Outlook 2018: Energy, health care straightening out; other distressed sectors under pressure

By Paul Deckelman

New York, Dec. 29 – During 2017, investors and traders in distressed debt – generally defined as issues trading at a yield of at least 1,000 basis points above comparable risk-free securities, such as U.S. Treasury issues – and in the stressed bonds and notes of otherwise underperforming companies and sectors, zeroed in on four major areas where such issues were concentrated – energy, health care, telecommunications and retailing, including supermarkets.

As the year was coming to a close, traders, analysts and other market professionals queried by Prospect News expressed the general feeling that although there were specific exceptions to the rule in each of those broad general areas, energy and health care seemed to have largely weathered the storm, unless some drastic new developments occurred.

But problems remained heading into the new year in telecom and retailing.

Energy seems to turn around

The gyrations of crude oil prices and the impact those prices have had on companies that explore for, drill, process and market oil and petroleum products have probably been the biggest story in the junk world over the past 3½ years – since oil cascaded down from above $106 per barrel in mid-2014 into the low $50s by the end of that year.

Many sharply slashed their drilling capital expenditures and idled rigs, hoping to wait out the downturn. Some defaulted on their debt, and there were sector names driven into bankruptcy during this dark period.

But a strengthening of crude prices since then – as the domestic benchmark West Texas Intermediate crude improved from year-end 2015 prices in the $30s back to the lower $50s by the end of 2016 and most recently, into the upper $50s – seemed to bring some stability to the hard-hit sector.

“Oil has kind of been trading in a range,” a trader said, although he noted that even in 2017, prices dipped at several points back into the $40s, bottoming at $42.53 on June 21 before laboriously making their way back up into the higher $50s at which they were on track to end the year.

Those low prices “weren’t necessarily great for certain credits,” he said, but he added “at the same time, a lot of these E&P companies went through their corrections a while back. A lot of them restructured, so they’re not really all that levered, or they came out as reorganized equities. A lot of these guys have cleaner balance sheets, so it’s not anything that’s really been a massive shakeup in that sector” over the past year – as opposed to the previous two years.

Oil, a second trader said, “has had a nice move back.”

He said that “a lot of E&P companies that, frankly, filed [for bankruptcy] over the last several years are coming out of restructuring and ‘climbing out of the grave,’ as one guy put it.

“If oil is able to hold these $50-to $55 kind of levels, you’ll see a resurgence in the oil and gas market in terms of issuance,” as the energy names seek to raise capital, some of which may go into expanding their current operations by re-starting idled drilling rigs, or even help fuel merger activity within the sector, as companies seek to acquire energy reserves with an eye toward future drilling.

At another desk, a market source suggested that oil prices “are gradually working their way up. How that flows through the market in the future has yet to be seen – but it certainly seemed to take some of the pressure off” that sector in 2017.

More stability eyed

As to whether that will continue into 2018, he said that “given where we are now, we’ll see a more stable environment for energy – not withstanding natural gas’ weakness – and we will see the credits become more stable as a result, and those that need to work through their credit issues have a better shot at that.”

Overall, he declared that “I’m positive on the energy markets, and I’m positive on energy credits, in a broader sense,” although he added the caveat that “obviously it comes down to the specifics of a credit,” with some companies perhaps still having work to do to improve their particular situations.

But as an influence in high yield, he said that energy “is not quite as topical now as it was at this time last year.”

The key bellwether bond in the oil and gas sector that most investors watch is Los Angeles-based exploration and production company California Resources Corp.’s 8% senior secured second-lien notes due 2022.

That $2.25 billion issue was sold at par in December of 2015 – as oil prices were continuing to cascade down. It quickly began plummeting, closing below 20 bid on Feb. 11, 2016, though it climbed back to close out 2016 in an 89-to-90 bid context.

Throughout much of 2017, the megadeal moved steadily downward from that point, bottoming at 53¼ bid on Aug. 23 – but since then, the issue has crept back up to end at just under 78 bid on Dec. 15.

Traders also mentioned “efficiencies in extracting oil from the ground” that the companies were forced to develop during the lean period of the last several years and which, along with their reinvigorated and slimmed-down balance sheets, should stand most of them in good stead.

And looking at the big international players on the energy scene, including the Saudi Arabia-dominated Organization of Petroleum Exporting Countries and such non-OPEC major drillers as Russia, one of the traders said that “Russia and Saudi Arabia need current income, they need the cash right now that oil brings in, so they would prefer to see higher prices, not lower prices,” and thus will likely do what needs to be done to support the price of the oil they sell.

