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MOODYS.COM
30 JANUARY 2017
NEWS & ANALYSIS Corporates 2 » Johnson & Johnson’s Credit-Negative Acquisition of Actelion
Involves a Rich Price and Large Portion of Its Cash » WestRock’s Acquisition of MPS Enhances Product and
Geographic Diversity » Plains All American’s Purchase of Concho Midstream Assets Is
Negative for Buyer, Positive for Seller » British Telecommunications’ Profit Warning Adds to Leverage » Tesco’s Proposed Merger with Booker Is Credit Positive » Morrison’s Debt Prepayment Further Improves Leverage, a
Credit Positive » Novartis’ Debt-Funded Share Buyback Programme Is
Credit Negative » Alibaba’s Stronger-than-Expected Quarterly Results Are
Credit Positive » PETRONAS and JX Holdings’ Ninth Liquefaction Train at
Malaysian Plant Is Credit Positive for Both
Infrastructure 12 » Keystone XL’s Revival Is Credit Negative for TransCanada
Banks 13 » Zions’ Credit-Positive Executive Pay Cut Allows Bank to Meet
Its Efficiency Target » Royal Bank of Scotland’s Provision for US RMBS Settlements Is
Credit Negative » Yorkshire Building Society’s Branch Closures and Rebranding
Are Credit Positive » Credit Agricole Records €491 Million Goodwill Impairment
Against LCL » Delays in Review of Greece’s Support Programme Threaten to
Jeopardise Banks’ Restructuring Plans » BDO Unibank’s Rights Issue Will Strengthen Its Capital Buffer
Insurers 23 » US Ruling to Block Aetna-Humana Merger Is Credit Negative
for Humana, Credit Positive for Aetna » Aetna’s Reinsurer Deal Provides Limited Risk Protection
US Public Finance 27 » Port of Long Beach Will Benefit from MSC and HMM’s Purchase
of Terminal Operator
Securitization 29 » Volkswagen Dealer Settlement Is Credit Positive for Its US
Floorplan ABS » Invitation Homes Will Pay Down Single-Family Rental
Securitizations with New Fannie Mae Loan, a Credit Positive
RECENTLY IN CREDIT OUTLOOK
» Articles in Last Thursday’s Credit Outlook 32 » Go to Last Thursday’s Credit Outlook
Click here for Weekly Market Outlook, our sister publication containing Moody’s Analytics’ review of market activity, financial predictions, and the dates of upcoming economic releases.
NEWS & ANALYSIS Credit implications of current events
2 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Corporates
Johnson & Johnson’s Credit-Negative Acquisition of Actelion Involves a Rich Price and Large Portion of Its Cash Johnson and Johnson (J&J, Aaa stable) on Thursday announced plans to buy Actelion (unrated), a Swiss pharmaceutical company, for $30 billion in cash. The deal is credit negative for J&J because it will deplete a significant portion of its cash for what may turn out be a poor investment. After the deal’s announcement, we affirmed J&J’s Aaa rating, reflecting its business attributes, financial ratios and qualitative factors. We had also already assumed that J&J would use its large and growing cash levels for business development.
At 33x adjusted last-12-month earnings, Actelion’s price is very rich compared with deals in other sectors, albeit less rich than pure-play pharmaceutical pipeline assets with negative earnings, which are currently popular among pharma companies. Even when incorporating lower research and development costs because a large portion of Actelion’s research function will be housed in a separate entity, the multiple is still high at about 25x last-12-month EBITDA. As shown in Exhibit 1, this is very rich compared with acquisition valuations in other sectors.
EXHIBIT 1
Actelion Is Valued at a High Enterprise Value/EBITDA Multiple Compared with Industry Medians
Notes: Medians from completed acquisitions of more than $1 billion since 1 January 2012. Sources: Dealogic and Moody’s Investors Service
Still, the deal is less risky than buying pure pipeline-stage assets. For instance, Gilead Sciences, Inc. (A3 stable) spent $11 billion in 2012 for Pharmasset, which had no earnings, while Pfizer Inc. (A1 stable) acquired Medivation in 2016 for an even higher multiple than Actelion, reflecting Pfizer’s expectations of high growth, including pipeline launches.
But Actelion’s valuation is less driven by future pipeline launches and more by J&J’s expectations for key products already on the market. Actelion has been profitable for years, and is a successful developer and marketer of drugs that treat pulmonary arterial hypertension (PAH). The separation of Actelion’s research and development programs into a separate entity – in which J&J will initially own a 16% stake – also helps reduce the risk associated with pipeline failures. That said, the multiple is still rich and assumes strong growth in Actelion’s revenues and profits.
J&J will fund the deal with cash that it has accumulated for several years and totaled more than $42 billion at year-end 2016. It will reduce J&J’s cash holdings to about $12 billion, and to about $8 billion considering
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Michael Levesque, CFA Senior Vice President +1.212.553.4093 [email protected]
This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history.
NEWS & ANALYSIS Credit implications of current events
3 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
the pending acquisition of Advanced Medical Optics. The large use of cash will leave J&J more susceptible to increases in gross debt.
Like other US pharmaceutical companies, J&J generates a significant portion of its cash flow offshore, and the company is unlikely to repatriate significant amounts of its cash – unless the US Congress adopts broad corporate tax reform. Absent tax reform, it is reasonable to assume J&J’s debt levels will grow over time to support its dividend, share repurchases and acquisitions. This would continue a trend in which J&J’s gross debt levels rose by $2.0 billion in 2013, $600 million in 2014, $1.1 billion in 2015 and $7 billion in 2016 (with the 2016 increase largely related to above-average share repurchases).
Actelion will add about $2.5 billion of revenue to J&J’s $72 billion revenue base. It will also improve the growth rates in its pharmaceutical business, which are slowing because of recent biosimilar competition for Remicade, a biotech that treats various autoimmune diseases. As J&J’s largest product, Remicade’s US sales totaled $4.8 billion in 2016, or about 7% of J&J’s revenues.
Actelion is the market leader in PAH, a rare type of high blood pressure that affects arteries in the heart and lungs. We expect solid growth in PAH drugs owing to rising treatments and expansion of eligible patients. Also, we believe PAH is somewhat less price-sensitive than other therapeutic areas because of the severity of the disease and somewhat limited treatment options.
However, Actelion’s largest PAH product, Tracleer, will face generics in 2017. Actelion’s newer PAH drugs include Opsumit and Uptravi. Uptravi, which treats a wider group of PAH patients, is expanding the market and contributing to high growth (see Exhibit 2). Opsumit is more similar to Tracleer in its approved patient population, and therefore could face pressure if payors become less willing to cover Opsumit once generic Tracleer is available.
EXHIBIT 2
Actelion’s Key Product Sales
Sources: Company filings and Moody’s Investors Service
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NEWS & ANALYSIS Credit implications of current events
4 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
WestRock’s Acquisition of MPS Enhances Product and Geographic Diversity WestRock Company (Baa2 stable) on Tuesday said that it had signed a definitive agreement to acquire packaging producer Multi Packaging Solutions Limited (MPS, B1 review for upgrade) for about $2.3 billion, including the assumption of debt. The addition of MPS’ 59 consumer packaging facilities across Europe, North America and Asia is credit positive for WestRock because it will further broaden its geographic and product diversification and generate cost synergies, while only modestly increasing its leverage.
MPS’s consumer- and healthcare-focused folding carton, rigid packaging, label and insert business will enhance and expand WestRock’s already-leading market positions across most of the primary corrugated and consumer packaging substrates. It will also significantly increase WestRock’s exposure to the premium end of the folding carton market, including customers focused on cosmetics, spirits, confectionary and over-the-counter drugs.
MPS’ packaging business is well run and currently generates EBITDA margins of about 15%, which is comparable with WestRock’s existing consumer packaging business. In addition, the integration will allow WestRock to internally supply 80,000 to 100,000 tons of paperboard that MPS currently buys from the open market.
WestRock plans to partly fund the acquisition, which it expects to close by June 2017, with an estimated $1 billion of net sale proceeds the company expects to reap from the recently announced sale of its Home, Health and Beauty business to Silgan Holdings Inc. (Ba1 review for downgrade). WestRock also plans to use about $300 million of cash on hand and about $1 billion of incremental debt. The company’s pro forma adjusted debt/EBITDA ratio will increase slightly as of 31 December 2016 to 3.0x from 2.8x, including our standard adjustments for pensions and operating leases.
We expect that WestRock’s adjusted leverage will quickly drop to 2.5x-2.7x, in line with the company’s target reported leverage of 2.25x-2.50x, given the strong cash flow generation we expect from the combined companies. We also believe WestRock will realize its projected $85 million in synergies within two years. The synergies will come primarily from increased paperboard integration, grade, machine and logistics optimization and increased scale and efficiencies.
With its principal executive office in Richmond, Virginia, and operating headquarters in Norcross, Georgia, WestRock is a leading integrated manufacturer of corrugated and consumer packaging. It is primarily focused on the manufacturing of packaging products from containerboard, bleached paperboard, coated natural kraft and coated recycled board.
