MOODYS.COM 29 SEPTEMBER 2016 NEWS & ANALYSIS Corporates 2 » Office Depot Will Sell Its European Business, a Credit Positive » India's Rafale Purchase Is Credit Positive for Dassault, Thales, Airbus, BAE Systems and Finmeccanica » Travelex's Disposal of Its US Insurance Business Is Credit Positive » Maersk's Planned Split Is Credit Negative » Saipem Wins $430 Million in New Onshore Drilling Contracts, a Credit Positive Banks 8 » Saudi Banks Will Benefit from Central Bank's Latest Liquidity Support Insurers 10 » Draft Capital Requirements for Canadian Mortgage Insurers Are Credit Positive Exchanges 12 » CBOE's Acquisition of Bats Is Credit Positive Sovereigns 14 » Lebanon's Weak Fiscal Performance During the First Half of 2016 Is Credit Negative US Public Finance 16 » Atlantic City, New Jersey's Impending Technical Default Is Credit Negative » Court Rules Kentucky Governor Must Release University Funds, a Credit Negative RECENTLY IN CREDIT OUTLOOK » Articles in Last Monday’s Credit Outlook 21 » Go to Last Monday’s Credit Outlook Click here for Weekly Market Outlook, our sister publication containing Moody’s Analytics’ review of market activity, financial predictions, and the dates of upcoming economic releases.
Transcript
MOODYS.COM
29 SEPTEMBER 2016
NEWS & ANALYSIS Corporates 2 » Office Depot Will Sell Its European Business, a Credit Positive » India's Rafale Purchase Is Credit Positive for Dassault, Thales,
Airbus, BAE Systems and Finmeccanica » Travelex's Disposal of Its US Insurance Business Is
Credit Positive » Maersk's Planned Split Is Credit Negative » Saipem Wins $430 Million in New Onshore Drilling Contracts,
a Credit Positive
Banks 8 » Saudi Banks Will Benefit from Central Bank's Latest
Liquidity Support
Insurers 10 » Draft Capital Requirements for Canadian Mortgage Insurers Are
Credit Positive
Exchanges 12 » CBOE's Acquisition of Bats Is Credit Positive
Sovereigns 14 » Lebanon's Weak Fiscal Performance During the First Half of
2016 Is Credit Negative
US Public Finance 16 » Atlantic City, New Jersey's Impending Technical Default Is
Credit Negative » Court Rules Kentucky Governor Must Release University Funds,
a Credit Negative
RECENTLY IN CREDIT OUTLOOK
» Articles in Last Monday’s Credit Outlook 21 » Go to Last Monday’s Credit Outlook
Click here for Weekly Market Outlook, our sister publication containing Moody’s Analytics’ review of market activity, financial predictions, and the dates of upcoming economic releases.
NEWS & ANALYSIS Credit implications of current events
2 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
Corporates
Office Depot Will Sell Its European Business, a Credit Positive Last Friday, Office Depot Inc..(B1 stable) said that it had agreed to sell its European business to Aurelius Group for an undisclosed equity consideration. The sale is part of a broader move to tighten Office Depot’s strategic focus and improve growth in its North American operations. We view the sale of Office Depot’s European division as credit positive.
The sale will remove a challenged facet of the company’s business and allow Office Depot to focus 100% of its efforts on the remaining components, particularly in the acutely competitive North American operating environment for the office supply business. The move will also simplify the business for the ultimate successor to retiring CEO Roland Smith. Office Depot’s operating performance continues to lag head-to-head competitor Staples, Inc. (Baa2 stable) by a wide margin. The European unit, which had annual revenue of about $2.25 billion in 2015, versus the parent’s total revenue of $14.5 billion that year, generated a $10 million operating loss in second-quarter 2016, versus the parent’s net income of $210 million for the period.
Office Depot had planned to sell its European operations as part of its planned merger with Staples to gain the European Commission’s regulatory approval for the merger. When the company failed to gain US regulatory approval last May, the company reiterated its intention to sell the European business.