Health care off critical list

At the start of the year, health care seemed to be an area that those of faint heart would shy away from.

After all, newly elected president Donald Trump had ceaselessly attacked the Patient Protection and Affordable Care Act – popularly known as Obamacare – during the 2016 presidential campaign. He had called it a bad law and said that that contrary to the promises made upon its passage of lower costs and expanded health care for all, it had caused health care premiums for many people to rise sharply, while available services were constrained. Republicans running for the House and Senate made the same assertions, promising that they would repeal the existing law at the beginning of the new congressional session and replace it with something better.

That proved to be easier said than done.

Despite having passed numerous bills during the previous Obama administration formally repealing the 2010 health care law – which were all naturally vetoed by the White House – the new Republican-dominated Congress was unable to pass the same such straight repeal legislation and send it on to Trump, who had promised to sign it.

Nor were several Capitol Hill efforts to craft what sponsors called better replacement plans, combining outright repeal with key changes to the system and pass one of those in place of the current law any more successful, – leaving the health care industry status quo largely intact as the year drew to a close.

But the prospect of possible repeal earlier in the year had sent health care debt, as well as equity for the sector, careening downward (and then back upward upon the failure of such votes) – a roller-coaster ride that continued until indications emerged that there would be no big changes in Obamacare coming from the Hill, at least this year, as Congress moved on to other priorities, including changing the tax code.

A trader said that in the hospitals sector “they didn’t know if they were going to get the health care [overhaul] passed, causing on average, “a 4- or 5-point hit” – but I think we’ve recovered most of that since then.”

He said that credits such as Franklin, Tenn.-based Community Health Systems Inc. and Dallas-based Tenet Healthcare Corp. were “wildly volatile for about two weeks or so” when the legislative focus was keenly attuned to possibly making health care changes.

“They were more volatile than the regular stuff that kept chugging along, because everything was so on-again, off-again about getting a health care bill passed – who was getting paid under Medicare, who wasn’t – so that was the one really dicey area” during the earlier part of the year.

He said that health care credits such as Nashville-based HCA Inc. – “the better-postured health care hospital companies – have held in there well, because they have a lot of BB and first-lien paper” secured by tangible assets, “but the levered stuff like CYH [i.e., Community Health Systems] just got hammered and continues to trade at lower levels.”

A second trader said that health care “has obviously been pretty topical, with [proposed] changes to the health care system, with Trump trying to reverse some of the things that happened before with Obamacare.”

Going forward, he said that “you could see some disruption – you’ve got come big levered companies there.”

The first trader – speculating on whether there might be renewed efforts to change or repeal the health care law, although that would seem to be unlikely in the coming election year – said that if that were the case, the proposed changes “would have to be pretty bleak. I think all of that stuff is built in [to market levels] right now.”

Among what he called “the weaker guys, CYH is the only one that would really get hurt like that, though Tenet has some single-B stuff that is not secured, but not to the extent that CYH is.”

But overall, he predicted that “unless some really dire stuff comes out, we’ve probably seen the worst.”

A third trader said that “you have to keep your eye” on Tenet and Community Health. “In pharmaceuticals, I think you have to watch [Israel-based] Teva [Pharmaceutical Industries Ltd.] and Valeant [Pharmaceuticals International, Inc.]” – although he said the debt-laden Laval, Que.-based latter company “seems to have squared themselves away with investors – but we’ll have to see.”

He continued that “in home health care, everything is pretty much status quo – there isn’t a whole lot going on there.”

Birmingham, Ala.-based post-acute surgical centers and home health care company HealthSouth Corp., he said. “seems to be on a stable footing.”

He said that risk in the sector “is reimbursement risk and bad-debt expense at the hospitals.” He said that dialysis services providers such as Denver-based DaVita Inc. “are going to continue to be OK.

“So in health care, I think what you see is what you’ve got right now – and the payors,” be they Medicare/Medicaid or private insurance companies “will try and squeeze the providers, again,” he concluded.

But not all sector names were necessarily under pressure. Heading into the last half of December, there was big news in the sector as Kindred Healthcare Inc., a B3/B- rated Louisville, Ky.-based operator of acute-care hospitals, rehabilitation centers, hospice facilities and a provider of home health care services, was reported on Dec. 18 to be in “advanced talks” about being acquired by giant insurer Humana Inc. and a pair of private-equity companies in a transaction having an enterprise value of about $4 billion, most of that in the form of assumed debt.

