, as it will not generate immediate financial benefits. However, it will enhance the platform for further growth and international knowledge exchange, which are important for the implementation of strategically important large-scale projects.
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MOODY’S WEEKLY CREDIT OUTLOOK
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NEWS & ANALYSIS
Credit Implications of recent worldwide news events
Gretchen French Vice President - Senior Analyst +1.212.553.3798 gretchen.french@moodys.com
Accounting Problems Raise Risk at Weatherford On 1 March, Weatherford International (WFT, Baa2 stable) disclosed the discovery of material errors relating to income taxes in its financial statements. The oilfield services and drilling company will have to adjust its 2007-10 financial statements by around $500 million, which has negative credit implications for the Switzerland-based company. The errors raise questions about WFT’s company-wide controls and how effectively it is managed on a systems and administrative basis. Under a worst-case scenario, WFT risks financial reporting covenant violations that may speed up its debt-repayment obligations. WFT acknowledges that its reporting problems stem from inadequate staffing and tax expertise, poor review and approval practices relating to income taxes, and inadequate processes to reconcile income tax accounts effectively. Most of the discrepancy, about $460 million, came from an error in determining the tax consequences of intercompany accounts. The company plans to solve this problem by year-end 2011 by hiring more staff with tax expertise for several departments, providing additional training, and by enacting new processes and controls. Although WFT’s management believes it has already completed much of the testing of its tax reporting calculations, the company says it still needs more testing time before it can file its 10-K for 2010 with the US Securities and Exchange Commission (SEC). The SEC has granted a 15-day filing extension for the company, which must now file its annual 10-K report by 16 March. If WFT fails to file by the new deadline, it will violate the reporting covenants under its bond indentures, starting a 90-day cure period during which it must either file its 10-K or seek another extension from the SEC. If WFT cannot do any of these, its indenture trustees will then have the option of accelerating WFT’s payment obligations. Corporate tax-reporting problems are not unusual, and generally amount to a relatively benign “material weakness” under Section 404 of Sarbanes-Oxley. For WFT, the accounting errors are noncash and will have no impact on key credit ratios. Even so, the company’s success in addressing its accounting issues related to income taxes will remain an open question until it resolves this weakness and files its 10-K. More generally, the discovery of the errors reflects another example of the challenges WFT has faced as a result of its aggressive growth strategy. WFT has expanded both organically and through acquisitions, and now has operations in over 100 countries. This strategy has given the company substantial scale and a more diverse product line. But the company’s investment in infrastructure and administrative personnel has not kept up with its rapid growth. In addition, WFT’s working capital management and returns have lagged those of its investment-grade oilfield services peers, such as Schlumberger (A1 stable) and Halliburton (A2 stable).
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MOODY’S WEEKLY CREDIT OUTLOOK
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NEWS & ANALYSIS
Credit Implications of recent worldwide news events
Richard Morawetz Vice President - Senior Credit Officer +44. 20.7772.5408 richard.morawetz@moodys.com
Carrefour’s Divestitures Are Credit Negative Last Thursday, Carrefour (A3 review for downgrade) announced the full spinoff of its Dia harddiscount division, as well as the partial sale of its Carrefour Property division. We view these pending transactions as credit negative since they will result in increased shareholder remuneration, which constrains Carrefour’s financial flexibility to undertake future investment plans. In particular, the partial spin-off of Carrefour Property is intended to crystallise the market value of the company’s property assets and distribute proceeds to shareholders. Carrefour will, nevertheless, retain 75% ownership of the Carrefour Property division, which will continue to be fully consolidated. The portion it will sell will be floated on the Madrid and Paris stock exchanges in July 201l. Its property assets were valued at €17.2 billion as of December 2010, of which Carrefour Property will retain 60% in terms of value. The properties to be floated are in the core markets of France, Spain, and Italy, while Carrefour will retain ownership of its emerging markets property portfolio. We expect that this partial deconsolidation of the property company will also increase dividend payments to the new minority shareholders of Carrefour. This is happening while the company is also stepping up its investments in its hypermarket stores. In our view, both the increased dividend payments and the increased investment will put negative pressure on its credit metrics over the next one to three years. Carrefour’s reported net debt position increased by approximately €1.4 billion to €8.0 billion in fiscal 2010, mainly as a result of share buybacks. While this program has now been suspended with the announcement of the new transactions, we view it as further evidence of the existence of shareholder pressure at the company.
