Gimme Credit

Orange reported a 5.6% decline in revenue for the second quarter. To put some context around that figure, it was better than the 5.5% drop in the second quarter of last year, but worse than the 4.6% decrease in the first quarter. As in recent periods, some of the biggest declines were in the France Mobile, Spain Mobile, and Rest of the World segments. The 9% drop in France PCS reflects the migration of the customer base to convergent offers, termination rate decreases, and the migration to SIM-only offers. On an adjusted basis, operating margins were flat to last year. However, on an actual basis, margins fell significantly. Orange has been able to slash expenses in areas such as labor, customer retention, and general costs. Event risk is considerable, as management disclosed that it explored consolidation opportunities with Bouygues and Iliad. However, it could not come to an agreement. We suspect further talks are on the horizon, and while it is pure speculation at this point, any deal could add a meaningful amount of debt. Orange has managed to reduce debt by EUR 3.3 billion since the end of the year, mostly via the issuance of hybrid bonds, which are viewed as equity under IFRS rules. However, given our outlook for much lower EBITDA, we estimate that leverage will only decline modestly in 2014, from 3.0x to 2.9x.

Baxter is moving forward in its efforts to focus upon hematology and immunology and to shed noncore businesses. When asked two weeks ago about progress in its exploration of strategic options for its vaccines business, Baxter management said there was nothing to report. This morning the company announced the sale of its vaccines for meningitis and encephalitis (along with some manufacturing facilities) to Pfizer for $635 million in cash. No use of proceeds was discussed. Baxter continues to explore options for its R&D programs for influenza and Lyme disease. The company expects the divestiture to close by the end of the year, to be mildly dilutive to fourth quarter adjusted E.P.S. and to be dilutive by fifteen cents/share next year. Curiously, Pfizer says the transaction will not affect its 2014 guidance. Depending upon the use of proceeds, the transaction is on balance credit neutral.

The 13% increase in second quarter revenue at R.R. Donnelley was driven primarily by the acquisition of Consolidated Graphics and the North American operations of Esselte. Measured on an organic basis, revenue was up just under 1%. Operating margins declined 60 basis points, the fourth consecutive quarter in which they have fallen. Declines in the Publishing and Retail Services, Strategic Services, and International segments more than offset a modest improvement in the Variable Print unit. Margins were hurt by price pressure in each segment as well as wage and other cost inflation. Free cash flow was minimal in the quarter, but RRD used cash to reduce debt by $70 million. Cash is now less than $300 million, which is unusual for the company. However, gross leverage is likely to fall to 3.2x by year-end on the lower debt and the better EBITDA we are projecting for 2014.

Phillips 66 second quarter adjusted earnings were $863 million, down $3 million sequentially, and down $58 million from a year earlier. Sequentially, higher adjusted earnings in Refining, Marketing & Specialties, and Chemicals were offset by weaker Midstream results and higher Corporate expenses. The story in Refining was similar, if not quite as good as, VLO -- higher volume and crude capacity utilitization using advantaged crudes, but weaker realized refining margins, due to weaker distillate crack spreads, resulting in an $84 million increase in Q2 earnings to $390 million. Marketing and Specialties income increased $25 million in Q2 to $162 million, attributable to seasonal demand and increases exports in Marketing. Second quarter Chemicals (PSX's investment in JV Chevron Phillips Chemical Company) earnings were up $8 million sequentially to $324 million on higher olefins and polyolefins margins. In Midstream, an $80 million decline in earnings to $108 million was attributed to: 1) $50 million lower earnings from DCP Midstream to $33 million - partly due to lower gains on unit issuances; 2) $28 million lower earnings in the NGL business to $15 million, largely on a seasonal decline in propane demand and prices; and 3) a $2 million decline in transportation earnings to $60 million on higher maintenance expense. YTD Cash Flow: FFO of $2.2 billion, versus capex of $1.1 billion and dividends of $510 million, for FCF of just under $600 million. FCF of $569 million, plus asset sales of $657 million funded have funded share buybacks of $1.276 billion. PSX ended the quarter with $5.0 billion of cash and equivalents, down $400 million YTD. Total debt was $6.2 billion, within rounding error of YE2013. TD/TC was 22% (5% net of cash). PSX has increased its 2014 capex program by $1.2 billion to $3.9 billion, in part to support the Gulf Coast crude oil and refined products terminal being acquired (see our June 6 report.) The dividend was increased by 28% in Q1 (now a $1.12 billion annual run rate), and this month the Board authorized another $2 billion of share repurchases, from time to time. While a "miss" from an EPS perspective ($1.51 adjusted, versus $1.685 "consensus"), we think the quarter was fine for bondholders.