Kindred’s debt firmed by as much as 6 or 7 points on the initial news and then settled back into a range of around 5 points above where they had previously been trading.

Telecom a wrong number

Another major area which saw some weakness in 2017 – and which could continue in 2018 – has been domestic wireline telecommunications companies, such as Stamford, Conn.-based Frontier Communications Corp., Monroe, La.-based CenturyLink, Inc. and Little Rock Ark.-based Windstream Holdings, Inc.

“I think that we’ve seen the wirelines really struggle, and that’s an area that – given cord-cutting, given wireless, given other means – it feels like there’s not a lot of real upside to those types of companies at this point,” a trader said.

“There’s big debt loads in Frontier and several other names, that being one of the bigger ones in the space that’s come under pressure.

“That’s probably the area that I would keep an eye on.”

One of Frontier’s most widely traded issues is its 11% notes due 2025. Those bonds started off the year trading at just under 104 bid and then moved up to their peak level for the year of 105½ on Jan. 6.

It was all downhill from there, however, with the notes gradually coming down to below the par level by early March. By early July, they had fallen below 90 bid and continued to erode, falling below 80 bid in early November. By late December, they had eased further, into the lower 70s, with no real end of the declines in sight.

“I was surprised at the very poor performance out of the high-yield telecom space,” a second trader said. “I think that while the future certainly is declining, there are some opportunities within that sector and really, I think the acceleration of the decline of bond prices and the rise in yields within that particular sector – namely, Frontier and Windstream, and I guess we’ll throw CenturyLink in there as well – did surprise me. I thought they would perform well, much better than they did in 2017.”

Yet another trader declared that “it certainly seems like that space [wireline telecom] is a concern, whether or not those businesses can grow – or are they dying businesses? They command a lower multiple and they’re already pretty levered.

“So I am not sure that these businesses can grow with their [current] balance sheets – they’ve got a ton of debt, and they may have bitten off more than they can chew.”

Frontier, for instance, once a sleepy provider of basic phone service to mostly small towns and rural areas, has grown considerably over the past few years, inking an $8.6 billion deal to buy wireline assets from Verizon in 2009, and taking on another $10.54 billion of Verizon assets in 2015, plus a $2 billion asset buy from AT&T in 2014. It has funded these shopping trips with visits to the credit markets, including junk bond deals of $3.2 billion in 2010 and $6.6 billion in 2015, including $3.6 billion of the 11% notes due 2025 and another $2 billion of 10½% notes due 2022.

He said that such companies “could certainly be in the next wave of restructurings.”

One problem besetting the traditional phone carriers – and others in the communications industry such as cable providers and satellite operators – has been the phenomenon known as “cord-cutting,” as subscribers of landline phone services abandon them in favor of strictly wireless service, or cable or satellite subscribers dump those kinds of services in favor of streaming content over the internet.

This is particularly true of younger customers, such as members of the Millennial generation, who’ve grown up with such alternative technologies readily available, rather than older customers used to the more traditional communications modes.

“Things are changing,” the trader said. “I don’t necessarily understand it all because I’m sort of old-school, just the way with watching cable, but some of these Millenials, they’ve got their SmartTV and as long as they have an internet or broadband connection to the house, they can watch everything through Netflix or through Hulu or whatever. Or maybe some of these guys can watch it through cellular, though obviously that costs a lot for data. But there are other alternatives for watching and getting your content than having to pay for cable or satellite.

“So changes in technology are disrupting that industry, certainly.”

No run-up for Sprint

Besides the problems of the wireline segment, even wireless was not immune to negative currents buffeting the telecom industry.

Kingman D. Penniman, the founder, president and chief executive officer of KDP Investment Advisors of Montpelier, Vt., noted that telecom was particularly hard-hit during November and said that “obviously, part of the disappointment in telecommunications in November was the Sprint [Corp.] announcement” that the Overland Park, Kan.-based wireless provider’s sporadic talks with Bellevue, Wash.-based sector peer T-Mobile US, Inc. on a possible strategic combination of the two cellular companies was not going to lead anywhere and that those negotiations had ended.

That caused Sprint’s bonds, such as its Sprint Nextel Corp. 6% notes due 2022 to nosedive from pre-announcement levels of nearly 106 bid on Nov. 3 to 102 on Nov. 6, the day of the announcement, and then continue to fall as low as 99 by Nov. 15. The notes only partly recovered after that, headed toward the end of the year in late December at around par bid.