Ed Sustar Senior Vice President +1.416.214.3628 [email protected]
NEWS & ANALYSIS Credit implications of current events
5 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Plains All American’s Purchase of Concho Midstream Assets Is Negative for Buyer, Positive for Seller Last Tuesday, Plains All American Pipeline L.P. (PAA, Baa3 review for downgrade) said that it had planned to spend $1.2 billion to buy the Alpha Crude Connector, a crude gathering system in the Permian Basin of west Texas, from Concho Resources Inc. (Ba1 stable) and Frontier Midstream Solutions (unrated). The acquisition is credit negative for PAA and credit positive for Concho. The deal, which initially PAA will significantly finance with debt, will stall the energy transportation company’s effort to deleverage from very high levels, forcing it to rely on equity issuance and asset sales to fund both the acquisition and negative free cash flow. We placed PAA’s rating on review for downgrade because of the transaction. Concho will benefit from the enhanced liquidity, which gives it the opportunity to ramp up its drilling program, fund acquisitions and reduce debt.
Concho, an independent exploration and production company, is the anchor shipper on the Alpha gathering system, which can transport more than 300,000 barrels of oil per day (bpd) today and can expand capacity to 350,000 bpd, along with crude storage facilities, truck terminals and multiple receipt points. However, Concho has no minimum volume commitments on the system, and total shipper nominations are about 85,000 bpd on Alpha today.
PAA plans to finance the Alpha acquisition and finance its negative free cash flow in 2017 by drawing from its revolving credit facilities, two of which total $3 billion and expire in 2019 and 2021, and will use equity issuances and asset sales in 2017 to pay back the short-term debt. The short-term borrowing will delay PAA’s effort to reduce its elevated debt/EBITDA ratio, which will have been around 6.0x for three consecutive last-12-month periods as of first-quarter 2017, forcing it to sell assets and issue equity to help fund the acquisition and negative free cash flow. We expect PAA’s EBITDA to grow in 2017 as contracted pipeline and terminal assets are brought into service, but turning growth capital into higher EBITDA and reduced leverage will remain difficult through the year.
Weak performance and high distributions have raised PAA’s leverage. PAA’s distribution coverage will improve to roughly a 1.1x run rate now that the company has eliminated incentive distribution rights payments since November 2016. Still, PAA’s gathering margins have fallen as US shale production has declined, leaving the company with more unused pipeline capacity than usual.
Meanwhile, PAA has weak liquidity to address the significant working capital it needs for its supply and logistics segment, its frequent acquisitions, and its distributions to unitholders. We expect the company to generate about $2.5 billion in EBITDA in 2017, including our adjustments, but the company will be cash flow negative after paying some $1.5 billion of distributions, $1.1 billion in capital spending and about $600 million in interest expenses.
For Concho, this transaction will bring in about $800 million in proceeds, assuming it exercises its option to buy out Frontier’s ownership interest at a price determined before the PAA deal. Concho has signaled that it will use these proceeds to scale up its drilling program, fund future upstream acquisitions, or reduce long-term debt. Deploying some of these proceeds into production and debt reduction will allow Concho to raise production to more than 170,000 bpd in 2017 from 153,000 bpd as of 30 September 2016. The sale also allows Concho to maintain its 50%-plus ratio of retained cash flow to debt. The transaction equals roughly a 600% return on capital for Concho, based on its investment in building and maintaining Alpha before PAA announced the deal.
Terry Marshall Senior Vice President +1.416.214.3863 [email protected]
Arvinder Saluja Vice President - Senior Analyst +1.212.553.1639 [email protected]
NEWS & ANALYSIS Credit implications of current events
6 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
British Telecommunications’ Profit Warning Adds to Leverage Last Wednesday, British Telecommunications Plc (BT, Baa1 negative) announced a significant revision of its earnings outlook for the next two years that included a profit warning, the conclusion of an independent review of its Italian business and challenges in the UK public sector and international services. BT’s profit warning is credit negative because it will increase the company’s already-high leverage following a recent hike in the pension deficit.
The revision in earnings guidance will increase Moody’s-adjusted leverage, as measured by adjusted debt/EBITDA, to 3.5x in full-year 2017 from our previous estimate of 3.3x. BT’s recent announcement also reduces visibility into the company’s operating performance.
The investigation into the Italian business revealed that the company had inadequate accounting practices and a complex set of improper sales, purchase, factoring and leasing transactions, all of which led to a meaningful overstatement of results over a number of years. Management has indicated that the revision is largely complete. However, even though the Italian business is a relatively small part of BT, the recent investigation signals inadequate operational controls at the company.
BT has meaningfully reduced its performance outlook for the next 18 months, with a reduction in EBITDA and free cash flow and flat revenue growth compared with previous guidance of moderate growth. BT has revised down its expectation of adjusted EBITDA growth for the full year by around £400 million to £7.6 billion for the next two years, which includes £175 million for the ongoing investigation in Italy and £225 million for significant revenue declines in the UK public sector and international corporate markets.
The company now expects reported normalised free cash flow to decline by £500 million to £2.5 billion in the full year to March 2017 and to £3.0-£3.2 billion in the full year to March 2018 from previous management guidance. The effect on free cash flow exceeds the reduction in earnings owing to negative one-offs arising from revisions of working capital movements. Furthermore, the company has maintained its dividend growth guidance at 10% per year.
The profit warning comes against the backdrop of an increase in the company’s pension deficit. The pension deficit surged to £11.5 billion (gross of tax) last October from £7.6 billion in June, in large part because of falling corporate bonds yields and higher inflation expectations (see exhibit), and has since declined to a still-high £11.1 billion as of December 2016. BT’s next triennial actuarial valuation should be finalised in the first half of 2018, and it appears increasingly likely that it will lead to an increase in pension cash contributions.
British Telecommunications’ Pension Deficit The pension deficit remains close to record high levels amid low yields.
Sources: The company and Moody’s Investors Service
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Laura Perez, CFA Vice President - Senior Analyst +34.91.7688.216 [email protected]
NEWS & ANALYSIS Credit implications of current events
7 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Tesco’s Proposed Merger with Booker Is Credit Positive On Friday, the boards of Tesco Plc (Ba1 stable), the UK’s largest food retailer, and Booker Group plc (unrated), the UK’s largest food wholesaler, announced that they had agreed to merge, pending approvals from regulators and Tesco’s and Booker’s shareholders. The proposed share-and-cash merger values Booker’s equity at approximately £3.7 billion, with the purchase consideration comprising cash of just under £800 million and new Tesco shares for the remainder. We understand that Tesco will use existing cash resources to fund the cash component. We consider the deal credit positive for Tesco.
Tesco management said that Booker’s wholesale activities will provide access to a larger, faster-growing market segment, the opportunity for efficiencies in the supply chain, and, in due course, innovation and improved asset utilisation that will drive significant potential synergies. We think the merger’s strategic logic is sound, although, as with any major merger deal, it carries execution risks and the possibility that planned synergies will not be realised in full.
Booker is a profitable business, with reported profit before tax of £153 million in fiscal 2016 (which ended 25 March 2016), and £81 million in the first half of fiscal 2017, at which time the company had no outstanding reported debt. Applying our usual adjustments to Booker’s pensions and operating leases, we calculate that Tesco’s pro forma Moody’s-adjusted gross debt will increase approximately £500 million to £25.1 billion. We also estimate that Tesco’s pro forma Moody’s-adjusted EBITDA will increase approximately £300 million to nearly £3.4 million, before taking account of the synergies that the companies expect will reach £200 million by the third year. Therefore, we estimate that Tesco’s current leverage of 7.9x will decline by approximately half a turn of EBITDA pro forma for the transaction, before factoring in any benefit from the synergies that Tesco expects.
As part of its announcement, Tesco outlined plans to reintroduce dividends during fiscal 2018 (which ends 28 February 2018), with guidance for earnings cover building toward 2x. Despite the proposed transaction’s positive effect on leverage and interest coverage metrics, Tesco’s credit quality is still weak for its Ba1 rating category. However, Booker’s cash generation will enhance Tesco’s cash flow. Furthermore, we continue to believe that Tesco’s management is committed to strengthening the company’s credit quality, including using cash resources to repay maturing debt as it comes due this year and next.
Tesco’s solid strategic rationale, pro forma improvements in leverage and interest coverage metrics, and enhanced post deal underlying free cash flow generation outweigh the negative credit implications of reintroducing dividends. However, and notwithstanding the operational progress evident in Tesco’s core UK retail business over the past year, the company remains weakly positioned in its Ba1 rating category and to be adequately positioned, would have to make further progress both operationally and in terms of credit metrics.
