Gimme Credit

This morning Newell Rubbermaid reported respectable fourth quarter results and initiated relatively bullish guidance for 2012, especially given an uncertain economic environment and in particular weakness in Western Europe. The stock market seemed to like this, sending shares up 8%. Core sales rose 3.7% in the quarter, while adjusted earnings were up 20%. Operating margin expanded by an impressive 150 basis points, benefiting from expense savings that more than offset a slight decline in gross margin because of input cost inflation and operational issues. All three segments posted stronger sales excluding currency led by a very strong performance in Tools, Hardware, & Commercial Products. But sales performance by geographic region was mixed, with currency adjusted sales falling in Canada and the Europe, Middle East, and Africa regions and up double digits in Latin America and Asia Pacific, with the U.S. in between with a 4.4% increase. The best news came on the cash flow and balance sheet front, where $250 million of free cash flow for the year enabled a $220 million decline in net debt. This led to an improvement in leverage, which fell below 2.5x for the first time since 2009. We expect a similar level of free cash flow this year with a further modest improvement in leverage.

Ford's strong 2011 ended with a whimper. The auto manufacturer reported fourth quarter results that fell short of consensus expectations due to weakness in Europe, flooding in Thailand, and higher than expected commodity costs. Fourth quarter automotive revenue was up 8% to $32.6 billion while automotive pre-tax operating income (excluding special items) fell 21% to $586 million. North America was the driver of fourth quarter performance with pre-tax income improving 33% to $889 million, but margins were down year over year due to higher production costs. Although still profitable, operating income in South America fell 62% to $108 million. But Europe and Asia Pacific Africa posted operating losses of $190 and $83 million, respectively. The company ended the quarter with $22.8 billion of automotive cash and $32.4 billion of total liquidity. Ford generated automotive operating-related cash flow of $700 million in the fourth quarter, down from $1 billion in the year ago period. For 2011, automotive operating-related cash flow was a healthy $5.6 billion. During the quarter, automotive debt increased $400 million to $13.1 billion as the company took advantage of U.S. Department of Energy loans to help fund its fuel-efficient cars. For the year, however, total debt was reduced $6 billion. Despite speed bumps along the way, improved operating results and cash flow generation should lead to stronger credit ratios over the intermediate term.

Time Warner Cable lost 129K basic video subscribers in the fourth quarter, but that was about the only bad news included in its operating results. The company added 117K high-speed data subs and 50K digital telephony subs. Roughly 75% of the broadband net adds took Turbo or higher packages. More impressive was the 37% increase in business services revenue, which drove total revenue up by 4%. ARPU rose 4.2% to $115. EBITDA margins rose by 120 basis points to a high for the year, attributable mainly to lower programming expenses. The solid revenue growth and better margins led to free cash flow of $2.1 billion in 2011. Unfortunately, the huge cash flow was not used to reduce debt. In fact, debt actually increased by $3.2 billion to fund the $2.7 billion of share repurchases and the upcoming Insight purchase. The increase in debt left leverage at 4.3x at year-end. TWC is raising its dividend by 17%, incrementally draining $110 million annually. The company also announced a $4 billion share repurchase authorization. Free cash flow will be diminished by higher cash taxes in 2012, stemming from the step-down of bonus depreciation.

Yesterday CAT reported strong fourth quarter and full year results and based upon a stronger global demand outlook the company has already raised its sales and revenue guidance for 2012 to $68-$72 billion. Year-over-year comparisons are distorted by the closing of the Bucyrus purchase in July and other acquisitions, but excluding the impact of the Bucyrus acquisition 2011 consolidated sales and revenues rose 35% and E.P.S. soared 88%. With the same exclusion of the Bucyrus impact, fourth quarter sales and revenues rose 24% and E.P.S. was up 53%. In 2011 CAT's sales grew faster than the industry and it was able to achieve modestly higher price realization. CAT's order backlog grew by $7 billion even without the impact of the Bucyrus acquisition, and for some products it is capacity-constrained. At the nonfinance operations (now called Machinery and Power Systems), the balance sheet remains extremely strong, with debt/EBITDA holding steady at 1x despite two large acquisitions (book leverage below 43% even with a big pension liability hit), while free cash flow followed earnings upward and also benefited from working capital management, increasing to a record $4.3 billion for the year, providing substantial financial flexibility. We expect management to continue to pursue conservative financial strategies especially after the big acquisition spending of 2011 and the expectation of elevated capital spending going forward.

