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Thursday, October 22, 2009

Daniel Barrett
daniel.barrett@us.icap.com +1-212-815-6673

Equity Trading
+1-800-488-1653

CREDIT2EQUITY
Leverage-Implied CDS vs. Current CDS spreads
We utilize fundamental and quantitative analysis in an effort to identify where risk markets (credit derivs, implied vol) and cash markets (stocks) diverge in their view of a particular company or sector. In our experience, these divergences typically do not last, with one market correcting significantly to bring them back into alignment. In this note, we screen for companies with leverage profiles that diverge with their current CDS spreads. These divergences would highlight where company risk may be priced too high or low with obvious implications for the stock. We compare a companys current CDS spread and our calculation of the companys leverage-implied CDS spread. To come to this calculation, we run a regression analysis, by sector, of company leverage ratios vs. their CDS spreads. For leverage calculations, we use total current debt and the companys five-year, weighted-average EBITDA (three years reported EBITDA, current year and next year EBITDA estimates). We use these figures in our regression analysis to produce a leverage-implied CDS spread. This figure, relative to the current CDS spreads, is useful in evaluating where credit spreads may be too rich or cheap or where risk is priced too high or low. The value to an equity investor. If credit investors price company risk high, by extension, the equity suffers. A decline in risk in a companys credit would suggest improving cashflows or leverage resulting in value flowing to equity investors. Where current CDS spreads trade multiple standard deviations wider than our leverage-implied CDS, it would suggest the potential for spread tightening if our correlation analysis holds up. This would be a positive catalyst for the companys equity. In the following table and chart we identify where leverage-implied CDS spreads differ most significantly from current CDS spreads. Given the differing cyclicality, capital spending and funding requirements between sectors, our analysis is done on a sector by sector basis. We highlight the most extreme differences where our leverageimplied spread is higher or lower than current CDS spread. Those highlighted in green suggest the potential for credit spread tightening (ie. positive for stock) and in red, the potential for credit spread widening (ie. negative for stock). Finally, we graphically present the result of our regression analysis for the Retail sector. Credit spreads below the regression line are susceptible to risk rising given spreads look tight vs. current leverage (ie. potential negative for stock) and those above the line are susceptible to narrowing (ie. potential positive for stock).
Highlighted Stocks
Computer Sciences Hewlett-Packard IBM Corp. Seagate Technology Amkor Technology Unisys Corporation Deere & Co. General Electric Caterpillar Inc. Ingersoll-Rand Cummins Inc Owens-Illinois Inc. FedEx Corporation Eastman Kodak Co. Eastman Chemical Sherwin-Williams Lubrizol Corp Du Pont United States Steel Ashland Inc PolyOne Corp AK Steel Corporation McDonald's Corporation Target Corporation CVS Caremark Autozone Inc. Liz Claiborne Inc. Office Depot Inc. Sears Roebuck Triad Hospitals Inc Hospira, Inc. Schering-Plough Coventry Health Care Merck & Co., Inc. Pfizer Inc. Humana Inc Heinz (HJ) Co. General Mills Inc. Conagra Foods Inc Kellogg Company Supervalu Inc. Smithfield Foods Inc Dean Foods Reynolds American CSC HPQ IBM STX AMKR UIS DE GE CAT IR CMI OI FDX EK EMN SHW LZ DD X ASH POL AKS MCD TGT CVS AZO LIZ ODP SHLD CYH HSP SGP CVH MRK PFE HUM HNZ GIS CAG K SVU SFD DF RAI

ICAP equity research leverages our role as the leading inter-dealer broker of OTC products and services in credit, commodities, rates, equities and F/X. We use this unique window into OTC & derivative markets to generate actionable ideas for institutional equity clients, particularly where opinions expressed in these markets diverge from those in related equity securities.

Disclosure: Please refer to the last two pages of this report for important disclosures & analyst certifications

Company Name
IBM Corp. Hewlett-Packard Computer Sciences Seagate Technology Amkor Technology Unisys Corporation Deere & Co. General Electric Caterpillar Inc. Ingersoll-Rand Cummins Inc Owens-Illinois Inc. FedEx Corporation Eastman Kodak Co. Eastman Chemical Company Sherwin-Williams Company/The Lubrizol Corp Du Pont E.I. de Nemours & Co United States Steel Corp Ashland Inc PolyOne Corp AK Steel Corporation McDonald's Corporation Target Corporation CVS Caremark Corporation Autozone Inc. Liz Claiborne Inc. Office Depot Inc. Sears Roebuck Acceptance Corp. Best Buy Co. Inc.