David Beadle Vice President - Senior Credit Officer +44.20.7772.5390 [email protected]
NEWS & ANALYSIS Credit implications of current events
8 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Morrison’s Debt Prepayment Further Improves Leverage, a Credit Positive Last Tuesday, UK grocer Wm Morrison Supermarkets plc (Morrison’s, Baa3 stable) announced the results of tender offers for certain outstanding debt. Those results enabled the company on 27 January to redeem early notes with face value totalling the equivalent of approximately £209 million. The debt reduction is credit positive for Morrison’s, providing clear evidence of management’s commitment to further strengthen the company’s balance sheet.
The latest early debt retirement, which follows an early redemption of £326 million of debt during 2016, will lead to a reduction in Moody’s-adjusted gross leverage of approximately 0.2x, as well as have a similarly positive effect on interest coverage ratios. As the exhibit below shows, Morrison’s leverage has fallen materially since September 2015, when we downgraded the company’s corporate family rating to Baa3 from Baa2. The improvement in this key credit metric (and others) has been achieved because of the combined effect of higher profitability and lower debt.
Morrison’s Deleveraging Positions It Well in Its Rating Category
Note: January 2017 estimated leverage is a Moody’s Investor Service estimate pro forma for the £209 million debt prepayment. Source: Moody’s Financial Metrics
Morrison’s has been successful in improving its operating profitability during fiscal 2017 (which ends January 2017) by focussing on cost efficiencies and on enhancing the shopping experience for customers. The company reported that its underlying operating profit margin rose to 2.6% in the first half of fiscal 2017, versus 2.0% a year earlier. Additionally, ahead of its full-year results announcement scheduled for early March, the company in its recent Christmas trading update guided to a full-year underlying profit before tax of £330-£340 million, compared with £242 million in fiscal 2016. The company in the trading update also confirmed ongoing momentum in like-for-like sales growth, which has now been positive since Christmas 2015.
As a result of the progress made both operationally and in terms of its financial profile, Morrison’s is now strongly positioned in the Baa3 rating category. However, the operating environment remains highly challenging and we have not yet witnessed to what extent the cost inflation emerging in the wake of sterling’s weakness will affect the UK grocery sector’s retail prices and margins, consumers disposable incomes, and potential shopping habits. In these circumstances, it remains too early to upgrade the rating or outlook.
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David Beadle Vice President - Senior Credit Officer +44.20.7772.5390 [email protected]
NEWS & ANALYSIS Credit implications of current events
9 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Novartis’ Debt-Funded Share Buyback Programme Is Credit Negative Last Wednesday, Novartis AG (Aa3 negative) announced with its full-year results that the company would execute a share buyback programme of up to $5 billion in 2017. The programme will exceed the company’s free cash flow in 2017, which we expect will total around $1.6 billion (as per our definition), and will be fully debt-funded, a credit negative. Following the announcement about the buyback, we changed Novartis’ outlook to negative from stable.
Novartis’ credit metrics were already weak for the Aa3 rating category as illustrated by its cash flow from operations (CFO)/debt of around 40% for 2016. Upon completion of the $5 billion buyback, we expect the ratio to weaken toward the low 30% range over the next 12 months. We do not expect the CFO/debt ratio to rebound to 50% – our expectation for the Aa3 rating – until 2019 at the earliest.
In its results presentation, Novartis also said that it would carry out a strategic review of Alcon, its ophthalmology division, during 2017 with a view to maximize shareholder value. Alcon could be a source of de-leveraging should Novartis sell the division and use the proceeds to pay down debt.
Novartis holds significant value through its ownership stake in Roche Holding AG (A1 stable), which is worth around $13 billion, and has a put option for its 36.5% stake in an over-the-counter joint venture with GlaxoSmithKline plc (A2 negative). The company can exercise the put option, which currently has an estimated value of around $10 billion, starting in March 2018. All of these assets could be monetized to partially or fully reduce debt. The future migration of Novartis’ credit rating likely depends on the company’s financial policies and to what extent it would prioritize shareholder-friendly actions over reducing debt.
During 2016, Novartis completed $765 million in acquisition net of divestments. The company has said that it may target bolt-on acquisitions, which could amount to $2-$5 billion per year. Debt-funded acquisitions toward the upper end of this range could put downward pressure on Novartis’ ratings unless mitigated by financial policies.
For 2016, Novartis reported flat sales in constant currencies of $48.5 billion. The innovative medicines division, contributing 67% of total revenues, suffered from generic competition owing to the loss of exclusivity of Gleevec, an oncology drug. Operating performance was stronger in Sandoz, Novartis’ generics division, whose sales rose 2% to $10.1 billion. Novartis continues to work on a turnaround of Alcon, whose sales declined by 2% and whose operating income was a negative $132 million.
For 2017, Novartis expects generic competition to continue and the company guided toward net sales being broadly flat compared with 2016 levels, with group core operating income being in line with the prior year or declining by a low single-digit percent.
Knut Slatten Vice President - Senior Analyst +33.1.53.30.10.77 [email protected]
NEWS & ANALYSIS Credit implications of current events
10 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Alibaba’s Stronger-than-Expected Quarterly Results Are Credit Positive Last Tuesday, Alibaba Group Holding Limited (A1 stable) announced better-than-expected fiscal third-quarter 2017 (which ended 31 December 2016) financial results, and raised its full-year revenue growth guidance to 53% year-over-year growth from 48%. We expect to raise our own revenue and cash flow forecasts as a result. These results and subsequent upward forecast revisions are credit positive because consistent strong cash flow generation will enhance Alibaba’s ability to invest in new business initiatives without jeopardizing its credit quality.
Alibaba has invested in growth areas globally, and earlier this month announced that it was part of a group that planned to take private Intime Retail (unrated) for a maximum consideration of $2.6 billion. Alibaba intends to further develop an omni-channel retailing format by integrating Alibaba and Intime’s strong presences both online and offline.
In the nine months to December 2016, Alibaba reported cash flow used in investing activities of RMB75 billion, while cash flow generated from operating activities was around RMB70 billion. Capital requirements to incubate new business initiatives, therefore, have been partially funded with debt. Total reported debt rose to RMB90.8 billion at the end of December 2016, from RMB57.6 billion a year earlier. Alibaba’s consistently strong cash flow generation from its core business is critical to buttressing the company’s financial profile, given its ongoing investment needs. Stronger-than-expected fiscal third-quarter performance illustrates the company’s ability to continue monetizing its large user base through marketing and commission revenue from brands and merchants. The exhibit below shows Alibaba’s increasing revenue per active buyer over the past few years.
Alibaba’s Revenue per Active Buyer by 12-Month Periods
Source: The company
We estimate that Alibaba will generate RMB70-RMB80 billion in operating cash flow over the next 12 months, which will enhance the company’s ability to invest in new business initiatives that will not immediately contribute cash flow. Strong cash flow from operations, together with a RMB43 billion reported net cash position, provide ample buffer room for Alibaba’s credit quality and reduce its reliance on debt funding.
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Lina Choi, CFA Vice President - Senior Credit Officer +852.3758.1369 [email protected]
Dan Wang Associate Analyst +852.3758.1529 [email protected]
NEWS & ANALYSIS Credit implications of current events
11 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
PETRONAS and JX Holdings’ Ninth Liquefaction Train at Malaysian Plant Is Credit Positive for Both Last Monday, Japan’s JX Holdings, Inc. (Baa2 negative) announced that on 1 January Petroliam Nasional Berhad (PETRONAS, A1 stable) had begun commercial operations at their ninth natural gas liquefaction train in the PETRONAS LNG Complex in Malaysia. The train has an annual liquefied natural gas (LNG) production capacity of 3.6 million tonnes per annum (mmtpa). The new capacity is credit positive for Malaysia-based PETRONAS because the additional LNG output will boost the company’s revenue and strengthen its position as the largest LNG producer by volume in Asia. For JX Holdings, one of the major offtakers of LNG from the complex, the completion of the ninth train will ensure a steady supply of LNG from Asia.
The train is 90%-owned by PETRONAS and 10% by JX Holdings. A liquefied natural gas complex or plant is made up of one or more trains that convert natural gas into liquefied natural gas for easier transportation.
Additional liquefaction capacity will increase PETRONAS’ ability to monetize its gas reserves in Malaysia by raising exports while domestic consumption growth remains low. Assuming full capacity utilization in 2017 and an average LNG selling price of $6.00-$7.50 per million British thermal units (MMBtu), PETRONAS’ total revenue for 2017 will increase by 2.3%-2.7% or $1.1-$1.3 billion from the company’s reported revenue of MYR206.4 billion ($50 billion) for the last-12-month period that ended September 2016. A 3.6 mmtpa increase in production volumes will partly compensate for currently soft crude oil and gas prices, which has resulted in a 22% year-on-year decline in PETRONAS’ revenue to MYR146.3 billion ($35.7 billion) for the nine months that ended September 2016.
The exhibit below shows how PETRONAS’ LNG will rise with the additional train.
