Morningstar Advisor - February/March 2012 - (Page 33)

generated $75 billion and $50 billion in annualized revenue, respectively, while not spending a lot on new store capital expenditures, which lends to solid free cash flow. Guziec: Which is why we’re excited from a debt perspective. Wahlstrom: That is exactly right. Both of these companies do have fairly large share-buyback programs, and they also pay dividends that yield between 2%–2.5% currently. But we do think that there’s ample free-cash generation beyond those. And that’s why Joscelyn likes both of these companies at this point. Joscelyn MacKay: We’ve been pretty bullish Guziec: Thinking about it from a bond perspective, do we see an economic downside, or are we secure on the cash flows and these firms’ ability to support the bonds? MacKay: Home Depot has maintained around 2 times lease-adjusted leverage for a number of quarters, all through the downturn and prior. The firm kept to that leverage target by watching EBITDA and being prudent with new debt issuance. Still, the risk for both companies is that they could change their leverage targets, and that would change our opinion on the bonds and where they should trade. To a lesser extent, there is also a risk that they could get caught flat-footed if there is a deep downturn, leading to a steep EBITDA decline, and not having the cash flow to pay down debt. But we see that as quite a low-risk proposition, considering their strong free-cash-flow generation, currently. Guziec: So, there’s plenty of cushion, and we really like the debt. Let’s move to the office-products industry. Is there a different story there? MacKay: There is. Office products tend to lag Amazon.com AMZN, Costco COST, and Wal-Mart WMT, have been exacerbating the industry’s competitiveness. They’re known as being low-price competitors, so it’s very easy for them to get into the game. Our argument here is that, in Staples’ case, it’s been going on for years, and we think that Staples, with its international presence and ability to leverage costs, can compete on price if it needs to. But being known as the office- supply superstore leader is benefiting the firm there. Guziec: Is there anything you like in this space from a debt perspective? MacKay: I would love to be able to recommend on Home Depot, from a credit perspective, for some time. We felt that the market was underappreciating the firm given its moderate leverage and very strong, stable free cash flow despite the heavy dividend and share-repurchase activity, especially relative to its peer, Lowe’s. In the spring, we had rated Home Depot one notch lower than Lowe’s, but we recently downgraded Lowe’s. We believed that the market was giving too much of a premium to Lowe’s bonds relative to Home Depot; we thought that gap should narrow, and this has proved true. We continue to like Home Depot given its strong, widemoat characteristics. Lowe’s is a company that we felt was getting a little too much credit; we ended up downgrading the firm to A from A+ in November 2011. Right after that, the company announced an even-larger share-buyback program and decided to take its leverage target to 2.25 times from 1.8 times, which are the factors we discussed when we downgraded them. As a result, the bond spreads widened— but a bit too much, in our view. We think the market’s reaction is exaggerated. We did downgrade them, and we feel that their credit quality is weaker, but now Lowe’s bonds are trading closer to a BBB+ credit instead of an A credit. Staples from a debt perspective, but the firm will be reducing a great deal of their debt over the next couple of years. In 2008, Staples increased their leverage by about half a turn to acquire Corporate Express, which changed their international landscape. The company has been very up-front about getting back to pre-acquisition leverage levels, and they intend to pay debt as it comes due. So, with their only outstanding maturities being just a few years out, we don’t see upside to those bonds. On the other hand, Office Depot and OfficeMax bonds are trading at pretty wide levels. We have them both rated at B–, which is the lowest rating before a potential default. We looked at these companies from a credit perspective and felt that an imminent-bankruptcy rating is not appropriate. We don’t believe they merit a CCC rating, given their very strong liquidity positions. They have a few maturities coming due in the next few years that we expect them to be able to cover through their revolver, and if not, with cash on hand. They have a free cash flow cushion of 1 times, which means that over the next few years, cash plus cash on the balance sheet can just about meet their contractual obligations, which include debt, capital lease obligations, and interest payments. Guziec: At current spreads, are the bonds interesting? economic recoveries because of the industry’s ties to unemployment—unemployment impacts the retail side and the contract and delivery side of the office-products distribution business. We had thought there would be a nice, slow rebound early in 2011; when it became apparent that wasn’t going to be the case, the office-products distributors warned that they weren’t going to hit their projected numbers. Numbers continue to be soft for all three of the office-products distributors, but Staples SPLS is far and away the leader in this industry. We’ve noted that, particularly in their contract business, Staples sees gains with their corporate customers, while its two peers, Office Depot ODP and OfficeMax OMX, have seen declines. Competition is very high in this industry, given that the products are very commoditylike. Nontraditional office-supply retailers, such as MorningstarAdvisor.com 33 http://www.Amazon.com http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2012

Morningstar Advisor - February/March 2012
Contents
Contributors
Letter From the Editor
Make a Difference Stories, Not Debates
How Concerned Are You About Europe?
Analytical and Independent
What to Ask When a Fund Manager Leaves
Past, Present, Future
Have Financials Gotten Cheap Enough?
Four Picks for the Present
Investment Briefs
Tactical Funds Miss Their Chance
Specialty Retail: Ad Hoc Opportunity
How Europe Is Making Its Crisis Worse
Impact on U.S. Economy Will Be Minimal
European Banks: Bargains or Value Traps?
Don’t Count the Euro Out Yet
Europe on the Brink
GoodHaven Realizes Its Vision
How Index Trading Increases Market Vulnerability
Nonlisted REITS: Handle With Care
Safety Picks for the Many Moods of Mr. Market
On the Prowl for Large- Blend Index-Beaters
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Math That Matters

Morningstar Advisor - February/March 2012