However, Penniman indicated that the market has not heard the last of Sprint – while the hoped-for announcement of a T-Mobile combination “didn’t come through, I think you will see further efforts to consolidate and synergize their overall operations, whatever the future will bring.”

He speculated that “the question is – is there anybody else that could be interested in Sprint or T-Mobile?” While antitrust concerns would seem to rule out a combination of either of them with larger industry players AT&T or Verizon, nothing would prevent another entity from becoming involved.

“I would say going forward that if they don’t get together, they may not be independent – somebody else may join forces with them,” although he did not hazard a guess of who such a white knight savior for one or both of the wireless carriers might emerge.

“I would say that’s the question for them. They’ve been aggressive” in cutting prices to go after market share and lure customers away from the AT&T/Verizon duopoly, “and they’ve been successful – but they need to make money, they need to refinance. Sprint particularly has a lot of money out there that they need to refinance,” with its balance sheet showing some $38.38 billion of total debt and capital lease obligations outstanding as of Sept. 30, according to the company’s most recent 10-Q filing with the Securities and Exchange Commission. Some $4.14 billion of that was considered to be current portion debt coming due within the next 12 months.

Penniman believes that “there will be some sort of combination at some point in the future – whether it’s between those two or other entities that join forces with them, that remains to be seen.”

A trader somewhat cynically suggested that “as long as SoftBank [Group Corp.]” – Sprint’s Tokyo-based 80% owner – “continues to be able to borrow money, I don’t think there’s an issue.”

He predicted that Sprint, the fourth-largest U.S. based wireless company, with 54 million customers, and Number 3 T-Mobile, with 70.7 million subscribers will continue to nip at the heels of industry leader Verizon (147 million subscribers) and runner-up AT&T (138 million customers) and “will continue to cause problems” for the larger companies, “as they continue to cut prices and do all of that stuff.

“They will be [market] disrupters.”

‘Amazon Effect’ roils retail

When Penniman was asked during his interview – only partly tongue in cheek – whether Sprint might wind up at the end of the day being bought by Amazon.com Inc. if no other buyer emerged, the KDP chief chuckled a little and drolly asked “who knows?”

It’s not such a completely far-fetched notion, since billionaire Jeff Bezos’ marketing octopus seemed to be expanding its tentacles into so many other businesses this past year.

“The ‘Amazon Effect’ generates a lot of fear in the high-yield market, whether it’s health care, or pharmaceuticals or retail or supermarkets – they’re there,” Penniman said.

“And you’ve seen other companies starting to take their own proactive actions to hopefully offset it, but obviously, that’s had a tremendous impact here.”

Since starting out as an online sales outlet for books in 1994, Seattle-based Amazon has grown exponentially, offering deals on a huge variety of merchandise that includes videos and consumer electronics, clothing, furniture, food, toys and jewelry. It has inspired numerous online imitators, becoming the driving engine behind the e-commerce boom that has upended the business model of traditional brick-and-mortar physical stores.

As an example of the inroads that online commerce has made versus traditional retailing, consider that according to the National Retail Federation, about 58 million Americans shopped only online from Thanksgiving Day to Cyber Monday, versus just 51 million who shopped only in actual stores. An additional 64 million customers did both.

Competitors respond

The shift in recent years has forced the operators of many of the physical stores to both downsize and consolidate that business by closing unprofitable outlets and to defensively start their own online sales operations, preserving at least some of their business, but essentially trying to play catch-up.

A number of familiar retail names were forced into Chapter 11 in 2017 by a combination of erosion of their revenues because of the rise of online retailing, as well as intense competition from larger and more financially solvent physical retailers such as Wal-Mart. These included such junk bond issuers and/or bank debt borrowers as Toys ‘R’ Us, Inc., Gymboree Corp., Payless ShoeSource, Inc., rue21, Inc., Gordmans Stores, Inc., hhgregg, Inc. and Radio Shack Corp., the latter company back for its second bankruptcy filing, having also restructured in 2015.

Besides the retailers actually forced into the bankruptcy courts this past year – versus no such major retailing names in 2016 – the debt of a number of other familiar storekeepers was seen under pressure at various times during the year, including J.C. Penney Co., Inc., PetSmart, Inc., Neiman-Marcus Group, Rite Aid Corp., Claire’s Stores, Inc. and Sears Holdings Corp.