This morning Eastman announced it was acquiring Solutia for an enterprise value of $4.7 billion in cash, stock, and assumed debt. The premium being paid is a whopping 42%. The use of stock to fund roughly 20% of the price for the equity (but only 15% of the total value) is obviously a gesture towards lessening the credit quality damage of the acquisition. Nonetheless, we estimate EMN's pro forma debt/EBITDA will nearly triple to 2.8x before synergies. Substantial free cash flow (much of it coming from the tax advantages of the deal) should allow debt reduction to proceed at a fairly swift pace. Management stated its commitment to investment grade ratings (as they all do) but we note that this could encompass a one-notch downgrade to weak triple 'B.' Although these are two specialty chemicals companies they are still subject to cyclical variability in cash flow, and we consider 3x leverage pushing the envelope for an investment grade company with this amount of business risk. In our view it would be best to consider the combined companies as having a weak triple 'B' credit profile with a good chance of improving as debt is paid down and synergies are achieved, assuming the global economy cooperates. New bonds issued to fund this deal (and there will be plenty) should be priced accordingly in order to offer value. Please see our upcoming report. UPDATE: The stock market has smiled upon the Solutia acquisition (EMN's stock was up as much as 11%) and so have the rating agencies. Both major agencies affirmed EMN's current mid triple 'B' ratings, although Moody's understandably lowered its outlook from "positive" to "stable." Both presume leverage will be reduced meaningfully over the intermediate term and that cash will not be used for share buybacks or M&A. We assume this crucial promise came directly from company management, as this was not quite the message we took away from the conference call.

Transocean won an important ruling in federal court yesterday, when its indemnity agreement with BP was upheld with respect to compensatory damages related to the Macondo/Deepwater Horizon disaster. At stake was whether or not RIG would be liable for any of the damages for which BP established its $20 billion fund. Per the WSJ, New Orleans District Court Judge Carl Barbier ruled the indemnification agreement is valid with respect to compensatory damages. At the same time, the judge ruled BP need not indemnify RIG against civil penalties and punitive damages that may be assessed under the Clean Water Act. This was a pre-trial motion - the actual damages trial begins the end of February.

OI's fourth quarter results beat market expectations but they were right in line with our projections. Global glass shipments were up 4% year over year in the quarter with good growth in Europe--a bit unexpected because that region has shown weakness. For the full year overall sales were up about 10% to $7.3 billion and adjusted EBITDA was a small 2% increase over 2010 at near $1.25 billion. Net debt of $3.63 million was basically flat with last year and net leverage (using the credit agreement EBITDA) was 2.9x. There was some noise in the quarter's EBITDA with a large goodwill impairment and restructuring charges that well exceed last year. Nevertheless, OI expects the business to continue to improve in 2012 and although inflation costs which dragged on 2011 won't be recouped, price increases this year will mitigate inflation. OI continues to generate good free cash flow (meeting its guidance this year at $220 million and next year has projected near $250 million. THere is also some good news on the asbestos front as payments have declined over the last 4 years (still substantial at near $170 million). OI is one of the more recession resistant high yield credits with strong credit measures and we had recommended bonds last November when yields were near 7%. The bonds have performed very well but current yields are low. Stay tuned for more details on the quarter and full year operations as well as our 2012 projections.

Charter announced the initial results of tender offers (see our note of 1/11/12) and tendering holders at the initial date received the additional early tender payment. Charter also said the total maximum purchase price will be $843 million. Holders of about $300 million of the 8% second lien notes due 2012 and $294 million of the 10.875% second lien notes due 2014 have tendered, easing near term maturities. Charter will accept those for purchase along with some of the $334 million tendered 13.5% senior notes due 2016 (that total issue is near $1.5 billion so a major part will remain outstanding as the total purchase price is $843 million).

