Gimme Credit

Poor Altria has been overshadowed in the news of late by Reynolds American. Yet when fielding investor questions after reporting its second quarter results yesterday, management predictably declined to discuss the new competitive environment it might face if the RAI/Lorillard deal goes through. Frankly, we don't think it has that much to worry about, given its continuing market leadership. In the second quarter adjusted earnings rose 3% on a modest net revenue increase of 1%. Management narrowed its full year adjusted E.P.S. forecast range, raising the lower end slightly to reflect a strong first half. The company's operating margin shrank slightly in the quarter because of investments in new products (such as the national rollout of its e-cigarette, MarkTen) and higher corporate expense, but every segment posted substantial margin expansion. In Smokeable Products (87% of sales), net revenues rose 1% and adjusted operating companies income was up 4%, leading to operating margin expansion for the segment of 120 basis points to 44.2%. Pricing more than offset the cigarette shipment volume decline of 5%, while Marlboro gained 30 basis points of retail market share, rising to 44%, its highest share in recent memory. Cash flow was seasonally low because of the annual MSA payment, but despite a generous dividend, free cash flow on a trailing twelve months basis remains exceptionally strong. The company announced a new $1 billion share repurchase program to be completed by the end of 2015. Although this may require a modest increase in net debt, we don't anticipate leverage increasing above 2x despite the high return of cash to shareholders.

Steel Dynamics' (STLD) second quarter EBITDA was short of consensus expectations. For the second quarter revenue was up 15% year over year to $2.1 billion reflecting higher shipments and pricing per ton. By segment, operating income for Steel Operations was up 80% year over year to $158 million, Fabrications increased 325% to $7.6 million, while the operating loss at Metals Recycling & Ferrous Resources decreased modestly to a loss of $1.5 million. On a consolidated basis, the second quarter EBITDA margin improved 220 basis points with EBITDA rising 50% to $189.5 million, less than the $201.3 million consensus estimate. For the latest twelve months, coverage and leverage were 5.4x and 2.7x, improvement from 4.8x and 3.4x in 2013. Liquidity remains solid and LTM free cash flow before dividends was $148 million. During the quarter, $272 million of the company's 5.125% convertible notes due in June were converted into common stock with $16 million of the bonds redeemed for cash, leaving no significant debt maturities until 2019. As noted yesterday, STLD announced the acquisition of Russian steelmaker OAO Severstal's mini-mill in Columbus, Mississippi for $1.625 billion. Permanent financing is expected to consist of a combination of new debt and cash on hand ($358 million as of June 30). While leverage will likely increase initially (no details on the potential financing has been disclosed), the company expects to restore its net debt leverage to "less than three times trailing EBITDA within a reasonable timeframe." This implies credit deterioration over the near term. We will update our projections and review our underperform rating shortly.

Peabody Energy (BTU) posted better than expected second quarter revenues and adjusted EBITDA. This was driven by higher volumes from the company's Australian and the Western U.S. Mining Operations. First quarter revenues were up 1.9% to $1.8 billion on a 1% increase in tons sold and improvement in pricing for Western coal, more than offsetting lower pricing for Midwestern and Australian coal. But with metallurgical coal pricing remaining depressed, the Australian gross margin per ton was $0.86 for the quarter, down significantly from $13.05 in the year ago period. Total U.S. gross margin per ton, however, improved to $6.30 from $5.94 in the first quarter of 2013. As a result, first quarter adjusted EBITDA fell 16% to $213 million, but was better than the $160 million consensus estimate and company guidance of $140-200 million. For the LTM, coverage and leverage were 2.2x and 6.6x, respectively. Total liquidity was unchanged at $2.1 billion. To conserve liquidity, the company slashed capital spending again to $210-250 million, down from $250-290 million. For the third quarter, BTU is guiding to adjusted EBITDA of $140-190 million compared to $312 million in the year ago period. This third quarter guidance was less than the current consensus estimate as lower coal prices and costs related to three longwall moves will impact results. We will update our forecast and review our rating shortly.

Reflecting the acquisition of Belo late last year, Gannett reported a 12% increase in revenue for the second quarter. On a pro forma basis, revenue rose 2%, including a 13% gain in the Broadcasting segment. The increase was driven by higher retransmission revenue and increased political advertising. Management provided guidance for even better growth in the Broadcasting segment in the third quarter. Gannett is confident that retransmission revenue will remain strong. Publishing revenue fell 4%, mostly because of lower advertising. Digital segment revenue, relying to a large extent on CareerBuilder, was up nearly 5%. Margins increased in the Publishing unit, but fell in the Broadcasting and Digital segment, leaving overall margins up slightly. Margins were hurt by a $23 million charge for workforce restructuring and $29 million in transformation costs and goodwill impairments. The encouraging aspect of the Gannett transformation is that the higher-margin Broadcasting operations are accounting for a greater portion of total revenue. Leverage soared to 4x upon the closing of the Belo deal. However, likely debt reduction and the EBITDA provided by the acquisition should allow leverage to drop to well below 3x by the end of this year. Gannett intends to pay down the $250 million note that matures in November.