The announcement that Amazon – heretofore almost exclusively an online retailer – would step into the supermarket business with its $13.4 billion purchase of upscale grocer Whole Foods Market – rocked an already low-margin industry beset by increasing competition from Wal-Mart’s new generation of “superstores.” That food stores sector had already seen the 2015 demise of the venerable but debt-laden Great Atlantic & Pacific Tea Co. – operator of the iconic A&P, Pathmark and Waldbaum’s store chains – and now feared that Amazon’s almost boundlessly deep pockets and marketing muscle could produce further casualties.

Greensboro, N.C.-based Fresh Market Inc. – which competes directly with Whole Foods in many areas in selling high-end organic and gourmet food items to its primarily affluent customer base – was especially hurt by this development. Its 9¾% notes due 2023 had begun the year in the mid-80s, peaking at 89.5 bid on Jan. 17. The bonds were still trading just a little bit off those lofty peak levels in mid-June, when the pending Amazon acquisition of Whole Foods was announced, cascading down nearly 10 points over the next several sessions to under 80 bid.

The TFM notes had managed to recover a little of those losses by late August, firming into the low 80s, but slid again on the Aug. 24 announcement that the Amazon takeover of Whole Foods would close on Aug. 28, dropping 6 points over the next week and gradually eroding down to around 60 bid by the end of September. The carnage did not stop there, with the notes continuing their nosedive until they were in the mid-50s by Dec. 18.

Camp Hill, Pa.-based drugstore chain operator Rite Aid’s bonds saw some downside volatility around mid-October, pushed lower by news reports indicating that Amazon had obtained wholesale pharmacy licenses in at least 12 states and was in talks with some large pharmaceutical manufacturers, possibly with an eye to carving out a piece of the potentially lucrative pharmaceutical pie by pushing aside traditional drug retailers like Rite Aid and its larger rivals CVS and Walgreens Boots Alliance Inc.

A trader said that “the disruption that Amazon is causing across a number of industries has created some volatility, but it is certainly impacting retailers – they’ve definitely been one of the more stressed/distressed sectors.”

He said “that’s been going on for a while – a name like Claire’s has been distressed for quite some time.”

He said the Hoffman Estates, Ill.-based specialty retailer had relatively favorable quarterly numbers, but “we’re going to see if it can sustain this improvement.”

He continued that “we’ll see how the big-box guys, like the J.C. Penneys and the Macy’s survive, and others like Bon-Ton [Department Stores, Inc].”

He said that much would depend on how the retailers do in their end-of-year quarter, “a big deal to a lot of these companies. The Christmas season is make-it or break-it for a lot of retailers. We’ll see how they fare.”

He called Wayne, N.J.-based Toys ‘R’ Us’ Sept. 19 Chapter 11 filing “unexpected,” even though “they certainly were levered, and there was concern about them.

“Once you had the chatter about vendors getting tight, etc., it became a little bit of a death spiral.”

He said that although the company “has their DIP [financing] and their plans, it all hinges on their fourth-quarter performance. If Amazon and Wal-Mart take away a ton of their market share over the Christmas holiday, they ‘re going to have to completely redo their numbers. It’s going to be pretty impactful.”

Another trader opined that Toys will successfully emerge from Chapter 11 with less debt.

As for some other sector names, he said, “I don’t know if there’s any saving Sears. Gap, I think, is doing OK. J.C. Penney – I think they’ they’re making progress in what they’re doing. I think Penney survives. I think Macy’s survives, Nordstrom, Neiman Marcus – I think they’re all OK, but it’s going to be a difficult year.”

He predicted that “the ones that have transitioned to online as well as brick-and-mortar – BestBuy, Wal-Mart, those guys – they’ll all be fine.”

“If oil is able to hold these $50-to $55 kind of levels, you’ll see a resurgence in the oil and gas market in terms of issuance.” – A trader

“I think that we’ve seen the wirelines really struggle, and that’s an area that – given cord-cutting, given wireless, given other means – it feels like there’s not a lot of real upside to those types of companies at this point.” – A trader

“The ‘Amazon Effect’ generates a lot of fear in the high-yield market, whether it’s health care, or pharmaceuticals or retail or supermarkets – they’re there.” – Kingman D. Penniman, the founder, president and chief executive officer of KDP Investment Advisors

© 2015 Prospect News.
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