Celulosa Arauco y Constitucion SA: November 23
…Arauco posted a positive free cash flow of $168 million in 3Q20 (3Q19: $93 million). Its net leverage decreased quarter-on-quarter to 5.6x (2Q20: 5.9x) and the company expects a continued reduction in 4Q and 2021. We also believe that a peak leverage of approximately 6x was reached in mid-2020 and we now forecast a net leverage of 5.4x in FY20, 4.7x in FY21 and approximately 3x in FY22 when the company will operate its new 1.6 million pulp line (MAPA project) and cut its capital expenditure. Arauco’s parent company (Empresas Copec S.A.) decision to increase Arauco’s capital by up to $700 million (with $250 million already paid in September 2020 and up to $450 million to be paid in 2021, depending on the resources required during that year) also contributes to this expected improvement in credit measures. Arauco’s leverage ratios remain quite elevated compared to its local peer CMPC but, with resilient market conditions in Wood products and a gradual recovery in pulp market conditions, we believe that Arauco is on track to substantially reduce its net leverage ratio within the next two years. Meanwhile, Arauco has a strong liquidity position and a good access to capital markets to counterbalance the still elevated capital expenditure expected in FY21 to complete the construction of its MAPA project. CELARA 4.2% 2030 notes trade at 110.4, a z-spread of 215bps and offer a yield-to-worst of 2.86%. This compares well to CMPC’s 3.85% 2030 notes which trade at a z-spread of 172bps. CHILE 2.45 2031 USD-denominated bonds trade with a z-spread of 85bps and we believe that the spread of CELARA bonds over the spread of the underlying sovereigns may tighten further. Hence, we change our rating from “underperform” to “outperform”, although we expect a limited upside potential.
Wells Fargo: November 23
…Wells Fargo has already decided to exit the private student loan business. The $10 billion portfolio is half the size of Sallie Mae’s business, which has $21 billion in private loans, and a small fraction of WFC’s total loans. Originations dropped 56% year-over-year in the third quarter, reflecting the decision to exit the business, as well as the negative impact of Covid-19 on college enrollments. President-elect Biden is supportive of the idea of allowing private student debt to be discharged in bankruptcy, although since WFC decided to exit the business in September, it is not clear that politics played a major role in the decision. The average FICO of borrowers is 771, with 84% of outstanding loans co-signed by a parent or other responsible party. Other business units which could potentially be sold include Wells Fargo Asset Management ($607 billion in assets under management) and a portfolio of store-brand credit cards (a segment in which WFC ranks behind larger players including Synchrony, Citigroup and Capital One.) Exiting noncore businesses is one way to ensure that Wells Fargo stays within the constraints of the Federal Reserve’s asset cap, which remains in effect, but does not answer the question of how the bank will generate new revenue to offset the activities it discontinues. Like other big banks, Wells Fargo has had to suspend share buybacks through at least year end, at the direction of the Federal Reserve. It is also among a smaller number of banks that had to cut its common dividend, because its earnings over the four preceding calendar quarters did not meet the Fed’s required benchmark. With distributions to shareholders and asset growth constrained, Wells Fargo’s CET1 ratio increased sequentially to 11.4%, up from 11.0% at the end of June (but down from 11.6% a year ago). Our credit score remains stable but given the risk for increased credit issues in 2021 (particularly in portfolios such as commercial real estate) and for ongoing disruptive restructuring activities, we maintain an underperform opinion on the WFC 2.572% notes due 2/11/31, seen at T+100.
Evergrande Real Estate Group Ltd: November 20
…The expected primary offering of Evergrande Services may be at risk, if the market turmoil worsens. Recent similar offering by some competitors have been followed by a fall in share prices, which will cause investors to become more cautious for such investments. KWG Living’s stock was reoffered at a price 34% lower, compared to its end-October offering price. Shimao Services also lost value since it priced on 29th October, despite receiving 13.9x more interest than the stock on offer. Not all offerings have underperformed: Sunac Services, for instance, rose +22% when it priced earlier this week. But the pricing was conservative, in the middle of the price talk, while previous offerings had been priced at the top of the range. Even if China has been able to contain the pandemic relatively better than the West, the global economic crisis is causing the economy to slow down and it is expected that the real estate sector will be hit. The authorities will most certainly soften their tightening measures to support any price slump, but the next few months will see weakness. It is the refinancing risk that is causing the most worries. Trust loans have been, over the past few years, an instrument of choice for the financing of real estate developments. However, over the last few months, Evergrande has dramatically reduced this source of financing, as a result of regulatory measures. The Chinese authorities are worried that the economic slowdown will cause a deterioration of speculative investments, in particular in the real estate industry. The new risk is a wave of defaults seen in the Chinese local high yield bond markets, which will make investors more cautious. Two issuers linked to the State have just announced the default on their local bonds, bringing the question of government’s willingness to step in. Evergrande bonds have always been a speculative play. The EVERRE 8.75% 06/2025s are currently yielding 16.9% (z-spread: 1,649bps), not a big difference from our last update. At this juncture, we believe that it is more prudent to avoid the bonds and weather the storm. It is time to be cautious. Change to UNDERPERFORM.
