Gimme Credit

In announcing its merger with Celgene in January, Bristol-Myers Squibb said that it expected all of the debt of the combined company would be pari passu, without specifying the mechanism. Today the company launched a massive exchange offer for all of Celgene's bonds (except for one near term maturity) totaling nearly $20 billion. Each bond would be exchanged for a BMY bond with an identical interest rate and maturity. In addition, in return for early participation in the accompanying consent solicitation, each bond would receive one dollar in cash. The consent solicitation amends the Celgene bond indentures to eliminate "substantially all" restrictive covenants, certain events of default, and any restrictions on consolidation, merger, or sale of assets. Considering that Celgene was a smaller, higher risk company than the combination with BMY, this seems like a pretty good outcome for Celgene bondholders. Furthermore, if a majority of Celgene bondholders approves the indenture amendments, any holdouts would lose nearly all indenture protection. So it's essentially an offer Celgene bondholders can't refuse (unless they want to take the risk of holding out for a higher consent payment). We would point out, however, that BMY has been blessed with extremely lenient treatment from the rating agencies for this transaction, and that merger documents demonstrate that BMY management was initially willing to pay a considerably greater amount of borrowed cash for Celgene. This underpins our belief that BMY bonds are rich given its level of event risk.

PepsiCo stormed into 2019 with a 5.2% increase in organic revenue. The last time growth was this impressive was back in 2015. Organic growth was evident in all segments except Quaker Oats, where it fell 1%. Fortunately, Quaker is by far its smallest segment. On a reported basis, revenue rose 2.6%. However, management maintained its forecast for 4% growth for the full year, implying slower growth over the next few periods. Operating margins improved 120 basis points, highlighted by gains in Frito Lay and Latin America. Free cash flow was negative in Q1, which is not unusual. PEP repurchased $940 million of its shares, using its massive cash hoard. FCF will probably be negative for the full year too. But with leverage of only 2.4x, debt reduction stemming some FCF is not a priority.

After turning the corner late in 2017, IBM has now turned in three consecutive quarters of revenue declines, including a 4.7% decrease in the first quarter. Revenue plunged 11.5% in Systems, reflecting the IBM Z product cycle dynamics and weakness in Storage. Technology Services dropped 7.4%, partly due to the exiting of lower value content, while Cloud and Cognitive Services decreased 1.5%. To be fair, total revenue only fell 1% when adjusting for the currency impact. Cloud revenue only rose 10%, well below the average over the past two years. On the bright side, operating margins were up 270 basis points, including a 100 basis point increase in gross margins. The company benefited from better performances in both services businesses, as well as implementing new ways of working and leveraging automation and infusing AI into its processes. In addition, IBM had lower workforce re-balancing charges this year. IBM added more than $4 billion of debt in Q1. $920 million was used for share repurchases. Total leverage is now up to 2.9x, but adjusting for financing debt, core leverage is 1.2x. Leverage will increase significantly with the forthcoming Red Hat acquisition, slated for the second half of the year. IBM intends to suspend share repurchases in 2020 and 2021 as it pays down debt from that deal.

Yesterday Walmart issued $4 billion in bonds in three maturities with a weighted average coupon of just over 3%. The stated use of proceeds is the usual "general corporate purposes," which may include refinancing maturing debt. At the end of the fiscal year, Walmart had short-term debt of $7.5 billion (it repaid $364 million in February). Walmart resumed its normal level of share repurchases after the investment in Flipkart last year, but typically excluding acquisitions Walmart mostly lives within its free cash flow means. Free cash flow was over $11 billion last year and should be slightly lower this year. Therefore all signs point to the new issue being used to refinance debt, not adding to debt, as rent-adjusted leverage was slightly elevated at 2.3x. We think the new issue was attractively priced at T+67 for the ten-year, and we expect it to outperform.

