From the Weeds


The two tables below represent 2nd quarter S&P 500 earnings and are sorted by aggregate earnings surprise and growth (largest to smallest). Only 49% have exceeded sales projections (aggregate surprise of 0.71%), but 74% have beat earnings estimates (aggregate surprise 4.13 %). Additionally, 51% had positive sales growth (aggregate growth -4.29% due largely to the negative influence of utilities, materials and energy sectors) and 60% had positive earnings growth (aggregate growth -2.73% again largely due to the negative influence of the energy sector).  These results are consistent with the recent trend of sluggish top line growth, but better than expected bottom line results as companies continue to effectively manage costs.  Perhaps not unexpected given the volatility of the oil markets, the energy sector continues to struggle from a growth perspective.  On the other hand, the healthcare sector continues to outperform.

Sales surprise data chart

Last season, 48% of S&P 500 companies exceeded sales projections (aggregate surprise 0.14%) and 71% beat earnings estimates (aggregate surprise 6.75%)

Sales growth data chart

Last season, 55% of S&P 500 companies had positive sales growth (aggregate growth NEGATIVE 3.01) and 63% had positive earnings growth (aggregate growth 0.50).


Reit earnings for Q2 reflected continued improvement in fundamentals as the economy continues with slow and steady economic and job growth.  Results were largely in-line or ‘beats’, with many raising guidance and leverage is generally declining on higher earnings.  Among property types, only suburban office continues to perform poorly.  Two trends worth noting given broader impact: 1. Apartments remain very strong despite an increase in new supply – rents continue to rise sharply impacting broader housing market and consumer spending.  2. Despite energy shocks and higher $, foreign capital is becoming more active in new asset types, perceiving US CRE as a diversifier with yield.  They are moving beyond ‘trophy’ office, apartments, hotels, and malls, with notable deals in the industrial and medical office space. Development exposures are rising, supported by fundamentals, and remain more profitable than buying stabilized assets in highly competitive acquisition markets.   Rating momentum continues with near 30:2 positive/negative actions.  A deluge of reit IPO’s has been delayed by weak equity results over the fear of higher rates, and many names are trading below NAV which could fuel privatization.  Concern over privatization and market volatility has postponed many debut debt deals but the market remains open to established issuers. The IG model remains overweight reits on stable to improving fundamentals, strong covenants, ratings momentum, positive outlook, and reasonable valuations that should track financials.

Metals and Mining
Thus far, 4 of our 6 core metals and mining holdings have reported: Freeport, Teck Resources, Vale and Rio.  Glencore and BHP report within the next two weeks.  In general, these companies have been able to beat (relatively low) earnings expectations, but the year-over-year comparisons have been grim given the widespread destruction in the commodity markets due to a combination of slower Chinese growth and record breaking production.  Offsetting some of the impact of these commodity price declines have been impressive cash cost improvements due to favorable exchange rates, higher sales volumes, improved productivity and lower energy costs.  Unfortunately, the low price environment and the capital intensive nature of the industry have resulted in negative free cash flow for most (Rio being the one exception).  However, they all seem to recognize the severity of the situation and are exploring a combination of the following options to stabilize their balance sheets and maintain their IG ratings: equity issuance, asset sales, production cuts, cap ex cuts, dividend cuts, partial IPOs of non-core segments, etc.  It appears the rating agencies will be patient and wait to see if these measures can be effectively implemented.  In the meantime, this sector will continue to exhibit extreme volatility with the lower rated, higher beta names like Freeport and Teck trading with a very high correlation to negative movements in the underlying commodity.

Earnings continue to be overshadowed by the staggering number of acquisitions, divestitures and overall high event risk.  Management commentary during Q2 earnings calls centered around M&A and further industry consolidation as Pfizer, Mylan, Gilead, Cardinal Health, Bristol-Myers, Abbot Labs, J&J, Stryker, Sanofi and Express Scripts all openly expressed interest in large scale M&A.  One positive from a bondholder’s perspective is the importance of maintaining IG ratings for both short and long term funding needs.  There is no longer a high value placed on being single A rated, but companies still have significant refinancing and funding needs so have issued equity to be low-mid BBB rated.  Healthcare reform and increasing generic drug competition (first biosimilar approved this year) have led to increasing pricing pressures for drug and medical device companies.  We continue to be underweight these sectors, however we have added positions in companies that are committed to deleveraging and have stable to positive growth outlooks: Zimmer, Celgene, Amgen, Medtronic, McKesson, and AmerisourceBergen.  