PETRONAS’ LNG Sales Volume Will Increase with the Additional Capacity
Sources: PETRONAS and Moody’s Investors Service estimates
Although the entire volume of LNG from the new train will be sold under long-term contracts, the selling price remains linked to crude oil prices, which is in line with the company’s existing long-term LNG sales contracts. PETRONAS’ LNG sales volume totaled around 30.17 million tonnes in 2015, which translates into a global market share of around 12%.1 The PETRONAS LNG Complex is one of the world’s largest LNG production facilities at a single location, with a total nameplate production capacity of around 30 mmtpa.
1 Based on global LNG trade of 244.8 million tonnes in 2015, according to the 2016 World LNG Report.
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Diana Beketova, CFA Associate Analyst +65.6398.3724 [email protected]
Vikas Halan Vice President - Senior Credit Officer +65.6398.8337 [email protected]
Kailash Chhaya Vice President - Senior Analyst +81.354.084.201 [email protected]
NEWS & ANALYSIS Credit implications of current events
12 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Infrastructure
Keystone XL’s Revival Is Credit Negative for TransCanada Last Thursday, TransCanada Corporation (Baa1 stable) formally re-submitted a Presidential Permit application to the US Department of State to build the Keystone XL pipeline. The resubmission came two days after US President Donald Trump signed the Presidential Memorandum Regarding Construction of the Keystone XL pipeline, which invited TransCanada to resubmit its application. This memo significantly increases the odds that the roughly $8 billion Keystone XL (KXL) will be built, which would be credit negative for TransCanada because of the incremental strain this project would place on the company’s already-weak financial metrics, as well as the execution risk associated with construction.
TransCanada has limited balance sheet strength to pursue a large capital project absent substantial additional credit friendly corporate action such as issuing equity or further asset sales. Increased capital spending on KXL, absent a clear funding plan that does not negatively affect its deleveraging plans, would be credit negative. However, later in the project’s life cycle after construction is complete, KXL would generate long-term stable cash flow, a credit positive.
TransCanada’s adjusted debt/EBITDA was 7.5x for the 12 months to 30 September 2016, although after adjusting to annualize the Columbia Pipeline Group, Inc. (Baa2 stable) acquisition completed on 1 July 2016 and a CAD3.2 billion equity issuance in November used to reduce debt, financial metrics improve to 6.4x. These levels remain well above the 5x thresholds we associate with the current rating. We expect debt/EBITDA of 5.0x-5.5x in 2017 and below the 5.0x in 2018. We expect the improvement in financial metrics to be largely driven by a sizable capital program during 2016-18 that totals approximately CAD25 billion of assets in service. This will drive an increase in EBITDA and improve leverage metrics, assuming limited incremental debt financing.
Mr. Trump’s memo significantly increases the odds that the pipeline will be built. The memo invited TransCanada to re-submit its application to the Department of State for a Presidential Permit , a permit that former US President Barack Obama had previously denied. It also provides for an expedited review process in several ways, including by directing the US Secretary of State to make a final permitting determination within 60 days of the application submission. And, it directs that the lengthy Final Supplemental Environmental Impact Statement issued by the Department of State in January 2014 may be used to meet various government requirements, expediting reviews and limiting some avenues for delays and challenges to the project.
Despite the shift to a favorable political and regulatory environment, substantial hurdles remain before construction can begin. Mr. Trump has insisted on better terms from TransCanada to ensure that the US national interest is met. He has also signed a memorandum aimed at maximizing the American manufacturing content of pipelines used in the US. It remains to be seen whether these terms and actions will drive some form of additional project cost that could materially affect project economics for TransCanada and its shippers. We assume that any terms would likely include the resolution of some legal claims in the US, including a $15 billion North American Free Trade Agreement claim filed by TransCanada following Mr. Obama’s denial of the permit in 2015.
Other obstacles to completing the pipeline remain and threaten to increase execution risk. TransCanada has not yet secured all state approvals. The Nebraska Public Utilities Commission has not completed its review of the pipeline and the route through the state has not been finalized. Furthermore, public opposition continues to challenge the execution of large pipeline projects. TransCanada will have the benefit of observing and learning from other large high-profile projects in the US and Canada. Other project specifics have yet to be determined as well, including for example the incremental cost to complete the project. TransCanada previously incurred CAD4.3 billion of costs before taking a write-down in January 2016.
Gavin MacFarlane Vice President - Senior Credit Officer +1.416.214.3864 [email protected]
NEWS & ANALYSIS Credit implications of current events
13 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Banks
Zions’ Credit-Positive Executive Pay Cut Allows Bank to Meet Its Efficiency Target Last Monday, Zions Bancorporation ((P)Baa3 no outlook) disclosed in its fourth-quarter earnings report that it had improved its efficiency ratio to 65.8%, meeting its 2016 adjusted efficiency target of less than 66%.2 In order to achieve this level, Zions’ management had to cut its own compensation, fulfilling a promise it made earlier in the year. This is credit positive because Zions’ high efficiency ratio has been a key driver of its below-average profitability and a 65.8% ratio is a significant improvement from prior years. The bank’s action to cut its executive compensation to meet its target demonstrates Zions’ commitment to cost management.
In 2015, Zions’ announced an efficiency initiative, which included the goals of an efficiency ratio of less than 66%, an adjusted noninterest expense of less than $1.58 billion in 2016, and an efficiency ratio in the low 60s in 2017. Zions also stated that, if necessary, it would adjust executive compensation to meet these goals in 2016. There were several expenses, most notably healthcare costs, which were unexpectedly higher in fourth-quarter 2016. To compensate, the company reduced management incentive compensation to an amount that was $5 million less than planned for the fourth quarter of 2016 in order to achieve an efficiency ratio less than 66% for the year.
The major contributor to Zions’ efficiency improvement was its ability to keep expenses flat at $1.58 billion, while growing revenue, as shown in Exhibit 1. It was able to contain costs largely by streamlining processes and consolidating seven bank charters into one in 2015. Compensation tied to efficiency targets was also part of its initiative.
EXHIBIT 1
Zions Improving Efficiency Ratio
Note: Adjusted data as reported by Zions. Source: Zions Bancorporation
Zions’ expense control in 2016 reinforces its ability to meet its 2017 goal of an efficiency ratio in the low 60s. Exhibit 2 shows that Zions’ fourth-quarter 2016 unadjusted efficiency ratio is moderately above the 63% median of its large bank peers, which is a narrower gap than in the past. In 2017, Zions expects that its expenses will increase 2%-3%, while 2016 was flat compared with 2015. Therefore, achieving its goal will require Zions to maintain revenue growth. Because almost 80% of its revenue comes from net interest
2 Adjusted efficiency excludes certain revenues and expenses. Details can be found in Zions’ financial disclosures.
73.5%
70.7%
65.8%
$1.0
$1.3
$1.5
$1.8
$2.0
$2.3
$2.5
50%
55%
60%
65%
70%
75%
2014 2015 2016
$ Bi
llion
s
Efficiency Ratio - left axis Expense - right axis Revenue - right axis
Rita Sahu, CFA Vice President - Senior Credit Officer +1.212.553.1648 [email protected]
NEWS & ANALYSIS Credit implications of current events
14 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
income, higher interest rates along with its asset-sensitive balance sheet – and the consequential rise in its net interest margin – will help it achieve this goal.
EXHIBIT 2
Large Banks’ Fourth-Quarter 2016 Efficiency Ratio Zions has narrowed the efficiency gap with its large bank peers.
Note: Unadjusted efficiency ratios for comparability. BAC = Bank of America Corporation; BBT = BB&T Corporation; C = Citigroup, Inc.; CFG = Citizens Financial Group, Inc.; CMA = Comerica Incorporated; HBAN = Huntington Bancshares Incorporated; JPM = JPMorgan Chase & Co.; KEY = KeyCorp; MTB = M&T Bank Corporation; PNC = PNC Financial Services Group; Inc.; RF = Regions Financial Corporation; STI = SunTrust Banks; Inc.; USB = U.S. Bancorp; WFC = Wells Fargo & Company; ZION = Zions Bancorporation. Source: The banks
63%
50%
55%
60%
65%
70%
75%
80%
KEY HBAN ZION BAC RF STI CMA PNC CFG WFC BBT C JPM MTB USB
Efficiency Ratio Median = 63%
NEWS & ANALYSIS Credit implications of current events
15 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Royal Bank of Scotland’s Provision for US RMBS Settlements Is Credit Negative Last Thursday, The Royal Bank of Scotland Group plc (RBS, Ba1 positive) announced an additional £3.1 billion ($3.8 billion) provision for investigations and litigations related to US residential mortgage-backed securities (RMBS). The additional provision is credit negative for RBS because it will negatively affect the firm’s 2016 earnings and reduce its capital position. RBS still faces a high level of uncertainty with respect to RMBS settlements with US authorities, and may recognise further substantial additional provisions and costs.
The provision would reduce RBS’ pro forma third-quarter 2016 common equity Tier 1 (CET1) capital ratio by 135 basis points to 13.6%, a level that still exceeds the median for global banks with large capital markets activities (see Exhibit 1). RBS targets a CET1 ratio of more than 13%, after settling large pending litigations and remaining budgeted restructuring costs. We continue to expect that RBS’ capital ratios will experience a decline in the coming quarters while the bank settles outstanding litigations, implements its remediation measures and records further restructuring charges and non-core losses.