Netflix posted some strong metrics and some weak metrics for the first quarter. The company added 9.6 million quarterly paid net adds, which was a record for the company. That total included 1.7 million domestic streaming customers and 7.9 million international streaming subs. Generally speaking, its international success is based on producing authentic local content and then taking that globally, rather than focusing on immediate global appeal. The subscriber increase, combined with a 3% increase in ARPU, led to a 22% increase in total revenue. Unfortunately, operating margins dropped 190 basis points, partly due to foreign currency fluctuations. The forecast for the seasonally weaker second quarter is not as impressive. Management is targeting paid net adds of 5 million, consisting of 300K U.S. subs and 4.7 million international subs. The skew reflects the impact of price changes that will be rolled out in the U.S. Management is expecting margins to improve due to the timing of spending. And now for the figure most critical to bond investors - free cash flow was a negative $440 million in Q2. Meanwhile, the company boosted its 2019 FCF deficit estimate to $3.5 billion because of higher cash taxes related to the change in corporate structure and additional investments in real estate and other infrastructure. Netflix expects to tap the high yield market to fund the difference. And it still expects to generate much better FCF in 2020, as it becomes self-funding. Management noted that it has no appetite for major acquisitions.

$1 billion of 10-year bonds at 115bps over and $1.25 billion of 30-year bonds at 145bps over Treasuries, or about 20bps inside the price talk, thus demonstrating a solid investor appetite for the new bonds. According to IFR, the initial book was as large as $7.5 billion, before falling back to $6.7 billion, as the lead managers tightened the initial price. The 30-year bonds seem to be particularly tight, given that they represent only a 30bps pick-up on the 10-year spread. We have an "outperform" on the Mexican telecom company, given the steady improvement in the credit profile and the free cash flow surplus.

Wells Fargo reported strong first quarter results, with net income of $5.9 billion up from the $5.1 billion the company earned a year ago. The results (ROA of 1.26%) show the resilience of the bank's franchise, despite ongoing regulatory problems which led to the recent departure of a second CEO, Timothy Sloan, last month (see comment on WFC dated 3/29/19). Shares are trading down in the equity markets this morning, however, as the company is guiding analysts to expect net interest income to decline by 2% to 5% in 2019, a sign that the cap on growth imposed by the Federal Reserve may be having some impact. Average deposits were down in the first quarter, but retail banking deposits increased, which we view as a positive indicator. Nonperforming assets increased sequentially, as there was a $500 million increase in C&I NPAs, but results were better than the year-earlier total, reflecting continued improvements in consumer credit quality. WFC said that the increase in commercial nonaccruals is partly because of "a borrower in the utility sector." The CET1 ratio is strong at 11.9%, even after WFC returned $6.0 billion to shareholders via buybacks and dividends. As we have previously discussed, WFC faces ongoing pressure from regulators, who believe the company's attempts to make amends and change its practices following the sales incentive scandal are falling short. The company now says it will seek a new CEO from outside the organization. Our credit score is stable.

In an unusual Friday morning merger announcement, Chevron said it is acquiring Anadarko Petroleum for an enterprise value of $50 billion. The E&P assets, especially in the Permian Basin, are complementary, but the price seems a bit steep for a friendly transaction at a 39% market premium. Anadarko's midstream business is less of an obvious fit, but management said they like these assets. Pretax cost synergies are expected to be a mere $1 billion, which seems small (at 1% of combined sales) for a transaction of this magnitude, with another $1 billion in annual capital spending savings. Chevron is financing the deal conservatively, with 75% stock and 25% cash, although it will increase its share buybacks by 25% or $1 billion. The cash portion is about $8 billion, an amount Chevron generated in free cash flow last year. In addition, Chevron plans to sell $15-$20 billion in additional assets from 2020-2022, with the proceeds used to reduce debt as well as to increase returns to shareholders. Our rough estimates show pro forma debt/EBITDA for Chevron increasing initially from 1.3x to 1.8x before synergies, mainly because of Anadarko's much higher leverage, but we expect this to be reduced over the next couple of years with free cash flow and asset sale proceeds. Pro forma book leverage will also increase from less than 20% to about 25%. We view this is a credit neutral event for Chevron, as the increased scale, opportunities for synergies, and better diversification offset the temporary increase in leverage. For Anadarko, a "five B" credit, this is a home run, even if Chevron assumes but does not guarantee its debt, as Anadarko will be a key element of Chevron's business, providing indirect support to the credit profile. Anadarko bondholders could also benefit from any refinancing of its high cost debt Chevron may embark upon, although Chevron management declined to comment on its plans for Anadarko's bonds.