Consumer
As the sluggish economic recovery decelerates and firms face tougher year-over-year comparisons, we do not expect much positive news to come from our consumer coverage as the calendar year comes to a close. In our view, consumer companies will face stagnant revenue growth and experience margin compression in the coming quarter.
Consumers are still skittish, and we expect retail and restaurant traffic to be flat to down. Consumer staples should hold up due to the segment's defensive nature, but we expect discretionary purchases to remain constrained.
Thus far in 2010, cost-cutting has borne fruit, and most companies have realised strong margin gains. However, for the remainder of the year, we expect to see some reversal in this trend as firms struggle to pass through higher commodity prices to the consumer and promotional activity remains elevated. We don't expect consumer products companies to ease promotional spending as they battle for market share. We also believe advertising spending will increase as companies endeavour to drive sales volume growth. After a muted back-to-school season, retailers will look to improve holiday traffic, and the value-menu party is still going for restaurants.
In light of these headwinds, we expect capital spending to remain conservative, which will allow for more free cash flow to go toward debt repayment. We believe improving the balance sheet--or maintaining a strong one--remains a top priority for management teams. For example, Macy's (M: BB+), J.C. Penney (JCP: BBB-) and Dollar General (DG: BB+) have all focused on using excess cash flow to pay down debt in the first half of 2010, a welcome sign that we expect to continue. In addition, Macy's and J.C. Penney are still abstaining from share repurchases, which we believe is prudent given the persistent economic weakness. Even with improving credit metrics, however, we don't expect credit spreads in the consumer space to outperform the general credit market absent a positive near-term catalyst.
A final risk for some of our names would be private equity financed M&A activity that could impair existing bonds depending on change-of-control provisions. Fuelled by the recent takeout of Burger King (BKC) by a private equity firm, rumours continue to swirl around Wendy's/Arby's (WEN: BB) and Saks Fifth Avenue (SKS: B).
The media sector generally continues to see a small top-line lift as the upward trend in ad spending improves. We expect margins to remain healthy as the sector has already been running lean, and any top-line growth should provide some operating leverage. As such, among the more stable credits in the sector, such as Viacom (VIA: A-), we expect share repurchase activity to continue, which we do not take issue with given its stable credit metrics. At this point in the cycle, we believe the bonds in the media sector are generally trading appropriately, and therefore have a higher risk for underperforming than outperforming.
Energy
If it weren't for an influx of foreign capital supporting drilling to hold acreage leased during the boom (much of it expiring in 2011 if drilling commitments aren't met), energy budgets and the US gas rig count would be much lower today, in our opinion.
At about 980, the US gas rig count is well above the 700 that were active at this time last year. This rising gas rig count flies in the face of what we expect will be lower gas prices in the fourth quarter of 2010 compared to 2009. Very few of the E&P companies we cover have been able to fund their drilling budgets through internally generated cash flow during 2009-2010. More than $40 billion has come in from foreign JVs, and those that haven't participated in JVs have mostly sold assets and issued long-term debt. If we assume half of the $40 billion raised in JVs went to immediate balance sheet repair (as many companies that signed JVs were among the most financially distressed), then the remaining $20 billion could help explain how drilling held up so well despite very low gas prices.
If we assume the average horizontal gas well costs $5 million, and it takes 50 days to drill and complete these wells (which we think is a reasonable average of Haynesville, Eagle Ford, Fayetteville, and Marcellus Shale wells), then each rig running would drive $36.5 million in capital spending annually for an E&P company. So how much are the extra 280 rigs (980 minus 700) requiring E&P companies to spend each year on new wells? That's an extra $10.2 billion per year, or roughly our $20 billion estimate of excess cash raised from the JVs spread over two years. With the new JV money sunk largely in the ground now (or used in debt repayment), and lease expiration pressures set to subside as we push through 2011, we are likely to see a different set of US supply fundamentals taking over. Those fundamentals will be driven largely by companies living within cash flow, which suggests a falling gas rig count. And, higher gas prices will be required to lift cash flows and fund greater drilling activity.
Companies have leaned more heavily on debt markets and asset sales relative to equity markets to improve liquidity, conduct deals, and fund budgets. This activity could support our view that energy sector equity appears a bit undervalued presently, though not by much. We'd need to see sustained oil- and gas-price strength or further equity multiples improvement to justify significant credit gains from here, in our opinion.
Health Care
With shares of both established and developing health-care companies often trading below what we think they are worth, we've seen more posturing around two activities that could hurt the credit profiles of covered firms--acquisitions and share repurchases.
For example, Genzyme (GENZ) and several Boston Scientific (BSX: BB+) units appear to be on the auction block, as those management teams feel the market hasn't been valuing their firms appropriately for an extended period of time. We wouldn't be surprised to see those and other deals finalised in the next few months.
In the case of Genzyme, our analysis suggests potential acquirer Sanofi-Aventis (SNY: AA) would deserve a credit rating downgrade if it completes the deal with Genzyme at recent prices or higher. On the other hand, the rumoured suitor for Boston Scientific's neuromodulation unit, Stryker (SYK: AA+), is so cash-rich that even a premium-priced deal for that unit probably wouldn't move the needle on its current credit rating.
Along a similar vein, share repurchases appear to be on the rise due to the recent slump in share prices in this sector. Established health-care companies typically have admirable cash-flow-generating abilities, which is one of the reasons why they often score so well in our credit rating methodology. However, with cash building on their balance sheets, manageable debt positions at low interest rates, and slumping stocks, health-care management teams may choose to reward shareholders rather than save that cash for future debt repayment. While we don't necessarily believe such behaviour is friendly to debtholders, we haven't been concerned about repurchases materially damaging these firms' abilities to repay debtholders yet. If repurchase activity accelerates beyond our current expectations, we may consider some credit rating downgrades at covered firms. For example, Baxter and Gilead are companies we currently have on a short leash.