EXHIBIT 1
Global Investment Banks’ Common Equity Tier 1 Ratios, September 2016
Note: CET1 ratios are on a look-through/fully loaded basis. RBS data is pro forma including the announced £3.1 billion provision. The median includes RBS. Sources: The banks and Moody’s Investors Service
The announced provision takes the total aggregate of such US RMBS reserves to £6.7 billion ($8.3 billion) as of 31 December 2016, including a significant portion related to litigation with the US Federal Housing Finance Agency. Based on RBS’ RMBS market share of 9.8% during 2004-07, and on the median and the high-end settlement cost per basis point of market share for selected banks (see Exhibit 2), we estimate the potential cost for RBS to settle remaining major US RMBS legal matters to be between $6.7 billion (median settlement) and $13.1 billion (high-end settlement). RBS would be able to fully cover the estimate in the median scenario with existing reserves, but the high-end scenario’s estimate would negatively affect RBS’ CET1 by around 160 basis points.
15.9%
14.0% 13.9% 13.6%12.6% 12.0% 11.9% 11.9% 11.6% 11.4% 11.4%
11.1% 10.9%
0%
3%
6%
9%
12%
15%
18%
MorganStanley
UBS HSBCHoldings
RBS (pro-forma)
Citigroup CreditSuisse
JP Morgan GoldmanSachs
Barclays BNP Paribas SocieteGenerale
DeutscheBank
Bank ofAmerica
CET1 Ratio Median CET1 Ratio = 11.9%
Alessandro Roccati Senior Vice President +44.20.7772.1603 [email protected]
Laurie Mayers Associate Managing Director +44.20.7772.5582 [email protected]
NEWS & ANALYSIS Credit implications of current events
16 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
EXHIBIT 2
Selected RMBS Settlements with US Department of Justice and State Attorneys General, RMBS Market Share and Settlement Cost per Basis Point of Market Share
RMBS Market Share 2004-07 Settlement Date
Settlement Amount
$ Billions
Settlement Cost per Basis Point of Market Share
$ Millions
JP Morgan 18.0% 19 November 2013 $3.1 $1.7
Citibank 4.9% 14 July 2014 $4.3 $8.7
Bank of America 16.5% 21 August 2014 $5.9 $3.6
Morgan Stanley 3.1% 11 February 2016 $2.8 $8.9
Goldman Sachs 7.4% 11 April 2016 $2.6 $3.6
Deutsche Bank 6.4% 23 December 2016 $3.1 $4.8
Credit Suisse 7.5% 23 December 2016 $2.5 $3.3
Notes: JPMorgan includes Bear Stearns; Bank of America includes Countrywide and Merrill Lynch. Market shares include resecuritizations of RMBS into collateralized debt obligations. Settlement amounts shown include only payments to the Justice Department and state attorneys general. Payments to other government agencies and consumer relief are not included. Sources: Asset Backed Alert and US Department of Justice
A settlement of US RMBS litigations in line with our expectation would be positive because it would reduce uncertainty and tail risk, and would allow management to focus on executing its restructuring plan, which, if successful, would benefit bondholders. We view the business plan’s ultimate objectives of de-risking the bank and strengthening and stabilizing its earnings as credit-positive goals.
NEWS & ANALYSIS Credit implications of current events
17 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Yorkshire Building Society’s Branch Closures and Rebranding Are Credit Positive Last Wednesday, Yorkshire Building Society (YBS, A3/Baa1 stable, baa13) announced the closure of 48 of its 308 branches and agencies and the rebranding of its subsidiary, Norwich and Peterborough (N&P), to the YBS name. YBS also announced that it was withdrawing N&P’s current account offering. These changes are credit positive for YBS because we expect them to improve the building society’s operating efficiency over the next three to five years, reduce overhead and eliminate some smaller and less efficient branches.
YBS, which operates significantly more branches than its peers do, leading to higher relative salary costs, plans to close 20 YBS branches in May 2017 and 28 N&P branches starting in September 2017. In 2015, YBS reported staff cost as a percentage of total income of 28.3%, versus 19.5% for Coventry Building Society (CBS, A2/A2 negative, a3), its closest peer. Although YBS’ total assets were only 12% higher than CBS’ at the end of 2015, the difference of managed assets per full-time branch employee is significant and has been increasing over the past few years (see exhibit).
Yorkshire Building Society’s and Coventry Building Society’s Ratio of Total Assets to Average Number of Full-Time Branch Employees
Source: The companies
YBS’ cost-to-income ratio (using our standard adjustments) has increased in recent years, reaching 63.8% at the end of June 2016 from 54.7% as of the end of 2012, partly because of the launch of a strategic investment programme in 2012 to integrate subsidiary brands and improve digital infrastructure. We expect that the branch closures will yield positive financial results within the next three to five years, although the immediate effect from increased restructuring costs is likely to increase cost-to-income in 2017 and 2018.
Risks related to the closure of branches include reduced business growth, as customers favour lenders with more branches, and funding shortages, as customers withdraw their deposits in favour of more convenient local options. However, we do not expect that YBS’ reduced footprint will materially affect business growth because the majority of its mortgage customers are sourced through mortgage brokers. Additionally, a majority of the closing branches are small and located in eastern England, where YBS only had 4.3% of its retail lending as of the end of 2015. Based on YBS’ closure in 2015 of 22 branches and the rebranding of Barnsley and Chelsea Building Societies to YBS, we do not expect any material deposit withdrawal from customers loyal to the N&P brand.
3 The bank ratings shown in this report are the building society’s deposit rating, senior unsecured debt rating and baseline credit
assessment.
0x
10x
20x
30x
40x
50x
60x
70x
80x
90x
100x
2010 2011 2012 2013 2014 2015
Yorkshire Building Society Coventry Building Society
Aleksander Henskjold Analyst +44.20.7772.1954 [email protected]
Gorka Nunez Palacio Associate Analyst +44.20.7772.1645 [email protected]
NEWS & ANALYSIS Credit implications of current events
18 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
YBS also announced that it was withdrawing its N&P current account offering to existing customers. This is credit positive because we expect that the capital needed to scale N&P’s current account offering across the YBS network will have higher return and lower risk if YBS applies it to the core business. Also, if YBS were to offer a current accounts product that was competitive against the high street market leaders, it would have required a significant investment.
NEWS & ANALYSIS Credit implications of current events
19 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Credit Agricole Records €491 Million Goodwill Impairment Against LCL On 20 January, Credit Agricole S.A. (CASA, A1/A1 stable, baa14) announced that it would take a €491 million goodwill impairment charge against its French retail bank LCL, whose declining contribution to CASA’s accounts reflects the current low interest rate environment. The credit-negative impairment charge will not affect CASA’s regulatory capital ratios because goodwill is deducted from the ratios’ calculations; nor will it affect the bank’s liquidity or dividend policy.
LCL, which had a €64 billion book of French housing loans as of 30 September 2016 that accounted for 64% of its outstanding loans, posted a 2.4% year-over-year decline in underlying revenues in the third quarter of 2016, and a 7.4% decline in the first nine months of the year. Revenue decreased amid high levels of housing loan refinancing at lower interest rates and early full redemptions, which reduced net interest margins. More than half of LCL’s stock of housing loans, or €36 billion, has been renegotiated or repaid early since 2014 amid a low interest rate environment (see exhibit). We expect that interest rates will remain low over the next 12-18 months. Therefore, LCL’s net interest revenues should remain negatively pressured.
LCL’s Housing Loans Refinancing and Early Full Redemptions as a Percent of Outstanding Housing Loans, 2014-16
Source: Credit Agricole
Although goodwill impairment tests are forward-looking, we expect that CASA might have to record additional declines in the value of LCL’s goodwill in its future accounts if very low interest rates persist. CASA disclosed total net goodwill of €13.1 billion as of 30 June 2016, with LCL composing the largest share of it. Post-impairment, we estimate that LCL will still account for €4.8 billion of goodwill. CASA also has net goodwill of €1.7 billion for its retail bank in Italy, but we do not expect significant goodwill impairments in Italy because housing loans there are mostly floating rate, making housing loan renegotiations and early repayments less frequent.
Despite LCL’s 3.2% year-over-year increase in outstanding housing loans at 30 September 2016, LCL’s net interest income declined, which bodes poorly for CASA’s €250 billion book of its regional banks’ housing loans as of 30 September 2016. Despite a 5.7% annual increase of the housing loan book at 30 September 2016, the regional banks’ operating revenues decreased 7.7% in the third quarter of 2016 and 4.1% in the first nine months of the year, also because of loan renegotiations and early repayments, despite a rural clientele that is less prone to home loan prepayment.
4 The bank ratings shown in this report are Credit Agricole’s deposit rating, senior unsecured debt rating and adjusted baseline
credit assessment.