Ticker
IBM HPQ CSC STX AMKR UIS DE GE CAT IR CMI OI FDX EK EMN SHW LZ DD X ASH POL AKS MCD TGT CVS AZO LIZ ODP SHLD BBY

Sector
Technology Technology Technology Technology Technology Technology Industrial Industrial Industrial Industrial Industrial Industrial Industrial Basic Mat Basic Mat Basic Mat Basic Mat Basic Mat Basic Mat Basic Mat Basic Mat Basic Mat Retail Retail Retail Retail Retail Retail Retail Retail

ST/LT Debt
33,925.00 17,852.00 4,234.00 2,727.00 1,493.36 1,060.60 22,419.00 523,762.00 35,535.00 5,124.10 698.00 3,334.10 2,583.00 1,303.00 1,455.00 833.74 1,345.80 9,650.00 3,156.00 66.00 434.30 633.30 10,217.80 18,752.00 11,754.60 2,726.90 749.04 880.72 2,919.00 1,963.00

5Yr Avg EBITDA


23,231.66 15,897.35 2,494.04 1,280.90 576.42 402.10 2,891.44 25,224.32 5,404.43 1,465.89 1,145.12 1,503.01 3,931.58 430.37 763.30 961.64 708.84 4,350.81 2,302.09 544.84 132.14 682.51 7,736.60 6,392.78 7,752.54 1,363.87 204.73 323.62 1,569.38 2,830.65

CDS TEV
175,262.60 118,518.67 10,460.15 8,897.73 2,410.33 1,847.66 42,029.83 580,729.18 68,143.86 14,866.84 10,553.24 9,676.89 25,285.40 1,308.40 5,109.91 8,085.64 5,791.14 39,698.91 7,768.35 4,851.90 871.22 2,486.02 73,535.01 54,925.18 64,596.59 9,949.54 1,358.67 2,567.85 11,191.91 19,098.78

Leverage
1.46 1.12 1.70 2.13 2.59 2.64 7.75 20.76 6.58 3.50 0.61 2.22 0.66 3.03 1.91 0.87 1.90 2.22 1.37 0.12 3.29 0.93 1.32 2.93 1.52 2.00 3.66 2.72 1.86 0.69

(bps)
32 27 39 378 524 923 60 205 96 56 54 319 72 961 44 30 47 53 311 175 753 603 25 68 43 62 670 556 414 190

Lev-Impl CDS (bps)


150.18 119.02 167.46 211.93 254.58 258.91 420.95 1,153.72 354.59 181.14 18.60 109.20 21.27 154.79 150.39 100.03 150.02 165.50 124.45 63.89 217.29 102.98 123.56 261.18 140.24 181.47 323.09 243.10 169.58 70.03

Std Dev
1.1 .96 .97 -.85 -.88 -.98 3.8 2.9 1.5 1.2 -.88 -.91 -.92 -1.05 .95 .86 .81 .77 -.91 -.93 -.98 -1.05 2.9 1.93 1.45 1.13 -1.01 -1.05 -1.07 -1.1

Sources: ICAP, Bloomberg

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Company Name
Triad Hospitals Hospira, Inc. Schering-Plough Corporation Coventry Health Care, Inc. Merck & Co., Inc. Pfizer Inc. Humana Inc Heinz (HJ) Co. General Mills Inc. Conagra Foods Inc Kellogg Company Dean Foods Co. Reynolds American Inc. Supervalu Inc. Smithfield Foods Inc

Ticker
CYH HSP SGP CVH MRK PFE HUM HNZ GIS CAG K DF RAI SVU SFD

Sector
Healthcare Healthcare Healthcare Healthcare Healthcare Healthcare Healthcare Consumer Defensive Consumer Defensive Consumer Defensive Consumer Defensive Consumer Defensive Consumer Defensive Consumer Defensive Consumer Defensive

ST+LT Debt
8,967.45 2,172.30 8,176.00 1,902.47 6,240.40 17,283.00 2,161.57 5,141.82 7,075.50 3,489.70 5,456.00 4,489.25 4,686.00 8,484.00 2,988.20

5Yr Avg EBITDA


1,594.23 829.47 3,835.50 687.40 8,702.97 23,367.30 1,457.51 1,839.38 2,816.47 1,489.47 2,413.92 932.17 2,600.89 2,483.77 388.78