First Data posted a 4.7% increase in second quarter revenue, the biggest gain since the second quarter of 2011. It was led by a 6% increase in the Financial Institutions segment, which benefited from volume growth and new card portfolios. International segment revenue rose 5.4%, while Merchant Solutions revenue was up nearly 2%. The higher revenue and cost reductions led to a 160 basis point improvement in margins. Huge increases in Merchant Solutions and Financial Services more than offset erosion in International. The latter was due to an uncollectible settlement receivable, litigation costs, and a provision for a merchant-related credit loss. More important than the operational performance was the $3.5 billion equity injection completed in early July. That deal allowed debt to be reduced by $3.4 billion. Nonetheless, as we indicated in our June report, leverage is still high, and one quarter of superb results does not constitute a trend.

Hess Corporation second quarter core earnings were down from a year ago, due to divestitures of E&P and downstream businesses. Adjusted net income was $432 million, versus $520 million for Q2 2013. In addition, Hess reported net gains of $499 million associated with repositioning its portfolio, down from gains of $911 million a year ago. Consequently, net income was $931 million, down from $1,431 million a year ago. Funds from operations for the quarter were $1.3 billion, unchanged from Q2 2013. First half FFO was $2.7 billion, down just $200 million from 2013, and equal to HES first half capex. Dividends are running $80 million per quarter, and working capital has consumed $595 million YTD ($368 million in Q2). HES Q2 asset sales totalled $1.6 billion, bringing first half sales to approximately $2.8 billion. In addition to funding working capital and dividends, asset sale proceeds funded first half share repurchases of $1.8 billion ($768 million in Q2). As of June 30, HES had $2.24 billion of cash versus $6.077 billion of total debt. Net debt of $3.84 billion was down from $3.98 billion at YE2013 and 13.6% of capitalization, versus 13.9% at YE2013. Through June 30, HES had completed $3.3 billion of a $4.0 billion share repurchase authorization, begun August 2013. That authorization has been increased to $6.5 billion, reflecting the $2.1 billion of assets held for sale as of June 30, and the pending sale of HES's retail business for total proceeds of approximately $2.9 billion. Operationally, the core assets HES intends to keep and develop appear to be performing well, with Bakken crude production up 25% to 80,000 boepd on a 12% YOY reduction in well cost, and Valhall (Norway) production averaging 31,000 boepd versus 13,000 boepd a year ago. Excluding production from assets sold and Libya, pro forma production in Q2 was 310,000 boepd, up 17% from a year earlier, and the midpoint of 2014 pro forma guidance of 305-315,000 boepd.

One positive way to view Sprint's second quarter results is that the company is making some progress. It lost 334K subs in the quarter, but that was better than the loss of 467K subs in Q1. Postpaid net losses of 245K were better than the loss of 333K in Q1. And wholesale and affiliate net adds were up substantially. Much of the success was due to the company's Framily plans. Unfortunately, that and a higher mix of tablets led to a 3.3% decline in ARPU. Wireless revenue was up modestly. But wireless margins rose for the third consecutive quarter, attributable to lower subsidy costs, lower customer care costs and lower cost of services. Wireline revenue slumped 18%, the worst performance was can remember in this segment. Management blamed the migration of wholesale cable VoIP customer off of Sprint's IP platform. Reflecting the poor top line results, margins fell dramatically. Sprint reported positive net income for the first time in seven years. Although capital expenditures fell considerably, free cash flow was still negative to the tune of almost $600 million. We estimate that cash burn for the full year will be well more than $4 billion, particularly since capital spending is likely to increase significantly in the second half.