Tech earnings have been weak in just about all categories: hardware (HP), networking (Cisco), software (Oracle/Microsoft), storage (EMC), semiconductors (Intel) and services (IBM).  The weaker than expected results and guidance can be attributed to more competition from smaller tech companies, unchanged (not increasing) business IT spending and continued FX headwinds.  In Q2 PC shipments fell -11.8% y/y as the sharp decline was attributed partially to the Windows refresh cycle in 2014.  The recent launch of Windows 10 should provide a boost to PC consumer demand over the next year.  Tech companies continue to take on additional leverage for share repurchases as their trapped overseas cash balances grow.  The majority of tech M&A has been small bolt-on deals, but during this quarter Avago Technologies agreed to buy Broadcom for $37 billion and Intel acquired Altera for $16.7bln. Overall we have a negative view on the IG tech sector given weak fundamentals, uncertain growth, leveraging risks, and poor relative value.

Cigarette volumes were flat in Q2 after declining by -3.1% last year.  Pricing continues to outpace volume declines as tobacco companies have been able to grow profits in mid-single digits.  Longer term risks for accelerating volume declines include a potential ban on menthol and raising the minimum age requirement from 18 to 21 years old.  Neither will likely go into effect until after 2017 if legislation is passed.  Harsher global legislation continues to be risks for PM, BAT, and Imperial: Australia/UK plain packaging, graphic images in Canada, new excise taxes in multiple countries, and UK banning small packs of 10 cigarettes (aimed at reducing young smokers).  There was $18bln in tobacco debt issuance related to the merger of Reynolds and Lorillard, which combined the #2 and #3 largest US tobacco companies.  We recently reviewed the tobacco sector and concluded we are comfortable with our modest overweight.  

Utilities had another boring quarter as earnings were generally in-line with estimates.  Higher earnings from rate increases were offset by milder weather and higher O&M.  AEP, DTE, EXC, PEG, and PPL raised their full year guidance while PCG was the only notable issuer that lowered guidance due to timing of its rate case.  Key themes were expectation for continued low utility demand growth and cautious optimism that Congress will extend bonus depreciation (provides boost to utility cash flows).  Companies were asked about EPA’s new carbon rule and most management team deferred the question since the ruling came out in late July and they needed time to digest before commenting.  

Commodity chemical producer earnings were better than expected on higher prices from tighter ethylene supply and continued access to low cost natural gas feedstocks.  The outlooks for 2H15 were fairly constructive supported by positive global GDP growth.  FCF generation was quite strong across all credits, and key theme had been to increase share buybacks after several years of deleveraging that brought leverage down to targeted levels.   The higher shareholder returns are not expected to impact ratings given sufficient breathing room within their respective ratings categories but the allocation of capital obviously halts further credit improvements.   The agriculture producers reported in-line results driven by solid fertilizer demand growth, partially offset by weaker pricing.  Risk shifted toward M&A as both MON and POT approached targets with unsolicited offers while CF successfully struck a deal with Netherland based OCI that emerged as credit/ratings enhancing.  

Earnings were quite strong supported by widening refining margins as benchmark Gulf 3-2-1 crack spreads averaged around $17/bbl compared to $10/bbl in Q1, and solid midstream and marketing volumes from higher product’s demand.  It is worth noting that crack spreads widened out even further in Q3 ($23/bbl on 8/11/15).  Key themes were to return cash back to shareholders and continue investment into midstream for growth.  