United Continental Holdings joined Delta, US Airways, and JetBlue in reporting better than expected revenue and earnings today for the fourth quarter. However, unlike the others, United's stronger fares were not enough to offset further increases in fuel expense. Consolidated revenue was up 6% versus a tough comp in 2010 when pro forma revenue increased 15%. Fuel expense was up 26% however, which was the primary reason that EBITDA was down 15% to $684 million (a 7.7% margin). The net profit was roughly $110, excluding unusual charges for restructuring and other items, versus similarly adjusted $160 million in 2010. United's respectable results were outshined by spectacular numbers posted by Delta yesterday, which reported an 8% increase in consolidated revenue. Delta managed to hold fuel expenses in check with strong hedging benefits--though that line item also included gains from previous periods--which drove a 32% increase in EBITDA and a whopping 138% increase in net income (excluding special items and gains). Delta's performance marked its most profitable December quarter ever, and it has trounced United for the second straight quarter. United is definitely up for the challenge, however, and we continue to rate it and Delta "outperform." We will have more discussion in an upcoming report.

Nokia and its investors can celebrate the fact that more than 1 million Lumia devices, the company's new Windows-based phones, have been sold since inception. But there is little else to cheer about. Revenue in the Devices and Services segment plunged 29% in the fourth quarter, its worst showing of the year. Smartphone unit sales dropped sharply, suggesting sales of the new phones were more than offset by decreases in the sales of older phones. Average selling prices were significantly lower. Margins were higher on a sequential basis, but remain well below targeted levels. Management revised its estimate for Symbian device sales downward, reflecting the disappointing performance in the quarter. Margins for the first quarter are expected to be essentially zero. Revenue in the Nokia Siemens Network segment fell 3.7%, and would have plummeted 11% if not for the assets acquired from Motorola Solutions. Although it did derive materially positive earnings for the first time in a few years, operating margins are projected to be negative in the early part of 2012. Overall, management is viewing 2012 as a year of transition, and therefore is not providing financial guidance for the full year. Nokia burned through roughly $1 billion of cash in 2011. The considerably lower EBITDA produced in 2011 drove leverage to 3.4x versus 1.4x at the end of last year.

Data released today showed that new home sales in December were much weaker than market consensus, down 2.2% versus November (which also was revised slightly lower) and down 7.3% y/y. Also troubling was that sales foundered even though the supply of new homes for sale also has dropped to a new all time low at a 157,000 annual rate--slightly lower versus November and down 17% y/y--so inventory crept higher to 6.1 months of sales. This comes on the heels of similarly disappointing numbers for pending sales and housing starts. Indeed, the only positive trend in recent data was a modest though less than expected increase in December existing home sales. We still believe that the housing market overall has probably bottomed, but we still aren't seeing sufficient catalysts to drive a meaningful rebound. Moreover, the data continue to support our concern that the new home market is suffering from the increasingly competitive supply of comparatively newer exiting homes which offer most of the same bells and whistles as new homes at lower prices. The current level of new home sales is decidedly unprofitable for all but the healthiest builders, yet efforts to increase prices in December obviously scared off buyers. This has set the stage as we expected for a decisive differentiation across the segment in 2012 as healthier homebuilders with higher margins and more cash gain increasing share of the relatively static market at the expense of weaker builders that simply can't afford to stay competitive. A great example of this is the broad and accelerating performance gulf between our top pick Lennar and Hovnanian, which remains on our critical condition list. Lennar continues to deliver above average sales, orders, and profit margins versus its peers and indicated industry trends. As a result, Lennar's LTM EBITDA margin is now more than twice the group average at 9.6% and it can comfortably cover both land and development costs plus interest costs on its debt and still retain strong unrestricted cash at above average levels versus its peers (as a percentage of sales). By comparison, Hovnanian has persistently trailed its peers in sales and profitability through most of the market decline, EBITDA has been negative, and unrestricted cash is critically weak. In the most recently reported quarter ended November, Lennar's housing revenue was up 12.5% on a 10% increase in homes delivered and a 2.5% increase in average pricing (see our report "Still On Top" on 1/13/12.) Orders were up an impressive 21%. Lennar continued to lead its peers with a housing gross margin (excluding interest and impairment charges) of 23.9% and EBITDA margin of 9%. As a result, Lennar has been the most consistently profitable of its peers with seven straight quarters of positive net income. Hovnanian, on the other hand, reported its seventh straight quarter of net losses as of October as housing revenue fell 8% on a 9% decline in homes closed. Orders fell 6%. (See our Hovnanian report "Oh No, Another Year" on 1/5/12.) Hovnanian's housing gross margin fell 150% basis points to 15.45%--well below guidance and the 20% peer average. EBITDA margin was 2.6%, a rare positive result as EBITDA of $8.7 million was boosted by the unusual sale of an $18 million lot in New Jersey. It's going to take much more than luck to sustain Hovnanian through even one more year of weak housing market sales, and we remain concerned that it may be forced to recapitalize before the year is out to preserve the cash it has left. We expect Lennar's competitive advantage in the market will continue to grow at an accelerating rate.