Valero Energy reported Q2 net income from continuing operations near the high end of the guidance provided a couple of weeks ago -- $651 million ($1.22 per share), up 41% from a year ago. The drivers were as advertised (and discussed in our July 17 report) -- higher throughput volume from less turnaround activity and a higher utilization rate using discounted North American light crude on the U.S. Gulf Coast. Moreover, VLO's crude slate carried a higher discount to Brent than the year-ago quarter (example: Brent less Louisiana Light Sweet was a $3.41 per barrel discount, versus a $1.78 premium a year ago). These positive drivers offset weaker crack spreads for gasoline and distillates (CBOB gasoline less Brent declined from $7.51 to $7.33 per barrel, Ultra-low-sulfur diesel less Brent declined from $16.79 to $12.81 per barrel), and higher natural gas fuel costs ($4.56 per MMBtu versus $4.00 for Q2 2013). Only partial cash flow data for the quarter, but NI+DD&A was $1.0 billion, versus capex of $806 million and dividends o $133 million, suggesting positive free cash flow. VLO paid off $200 million of debt in the quarter, ending Q2 with $3.5 billion of cash versus $6.4 billion of debt. VLO closed on a $154 million drop down transaction with MLP Valero Energy Partners on July 1, and repurchased $104 million of shares in July. Strong quarter.

CONSOL Energy (CNX) reported second quarter adjusted EBITDA from continuing operations of $245 million, a little short of the $258 million consensus estimate, but up 36% from $181 million in the year ago period. In addition, the company issued a $250 million (upsized from $200 million) add-on to its $1.6 billion of 5.875% senior notes due 2022. Proceeds from this transaction will be used to fund a tender offer for $200 million of its 8.25% senior notes due 2020. We expect Gas Division growth to help improve credit metrics over the intermediate term. The 5.875% senior notes due 2022 yield 5%. We maintain our outperform rating.

NextEra Energy's second quarter earnings were solid, particularly at Florida Power & Light. Consolidated adjusted earnings of $630 million were up $10 million, YOY. FPL contributed $423 million, up $32 million, on increased investment and much improved economic conditions and customer growth (+91,000 YOY, the largest average increase in customer count since Q2 2007.) FPL's first half cash flow: FFO of $1.5 billion, versus capex & nuclear fuel of $1.7 billion and $400 million of dividends to NEE holdco, for a FCF deficit of about $600 million. Working capital liquidation funded approximately one-third, and a net increase in borrowings of $417 million funded the rest. The only news that gave us pause was FPL's request to the Florida regulator that it be permitted to invest up to $200 million in partnership with PetroQuest Energy to develop natural gas wells in the Woodford Shale play in southeastern Oklahoma. NEE has asked the Florida Public Service Commission to develop a set of guidelines for subsequent projects. The desire is to effectively "hedge" future natural gas costs to FPL customers, by participating in future price increases for natural gas. A decision is expected by the end of 2014 or early in 2015. NEE Resources Q2 adjusted earnings were $213 million, down $25 million YOY. That's net of approximately $67 million of one-time charges (one-third actual expenses, two-thirds non-cash tax charges) associated with the creation of yieldco NEP (NextEra Energy Partners) at the end of the quarter. We estimate NEER's six-month FFO at just under $1 billion, versus capex and nuclear fuel purchases of $1.5 billion. NEER received $323 million of capital from NEE in the first half, and net borrowings totaled $307 million. With the launch of NEP, NEER has a vehicle with which to recoup capital invested in renewables projects, once development is completed. NEE touched upon its interest in acquiring Oncor Electric Delivery from the EFH bankruptcy process. NEE views it as a logical extension of its over $7 billion of investment in power, transmission, and other investments in Texas over the years. NEE will move ahead if it can "within acceptable financial and risk parameters....if we can see a reasonable path to all necessary regulatory approvals." Later, management noted that an Oncor acquisition would have to be done in a way that was supportive of its current credit position. Finally, NEE updated its 2014 adjusted EPS guidance, tightening the band from $5.05-5.45 to $5.15-5.35, including the $.15 expensed in connection with the launch of NEP.

Arrow Electronics reported a 7% increase in revenue for the second quarter, or 1% when adjusting for acquisitions and currency changes. The Components segment posted a gain of 5%, while the Enterprise Computing unit rose nearly 11%. Based on the midpoint of management guidance, revenue is expected to increase roughly 8% in the third quarter. Operating margins were up 80 basis points, with increases of 40 basis points in each segment. Management still hopes to achieve full-year margins of 5.0% in the Global Components segment, or 40 basis points more than where they were in the second quarter. That goal is based on outgrowing the market because of the additional salesmen the company has added recently. Typically there is a six-month lag between the time they are hired and the influx of added sales. Arrow generated free cash flow of $130 million in the quarter, putting it on track to produce well more than $400 million for the full year. The company has reduced debt by $130 million through the first six months of the year. Taking into consideration the lower debt and our outlook for a substantial increase in EBITDA, we think leverage will plunge below 2x by the end of the year.