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MOODY’S WEEKLY CREDIT OUTLOOK
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Credit Implications of recent worldwide news events
Niel Bisset Senior Vice President +44.20.7772.5344 niel.bisset@moodys.com
E.ON Sells Its UK Power Networks, Reducing Debt Last week, E.ON AG, the giant European power group (A2 stable) agreed to sell its UK power distribution business to PPL Corporation (Baa3 stable) in a deal that will reduce by roughly 17% its net debt, which stood at approximately €27 billion at the end of September 2010, a credit positive for E.ON. Under terms of the deal, PPL, whose rating and outlook were affirmed on the news, will buy Central Networks (comprising Central Networks East and Central Networks West) for £4 billion (€4.7 billion), including the assumption of £500 million of existing third-party debt and the repayment of £900 million intercompany debt. The high price of around 8x adjusted EBITDA of £500 million and an estimated 33% premium to a regulated asset value of approximately £3 billion imply that E.ON achieved a good price on the sale of Central Networks. The sale is an important part of its asset disposal programme, which targets proceeds of approximately €15 billion by year-end 2013. Combined with other asset sales, including its former Gazprom shareholding, proceeds from the programme will have reached in excess of €8 billion when the deal is finalised, expected by April. E.ON’s progress on its disposal programme is credit positive because it strengthens the company’s financial risk profile in advance of negative earnings pressure it faces over the next three years. Like with other European utilities, lower electricity prices and the negative gas/oil spread are likely to reduce E.ON’s cashflow versus 2011. In addition, like other nuclear power producers in Germany, it will be required to pay the nuclear fuel tax from 2011 until 2016. E.ON’s sale follows the €6.7 billion disposal by EDF (Aa3 stable) in October 2010 of its three electricity distribution companies. Both deals reflect large European utilities’ efforts to reduce debt following an acquisition spree near the end of the previous decade. From a business risk perspective, the sale of Central Networks is consistent with E.ON’s recently announced strategy to focus on competitive businesses and integrated markets in Europe. This sale should have a relatively limited impact on E.ON’s proportion of earnings from low-risk activities, which we estimate will continue to represent roughly 22% of adjusted EBITDA on a pro forma basis. However, the outlook is for regulated activities to contribute proportionally less to E.ON as nonregulated power-generation assets come on stream and it carries out its new, more focused strategy. Given the less stable nature of non-regulated income, this would worsen its business risk profile and cashflow predictability.
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MOODY’S WEEKLY CREDIT OUTLOOK
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Credit Implications of recent worldwide news events
Noriko Kosaka Vice President - Senior Analyst +81.3.5408.4028 noriko.kosaka@moodys.com Mariko Miyake Associate Analyst +81. 3.5408.4208 mariko.miyake@moodys.com
Daiichi Sankyo Acquisition of Plexxikon Is Credit Negative Last Tuesday, Daiichi Sankyo Company Ltd. (A1 stable) announced that it agreed to acquire Plexxikon Inc (unrated). Although we expect the acquisition to strengthen Daiichi Sankyo’s pipeline of cancer products, it will diminish its cash position and increase its business risk, making it credit negative. The purchase price is approximately $805 million and additional payments potentially totaling $130 million will be made because of the imminent launch of PLX4032 for the treatment of malignant melanoma. The drug is now in its phase III trial and the company will file for EU and US marketing approvals this year. The deal gives Daiichi Sankyo co-promotion rights in the US for PLX4032, which was jointly developed by Plexxikon and Roche Holding AG (A2 stable). The company’s revenue will benefit from expected running royalties from PLX4032. Whether this acquisition creates meaningful revenue for Daiichi Sankyo depends on whether it can develop other cancer-treatment drugs over the longer term in addition to successfully promoting PLX4032. New drug development can be challenging and gaining approval for new products in the three major markets of the US, Europe and Japan is costly. In addition, as effective new drugs have already been developed for many major diseases, such as high blood pressure and diabetes, development competition in the remaining areas of growth, such as oncology, intensifies.