0%
1%
2%
3%
4%
5%
6%
7%
8%
Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Q2-15 Q3-15 Q4-15 Q1-16 Q2-16 Q3-16
Renegotiations Early Redemptions
Guillaume Lucien-Baugas Vice President - Senior Analyst +33.1.53.30.33.50 [email protected]
NEWS & ANALYSIS Credit implications of current events
20 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Delays in Review of Greece’s Support Programme Threaten to Jeopardise Banks’ Restructuring Plans Last Thursday, Eurogroup President Jeroen Dijsselbloem pressed the parties involved in negotiating the second review of Greece’s support programme to accelerate their work to reach a long-delayed staff-level agreement as quickly as possible. The continued delay in concluding the programme’s second review is credit negative for Greek banks because it jeopardises their restructuring plans, including the main pillar of reducing nonperforming exposures (NPEs) by around 40% by the end of 2019. The timely implementation of the Greece’s support programme is vital for the economy to grow during 2017-19, and to gradually restore bank depositors’ and investors’ confidence in the country and its banking system.
The delay in concluding the second review centres on Greece’s disagreement to legislate any fiscal measures beyond August 2018, when its third economic adjustment programme ends. This raises the risk that banks’ strategic planning will be scuttled, given that the crisis-hit economy is likely to be negatively affected by a potential suspension of new investments and liquidity squeeze in the market. Greek banks are eager for the government to finalise and revise the framework for managing their bad debts.
According to banks’ restructuring plans approved by the European Central Bank’s (ECB) single supervisory mechanism (SSM), NPEs are to decline by approximately 40% by the end of 2019, or, in nominal terms, to €67 billion in December 2019 from €107 billion in September 2016. As shown in the exhibit below, the NPE-to-gross loan ratio for the system will need to decline to 34% in December 2019 from a high of 51% in September 2016. The decrease in NPEs will be mainly driven by loan restructurings and curing of loans, but also through write-offs and liquidations.
Greek Banks’ Nonperforming Exposure Operational Targets, 2016-19
Note: Exposures refer only to on-balance-sheet items of all commercial and cooperative banks in Greece on an individual basis and not on a consolidated group basis. Source: Bank of Greece
Greek banks are expecting that the legislation and implementation of certain tools and reforms will help them in this regard. But these have been delayed by the still-pending conclusion of the second review. Some of these tools include an out-of-court arbitration process, changes to Greece’s antiquated bankruptcy code, legal immunity for banking executives who approve corporate restructuring plans and electronic auctions of foreclosed property.
Additionally, the completion of the second review is also important in terms of Greek banks’ ability to improve their funding profile through increasing customer deposits and reduced reliance on emergency liquidity assistance (ELA). The much-coveted re-inclusion of Greek government bonds into the ECB’s quantitative easing programme sometime in the spring of this year is also contingent on the conclusion of
€ 106.90 € 106.90 € 105.80 € 105.20 € 103.40 € 102 € 98.20 € 83.30 € 66.70
51% 51% 51% 51% 50% 50%48%
42%
34%
0%
10%
20%
30%
40%
50%
60%
€ 0
€ 20
€ 40
€ 60
€ 80
€ 100
€ 120
Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Dec-18 Dec-19
€Bi
llion
s
Gross Nonperforming Exposures - left axis Nonperforming Exposure Ratio - right axis
Nondas Nicolaides Vice President - Senior Credit Officer +357.25.693.006 [email protected]
NEWS & ANALYSIS Credit implications of current events
21 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
the second review. This is likely to improve significantly depositors’ confidence, and trigger deposit inflows from the more than €15 billion cash placed outside of Greece’s banking system, as per the Bank of Greece governor’s estimate. A reduction in the ELA and an increase in customer deposits will help reduce banks’ cost of funding and support earnings.
Further delays in the second review of Greece’s third bailout programme risk rendering banks unable to implement their restructuring plans both in terms of reducing their NPEs and returning to profitability after being loss-making during the past few years. Such a scenario would place banks in a more vulnerable position ahead of another round of stress tests by the ECB in 2018, elevating significantly risks for creditors and depositors.
NEWS & ANALYSIS Credit implications of current events
22 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
BDO Unibank’s Rights Issue Will Strengthen Its Capital Buffer Last Thursday, BDO Unibank, Inc. (Baa2/Baa2 stable, baa25) announced that it had raised approximately PHP60 billion ($1.2 billion) in new capital via a rights issue. The capital increase is credit positive because it strengthens the banks’ capitalization ahead of implementation of the domestic systemically important bank (D-SIB) buffer and supports future credit growth.
Under the Bangko Sentral ng Pilipinas rules, banks designated as D-SIBs will be required to hold additional loss-absorbency capital of 1.5% or 2.5% of risk-weighted assets to be phased in over two years and fully in place by January 2019. We expect that BDO, the largest bank in the system with a market share of 17.8% of deposits and 20.8% of loans as of 30 September 2016, will be required to maintain a minimum common equity Tier 1 (CET1) ratio of 11.0% and a total capital ratio of 12.5% (including a 2.5% capital conservation buffer and a 2.5% D-SIB buffer) by January 2019.
Because of the capital raise, we estimate BDO’s CET1 ratio will improve to 14.2% at year-end 2016, from 11.1% at 30 September 2016 (see exhibit), providing sufficient headroom to meet the Basel III capital rules.
BDO Unibank’s Capitalization
Sources: Company data and Moody’s Investors Service forecast
Furthermore, the additional capital will support the bank’s credit expansion in a period of strong loan growth in recent years amid the country’s favorable macroeconomic prospects. We expect that BDO will grow its loan book by 15%-18% by year-end 2017, in line with growth over the past five years. Taking into account this credit growth, we estimate that BDO’s CET1 ratio will be about 13.7% and its total capital ratio will be about 15.2% at 30 December 2017.
The capital raise will also bring BDO’s capitalization in line with the domestic peers Bank of the Philippine Islands (Baa2 stable, baa2), whose CET1 ratio was 13.3% as of 30 September 2016, and Metropolitan Bank & Trust Company (Baa2 stable, baa2), whose CET1 ratio was 14.5% as of 30 September 2016. Both banks raised capital in the past two years.
5 The bank ratings shown in this report are the bank’s deposit rating, senior unsecured debt rating (where available) and baseline
credit assessment.
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
Sep 2016 Dec 2016 Pro-forma Dec 2017 Forecast
Common Equity Tier 1 Tier 1 Tier 2
Alka Anbarasu Vice President - Senior Analyst +65.6398.3712 [email protected]
NEWS & ANALYSIS Credit implications of current events
23 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Insurers
US Ruling to Block Aetna-Humana Merger Is Credit Negative for Humana, Credit Positive for Aetna Last Monday, a US federal judge blocked Aetna Inc.’s (Baa2 stable) proposed $37 billion merger with Humana Inc. (Baa3 review for upgrade), ruling in favor of the plaintiffs, including the Department of Justice (DOJ), which challenged the merger on antitrust grounds.
The ruling is credit negative for Humana, which loses the opportunity to be part of Aetna’s larger organization and expanded market share, medical membership and product offerings. For Aetna, the deal’s derailment means paying a $1 billion breakup fee (about a quarter’s worth of pre-tax earnings), not capturing Humana’s sizable Medicare Advantage business and missing a diversification play. However, Aetna no longer faces the integration risks of a large acquisition and its leverage will drop substantially because it is obligated to repay about $10 billion of acquisition financing (on standby as cash at the holding company) if the deal is cancelled.
The court ruling is the latest setback in a nearly two-year-old merger process. The court mostly agreed with the main contentions of the DOJ’s antitrust case. The court concluded that a merger would substantially lessen competition across 21 states in Medicare Advantage markets where Aetna and Humana compete head to head. The decision also identified similar anticompetitive risks in three Florida counties where both firms sell individual commercial business on public exchanges.
It is unclear whether Aetna and Humana will appeal the court’s decision. In December, the companies extended their merger agreement to 15 February to accommodate the timing and outcome of the trial. We said that we would affirm Aetna’s ratings and upgrade Humana’s should the merger succeed. However, if the deal fails, we still expect to affirm Aetna’s Baa2 and Humana’s Baa3 ratings.
Our review for upgrade of Humana’s Baa3 rating reflects our view that the merger would significantly broaden the company’s product set, reducing its concentration in government-sponsored business (Medicare and Medicaid), which accounts for 78% of premiums and fees and 38% of membership. Medicare Advantage is the company’s largest risk concentration at 34% of Humana’s membership. The exhibit below compares the product profiles of the five largest publicly traded health insurers we rate, including the counterparties of the Aetna-Humana merger.
