DS Smith: Game, Thermoset and Match

As we make our way through the closing week of Wimbledon, most of the initial competitors will be home or making their way back. However, the stands will remain at full capacity and the traditional heavy consumption of strawberries and cream will continue unabated. So popular is the snack, that an expected 27 tons of strawberries and 7,000 litres of cream will be consumed during the event, all packaged up in an estimated 166,055 single-use plastic tubs, incorporating a plastic lid to allow the customer to be able to view the snack prior to purchase. At a time when Wimbledon organisers are focusing on being more environmentally friendly – as evidenced by Evian’s recycled plastic RPET bottles with recycling points dotted around the ground – a handful of packaging specialists are also looking for a more sustainable approach.

With the recently agreed sale of their plastics division, DS Smith aim to concentrate on their paper and corrugated business, an area it views as being the future for sustainable packaging. Whilst the company’s target of 100% reusable or recyclable packaging by 2025 is an admirable one, paper versus plastic use remains contentious. Svenska Cellulosa, who act as a key supplier to DS Smith, have fuelled controversy over deforestation in Indonesia, and critics of cardboard continue to cite the (now debunked) idea that paper requires more water for production than that of plastics. As well as the direct environmental effects, there is also the “double fault” of increased carbon production and a loss of carbon absorption to consider.

DS Smith are working towards innovative solutions in recycling existing cardboard and paper to create sustainable corrugated packaging materials. Whilst there are competitors who are larger and have merited better ESG scores on some metrics, DS Smith are uniquely focused on the environmental aspects of their products. With public awareness and concern over the environmental impact of production methods increasing all the time, the emphasis on sustainable packaging is rapidly growing beyond single companies or events. France is leading the way in this regard, aiming to ban all single-use plastics by 2020. France follows a long list of countries who are aiming to cut or reduce plastics use, putting innovative players like DS Smith at a distinct advantage should their environmentally-friendly production methods be able to keep pace.

From a credit perspective, we like DS Smith not only for its strong business profile and clear deleveraging targets post its Europac acquisition, but also for its focus on managing environmental concerns and ESG tailwinds that it should benefit from in the medium term.

At the time of writing Kames Capital holds bonds from DS Smith in its fund range.

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Ad Break

ITV posted first quarter numbers that came in-line with their guidance. We’ll all be aware of how TV markets have been disrupted by changes to viewing habits, caused by online streaming and the provision of “on demand” services from alternative providers such as Netflix and Amazon, as opposed to the historic UK players of the BBC and ITV.

In some respects this is proving beneficial for ITV, with their Studios business busy providing content and the joint development of a product to exploit the BBC and ITV back catalogues – “BritBox”, which should launch later this year.

The big downside for ITV is the impact these secular changes are having on advertising, which showed a 7% decline year-on-year and is expected to be down again for the rest of the year. It is worth noting, however, that some of the Q1 decline was due to the timing of Easter and a comparison to a previous year boosted by the football World Cup.

ITV always features highly in any review of likely takeover candidates, with possible bidders including the new “broadcasters” such as Netflix, Amazon or Apple, together with other operators such as Liberty Global who already hold an “investment” stake of 10%. This leads to ongoing volatility in both its bonds and associated CDS.

We, at Kames, prefer bonds that have protection language that would see coupons rise if the firm is downgraded below investment grade, giving investors compensation for an increase in perceived credit risk and an incentive for management to retain their Baa3 rating to keep financing costs lower.

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Is there going to be a Dutch Auction?

Last Friday, news broke that Brookfield Asset Management was speaking to Dutch pension funds to try and engineer a takeover of KPN, the Dutch telephony company. This follows a move by Macquarie last year to achieve a similar deal to buy TDC (a Danish telecom company), with Danish pension funds.

No formal bid has been seen, but KPN was subject to a bid in 2013 from America Movil. This was prevented by the KPN Foundation (or ‘Stichting’) which controlled voting rights.

If Brookfield followed a similar approach to that used to take TDC private, it would mean increasing the leverage of KPN and a likely move into junk bond status. Most bonds include a change of control clause which would be triggered on this presumed downgrade to high yield, meaning bonds could be called or put at par. This should lead to a “pull to par” move for bonds, with consequent mark-to-market gains/losses depending on where the price was before the news broke.

KPN also has hybrid capital with fixed call dates. Any bid would likely lead to the hybrids being called at the first opportunity to avoid a 5% increase in coupons.

Whether Friday’s news was a “cheap” attempt to gauge the attitude of the Stichting, KPN management, and the Dutch public to a deal, or whether it was a genuine leak, the news may prompt other players to look at whether there could be value in a deal. America Movil is unlikely to want to buy, as it now holds its stake as a financial investment, but it will not be an uninterested bystander. The final ownership of KPN remains uncertain and will make for more volatility in bond prices.

It could provoke interest from others such as Deutsche Telekom, although they may need to exit their recent joint venture with Tele2. Macquarie might also be interested if it thinks it has been successful in Denmark.

Bonds are likely to be volatile, depending on how the story develops, and this may present opportunities to play the technicalities of the bond documentation.

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Who says Americans don’t do irony?