HealthSouth, one of our longtime favorites, continued to delight this morning with EBITDA up 14% on revenue up 7% even versus strong results in the same quarter last year which had been boosted by meaningful unusual items. Pricing was particularly strong on favorable adjustments from Medicare and managed care plus better patient mix with higher acuity. This plus disciplined cost management drove a 150 basis point increase in EBITDA margin to a commanding 25.7%. Cash flow was robust, with cash from operations up more than 21% and free cash flow up 43% after capex. Indeed free cash flow was an impressive 16% of net revenue, still some 2-3 times higher (as a percentage of revenue) versus what is typical for the largest high yield hospitals. This easily funded dividends plus another $17 million spent to repurchase stock with enough left over to push cash up 256% y/y. Leverage also remained dramatically lower versus the hospital sector at 2.6x. HealthSouth increased full year guidance for EBITDA and e.p.s., and we continue to expect it will hit the high end and potentially exceed those targets. Maintain "outperform."

BP's second quarter earnings were pretty good, with underlying replacement cost profit of $3.6 billion, up 34% YOY and up 13% sequentially. After inventory holding gains of $187 million, profit attributable to BP shareholders was $3.4 billion. Replacement cost profit before interest and tax was $5.2 billion, of which approximately 20% was contributed by BP's investment in Rosneft. BP acknowledged (as we first flagged on March 4) that "If further increased international sanctions are imposed on Rosneft or other Russian individuals or entities, this could have a material adverse impact on our relationship with and investment in Rosneft, our business and strategic objectives in Russia and our financial position and results of operations." On the bright side, BP said it received its share of Rosneft's dividend (declared on June 27, pertaining to 2013 earnings) in he amount of $693 million, late last week. For the first half of 2014, BP's cash flow was approximately $16.1 billion, versus capex of $11.4 billion and dividends of $3.2 billion, for excess cash of $1.5 billion. Asset sales and business divestitures generated approximately $1.8 billion. Net share repurchases totaled $2.2 billion through June (and BP noted it completed its $8 billion share repurchase authorization in July.) Financing raised a net $3.9 billion, increasing gross total debt to $52.9 billion. Net of FV hedge adjustments of $1.0 billion and cash of $27.5 billion, net debt is $24.4 billion, or 15.5% of capitalization -- near the middle of BP's 15-20% targeted band. Legal proceedings pertaining to the 2010 Macondo oil well disaster are progressing glacially, with the penalty phase to assess Clean Water Act liability due to begin in January 2015. BP is seeking Supreme Court review of an adverse ruling pertaining to compensation claims under the Economic and Property Damages Settlement Agreement. Overall, BP has a number of good things going on operationally, but several potentially damaging contingencies pending. More in a future report.

Masco met our expectations for impressive second quarter results with adjusted operating profit up 21% on a 5% increase in revenue--enough to push net income from continuing operations up a showy 65%. With market expectations soundly trounced, the stock is up more than 8% today, back near its 7-year high hit last March. Most all segments reported strong sales and profits, especially flagship Plumbing (38% of total revenue and 50% of operating profit) where segment profit was up 26% on revenue up 6%. Management attributed ongoing efforts to bolster more profitable product mix and grow market share via aggressive product development and stronger customer relationships. Only the Cabinets segment lagged, again, hurt by slower retail sales plus isolated disruptions from continued optimization efforts in one particular plant producing the Merillat line (20% of Cabinet sales). This speed bump was handily offset by broad-based strength across the rest of Masco's businesses, in the U.S. and abroad, a credit to recent years of intensive restructuring to create Masco's leaner and strategically more favorable business mix which can now generate 70% of revenue from repair & remodel markets, particularly from big box retailers like Home Depot and Lowe's (see our report "Mixing It Up" on 7/17/14). Yet Masco also remains well positioned to thrive as a formidable market leader and supplier of choice for major builders as well as regional building supply wholesalers and dealers when construction markets finally take off down the road. Maintain "outperform."