Total Medical Membership of Largest Publicly Traded Moody’s-Rated Health Insurers
Note: Based on medical membership at 30 September 2016. Sources: Company filings and Moody’s Investors Service
0
10
20
30
40
50
60
UnitedHealth Anthem Aetna CIGNA Humana
Mill
ions
Medicare Medicaid Commercial Risk Administrative Services Only
Pano Karambelas Vice President - Senior Credit Officer +1.212.553.1653 [email protected]
NEWS & ANALYSIS Credit implications of current events
24 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Aetna’s Baa2 ratings and stable outlook reflect the offsetting credit merits and risks of the merger. The company would acquire Humana’s historically profitable portfolio (and 10 million members, a 40% membership increase pro forma) with solid EBITDA margins averaging near 6% in recent years (6.2% in the first nine months of 2016) and stable underwriting results with medical loss ratios averaging 83.3% (83.6% in the first nine months of 2016). Humana’s sizable Medicare Advantage portfolio (a relatively small segment for Aetna) would incrementally diversify Aetna’s business distribution.
These benefits are overshadowed by the challenge of integrating a large health insurer, the substantial goodwill associated with the deal and much higher financial leverage (53.9% adjusted financial leverage at 30 September 2016 versus 34.8% at year-end 2015) from $13 billion of acquisition financing (issued in June 2016) with annual interest costs of nearly $400 million. We downgraded Aetna’s ratings in June 2016 based on the increase in leverage following the issuance of this debt. Post-acquisition, Aetna would also assume about $4 billion of debt from Humana. The company plans to de-leverage within two years after closing.
Should the transaction not close, Aetna may be required to pay Humana a termination fee of $1 billion, depending on the circumstances, which would significantly reduce earnings. However, the company would be obligated to redeem approximately $10 billion of the recently issued $13 billion debt financing, substantially improving the company’s leverage profile and financial flexibility. Despite the improvement, Aetna’s demonstrated appetite for large, debt-financed acquisitions constrains our overall credit view and informs our expectation of affirming Aetna’s ratings if the merger does not close.
NEWS & ANALYSIS Credit implications of current events
25 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Aetna’s Reinsurer Deal Provides Limited Risk Protection Last Wednesday, Aetna Inc. (Baa2 stable) announced that it had completed a new $200 million four-year reinsurance arrangement with Vitality Re VIII Limited, a special-purpose reinsurer. The arrangement mirrors similar transactions that Aetna has completed. Each transaction provides collateralized excess of loss (tail-risk protection) reinsurance coverage limited to the principal amount of the notes issued by the reinsurer on a portion of Aetna’s group commercial health business. In conjunction with these transactions, Aetna has obtained regulatory approval from regulators in Vermont and Connecticut to consider these as risk-reduction transactions that lower its capital requirement by allowing statutory capital credit for the assets held by the reinsurer in collateral accounts.
We view the risk and required capital reduction from these transactions as quite modest and temporary. To the extent that Aetna replaces a significant portion of long-term capital at its regulated subsidiaries with the capital credit from these transactions, the credit implication would be negative.
However, Aetna has so far limited the coverage obtained in these transactions to a relatively small amount, totaling $600 million as of 31 December 2013, $500 million as of 31 December 2014, $550 million as of 31 December 2015 and $750 million as of 31 December 2016. The new $200 million transaction effectively increases the overall amount of outstanding reinsurance to $800 million. The exhibit below lists Aetna’s Vitality-type insurance transactions.
Aetna’s Vitality-Type Insurance Transactions
Vitality Deal Amount
$ Millions Closing Date Maturity Date
I $150 January 2011 January 2014
II $150 April 2011 January 2014
III $150 January 2012 January 2015
IV $150 January 2013 January 2017
V $200 January 2014 January 2019
VI $200 January 2015 January 2018
VII $200 January 2016 January 2020
VIII $200 January 2017 January 2021
Source: Aetna
In our credit analysis, we focus on the risk-reduction aspect of the transaction and the quality of the capital credit the reinsurer supplies. The reinsurance agreements are structured with relatively high attachment points. The initial attachment points for the latest Aetna transaction are medical loss ratios (MLRs) of 102% ($140 million of Class A notes) and 96% ($60 million of Class B notes). The reinsurance initially exhausts at MLRs of 116% for the Class A notes and 102% for the Class B notes, levels that are unlikely to be reached given that Aetna’s MLR over the past three years falls into the narrow range of 81%-83%.
The Vitality Re VIII MLR attachment points will be reset annually to maintain an attachment probability and expected loss at or below those initially modeled and established at inception. Although we recognize some extreme tail risk reduction for Aetna as a result of these transactions (for example, in the event of a pandemic), we believe the probability of claims reaching the attachment point is fairly remote. Therefore, we do not believe that the transaction provides a substantial risk reduction.
Ellen Fagin Associate Analyst +1.212.553.1650 [email protected]
Pano Karambelas Vice President - Senior Credit Officer +1.212.553.1653 [email protected]
NEWS & ANALYSIS Credit implications of current events
26 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
The capital credit insurance that state regulators are allowing is generated from risk-linked bonds issued by the reinsurers, whose proceeds are then held in dedicated collateral accounts to pay any losses incurred under the reinsurance agreements. The balance goes to investors upon maturity of the bonds.
The funds held in the collateral accounts only cover the risk of excess claims for this specific block of policies and therefore are not available to support other businesses and financial risks at Aetna. This contrasts with unallocated capital held at operating subsidiaries, which is generally available to cover multiple liabilities and contingencies. Furthermore, because the reinsurance transaction will be in effect for a limited number of years, and there can be no assurances that the transaction will be replicated at maturity, the capital support provided by the funds in the collateral accounts is temporary. As a result, the capital support from this transaction is more limited and temporary in the financial protection it provides.
Based on this analysis, we give some limited recognition to these funds in our assessment of the insurer’s capital adequacy. In our analysis, we allow credit to the capital held in the collateral accounts to the extent that it supports no more than 25 percentage points of the insurer’s consolidated risk-based capital ratio at the National Association of Insurance Commissioners’ defined company-action level. We estimate that the current total of $800 million constitutes approximately 24 percentage points of Aetna’s risk-based capital ratio.
NEWS & ANALYSIS Credit implications of current events
27 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
US Public Finance
Port of Long Beach Will Benefit from MSC and HMM’s Purchase of Terminal Operator On 18 January, a US bankruptcy court approved the sale of Hanjin Shipping’s 54% stake in Total Terminals International (TTI, unrated), a marine terminal operator with concessions at the Port of Long Beach (Aa2 stable) in California. The sale of TTI is credit positive for the Port of Long Beach because it preserves the highly valuable lease of the Pier T container terminal through 2027. Additionally, it strengthens the corporate guaranty securing the lease and places the underutilized Pier T with an experienced and financially stable terminal operator affiliated with a carrier network that controls 21% of the trans-Pacific ocean shipping market. The sale also avoids a foreclosure by TTI’s senior lenders, preserves the minimum revenue guarantees contained in the lease, and will likely increase cargo volume at the port.
Mediterranean Shipping Company (MSC), the current minority owner of 46% of TTI, acquired the remaining 54% interest in a deal valued at $300 million. Upon closing, MSC will sell 20% of TTI to Hyundai Merchant Marine (HMM), a strategic partner of the shipping alliance formed by MSC and Maersk.
Landlord port authorities such as Long Beach depend on stable minimum revenues from tenants, even requiring varying degrees of additional security to ensure the receipt of minimum revenues in the event the tenant cannot fund its obligations. The lease of Pier T accounted for a significant 30% of Long Beach’s revenues for fiscal 2015 (which ended 30 September 2015). A failed bidding process or liquidation of TTI would have been highly disruptive for Long Beach, with its only immediate recourse to invoke the financial guaranty provided by the bankrupt Hanjin Shipping. Upon the change in ownership, TIL will provide a guaranty securing the full lease at Long Beach and a guaranty securing two years of rent payments at Seattle.
TTI’s operations were severely affected by Hanjin’s bankruptcy because TTI depended on contractually committed cargo volume from Hanjin for the majority of its business. Hanjin provided 650,000 of the 1.3 million containers of volume at Pier T, and revenue throughput fell by half after the bankruptcy. With most trans-Pacific cargo contractually committed to other marine terminals on the West Coast, TTI was unable to secure sufficient replacement volume and defaulted on a senior bank facility debt service payment in December 2016.
The leased terminals are now in stronger hands, both financially and operationally, which is important given that the trans-Pacific container shipping market is highly competitive and available cargo volume is increasingly concentrated among large shipping alliances with the negotiating power, network reach and economies of scale to outcompete smaller carriers. MSC, the second-largest ocean carrier by capacity globally, controls significant cargo volume through its contracts with cargo owners and shippers and through its participation in the 2M Alliance with Maersk. HMM’s 20% interest in TTI will allow the carriers to leverage additional cargo controlled through the 2M Alliance’s capacity-sharing agreement with HMM. Indeed, HMM has already announced that it will shift service to Long Beach from the Port of Los Angeles (Aa2 stable).
Beyond stabilizing TTI, the new ownership offers the potential for growth at Long Beach (see exhibit). Despite being the largest shipping alliance globally, 2M was underrepresented in the trans-Pacific market. But Maersk’s acquisition of Hamburg Süd and 2M’s slot-sharing agreement with HMM, both finalized in December 2016, provide the alliance partners with approximately 21% of the trans-Pacific market. MSC already leases Pier A at Long Beach, and the decision to secure capacity and acquire a second and much larger minimum revenue commitment at Pier T reflects the alliance partners’ intent on growing market share, which will benefit volume growth at Long Beach.