Office Depot continues to integrate OfficeMax, which has been generating meaningful synergies and will continue to support credit metrics. Even so, the company remains in a weaker competitive position as it continues to defend its turf against better-capitalized Staples. Office Depot is also competing against Amazon.com Inc. (Baa1 stable), which continues to make inroads in a broad spectrum of commercial and retail goods such as office supplies.
As part of a broader strategic shift to improve top-line growth, Office Depot has been closing underperforming stores, reducing exposure to higher dollar-value inventory items and focusing more on e-commerce platforms, among other steps. Office Depot previously said that it will return up to $100 million to its shareholders, a sum that we regard as benign from a credit perspective in the context of its more than $1 billion in cash and the $250 million break-up fee that Staples paid after their planned merger failed to gain regulatory approval. We continue to think the “other shoe” is likely to drop with respect to ramped-up returns to shareholders and would not be surprised if 2017 is a big year on this front. To that end, we believe Office Depot is more likely to increase returns given its cash balance and headroom within its current rating, as well as the removal of the European business.
Charlie O’Shea Vice President - Senior Credit Officer +1.212.553.3722 charles.o'[email protected]
This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history.
NEWS & ANALYSIS Credit implications of current events
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India’s Rafale Purchase Is Credit Positive for Dassault, Thales, Airbus, BAE Systems and Finmeccanica Last Friday, India signed a deal to buy 36 Rafale fighter jets from the government of France. The deal follows almost 18 months of negotiation between the Government of India and French aircraft manufacturer Dassault Aviation SA (unrated). In addition to Dassault as the prime contractor, the deal is credit positive for multiple entities, including key Dassault suppliers Thales SA (A2 stable) and MBDA Missile Systems, a consortium comprising Airbus Group SE (A2 stable), BAE Systems plc (Baa2 stable), Finmeccanica SpA (now known as Leonardo-Finmeccanica, Ba1 stable) and Safran SA (unrated).
This deal and two earlier transactions with the governments of Qatar and Egypt (24 jets each) will help offset Dassault’s deferred deliveries to France and better secure the production rate on the Rafale program at two aircraft per month.
Thales is a particularly noteworthy beneficiary, with an approximate 25% shipset value for each Rafale produced. As one of the leading French defense contractors, Thales provides the avionics, radar and other electronic equipment (e.g., warfare systems, optronics, communication, navigation and identification system) on the Rafale aircraft. The company will also contribute to the majority of the cockpit display systems, power generation systems and a component of logistics support.
The Rafale was chosen as the preferred aircraft over the Eurofighter Typhoon at the beginning of 2012 under a potentially much larger contract for 126 fighters, and the original request for proposal dates back to mid-2008. The larger deal stalled because of cost, technology transfer and local production issues, although such offset requirements are still likely to be comparatively high at up to 50% on the smaller order. India remains one of the top importers of military goods globally, but is actively trying to develop more advanced technological capabilities for greater in-country production.
The value of the new contract is roughly €8 billion, a little less than half of which is for the aircraft and the balance for weapons, spare parts and other services. Deliveries are scheduled for late-2019 through 2022. India has an added sense of urgency about its deliveries given the aged status of its fleet in conjunction with a heightened security environment, both of which are key factors spurring the government-to-government sale over a relatively compressed time frame.
We believe that the deal’s included options for up to 18 additional aircraft have a reasonably good chance of being exercised. But there will be stiff competition from other bidders (many of which already maintain sizable military-related export ties to India) for follow-on business. They include the F-16 from Lockheed Martin Corp. (Baa1 stable), the F-18 from Boeing Co. (A2 stable) and others from Russia, Sweden and potentially elsewhere. All of these companies are increasingly competing for a relative paucity of new bid opportunities in a still-constrained global spending environment, and they are notably willing to invest in new facilities for local production, which we expect will remain integral to winning new business.