While Arch Coal's (ACI) second quarter adjusted EBITDA was down significantly year over year, it was a big improvement from the first quarter and ahead of consensus expectations. Second quarter revenues declined 7% to $714 million reflecting declines in both average sales price and tons sold. The operating margin per ton contracted to a loss of $0.21 from income of $0.18 in the second quarter of 2013, but improved from a loss of $1.61 in the first quarter. As a result of a decrease in both revenues and margin, second quarter adjusted EBITDA declined 30% to $65 million, but easily beat the $44 million consensus estimate and was up from $28 million in the first quarter. For the latest twelve months coverage and leverage were 0.96x and 13.9x, deterioration from 1.1x and 12.1x in 2013, but unchanged sequentially. ACI ended the quarter with $1.25 billion of liquidity, down about $150 million sequentially. Despite lower capital spending, first half free cash flow (cash flow from operations less capitals spending) widened $57 million to a shortfall of $174 million. In response to continuing weakness in global metallurgical coal prices, ACI recently announced the idling of its Cumberland River complex. As a result of ongoing transportation bottlenecks for thermal coal and metallurgical production curtailments, ACI lowered its 2014 volume guidance. The company also scaled back its 2014 capital spending plans by $10 million to $170-180 million. We will update our projections and review our rating shortly.

UPS reported second quarter net income of $454 million, down from $1.071 billion a year earlier. The decline reflects a $665 million A.T. charge in connection with the transfer of post-retirement liabilities for certain Teamster employees to defined contribution healthcare plans. Otherwise it was a fairly good quarter, with consolidated package volume up 7.2% YOY and consolidated revenue of $14.3 billion up 5.6% YOY. Operating expenses were up 7.6% to $5.1 billion, with the biggest driver a $257 million increase in purchased transportation (primarily in US Domestic) necessitated by "very poor rail performance during the quarter" that required UPS to make short-term alternate arrangements to maintain service commitments. UPS released partial cash flow information: YTD cash from operations of $1.842 billion handily covered capex of $813 million. With adjustments for minor asset sales, finance receivables and other items, UPS reported "free cash flow" (CFO less capex) of $1.009 billion. But judging from the summary balance sheet, working capital liquidation provided approximately $1.6 billion of the $1.8 billion of CFO, making FFO roughly $200 million. Dividends totaled $1.2 billion, so by our calculation, YTD FCF was a deficit of $1.8 billion. UPS also repurchased $1.4 billion of its stock. Cash at the end of the quarter was $4.6 billion. UPS added an additional $75 million (for a total of $175 million) of incremental 2014 operating expense to ensure peak activity performance this coming holiday season. As a result, UPS lowered its full-year EPS guidance range, from $5.05-5.30 to $4.90-5.00. UPS considers the world's current geopolitical hot spots to be "emerging markets" and has not made major investments that are at risk. UPS recognizes that Ukraine could impact Poland, or Syria could impact Turkey, and therefore is paying close attention -- but "so far, no damage."

Yesterday, Dollar Tree (DLTR) announced it was acquiring Family Dollar Stores (FDO) for total consideration of $9.2 billion in cash and stock or 11.3x Family Dollar's LTM EBITDA (8.2x including expected synergies). The discount store retailer plans to permanently fund this transaction using a combination of $5.4 billion of term loans, this issuance of $2.8 billion of senior notes, $1.25 billion of revolver borrowings, and $569 million of cash on hand. At closing, Family Dollar shareholders will own 13-15% of Dollar Tree stock. Pro forma for this combination, DLTR expects its leverage ratio to increase to 5.6x from 3.3x for fiscal 2013. The transaction is expected to close by early 2015, be accretive to earnings within the first year and result in $300 million of synergies within three years. Cost savings are expected in the areas of sourcing and procurement, SG&A leverage, distribution and logistics efficiency, and format optimization. This acquisition will result in the DLTR becoming the largest discount retailer in North America, ahead of Dollar General. LTM pro forma revenues would be $18.4 billion with adjusted EBITDA of $2 billion. The new bonds expected to be issued related to this transaction will likely be rated below investment grade. We look for both credits to be downgraded. FDO currently has $300 million of 5% senior notes due 2021 outstanding (Baa3/BBB-). These bonds contain a change of control put and can be redeemed at any time using a make whole provision. Dollar Tree has three tranches of senior notes issued last September (Not Rated) totaling $750 million that also contain a make whole provision and could be redeemed. We intend to initiate coverage of DLTR over the near term.