Signals From CDS Widening

by: Ploutos

Recently, I published an article that discussed the constituents of the S&P 500 with the highest and lowest credit default swap spreads. Given the lack of public information on credit default swap spreads, this can be difficult data to obtain for Seeking Alpha readers. Widening credit default swap spreads can be a sign that investors are becoming more concerned about the health of a company's balance sheet. Investors may wish to apply a higher discount rate to the company's future earnings. Below is a list of the ten S&P 500 constituents that have seen their credit default swaps spreads widen the most year-to-date.

Chesapeake Energy Corporation (NYSE:CHK) is the nation's second largest producer of natural gas. The Oklahoma City-based company tops this list due to a combination of weak operating results and accusations of corporate malfeasance directed at company co-founder and chief executive officer, Aubrey McClendon. Founded in 1989, the company owes its spectacular growth to its focus on innovative drilling techniques and unconventional reservoirs. The revolution in natural gas drilling, in part pioneered by Chesapeake, has led to a tremendous increase in natural gas supply; however, the economic recession has led to a cyclical downturn in demand, which has led to a collapse in prices.

The collapse in natural gas prices has hurt the finances of the highly levered Chesapeake, but more notably has damaged the wealth of its outspoken CEO. In 2008, McClendon owned a large stake in Chesapeake on margin. The collapse of U.S. equity prices in the back half of that year forced McClendon to liquidate the majority of his vast holdings at prices roughly $2 billion less than their market value from a year prior. The company, which boasted McClendon as both its chairman and CEO, gave the executive a one-time $75 million bonus, making him the highest paid S&P 500 executive in a year that saw the company's stock fall from $38 to $16.

Shareholder angst regarding managerial compensation arrangements was rekindled in the last few weeks when it was announced that the CEO had taken out hundreds of millions of dollars of personal loans against company wells. He had amassed stakes in the wells through the company's Founder's Well Participation Program, which granted him the ability to take a 2.5% stake as long as he paid a pro-rata share of development costs, a program that several board members did not know even existed. Days later, it was reported by Reuters that McClendon and former Chesapeake co-founder, Tom Ward, CEO of Sandridge (NYSE:SD), had been running a commodities hedge fund on the side. Given that Chesapeake controls 5% of natural gas supply, and runs an enormous hedging platform, his side fund certainly could have "front-run" company operating or hedging decisions, influencing market prices that could put McClendon at odds with his firm.

Chesapeake is an asset rich company. Its pioneering technology allowed it to see value in properties before others fathomed the drilling potential. The company holds net leasehold interests in the U.S. that are roughly the size of West Virginia. The company is basically a highly levered call option on the price of natural gas, and McClendon has evidently blown through several fortunes waiting for this option to come into the money. Expect the company to focus on oil production to improve cash flow while it waits for natural gas demand to catch up with the supply glut that the company helped generate. Questions remain. Will shareholders will let McClendon continue to run the company he built from scratch over the last generation? What skeletons will the SEC and IRS uncover in their respective investigations? The land rush to shale drilling properties was aggressive, did Chesapeake overstep any financial or legal bounds? Given how McClendon has absconded his personal balance sheet, are investors to trust the valuations of CHK's assets given the myriad of inherent assumptions? These questions have pushed the share price down and CDS wider. While it seems that both now offer value, it is difficult to handicap probabilities with so much uncertainty.

Best Buy (NYSE:BBY), the beleaguered big-box retailer of consumer electronics, has seen its bond and equity prices swoon as investors have become increasingly concerned about the long-term viability of its franchise. Like CHK, the company also went through a management scandal regarding its now former CEO. The 5.5% coupon bonds maturing 3/15/2021 (CUSIP 086515AL5) issued just last March are now trading at $94 to yield 6.4%, a spread of 460/10yr or roughly double the average BBB spread. With the stock now trading at its post-Lehman multi-year low, credit markets are already beginning to price in the deterioration of investment grade credit metrics and the usage of the company's robust free cash flow generation to reward shareholders.

Best Buy trades at only 2.6x trailing twelve month EBITDA and under 4x its trailing free cash flow, which are amazingly low multiples for a company that remains profitable. While the near-term outlook remains cloudy, and the company will have some noisy restructuring of its domestic store count and its international footprint along the way, good things can happen at this type of valuation. The company will likely end 2012 with little to no net debt (excluding rent adjustments and dependent on what new management decides to do with leverage), and will still be generating healthy free cash flow. With capital expenditures on its retail stores likely declining given announced closings, the company can focus on returning some cash to shareholders through an increased dividend or share repurchases. Perhaps, declining unemployment domestically could drive a cyclical upturn that mutes some of the secular weakening in the company's operating results, putting pressure on the short interest in the stock. With a strong balance sheet, the company has time to restructure its operations, build a strong e-commerce offering, and figure out the appropriate balance between ballyhooed customer support at the store level and its margins. While time does appear to be on the company's side, understand that other investors in the CDS market are taking long-tailed bets that the company will fail.

J.C. Penney (NYSE:JCP), like Best Buy, has also fallen out of investor interest as consumers have left the regional mall, location of the majority of J.C. Penney's 1,100 stores, and taken their shopping dollars on-line. Credit default swaps are an institutional put option on a company with a five year time horizon, and while JCP still maintains a decent balance sheet (cash of $1.5bn; debt of $3.1bn; conservative mid 40% debt/capital), the cost of protection against continued weakness in the business model is being purchased by some investors in this market. Spreads widened shortly after the April 11th announcement of the departure of CFO Michael Datague, a 20-yr company veteran, a curiously timed departure amidst the company's re-positioning efforts that was the most notable departure in a series of sweeping management changes.