Peabody Energy (BTU) reported disappointing fourth quarter EBITDA, falling short of our forecast due to lower than anticipated output at its Australian operations. A roof fall and delayed longwall relocation at the North Goonyella mine that reduced output in the third quarter continued to adversely affect output in the fourth quarter. In addition, the company provided first quarter guidance that was below the consensus estimate as the company will be moving a longwall at a mine in Colorado. Revenues for the fourth quarter rose 26% to $2.3 billion reflecting an increase in tons sold and selling price. Operating profit per ton improved $0.98 to $6.11. As a result, fourth quarter EBITDA increased 29% to $587 million. For 2011, EBITDA of $2.1 billion was about $50 million less than our estimate, covering interest 11x and leverage was 3.1x. For the first quarter, BTU forecasts EBITDA of $500-600 million, up from $416 million in the first quarter of 2011, but below the $710 million consensus estimate. We will be initiating 2012 projections and reviewing our rating shortly.

Similar to Verizon, AT&T reported tremendous progress in its wireless operations. The company added 2.5 million net subscribers in the fourth quarter, including 717K net postpaid adds, 159K net prepaid adds, 592K reseller net adds and 1 million connected device net adds. AT&T activated more than 7.6 million iPhones (compared to 4.3 million at VZ), and had 9.4 million smartphone sales. Smartphone users now comprise 57% of the total customer base. These additions and a 1.4% increase in postpaid ARPU led to a 10% increase in wireless revenue. And just as margins were battered at Verizon, AT&T reported a wireless operating margin decline of more than 900 basis points. Wireline revenue fell 1.4%, which was not surprising. However, margins plunged more than 200 basis points, which was unexpected. Net income was negative, reflecting a huge charge for the break-up fee associated with the T-Mobile USA proposed deal. AT&T used its cash hoard to reduce debt by $6.3 billion in the quarter, bringing leverage down to 1.6x at year-end. The company announced a 300 million share repurchase program, which at current prices amounts to roughly $8.9 billion. Stock investors appeared to be disappointed with guidance for 2012 EPS growth of at least mid single digits, as consensus called for an 11% increase. Revenue is expected to rise 2% while capital expenditures are estimated to be $20 billion.

Updating our earlier comments on EQT earnings and near-term liquidity, the company intends to file an S-1 this quarter for an MLP of its midstream operations. While this does not foreclose a JV or outright sale of the segment, EQT is moving ahead with this option. Until the S-1 is filed, we will not know how much cash EQT expects to realize from creation of the MLP, and of course the timing is largely up to the SEC. EQT's year-end cash was $830 million, which is primarily the $750 million of bonds issued in early November. With Q3 ending cash of $335 million, this implies a Q4 net cash flow deficit of about $255 million. All of EQT's $1.5 billion revolver remains available, with a facility expiry in November 2014.

After expanding substantially because of the ACS merger, Xerox's revenue growth slowed the last two quarters and actually fell slightly in the fourth quarter. Revenue in the Services segment rose 5.6% due to strong gains in Business Process Outsourcing, which was driven by the healthcare, human resources, and transportation solution businesses. Technology segment revenue fell 4.7% because of weakness in Europe, price declines of 5% to 10%, and a shift in mix. Xerox now generates more revenue from services than technology. Operating margins were flat in the Technology segment, but dropped 170 basis points in the Services segment. The margin erosion was due to costs related to the ramping of new services contracts and lower contract renewals (three or four specific situations). As usual, Xerox generated more than $1 billion of free cash flow in the fourth quarter, allowing the company to reduce debt by $550 million. Leverage, including financing debt, fell to 2.8x. Management provided guidance for revenue growth of roughly 2% in 2012, including a mid to high single digit expansion in Services and flat to modestly lower revenue in Technology. Operating margins are expected to be relatively flat, but they should improve over the course of the year. Free cash flow is not going to expand as much as initially expected because of higher pension contributions, higher restructuring expenses, and lower earnings stemming from the European troubles. Nonetheless, free cash flow remains robust, and will allow Xerox to continue repurchasing shares while driving leverage lower via higher EBITDA.