Pipeline earnings were generally in-line with estimates as the benefit from new project growth was partially offset by lower pricing and volumes on commodity sensitive NGL assets.   With the exception of DCPMID, ENBL and OKE/OKS, none of the IG pipes have a significant exposure to unhedged commodity sensitive assets.  PAA (Baa2/BBB+/S/N), who had been a solid and consistent operator historically, shocked the MLP sector by lowering its distribution coverage ratio guidance driven by loss revenues from a CA pipeline that experienced a rupture, and  increased competition from liquids pipes operating in Permian and Eagleford plays.  The news were more negative for the equity (i.e., slowing growth) than for credit.  S&P affirmed the BBB+ but revised the outlook from stable to negative.   M&A was also a theme that came up; specifically on possible combination between ETE and WMB.   

The majors reported weaker results as lower commodity prices dragged down earnings, which were partially offset strong performance from refining and chemicals.   Most companies were positioning for oil prices to stay “lower for longer” as they guided down capex to accommodate this view.  
Earnings for the independents were ahead of estimates on solid production growth and lower cost, offset by lower prices (especially NGLs).   Despite continued weak commodity prices, most producers guided for flat to lower spending while raising production for the remainder of the year, which fed into to theme of “spend less to produce more”.  They can achieve these targets thru continued cost reduction from service cost deflation and efficiency gains.    
US aerospace/defense companies overall reported decent 2Q earnings, with continued pressure on the top line due to US troop withdrawals and some mild negative effects from sequestration.  For the prime contractors, revenues y/y ranged from -5% to +5%, with Boeing’s +11% a strong exception.  Earnings growth was more universal, however, as a focus on cost containment continues.  Looking forward, commercial aerospace fundamentals remain solid, even with expected order declines this year, as both Airbus and Boeing have 5+ year backlogs.  Global military outlays are expected to be flat to -2% in 2015, placing continued mild pressure on defense businesses’ top lines.   

US manufacturing companies posted a more mixed quarter, with the strong USD negatively impacting results and certain end markets (agriculture, oil and gas, metals and mining, non-US construction) remaining or becoming weak.  US residential construction was notably strong.  GE, a good example for the sector, posted 5% organic revenue growth but zero reported growth after F/X effects, while operating profit was reduced from 11% organic to 5% reported.  Several companies in the sector (JCI, Danaher, Honeywell, UTX) have announced sizable acquisitions or spins/splits in an effort to increase growth.  With many of the larger IG issuers generating more than 40% of revenues from outside the US (GE, MMM, JCI, UTX, HON, DHR), we expect continued F/X pressure along with some end market weakness.    

GM and Ford both posted very strong 2Q results, with strong North American sales, closer to breakeven results in Europe and overall better margins on a consolidated basis.  European OEMs were more mixed, with VW bringing 2015 volume guidance down but BMW posting decent numbers and Daimler posting a strong quarter.  Much of the commentary centered on Chinese auto sales, where June and July industry sales were negative y/y and growth prospects for the year will likely be lower than the current +3% estimate.  Currency devaluation is less of an issue for global OEMs as most vehicles sold in China are produced in China.  Most exposed to a Chinese auto slowdown are VW and GM, where sales in China account for 39% and 36% of total volumes sold.  In the US, current UAW negotiations may pose negative headline risk into September but we do not expect any material issues.  
Telecom (wireless, wireline and cable) companies reported decent 2Q’15 earnings, with several trends taking hold.  For wireless/wireline, VZ and T both saw small single-digit revenue increases as wireless subscriber growth remains strong with even better earnings growth.  Churn was lower in the quarter and EBITDA margins improved due in part to reduced device subsidies.  However, more intense competition y/y led to a 6.6% drop in average ARPU for the four US major wireless companies.  Cable companies reported better y/y revenue growth (CMCSA up 11%, CHTR up 7.6%, TWC up 3.5%) as broadband growth continues to outpace video losses.  Video sub losses were notable at 368K, with DTV alone losing one third of that number.  European telecoms have shown several positive signs of stabilization this year and continued consolidation (most recent moving from 4 to 3 wireless carriers in Italy, for example) should create more rational competition for subscribers.    