T-Mobile US: November 20
…T-Mobile now covers 270 million people across 1.4 million square miles with its 5G network and expects to cover 100 million people with its 2.5 gigahertz spectrum by the end of the year. Free cash flow may be constrained even further by the potential for more spending on spectrum, as the C-band auction is coming up, although we do not expect T-Mobile to be as aggressive as Verizon or AT&T. T-Mobile used cash on hand to reduce debt by more than $6 billion in the third quarter, bringing leverage to 3.4x. However, T-Mobile issued $9 billion of secured debt after the quarter closed, pushing leverage back near 4x. We suspect much of the cash will be used to redeem forthcoming maturities of debt. However, the secured funding disadvantages the unsecured bondholders. Although margins rose in the third quarter, they are likely to be pressured by extensive merger-related costs, which management has warned will increase significantly in the next few quarters. Meanwhile, integration expenses are likely to amount to nearly $15 billion. Unfortunately, COVID-related spending may increase significantly, depending on the extent of its spread. In addition, fourth quarter margins typically decline because of the added selling and promotional expenses associated with gross adds during the holiday season, especially with the launch of the new 5G iPhones. Lease expenses will be higher because of the recent tower agreement. We noted in our last report that T-Mobile intends to derive substantial synergies from the decommissioning of Sprint sites. However, those savings may not appear for a year or more. Conversely, the integration expenses should be heavier in the near term. Admittedly, the industry-leading subscriber additions and declining churn within the context of a superior 5G network are impressive. However, we expect some margin pressure from the hefty integration charges. Meanwhile, free cash flow will likely be negative in the near term because of the huge capital spending. The purchase of additional spectrum could require further cash outlays. We confirm our sell recommendation, with the 2028 unsecured notes trading at a spread of +125, and a yield of 2.13%.
Meritor: November 20
…While the COVID-19 pandemic remains an overhang, the global industry is projecting fiscal 2021 production volumes of 300-350,000 medium to heavy duty truck units, down to up slightly from 345,000 units in fiscal 2020. Based on this estimated global production range, the company provided fiscal 2021 guidance consisting of expected sales growth of 2-10% to $3.1-3.35 billion (including $100 million of new business partly offset by $75 million in lower Aftermarket revenue from the WABCO distribution termination), a 30-130 basis points increase in the adjusted EBITDA margin to 9.2-10.2% (from higher volume and $30 million of fiscal 2020 cost actions), cash flow from operations of $145-185 million (down from $265 million), and free cash flow of $60-100 million (down from $180 million). Based on our updated projections we look for fiscal 2021 leverage to decrease to 3.8x. The company noted a commitment to maintaining strong BB level credit metrics. As MTOR’s adjusted EBITDA starts rebounding in fiscal 2021 and benefits from new business in fiscal 2021 and 2022, leverage should head towards pre-pandemic levels aided by expected second half fiscal 2021 debt reductions (share repurchases are likely to resume in fiscal 2022). For the near term, global pandemic uncertainty keeps us cautious. The 6.25% senior notes due 2024 yield a skimpy 3.5%. We reaffirm underperform.
TJX: November 20
…TJX is in much better shape to withstand a second wave of store closings or capacity restrictions. Third quarter cash flow jumped by $3 billion, owing entirely to working capital movements. Having suspended the dividend and share repurchases and slashed capital spending, TJX generated a whopping $4 billion of free cash flow in the quarter. With total debt unchanged, this cash built up on the balance sheet. TJX ended the third quarter with $10.6 billion of cash, well in excess of its $6.2 billion of debt. The significant decline in EBITDA over the past four quarters has sent lease-adjusted leverage up over 4x. We project leverage will get somewhat worse by the end of the year, assuming none of the balance sheet cash is applied to debt reduction. With such strong liquidity and vastly improved financial flexibility, TJX will reinstate its dividend at a 13% higher level this quarter (prematurely, in our view, given continued uncertainty). We estimate this will consume $1.3 billion of cash annually. The company refinanced some debt this week, tendering for up to $750 million of bonds issued at the worst of times in April. (Ross recently did a similar refinancing.) This will result in considerable interest savings but will leave debt levels unchanged. It tells you all you need to know about corporate spreads (especially for pandemic sensitive names) that TJX’s new ten-year bond was issued at a spread of T+73, replacing a ten-year bond issued in April at T+320. Still, we thought the new issue was priced attractively relative to high quality retailing peers. Therefore, we are moving to an “outperform.”