Simon Wong Vice President - Senior Analyst +65.6398.8322 simon.wong@moodys.com Dylan Yeo Associate Analyst +65.6398.8322 dylan.yeo@moodys.com
Middle East Turmoil, Rising Bunker Prices, Add to Shippers’ Woes Last week, oil prices reached their highest levels since August 2008 on fears that unrest in Libya will spill over into other large oil-producing nations in the region. Similarly, bunker fuel1 prices have risen over 25% since the start of the unrest in Africa and the Middle East (see exhibit below). This has added further pressure on shipping companies, particularly liners and vessels leased out on a spot charter basis, as they already face weak operating margins owing to the supply-demand imbalance seen in most parts of the shipping industry. If the unrest is prolonged or spreads to the major oil-producing countries in the region, it will reduce trade volume, the viability of routes, and lead to sustained higher bunker prices, all of which are credit negative for the global shipping industry. Bunker Price (USD/Ton) 650 600 550 500 450 400
Source: Bloomberg.
1
Bunker fuel refers to any type of fuel oil that powers the engine of a ship.
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MOODY’S WEEKLY CREDIT OUTLOOK
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NEWS & ANALYSIS
Credit Implications of recent worldwide news events
Faced with depressed freight rates and limited ability to fully pass through higher fuel costs to charterers, some shipping companies regularly enter into short-term financial derivatives contracts to reduce their exposure to fuel price fluctuations. Such hedging strategies, however, have proven to be tricky, as shipping companies might lock in high bunker fuel prices. At the same time, shipping companies such as MISC Berhad (A3 stable) have adopted slow-steaming to reduce fuel usage, optimize voyage planning and routing, and deploy measures to monitor vessels’ performance and fuel consumption. Slow steaming refers to slowing down vessels to save fuel, while maintaining shipping schedules by adding vessels to routes. However, such savings are limited, as the extension of transit time is restricted by the time sensitivity of shipments. Furthermore, the risk of engine damage increases at extremely low steaming levels if a ship is not designed for slow steaming. Throughout the turmoil, the violent unrest has shut down key ports in Egypt and Libya for varying periods of time, disrupting loading and unloading operations for shipping operators with established routes to the region. Shipping companies such as Pacific International Lines (B1 stable), which have operations in that region, are monitoring the situation closely for possible contagion to nearby ports. Libya, unlike Tunisia and Egypt, is an oil exporter, accounting for around 2% of global production. Reports indicate more than half of this has been taken off the market since the start of the uprising. Consequently, petroleum and chemical tankers need to be redeployed elsewhere owing to the reduced output in Libya. This may be mildly positive for tanker rates as reduced oil shipments from Libya are likely to be replaced by higher output from other parts of the Middle East and West Africa, resulting in lengthened voyage distances to Europe and the US. However, the fundamental structural imbalance is still the key negative driver for the shipping industry. Besides the oversupply forecasted in the dry-bulk shipping industry,2 a similar demand and supply structural imbalance exist for liners and the tanker business over the next 12-18 months. Such pressures were evident in the weak performance of MISC Berhad’s chemical, petroleum, and liner segments in its recently released fiscal third-quarter 2011 results.
2
See Moody’s Special Comment: Dry-Bulk Shipping: Oversupply May Impair Performance in 2011-2012, but 2013 Could Offer a Recovery, 28 February 2011.
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MOODY’S WEEKLY CREDIT OUTLOOK
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NEWS & ANALYSIS Banks Juan P. Lopez Associate Analyst +1.212.553.7946 juan.lopez@moodys.com
Credit Implications of recent worldwide news events
US Mortgage-Servicing Enforcement Action Will Be Credit Negative Last Tuesday, PNC Financial Services Group Inc. (A2 positive; C+/A2 positive),3 became the latest among the large US banks4 to disclose in their 2010 10-K that they are among the top 14 federally regulated mortgage servicers subject to a publicly disclosed interagency review of residential mortgage servicing operations. The review is likely to culminate in formal enforcement actions against many or all of the companies. For larger banks with sizable servicing platforms, the potential settlement cost could materially affect quarterly results. However, we note these banks have the earnings power and capital to absorb most, if not all, of these charges during a quarter. The mortgage servicing market is dominated by 14 servicers responsible for servicing more than 85% of total mortgages outstanding. At this time, it is unclear what regulators will deem an appropriate global settlement amount. Press reports based on apparent leaks from public officials have cited amounts as large as $20 billion, although how these amounts would be allocated among fines, loan writedowns, or other costs is unclear. In order to assess the potential effect on the firms, we performed the analysis shown in the exhibit below. We allocated three different possible settlement amounts across the largest mortgage servicers based on their serviced loans outstanding as of 30 June 2010, and compared it with each company’s consolidated 2010 pre-provision profits.5 Although the charges will surely impact these company’s financials under the various scenarios, the impact itself will not be uniform. For instance, larger banks have the ability to absor