Apple recently announced their latest range of new products. There were no surprises in the line-up given the usual speculation and leaks in the run up to the event. The iPhone range is now topped by the new XS Max with a base price in the US of $1,099 for a larger screen version of its latest phone, and $1,449 for the highest specification version. The price increases over the previous record levels for the X model were the big surprise. However, given the success of the iPhone X which was launched at a premium to the iPhone 8 (launched at the same time), there is clearly a part of the Apple customer base that is price insensitive and likes to acquire the latest technology from Apple at (almost) any price. This seemingly allows Apple to flex its pricing ever upwards. It also helps drive demand for its enhanced Watch which will now contain a heart-rate monitor medically approved by the Food and Drug Administration (FDA). Handy for when Apple bills you for the iPhone and Watch!

For bond holders in Apple, this successful projection of the iPhone as the ultimate luxury good continues to drive strong positive cash flows. This makes the commitment of Apple to reduce its net cash position to zero an ever longer prospect and supports the strong credit rating. It reduces the need to issue bonds which provides better technical support for the outstanding issuance.

It was quipped on the desk that the next model may be called “Max Gouge”.

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Orange is the new bank

Orange results reported today included the first information on their recently launched digital bank “Orange Bank”. This was launched on 2 November 2017 and had 55,000 customers by the reported year end. So far the impact on Orange is negative due to the launch costs and IT investments required to support the commercial launch.

They have ambitious aims of attracting 2 million customers (roughly a 2.5% market share) and the timing looks good as more and more people carry and use smartphones for daily services. Also, legislation such as the EU’s “Payment Services Directive 2” is allowing new entrants to access account data for customers and initiate payments. It opens up banking to other companies that can be innovative in the use of customer data and usage, potentially allowing new cross-selling avenues and generally reducing the “stickiness” that traditional banks have had with their customer.

It is early days with Orange Bank and it is likely to be loss making for a number of years during its build out, but potentially it adds more value for creditors of Orange providing an additional diverse stream of earnings that taps into the growth of on-line, smartphone linked transactions rather than just the sale of a generic “data allowance”. For the incumbent banks, it will require more investment in innovation to prevent the loss of customers and the disintermediation that has hit other industries such as retail. There could be some complacency in the sector – Philippe Brassac, chief executive of Crédit Agricole in an interview with the Financial Times recently commented …”Orange Bank? Ah, I had trouble combining the two words.  It’s not a bank. Annoying? Maybe. But frankly it’s a mono-player on mobiles that does nothing more than what we offer.”

Certainly Orange starts the process with a strong brand and a large customer base that is increasingly tech savvy, so the gauntlet has been thrown down and we await to see if the banks pick it up.

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AT&T and the Justice League

AT&T has hit a roadblock in its merger with Time Warner Inc. in the form of a law suit from the Justice Department to prevent the deal. This may offer an opportunity for investors to benefit.

Special Mandatory Redemption Provisions

When undertaking a large acquisition, bonds can be issued to pre-fund the deal before the final legal closure occurs. Often this requires shareholder or regulatory approval and there may be doubts over whether the deal will actually be consummated. For some of this pre-finance, they may include SMR language – Special Mandatory Redemptions. Essentially if the deal fails to materialise (usually by a back-stop date) then the bonds are redeemed at 101 (plus accrued interest to that date).

This can be both a positive and a negative for holders of the bonds. If the price has moved above 101, then there can be a painful loss of value. However, with a bond price below 101, there is scope for some capital appreciation. With yields rising, however, a number of bonds with this language sit with prices below 101. This gives the potential for a capital gain if the acquisition process fails.

AT&T, the US telephony company, is in the process of acquiring Time Warner Inc., owner of a number of media brands and assets such as CNN, Warner Bros. films, HBO and Turner Sports. This would fit well with AT&T’s purchase of satellite broadcaster DirecTV and diversify revenues from its reliance on telephony.

At the end of July, AT&T issued $22.5 billion — ranking as the third-largest corporate bond sale on record. Issuance consisted of seven series, all subject to a special mandatory redemption at “101 percent of the principal amount of the notes plus accrued but unpaid interest if the merger agreement with Time Warner is terminated or the acquisition of Time Warner does not close by April 22, 2018”. It also issued two euro tranches and a sterling bond in June with the same clause.

The market was expecting the deal to close this quarter well before the back-stop date but, as they say in America, in “a left-field move” the Justice Department (taking a leaf out of the Warner film franchise “Justice League”, possibly) has instigated a lawsuit to block the merger. The Justice Department’s argument is that the deal is anti-competitive and therefore unlawful. AT&T is seeking to argue against this but there is a political element hanging over the deal as President Trump has in the past said the merger should be blocked and dislikes CNN.

A deal could be struck, like the one for Comcast when it merged with NBC in 2011, which imposes conditions on AT&T to improve its “behaviour” post a merger. However, the Judge appointed, Richard J. Leon is viewed as conservative and unlikely to move for a settlement, and looks to be sceptical of behavioural remedies given his negative views on the Comcast/NBC consent decree.