Similar to Interpubic, Omnicom Group posted a very impressive increase in revenue for the second quarter. Total revenue rose 6.4%, reflecting organic growth of 5.8%, a 70 basis point benefit from foreign exchange rates, and a negative impact of 10 basis points from dispositions. Unlike IPG, domestic operations led the way with an organic increase of 8.8%, while international was up 4.9%. With respect to the international operations, Latin American posted the best growth, followed by the Asia Pacific region. Even Europe is showing some promise, with organic revenue up 2.1% in Q2. Key areas of growth were retail, travel and entertainment, and automotive. EBITDA margins dropped 30 basis points because of the negative impact of foreign currency, the shift in business mix, and professional fees associated with the planned merger of the company with Publicis. That deal was terminated in early May. Looking at the excellent organic growth, evidently OMC was not distracted by merger planning or the abandonment of the deal. Free cash flow was only $45 million in the quarter, but that is not unusual given the typical seasonality of the advertising business. The company raised its dividend in May by 25% so free cash flow will likely be lower than last year. Since leverage is only 1.8x, debt reduction is not imperative.

It was more of the same for Comcast in the second quarter. Cable segment revenue rose 5.4%, very similar to the first quarter, and slightly below the growth rate in 2013. It was driven by a 23% increase in Business Services revenue and a 10% gain in high-speed Internet revenue. Comcast added 203K high-speed Internet subs, which was better than last year, and lost 144K video subs, which was fewer than last year. Cable margins were flat versus last year as cost savings offset increases in programming expenses. NBC Universal revenue increased only modestly, as a steep decline in Film offset increases in the other segments. Film suffered from fewer releases this year and less successful films. But margins rose almost 400 basis points, with improvements in each segment except for Theme Parks. Free cash flow in Q2 was constrained by a huge use of working capital and higher capital expenditures. Nonetheless, Comcast reduced debt by nearly $900 million. We estimate that leverage will be 2.0x at year-end. Therefore the company has excellent financial flexibility as it approaches a potential acquisition of Time Warner Cable.

The news that activist investor Jana Partners has accumulated a $1+ billion stake in Apache has triggered discussion about what happens next at APA. Jana would like for APA to be even more aggressive in exiting its international holdings, in order to concentrate exclusively on U.S. opportunities. A WSJ article also notes that Jana wuld like for APA to exit LNG export projects in Canada and Australia, as they consume too much capital with returns too far into the future. If APA is unwilling to restructure, Jana says, it should consider putting itself up for sale. While all of this has been a great tonic for APA's stockholders (the stock us up almost 5% today), bondholders should take a more cautious view. While it is true that certain asset sales (or project cancellations) would lessen APA's business risk, proceeds are almost never earmarked for debt reduction, but rather used for greater share repurchases. And with a $40 billion equity market capitalization, there aren't many suitors that could make a bid for APA that would not put pressure on APA's high triple-B/low single-A ratings. Since our April 2 "outperform" recommendation, APA's 4.25% notes due 2044 tightened from T+104 to T+95 on July 8. In trading this morning, they've gapped as much as 14 bps to T+115, recovering to T+110 a little while ago. (APA's 2023 maturity, which we did not recommend, is roughly unchanged from April, with small trades in the low 50s.) We don't know what the final outcome will be, but do not see a catalyst for positive bond performance. Changing our call on APA 2044s to Underperform.

Private equity announced its intent to combine subsidiaries (both in the sampling business) of KKR owned Visant and a unit owned by funds of Oaktree (Ileos) --but the release was short on details. The two groups are waiting discussions of the Works Council in France before entering a definitive agreement. Once we learn more about terms and whether cash is involved we will comment as to whether it impacts credit quality. In the meantime Visant recently announced sale of its Lehigh Direct business to SG360--Lehigh provides services in the production of direct marketing programs. Again details on the terms were lacking but a statement that Visant was pruning its portfolio in pursuit of its deleveraging strategy sounds positive.

Verizon had already indicated that it added 1.4 million retail postpaid subscribers in the second quarter. And it had also noted that churn would be consistent with last year (retail postpaid was 0.94%). We knew that margins would good as well, but we did not anticipate margins improving so much. Overall margins rose 170 basis points, including a 100 basis point gain in the wireline segment and a 50 basis point improvement in wireless service margins. Revenue was up in the wireline segment for the first time in seven years. Meanwhile margins have now risen for four consecutive quarters. Wireline revenue was driven mainly by the addition of 139K FiOS Internet customers and 100K FiOS video subs. Penetration rates are now 40.1% and 35.3%, respectively. Despite a 4.7% increase in average revenue per account, wireless service growth was down from previous periods, but equipment revenue rose sharply, reflecting the implementation of new installment sales rather than the former subsidy model. The take rate for the EDGE program was only 18% in the quarter, far less than management?s forecast of 30%. Most of the subscriber growth stemmed from the addition of tablets, as smartphone additions were only about 300K. Verizon generated free cash flow of $1.3 billion in Q2. Only a modest amount of debt was paid down in the quarter, but we expect much more significant sums to be slashed in upcoming quarters. Verizon plans to use the cash that is accumulating for the spectrum auction coming up at the end of this year.