Over the course of two days of investor meetings, Penney outlined its latest "transformation" plan devised by its new management team (including yet another new logo). We've seen retailer transformations come and go over the years, some more successful than others but all subject, when all is said and done, to the economy and consumer spending trends. Naturally new leaders want to put their stamp on a company, and this team (led by a retailing cult figure, Ron Johnson) is making a big splash in its first ninety days. Yesterday's presentations were mostly about selling the new vision, while today's included some (although not much) financial detail. We found it noteworthy that the CFO did not lead the financial presentation, and is the only member of the old team still in place. With all the new merchandising and pricing strategies, the bottom line is that Penney expects to meet or exceed 2010 E.P.S. on an adjusted basis of $2.16 (i.e., before pension expense), it will no longer give quarterly earnings guidance or disclose monthly sales, it expects to achieve higher gross margins and lower expense rates, making the transformation "self funding" -- unless of course there is a worse than expected dramatic sales impact, which remains the great unknown, as it always does with retailing. The financial risk, however, does not appear to be high (the somewhat higher capital spending required can be funded out of cash flow), although we think the risk of confusing and alienating its current customer base is. The stock market seemed unconvinced yesterday but gave the plan wow reviews today, with the stock up more than ten percent. We don't envision a material credit profile impact, but don't expect Penney to reach investment grade status any time soon. Please see our upcoming full report.

Occidental Petroleum reported very strong earnings yesterday, $1.6 billion from continuing operations for Q4, up about 28% from a year earlier. Full year 2011 core earnings of $6.8 billion were up 46% from 2010. OXY's total production was 748 MBOE/d in Q4 and 733 MBOE/d for the year, increases of nearly 5% and 4%, respectively. Domestic Q4 production set a record (and was 60% of OXY's total) with the highest ever proportion of liquids (we estimate about 69%.) OXY's 2011 Cash Flow from Operations of $12.3 billion funded capex of $7.5 billion, acquisitions (net of divestitures) of $2.2 billion and dividends of $1.4 billion, with $1.2 billion of cash to spare. Net debt financing generated another $0.6 billion. OXY's cash balance at the end of the year was $3.8 billion, versus total debt of $5.9 billion (13% of capitalization.) Subtract the cash from debt, and the net debt/capitalization ratio was about 6%. OXY announced it is increasing its 2012 capital program by about 10% to $8.3 billion, with $500 million of the $800 million increase to be invested in the Permian Basin. About 84% of capital will be in E&P, and 20% of total capex will be in the Permian Basin. International capex will be about 30% of the total budget, with modest increases in Iraq and Libya, and 7% of total capital invested in the Al Hosn Shah sour gas project in Iraq. OXY intends to size its capex to available cash flow, with free cash allowing it to grow its dividend.

EQT Corp. reported good fourth quarter and full year results, in terms of earnings growth, production increases and reserve growth. Q4 earnings of $90.8 million were up 24% from a year ago. Full year earnings of $479.8 million were up 111% from 2010 (including $128 million of A.T. gains on asset sales.) Production sales volume was 44% greater than 2010, at 194.4 Bcfe. And proved reserves of 5.4 Tcfe were up 145 Bcfe from YE2010, an increase of nearly 3% and a reserve replacement ratio of 173%. What we're not seeing is a complete balance sheet or statement of sources and uses. EQT reported full-year operating cash flow (approximates FFO) of $886 million, versus capex of $1.367 billion (original guidance was $970 million) and estimated dividends of $132 million, for a FCF deficit of $613 million. Asset sale proceeds (Big Sandy pipeline: $390 million; Langley Natural Gas Processing Complex: $230.5 million) funded the deficit. EQT's 2012 guidance calls for operating cash flow of $900 million and capex of $1.465 billion (a $135 million reduction from previous guidance, attributable to reduced drilling activity in the Huron because of low natural gas prices). Assuming level dividends, this implies a FCF deficit of about $700 million for 2012. Recall EQT is exploring alternatives for separating its gathering and processing activities (Goals: realize value, establish a second balance sheet for capital-raising purposes, but retain strategic control.) We assume a strategic reorganization will also fund the gap in 2012, but we just don't know. On the plus side, EQT has about 50% of its expected production hedged at prices well above market, and at last report, its $1.5 billion revolver was unused.