Media companies posted decent 2Q’15 earnings that were overshadowed by several negative trends, including negative advertising revenue growth (-0.4%) for the sector for the first time since 2010.   DIS warned that affiliate revenues, more stable than ad revenues, were also seeing slower growth.  That, in addition to weak subscriber trends, caused an average 12% equity sell- off over two days for the six IG media names.  Earnings for the group were mixed, with four seeing y/y growth but also four missing street EPS expectations.  DISCA management noted that the rating agencies were becoming more conservative given negative subscriber and advertising trends, and that it would suspend share repurchases to reduce leverage by year-end, another factor spooking the equity market.  Average leverage in the sector has crept up in the past two years from 2.2x to 2.9x.  Looking forward, we see the business model for media companies changing in a more direct-to-consumer environment, but we like the scale and diversity of content in the three names (TWX, FOXA and DISCA) where we have an overweight.  

U.S. Banks
Large U.S. banks reported good 2Q15 results mostly exceeding analysts’ estimates and showing improvement over prior year’s quarter. The banks benefited from steady revenues and lower operating costs. Net interest income rose on moderate growth in loans somewhat offset by lower net interest margins. Fee income was steady with strong M&A advisory and equity trading revenues, as well as asset management, wealth, mortgage and card revenues. Fixed income trading revenues were weaker reflecting lower client activity in foreign exchange, credit and commodities. Commercial Real Estate/Construction and Commercial & Industrial lending, as well as auto and credit card loans contributed to 2% q/q and 5% y/y loan growth. Asset quality remained strong but further improvement is not likely amid competition and loosening underwriting standards and loan terms. The focus this quarter was on energy sector loans, though majority of banks have manageable exposure. Capital ratios improved q/q for most large banks with earnings retention and lower risk-weighted assets, and despite higher share repurchase activity, capitalization should remain robust. We expect U.S. banks to maintain strong fundamentals with further benefit to earnings if interest rates rise. U.S. regulators are expected to finalize bank resolution rules and minimum debt requirements in 2015 leading to higher debt supply in the next several years. IG model and accounts hold an O/W in U.S. banks.  

U.S. Life Insurance
While large U.S. life insurers (MET, PRU, AMP and PFG) posted strong 2Q15 earnings, results were weak for credits like LNC, RGA, VOYA. Several companies reported adverse mortality in the individual life segment, as well as weaker international results. Equity sensitive accumulation products performed well with higher AUM boosting fee income. Underwriting performance which could be volatile from quarter to quarter is increasingly driving results, as investment income, DAC reserve releases and operating efficiencies are providing less benefit. Insurers maintained strong balance sheets and capital levels which mitigates expected increase in share buybacks. Consolidation is increasing in the sector with Japanese insurers acquiring two smaller U.S. life companies, Symetra and StanCorp. While we view the non-bank SIFI designation for MET, PRU and AIG as credit positive, there is still uncertainty as to the rules governing capital adequacy for these firms. Another major legislative development to watch is the Department of Labor’s Fiduciary proposal that could negatively impact variable annuity and retirement product sales. Life insurers are sensitive to macroeconomic factors: continued low interest rates as well as equity market correction are among risks for the sector. Life insurers typically go through actuarial assumptions reviews in 3Q15 and low interest rates could drive charges. IG model and accounts maintain O/W in life insurers driven by good fundamentals and relatively attractive valuations.