CDS TEV
12,470.56 9,062.34 54,813.33 2,849.86 67,295.02 111,471.59 6,550.76 17,795.89 28,369.49 12,983.73 24,425.72 7,244.11 16,796.02 12,027.97 5,167.06

Leverage
5.62 2.62 2.13 2.77 0.72 0.74 1.48 2.80 2.51 2.34 2.26 4.82 1.8 3.42 7.69

(bps)
86 57 47 393 31 49 272 35 37 36 37 351 186 333 802

Lev-Impl CDS (bps)


439.16 178.82 136.63 191.70 14.11 16.07 80.45 148.45 136.92 130.03 126.67 230.7 108.9 173.70 347.51

Std Dev
3.5 1.6 1.4 -.87 -.90 -1.07 -1.06 1.6 1.25 1.2 1.0 -1 -1.06 -1.1 -1.2

Sources: ICAP, Bloomberg

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Retail Sector: Leverage-implied CDS spread vs. Current CDS spread

Retail - CDS vs Leverage


1000 Regression Line 900
RAD

800
DDS LIZ SKS

700

600
ODP

500
SHLD

400

300

200

BBY

100
AZO CVS MCD TGT

0 -

2.00

4.00

6.00

8.00

10.00

12.00

Sources: ICAP, Bloomberg

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Important Disclosures
Analyst Certification
I, Dan Barrett, certify that the views expressed in the research report accurately reflect my personal views about the subject securities or issues, and no part of my compensation was, is or will be related, directly or indirectly, to my recommendations or views in this report.

Ownership and material conflicts of interest


To the best of our knowledge, neither ICAP nor its affiliates holds a beneficial ownership in any of the recommended securities, and does not hold 1% or more of the subject companys equity securities. Neither we, nor any member of our household, nor any person that depends on us for financial support, directly holds shares in the subject company(s) in this report. The research analyst who prepared this report receives no compensation that is based on investment banking revenues. ICAP conducts no investment banking. It has not received compensation for investment banking activity or from any activity from any company mentioned in this report within the twelve months preceding publication. ICAP does not expect to receive or seek compensation for investment banking activity in the three months following publication. ICAP does not compensate its research personnel for investment banking services. ICAP does not act as a market maker in the stock of the subject company. Neither the analyst(s) nor any member of the analysts household is an officer, director or advisory board member of any company mentioned in this report.

Explanation of ratings
Buy Based on analysis of the Equity and the Equity-Credit relationship we expect the stock to appreciate by 15% or more over a 1Yr horizon. Neutral Based on analysis of the Equity and the Equity-Credit relationship we expect the stock to neither appreciate nor depreciate in value beyond market moves. Sell Based on analysis of the Equity and the Equity-Credit relationship we expect the stock to fall 15% or more over a 1Yr horizon.

Ratings distribution
Coverage Universe
Count
*

% Total rating

Buy Neutral Sell TOTAL


*ICAP conducts no investment banking business

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Additional Disclosures
ICAP prepared the information and opinions in this report. ICAP has no obligation to tell you when opinions or information in this report change. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. ICAP may be involved in other businesses that relate to companies in this report. ICAP has not engaged in, currently engages in or intends to pursue investment-banking opportunities with companies mentioned in this report. This report is based on publicly available information. ICAP makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We are not offering to buy or sell the securities mentioned or soliciting an offer to buy or sell them. Any decision to purchase or subscribe for securities in any offering must be based solely on the information in the prospectus, or other offering document issued in connection with such offering, and not on this report. This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient. No member of ICAP serves as an officer or director of any company mentioned in this report.

Neither ICAP nor any officer or employee of ICAP accepts any liability whatsoever for any direct, indirect or consequential damages nor losses arising from any use of this report or its contents. The securities discussed in this report may not be suitable for all investors. Investors must make their own investment decisions based on their own objectives and financial position. ICAP recommends that investors independently evaluate each issuer, security or investments discussed, and use any independent advisers they believe necessary. The value of and income from your investment may vary because of changes to interest rates or foreign exchange rates, changes in the price of securities or other indexes in the securities markets, changes in operational or financial conditions of companies and other factors. There may be time limitations on the exercise of options or other rights in your securities transactions. Past performance is not necessarily a guide to other future performance. This report may not be sold or redistributed without the written consent of ICAP. All rights are reserved. information on any security or financial instrument mentioned herein is available on request. Further

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