Realogy is up to its usual financial engineering tricks. Late yesterday the company priced $918 million of new senior secured notes to repay the non-extended amounts outstanding under its senior secured credit facilities. The two tranche offering included $593 million of 7.625% senior secured first lien notes due 2020 and $325 million of 9% senior secured first and a half lien notes due 2020. The new first lien notes will be pari passu with the senior secured credit facility and senior to the new and existing first and a half lien notes. Realogy plans to use the $918 million of net proceeds from this offering to repay the $629 million non-extended term loan due October 2013, $133 million outstanding under the non-extended revolver due April 2013, and $156 million outstanding under the extended revolver due April 2016. Availability is expected to be $239 million under the company's $275 million extended revolving credit facility at closing. Since the first and half lien notes are excluded from the calculation of the senior secured leverage ratio (maximum permitted is 4.75x), this transaction will give the company more room under this covenant in the senior secured credit agreement. For the latest twelve months ended September 30, this ratio stood at 4.15x, but falls to 3.6x pro forma for this transaction. And this extra room may come in handy if a more robust housing recover doesn't lift EBITDA and cash flow generation in 2012 and 2013. According to an 8-K filing, Realogy reported preliminary 2011 revenues of $4.1 billion, flat with 2010, while 2011 EBITDA before restructuring charges was $474 million, down 11% from $534 million in 2010. With the outlook for a recovery in the housing market in 2012 remaining uncertain, we maintain our rating of underperform.

Motorola Solutions' fourth quarter revenue was fairly consistent with results for the previous quarters, rising 5.3%. Government segment revenue was up 6.4%, reflecting strong growth in all regions but Europe. Enterprise segment revenue rose 3%, with particular strength in wireless LAN and mobile computing. However, while margins were up again in the government segment (rising in three of the four quarters this year), margins fell sharply in the Enterprise segment. The decline was attributable primarily to a fall-off in iDEN revenue. Management expects iDEN revenue to drop roughly $75 million in 2012. Nevertheless, Enterprise revenue is projected to increase in the high single digits this year. Government revenue is slated to rise in the low to mid singe digits, leaving overall top line growth at about 5%. Despite the loss of higher margin iDEN revenue, margins are expected to rise modestly. The more exciting part of the company's results was the generation of nearly $600 million in free cash flow. This allowed MSI to reduce debt by $1.2 billion in 2011. As the result, leverage plunged to 1.2x. Further debt reduction is not likely since free cash flow should be eaten up by share repurchases in 2012. MSI has $900 million remaining on its stock buyback authorization, after repurchasing $1.1 billion in 2011. MSI has $400 million coming due in the fourth quarter, but did not reveal how it will handle the maturity.

Two press releases from FirstEnergy this morning. The first is the news that the company will retire six of its older coal-fired generating plants by September 1 this year. The plants generated, on average, about 10% of the electricity produced by FE over the last three years, and had a total capacity of 2,689 MW (out of FE's 23,000 MW fleet). The EPA's Mercury and Air Toxics Standards (MATS) rules would requre uneconomic investment in the plants. The closures will will result in a $.38 per share A.T. charge to FE's Q4 2011 earnings - approximately $160 million. It is not clear how much of that will be cash -- the 529 employees affected will either be eligible for positions elsewhere in the system, eligible for early retirement, or existing severance benefits. Closures due to MATS has been predicted by industry participants, most recently by Exelon Chairman John Rowe in earnings call comments made yesterday. The EPA's Cross State Air Pollution Rule ("CSAPR"), currently being challenged in federal court, will also factor in these decisions. Separately, FE announced accounting changes pertaining to pension and other post-employment benefits, and a $600 million contribution to its pension plan. The accounting changes will, among other things, result in a net increase to common shareholders' equity of $350 million, the biggest pieces being a $2.3 billion increase in OCI, offset by a $1.8 billion reduction in Retained Earnings. PP&E will increase by $855 million. FE increased full-year adjusted (non-GAAP) EPS guidance from $3.30-3.50 to $3.63-3.65.