The largest JCP shareholder remains Bill Ackman's Pershing Square, which holds a 26% economic stake (18% shares and 8% cash-settled total return swaps.) When Ackman lured CEO Ron Johnson away from Apple (NASDAQ:AAPL), where he was the very successful head of retail operations, he did so with assurances that his stake in the company would allow Johnson time to turnaround the JCP franchise. In-store transformations, a transition to everyday value pricing, and the launch of new lines and initiatives are the keys to the turnaround effort. It appears that the company has a long runway given limited near-term debt maturities and a patient investor base, but whether the company's initiatives can offset secular downtrends in department store retailing is the overarching question.

Safeway (NYSE:SWY), the second largest grocery chain in the United States, is again attracting the interest of private equity. Twenty-six years after its leveraged buyout by KKR, Safeway again appears to be for sale, and credit spreads have widened correspondingly. Leverage is rising as long-term debt increased from $4.2bn to $5.4bn in the first quarter as the company used the proceeds to repurchase approximately $1bn worth of shares (roughly 22% of current market cap). With net debt/capital now around 70% a debt-fueled leveraged buyout appears less likely given the amount of re-leveraging the company has already done. With a 3% dividend yield and the company actively engaged in shareholder-friendly activities, I prefer the equity to the bonds despite the challenges grocers face. The company's five year bonds issued in late November 2011 yield 2.9%.

Avon Products (NYSE:AVP), the personal care manufacturer and world's largest direct selling enterprise, is the best performing stock on this list year-to-date. The company's shares have advanced amidst bids from Coty Inc. and privately held Richmont Holdings. In addition to uncertainty surrounding long-term ownership of the firm and the potential for re-leveraging, metrics continue to weaken. Standard and Poor's recently downgraded the firm citing a four month leverage increase from 2.5x at year-end to 3.1x currently. Even without looming M&A speculation, AVP has seen a 30% decline in EBITDA, which may have gotten them close to this ignominous list without the activism. If there is not a deal in the near-term, this is a long-tailed restructuring process and the stock price will weaken.

R.R. Donnelley & Sons (NASDAQ:RRD) is the world's largest commercial printer, an industry like big box retailing, that is undergoing a secular transformation. In RRD's case this changing business landscape is due to the digitization of books, newspapers, and other media. The commercial printing industry remains highly fragmented, and RRD's market share of non-newspaper printing is roughly four percent. Given the highly fragmented and commoditized nature of the industry, declining volumes could see the weaker players forced out, which could give surviving companies a chance to increase scale and improve market power. The company sacrificed its investment grade ratings in mid-2011 with an aggressive share repurchase plan, but took a more cautious tone in its 4Q11 earnings call regarding capital allocation. So far in 2012, the credit markets have not been convinced as credit spreads have moved wider.

Pitney Bowes (NYSE:PBI) is one of the highest dividend payers in the S&P 500, and is currently sacrificing its credit rating to continue its thirty year streak of consecutive annual dividend increases alive. One of the original 500 members of S&P's benchmark index, Connecticut-based Pitney Bowes manufactures hardware and software related to mailing and shipping. With "snail mail" increasingly giving way to electronic mail and transactions, PBI is seeing declining earnings prospects.

At its most recent earnings release, the company cut guidance for revenues and earnings to forecast negative growth. Every business unit showed either flat or negative revenue and margin growth in the reporting period. The dividend now looks to consume upward of two-thirds of analyst projections for 2012 earnings.

At an enterprise value of 6.4x its 2011 EBITDA, PBI is probably overvalued given its declining business prospects, and we will likely see its history of consistent dividend growth snapped in the intermediate term.

Goodyear Tire & Rubber (NYSE:GT), the Ohio-based tire manufacturer, has seen its credit default swap spreads widen in 2012 given elevated rubber prices and weakened economic conditions in western Europe (EMEA 41% of volume in 2011). The company maintains a strong competitive position as a leading brand in the replacement and original equipment tire segments, but consistently negative free cash flow performance , working capital increases, and substantially underfunded pension obligations pressure the credit profile. Top line performance has been strong, and was driven in 2011 by better pricing and a mix more tilted towards its premium product offerings. The company's combination of operating risk and financial leverage can lead to volatile performance.

Alpha Natural Resources (ANR) acquired rival Massey Energy in early 2011 to form the second largest coal miner by market capitalization. The company was downgraded to BB- by S&P on May 8th. The downgrade and the CDS widening have both been driven by sharp downturn in domestic coal demand driven by the mild winter and natural gas substitution. ANR has reduced its production guidance accordingly, and the resultant reduction in EBITDA could send leverage towards 5x. I am not a long-term player in coal because I believe that natural gas is a cleaner, affordable, and more efficient substitute.

Supervalu (NYSE:SVU) is the nation's third largest grocer behind Kroger and the aforementioned Safeway, operates a highly leveraged balance sheet. The company was downgraded from B+ to B at Fitch in January, taking it to five steps below the investment grade level. The company's continued sales declines, market share losses, and margin pressures were all cited as factors to the ratings change. Same store sales fell by six percent in 2011. The company's pension plans were estimated by Credit Suisse to be $3.5bn underfunded, which is over 3x the current market capitalization. Whereas I liked SWY's equity versus debt given the opportunity to re-lever, here the balance sheet constraints are such that I like neither.

In the "new normal" of slower economic growth in developed markets, the tradeoff between debtholders of a corporation and stockholders could become more contentious. Many of the names above maintain reasonable balance sheets, but the market's expectation of balance sheet degradation to the support of the share price is causing CDS spreads to widen. I hope that this list helps Seeking Alpha readers understand what drives CDS spreads, and how readers might want to think about the changing discount rate in their equity valuations.

Disclosure: I am long SPY.