast for this year, to reflect the strong 2Q results and expectations that steel and iron ore prices are set to remain at relatively high levels in the back half of this year. In 2Q21, NLMK generated a pre-dividend free cash flow of $864 million as the increase in EBITDA was partly offset by an increase in working capital (higher inventory prices). Net of a dividend payment of $592 million, NLMK posted a free cash flow of $272 million. Net debt decreased accordingly, and its net leverage reached 0.4x (1Q21: 0.6x). Management recommended the payment of $1.1 billion of dividends for 2Q21 results, that is approximately 30% above the pre-dividend free cash flow it generated in 2Q. NLMK won’t boost its capital expenditure this year compared to FY20. In this context, we expect a continued decrease in net leverage throughout the end of this year and forecast a year-end ratio of 0.2x. Our most recent view on NLMKRU 2024 bonds was “outperform” at a z-spread of 148bps (on April 29, 2021). At that time, we reiterated our optimistic stance on these bonds as they were offering an attractive pick-up over underlying sovereigns and were trading close to levels offered by Evraz or Metalloinvest despite their weaker credit rating. NLMKRU 2024 bonds now trade with a z-spread of 75bps which, in our opinion becomes unattractive when compared to aforementioned peers (EVRAZ 2024s trade with a z-spread of 167bps). Overall, we believe that steel prices should remain elevated in the near term. In this context, we think that it makes sense to look for relatively more leveraged bond issuers which offer higher value. NLMKRU 4.7% 2026s trade at a price of 111.7, a z-spread of 130bps and offer a yield-to-worst of 2%. We change our rating on NLMKRU curve to “underperform” and we would recommend waiting for a more attractive entry point to reinvest into the company’s bonds.

Steel Dynamics: July 23

… Second quarter sales rose 113% year over year to $4.5 billion on higher pricing and shipments. Steel operating income surged almost six-fold to $1.0 billion on gains of 71% in the average steel price and 16% in external shipments. Metals recycling operating income swung $57 million to positive $51 million as higher domestic steel mill utilization led to increased ferrous scrap demand and pricing. Fabrication operating income improved a moderate 5% to $28 million as increased shipments and realized selling prices were partly offset by higher steel input costs. On a combined basis, the adjusted EBITDA margin widened 1,270 basis points on spread expansion as significantly higher steel selling prices more than offset an increase in ferrous scrap costs, especially for flat roll steel. Reflecting meaningfully higher sales and margin, the second quarter adjusted EBITDA jumped 375% to $1.0 billion, in line with the consensus estimate and up 55% from the first quarter. For the LTM, adjusted EBITDA of $2.3 billion (up $1.1 billion for the six months) covered interest 32x and leverage was 1.4x, significant improvement from 12.4x and 2.6x, respectively, in 2020. The company ended the second quarter with $2.3 billion of liquidity and no bond maturities until 2024. For the six months, free cash flow (cash flow from operations less capital spending) increased $92 million to $262 million as higher earnings were partly offset by increased working capital usage and capital spending related to the new Sinton Texas flat roll steel mill, shrinking the LTM FCF shortfall to $119 million before $213 million of dividends, $393 million of share repurchases (all in the second quarter), and $60 million of acquisitions. Reflecting this FCF shortfall, total debt rose $399 million year over year to $3.1 billion (flat sequentially) while cash on hand decreased $452 million to $1.1 billion. STLD continues to pursue both organic and transactional growth. Reflecting heavy rains in Texas, first shipments from the new Sinton flat roll mill will be delayed to mid-fourth quarter (100,000 tons in 2021 and 2.2-2.4 million tons in 2022). In addition, STLD is adding two new coating lines at a cost of $225 million to support product diversification at Sinton and spending $175-200 million for another two coating lines somewhere in the Midwest to support its regional flat roll steel operations with all four lines scheduled to be operating by the second half of 2022. At the same time the company moves forward with organic expansion, it is also exploring an active pipeline of potential downstream and/or value-added steel acquisitions. On its second quarter earnings conference call, management came across as highly optimistic macroeconomic and market conditions are in place to support strong domestic steel demand in 2021 and beyond. We look for leverage to decrease this year to 0.9x. The 3.45% senior notes due 2030 yield 2.1%. Reaffirm outperform with limited upside.

Coca-Cola: July 23

…Operating margins soared more than 200 basis points in the quarter, attributable primarily to the higher sales and the favorable channel and package mix, particularly the increase in away-from-home business. The discontinuation of the finished goods business of Odwalla also helped margins. These factors offset higher input costs, including commodity and transportation expenses, as well as the considerably higher marketing spending, which doubled year-over-year. The company is managing potential supply chain disruptions via supplier diversification and inventory management. The margin expansion was driven by the North America and Bottling Investments segments. Management expects the margin expansion to be constrained in the second half of the year because of the increased spending on marketing. Management clearly sees an opportunity to seize more market share and is actively pursuing that goal. Marketing goals include the increase of consumer-facing spending toward 2019 levels, improving the quality of the spending, and more effective targeting. The company will use pricing to counter some of the input cost inflation, as well as hedging some of the input cost pressures. Using its free cash flow of roughly $1.45 billion year-to-date along with some cash on hand, Coca-Cola slashed debt by $3.7 billion in the second quarter. Free cash flow rose versus last year because of the better income, some working capital initiatives, and a decrease in capital expenditures. Combined with the better EBITDA, leverage has dropped to 3.4x. The last time leverage was this low was in 2013. We think leverage could go even lower next year with some debt reduction and higher EBITDA. In addition, the company still has $9.5 billion of cash on the balance sheet. Coca-Cola has spent only a little more than $100 million on stock buybacks this year, providing plenty of flexibility for cutting debt further. Coca-Cola is generating impressive revenue gains, expanding its market share, boosting margins, and producing excellent free cash flow. Declines in debt and better EBITDA are pushing leverage lower. We think the stellar revenue growth will continue even after COVID-19 impact cycles by the end of the year. These positive factors outweigh the possibility that variants of the coronavirus lead to reduced consumer mobility and lower away-from-home consumption. We reiterate our outperform recommendation, with the 2031 notes trading at a spread of +34.

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