Moses Kopmar Analyst +1.212.553.2846 [email protected]
NEWS & ANALYSIS Credit implications of current events
28 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Container Capacity of Ship Lines Affiliated with Pier T at Long Beach, Effective 1 April 2017
Note: Container capacity is expressed in twenty-foot equivalent units (TEUs) Source: Alphaliner
2.85
-0.63
3.26
0.61
0.460.03
6.58
0
1
2
3
4
5
6
7
Mediterranean Shg Co Hanjin Shipping APM-Maersk Hamburg Süd Group Hyundai M.M. SM Line Total
Mill
ions
of T
wen
ty-F
oot
Equi
vale
nt U
nits
NEWS & ANALYSIS Credit implications of current events
29 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Securitization
Volkswagen Dealer Settlement Is Credit Positive for Its US Floorplan ABS On Monday, Volkswagen Aktiengesellschaft (VW, A3 negative) received final approval from a US federal court for a $1.2 billion cash settlement with the 652 authorized VW dealers in the US affected by the company’s diesel-emissions scandal. The settlement also requires the company to repurchase all affected vehicles in dealer inventory for which no fix is available.
The settlement is credit positive for the outstanding US auto dealer floorplan asset-backed securities (ABS) transaction issued by VW’s indirect subsidiary, VW Credit, Inc. (VCI, A3 negative), because in addition to benefiting from cash payouts and inventory repurchases, the dealers will continue to receive manufacturer incentive payments for a period of 12 months and can defer their capital improvement obligations. The settlement provisions will help boost payment rates in the US floorplan ABS trust as a result of the repurchase or sale of affected inventory from dealers’ lots as well as the improvement in the financial health of the dealers.
The settlement, approved by Judge Charles Breyer of the US District Court for the Northern District of California, resolves litigation with affected authorized VW dealers following the disclosures in 2015 that the automaker had equipped diesel-powered vehicles with devices designed to evade emissions-testing standards. The emissions issues led to VW issuing a stop-sale order for affected vehicles, which hurt the dealerships’ sales. This settlement follows an earlier $14.7 billion settlement between VW and customers who bought or leased 2.0-liter diesel vehicles affected by the emissions scandal.
Under the settlement with the dealers, VW will compensate each dealer an average of $1.85 million within 19 months and continue to make payments for volume-based and customer satisfaction for 12 months following the settlement. The settlement also requires the company to repurchase all new and used 2.0-liter and 3.0-liter diesel vehicles in dealer inventory for which there is no fix available.
Additionally, the dealers will have an option to defer obligations to make any capital improvements to their dealerships for two years. Although VW floorplan losses have been de minimus, and the VW US floorplan ABS trust has never incurred a loss, the settlement partially alleviates financial pressure dealers have faced following the emissions crisis. As a result of increased financial stability, the probability of default among dealers will decline.
The monthly payment rates in VW’s US auto floorplan trust, Volkswagen Credit Auto Master Trust, have remained well above the level at which performance triggers would necessitate early amortization or additional credit enhancement for the ABS. The trust’s payment rates, as the exhibit below shows, have averaged about 50.0% since the emissions scandal, owing to strong US demand for autos and high manufacturer incentives. That far exceeds the two trigger levels of 27.5% and 35.0% in the trust. We expect payment rates in the trust to increase following the settlement, as typical higher seasonal sales that begin in the spring months combine with positive effects of the settlement; dealers will move stop-sale inventory, utilize their cash payouts and benefit from incentives and monthly assistance that will improve the financial health of their dealerships. We believe that the positive effects of the settlement on the payment rates will be both modest and temporary.
Anna Burns Associate Analyst +1.212.553.7813 [email protected]
Keith Van Doren Analyst +1.212.553.4163 [email protected]
NEWS & ANALYSIS Credit implications of current events
30 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
VW’s US Floorplan ABS Trust Monthly Payment Rates Volkswagen Credit Auto Master Owner Trust 2014-1
Sources: Moody’s Investors Service and servicer reports
0%
10%
20%
30%
40%
50%
60%
70%
Mon
thly
Pay
men
t Rat
e
Monthly Payment Rate 3 Month Average Payment RateEarly Amortization Trigger Additional Credit Enhancement Trigger
NEWS & ANALYSIS Credit implications of current events
31 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
Invitation Homes Will Pay Down Single-Family Rental Securitizations with New Fannie Mae Loan, a Credit Positive On 23 January, Invitation Homes Inc. filed a preliminary prospectus with the US Securities and Exchange Commission that noted that it had secured a $1 billion, 10-year loan commitment from Fannie Mae and Wells Fargo, and plans to use the proceeds to pay down all or a portion of the loans backing two Moody’s-rated single-family rental securitizations. The loan commitment is credit positive for Invitation Homes’ remaining outstanding single-family rental transactions, and the single-family rental market more broadly.
The Fannie Mae loan, which will be securitized and backed by a pool of single-family rental properties, comes amid a larger capital raise for Invitation Homes that also includes an expected initial public offering and a $2.5 billion credit facility from a group of lenders. By supplementing its short-term, private-label securitization financing with long-term, government-sponsored-enterprise-backed funding, Invitation Homes diversifies its funding sources and shores up its liquidity, a credit positive for its remaining SFR transactions.
In the SEC filing, Invitation Homes said that it expects to use proceeds from the $1 billion Fannie Mae/Wells Fargo loan to pay down the Invitation Homes 2014-SFR1 Trust in full and a portion ($275 million) of Invitation Homes 2014-SFR2 Trust (see exhibit).
Invitation Homes’ Outstanding Single-Family Rental Transactions Deal Name Initial Balance Balance as 6 January 2017
Invitation Homes 2013-SFR1 Trust $479,137,000 $462,035,193
Invitation Homes 2014-SFR1 Trust $993,738,000 $977,805,424
Invitation Homes 2014-SFR2 Trust $719,935,000 $710,664,932
Invitation Homes 2014-SFR3 Trust $769,322,000 $766,422,481
Invitation Homes 2015-SFR1 Trust $540,854,000 $531,372,916
Invitation Homes 2015-SFR2 Trust $636,686,000 $630,283,449
Invitation Homes 2015-SFR3 Trust $1,193,950,000 $1,184,191,515
Sources: Moody’s Investors Service and trustee data
Under the loan terms, Invitation Homes will have to adhere to certain Fannie Mae underwriting standards for the single-family rental properties collateralizing the loan. Although the specific underwriting standards Fannie Mae will impose on the properties securing the loan are not available, they will include loan-to-value and debt-service-coverage ratio requirements, according to the filing. Furthermore, Fannie Mae has a strong track record in multifamily loan performance compared with other portfolio lenders and commercial mortgage-backed securities. Also, in the residential mortgage market, Fannie Mae has shown strong counterparty oversight and ongoing review and monitoring standards.
Fannie Mae’s entrance into institutional single-family rental financing lends support to the market’s long-term sustainability, reducing operational uncertainty in the single-family rental business model and lending support to the viability of the business. Separately, single-family rental operators have taken several steps to improve operational efficiencies and economies of scale through more targeted purchases of individual homes in specific markets and investments in technology and property management infrastructure.
Sang Shin Vice President - Senior Analyst +1.212.553.7779 [email protected]
Max Sauray Assistant Vice President - Analyst +1.212.553.3677 [email protected]
RECENTLY IN CREDIT OUTLOOK Select any article below to go to last Thursday’s Credit Outlook on moodys.com
32 MOODY’S CREDIT OUTLOOK 30 JANUARY 2017
NEWS & ANALYSIS Corporates 2 » Obrascon Huarte Lain Sells Remaining Stake in Abertis, a
Credit Positive
Infrastructure 4 » NGPL PipeCo’s FERC-Prompted Rate Review Is Credit Negative
Banks 5 » Chile’s Monetary Policy Rate Cut Is Credit Negative for Banks » Merger of Kazakhstan’s Two Largest Banks Would Be
Credit Positive » Saudi Banks’ Rising Provisioning Charges Erode Profits » MCB’s Acquisition of Fellow Pakistani Bank, NIB, Is
Credit Positive » Korea’s Measures to Reduce Accounting Fraud Are Credit
Positive for Financial Institutions » CIMB Thai’s Proposed Rights Issue Is Credit Positive
Insurers 15 » NAIC’s Desire to Repeal US Regulator’s SIFI Process Is Credit
Negative for Life Insurers » Argentina’s New Workers’ Compensation Regulation Is Credit
Positive for Insurers
Sovereigns 18 » Zambia Receives Grant from EU to Expand Electricity
Network, a Credit Positive
Structured Finance 19 » Rulings on Spanish Mortgage Interest Floors Will Likely Have
a Limited Negative Effect on RMBS Transactions
MOODYS.COM
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