U.S. P&C Insurance
P&C insurers reported mixed 2Q15 results with ACE, CB, TRV, HIG posting strong earnings while ALL, LIBMUT and CNA missed expectations. Insurance brokers reported earnings that were in line with expectations. During the quarter many P&C insurers benefited from lower catastrophe losses, reserve releases and better investment income. Allstate’s miss was driven by weaker underlying results in auto insurance due to higher auto claims frequency and severity, and the firm is raising prices in response. LIBMUT’s results deteriorated on FX losses from Venezuelan devaluation, higher catastrophes and losses in its energy portfolio, however, this was mitigated by good underlying profitability and strong balance sheet. Commercial insurance pricing continued deceleration trend over the past 2 years but market remained rational, while personal lines exhibited stable pricing trends in auto and increasing prices in homeowners’ insurance. P&C insurance industry is overcapitalized following several years of low catastrophe losses, which pressures prices. Share repurchases continued during 2Q15 but were manageable in light of strong capital levels. Consolidation activity is accelerating in the P&C sector worldwide amid competitive market conditions, weaker pricing and lower growth as evidenced by ACE/Chubb, XL/Catlin, Tokio Marine/HCC, several reinsurance M&A deals and potentially Zurich/RSA. We expect M&A activity to continue, particularly in reinsurance but primary P&C carriers could also get involved. BRK, ALL, XL and TRV are mentioned as buyers while reinsurers (AXS, RNR, RE), as well as WRB, HIG and CINF could be targets. IG accounts and model maintain M/W in P&C insurance sector driven by relatively tight valuations.

U.S. Health Insurance
2Q15 was characterized by large acquisitions announced in the health insurance sector with Anthem/Cigna and Aetna/Humana consolidating the sector. Both acquisitions will take 12-18 months to complete and will require regulatory/antitrust approvals. UnitedHealth funded $13 bn acquisition of pharmacy benefit manager, Catamaran through $10.5 bn in bond issuance. All companies reported strong 2Q15 results beating expectations, however, investors will mainly focus on $16 bn of debt planned for AET/HUM and $22 bn for ANTM/CI acquisitions. While the mergers have strong strategic rationale, we believe spreads will remain wide ahead of rating downgrades and debt issuance.

European Insurance
European insurers posted mixed results in 2Q15 with AXA and Allianz outperforming expectations with Swiss Re in line and Zurich missing expectations. Axa’ earnings were solid with good results in life & savings and asset management and improvement in economic solvency ratio driven by interest rates. Allianz benefited from solid results in P&C business boosted by low catastrophe losses and stable underlying loss ratio, while life results declined due to low interest rates and PIMCO’s revenue was down on outflows. Swiss Re reported slightly worsening underwriting results in P&C which were partly offset by the improvement in life and health reinsurance segments. Zurich’s results reflected weaker than expected P&C underwriting while capitalization remained solid. We expect more sub debt issuance from Zurich, particularly to fund potential acquisition. With capital certainty brought by Solvency 2 implementation in 2016 and low borrowing costs, most large European insurers will likely become more active in M&A. This is evidenced by Zurich’s likely bid for UK insurer RSA, as well as reported Axa and Allianz’s interest. We expect acquisitions to result in hybrid debt issuance, but note that ratings will remain of importance for the sector. We continue to favor subordinated debt of large multi-line European insurers.

Railroads reported mixed Q2 results with pressure on the top line due to weaker volume growth and lower fuel surcharges.  Commodity related volumes led the weakness with y/y declines in coal, agriculture and metals.  Volumes continue to be positive in intermodal, autos and construction related categories.  Underlying core pricing gains remain positive.  Lower diesel fuel costs offset some of the revenue declines and operating ratios were flat to slightly higher q/q.  YTD issuance for rails has increased y/y, largely for funding share repurchases and dividends, however leverage for the sector remains stable. Looking forward, volumes are expected to be slightly down for 2015 relative to 2014, (compared to beginning of the year expectations of +2-3% growth), however operating ratios are expected to improve with lower fuel costs.

European Banks
European Banks had solid Q2 earnings with most banks in-line or beating expectations.  Capital ratios improved across all geographies in Q2. Credit metrics such as liquidity, asset quality and leverage ratios improved across the board as well. Revenue growth remains tempered given the low interest rate environments continuing to put pressure on NIM, however many banks reported volume growth in both retail and commercial lending as well as growth in  fee and commission income. Reduction of non-core assets, focusing on more stable revenue sources by reducing size of investment banking units and exiting non-core geographies will continue to be a theme for the large global banks for remainder of 2015. TLAC issuance requirements and litigation concerns remain an overhang for the sector, however we expect ongoing balance sheet improvement/strengthening of credit fundamentals for the remainder of the year.

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