The clock is now ticking and AT&T has four months to close the deal. It could seek to extend the deadline with bondholders but it may need to offer an incentive to do so. Currently all the dollar bonds are trading below 101 in price and therefore offer some upside to investors. The euro issuance is above 101 and therefore could see a price drop. In the sterling market, the 2037 bond also sits below par, offering the chance for a capital gain.

Note: Since we published this article, the court date has been set later than AT&T and Time Warner had hoped. It is now set for March and it looks like the SMR provisions are likely to be triggered. AT&T have a few months to decide and it is possible they will seek to extend the deadline for the provisions. This would require a ‘consent solicitation’, which usually involves them paying a fee to bondholders or they could redeem and re-issue the bonds. Either way, bondholders should benefit.

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Is everything still on track?

The announcement of the agreement to merge Siemens and Alstom’s train assets will create a large European champion, which should be better placed to compete with increased competition from China’s CRRC. It marks the end of speculation on a number of outcomes, and on whether the vested interests of both France and Germany could be satisfied.

The framework agreement still has to be approved by regulators and shareholders. However, assuming the approval is forthcoming, the increased scale will make the combined businesses more able to compete with the behemoth of CRRC, which has annual revenues larger than the prospective combined European entity. CRRC has been increasingly looking to compete outside of China, and has already won projects in both the UK and Czech Republic. It is also expected to bid for work from HS2 (a planned high-speed railway in the UK).

Bombardier – a Canadian manufacturer with a large European business – is thought to be the biggest loser from the announcement, since it remains a subscale competitor in Europe. Bombardier’s bonds were already weak due to the headlines about its aerospace division, and this agreement is unlikely to help.

Rail infrastructure offers a variety of opportunities for bondholders to invest in, including the manufacturers of “kit” such as Alstom, Siemens and Bombardier. These opportunities also extend to the national rail companies such as Deutsche Bahn, Network Rail Infrastructure and SNCF Réseau, who pay for the signalling and other technical equipment that the manufacturers provide. The rolling stock companies such as Great Rolling Stock, Angel Trains and Porterbrook acquire trains and carriages and lease them to operators. These train operating companies (such as First Group and Stagecoach) run the trains. All will be affected by any changes to the choice or price of rolling stock and associated infrastructure, or to any further change in competitive dynamics. We are keeping a close eye on these developments, which have both potential positives and negatives for the end passenger and the bond investor in the railway industry.

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Testing times

The recent egg scandal has once more brought the issue of food safety into the public spotlight. Along with the horse meat scandal and baby milk in China, there are strong reasons to suggest that food testing will continue to be required to ensure the quality of the food chain and human health.

One of our recent additions to portfolios is Eurofins Scientific, a global laboratory and advisory service that offers a wide range of testing services across a variety of industries. Eurofins believes it is the world leader in the food and feed testing market where it tests for dioxins and organic contaminants, pesticides, mycotoxins, allergens, authenticity, pathogens and vitamins. Its wider environmental testing services are underpinned by increasing regulations for a clean and healthy environment

The company also offers services to the biopharmaceutical industries and speciality clinical diagnostics where its laboratory services, backed by high R&D spend, support the more accurate diagnosis and treatment of diseases and improve healthcare.

The company has a history of growth through acquisition, but these are largely bolt-on services or geographies such as its recent acquisitions of Japan Analytical Chemistry Consultants (“JACC”) and Ecopro Research (“Ecopro”). JACC is one of the largest independent agro science testing laboratories in Japan and Ecopro is a leading food testing laboratory in Japan. The cost of these purchases remains relatively low and they have a strong track record in managing leverage downwards post deals.

This remains an attractive credit to own.

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Facing a squeeze – new issue premiums

Corporate bond issuance has been strong over the last two months despite a brief slowdown prior to the French presidential elections. Syndicate desks at investment banks continue to aggressively tighten guidance from the Initial Price Talk (IPT). The level of new issuance tightening is usually a strong guide to market appetite and the attitude to risk. It implies there is still a lot of mileage in investment grade credit.

At the moment syndicate desks are squeezing the new issue premium 15-20bps, bringing new deals at or very close to secondary curves. By pricing at levels near to existing bonds or comparable issues, we are seeing new issue premiums squeezed to 2bps. Earlier in the year the revisions to initial guidance were generally 10-15bps.

The continuation of the ECB’s bond buying programme is providing a strong technical push in Europe; it has now purchased about €90bn of bonds or the equivalent of 90% of net new issue (i.e. new bonds less redemptions). The hunt for yield and income is also continuing to attract strong demand in the US. Even large M&A-led issuance such as the recent Cardinal Healthcare multi-tranche issue tightened (in some tranches) by 30bps pre-launch. Normally these types of deals require some concession from the issuer to ensure that the new large supply of bonds finds a stable home.

But as long as books are reasonably well covered, this indiscriminate cutting by 20bps continues and it makes relative and absolute value analysis of individual deals harder to discriminate between the good, the bad and the ugly. With a number of outstanding M&A transactions yet to be financed, supply until the end of the year is likely to remain strong. As long as the market remains robust this supply will be readily bought; however initial guidance and the subsequent revisions are likely to be tested if demand into investment grade credit starts to slow.