We expect that this growing export business will bolster Thales’ already-strong liquidity and ongoing restructuring initiatives to boost profitability, lending incremental support to our August 2016 decision to affirm the company’s ratings and raise its baseline credit assessment to baa1 from baa2. More broadly, the latest and recent Rafale deal supports our view that market opportunities in Europe, the Middle East and Asia will continue to be selectively available for defense contractors given rising geopolitical risk – notwithstanding lingering fiscal pressures – albeit under a more heightened competitive environment.
Russell Solomon Senior Vice President +1.212.553.4301 [email protected]
NEWS & ANALYSIS Credit implications of current events
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Travelex’s Disposal of Its US Insurance Business Is Credit Positive On 26 September, Travelex Holdings Limited (unrated), a holding company owning 100% of UK-based retail foreign-exchange specialist Travelex, announced that it had agreed to sell its travel insurance business (Travelex Insurance Services Inc. or TIS) to Cover-More Group (unrated), an Australian-based travel insurance provider. This disposal, pending certain closing conditions, is credit positive for TP Financing 3 Limited (Travelex, B3 negative), an intermediate holding company fully owned by Travelex Holdings Limited and holder of the group’s operating subsidiaries. The cash proceeds of $105 million (approximately £80 million) from the sale will alleviate pressure on Travelex’s liquidity.
Through TIS, Travelex is active in travel insurance brokerage in the US, which is a highly regulated market. Travelex considers TIS a non-core business. TIS contributed a limited portion of Travelex’s profitability (£7.6 million EBITDA, or 9% of consolidated EBITDA in 20151). Although historically profitable (23% EBITDA margin versus 11% for Travelex as a whole in 2015), TIS has been adversely affected by the renegotiation of terms with insurance underwriters, which occurred at the end of 2014.
Travelex intends to use part of the cash proceeds to reduce its net debt. The disposal of this non-core asset will enhance Travelex’s liquidity, mainly by reducing usage of its revolving credit facility. Travelex’s liquidity has weakened in the past 12 months owing to a severe decline in its profitability and sustained negative free cash flow generation, as shown in the exhibit. As of 30 June 2016, Travelex utilized around £80 million of its £90 million revolving credit facility, comprising around £50 million cash drawings and around £30 million of letters of credit. In addition, Travelex’s usable cash2 on the balance sheet at the end of June 2016 was modest at £35.5 million (versus £60.7 million in the prior year).
Travelex Holdings Limited - Key Indicators, £ Millions
Note: Moody’s free cash flow is defined as cash flow from operations, minus capital expenditures, minus common dividends, preferred dividends and minority dividends. Sources: Company reports and Moody’s Financial Metrics
This is the second time this year that Travelex has disposed of an asset. On 1 April, Travelex sold its Dynamic Currency Conversion business to Global Blue Finance S.a.r.l. (B1 stable) for £36.1 million. The disposal of non-core assets brings in needed cash and enhances near-term liquidity, but we do not consider it a sustainable mitigant to Travelex’s structural cash burn.
1 Defined as core group EBITDA, which consists of EBITDA adjusted to include 100% of the EBITDA of joint ventures, share-based
payment incentive charges, and Banque Travelex SAS (which was disposed of in 2015 but which the group continues to manage), and excludes EBITDA attributable to the Travellers’ Cheques business (which does not form part of the restricted group).
2 Defined as the amount of net cash available to Travelex for immediate use and excluding cash in tills and vaults.
NEWS & ANALYSIS Credit implications of current events
5 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
We caution that Travelex still faces the challenge of weak operating performance in its core retail and wholesale businesses. We expect Travelex’s free cash generation to remain negative in the next 12-18 months owing to challenging conditions in Brazil and Nigeria, continued investments in digital and adverse working capital movements this year.
Travelex also provides wholesale foreign-exchange currencies to central banks, financial institutions and travel agents and has partnerships with supermarkets, banks, travel agencies, hotels and casinos as a provider of outsourced foreign currency services. At year-end 2015, Travelex reported core group revenues (as defined by the company) of £734 million and core group EBITDA of £83.2 million.
NEWS & ANALYSIS Credit implications of current events
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Maersk’s Planned Split Is Credit Negative On 22 September, A.P. Møller-Mærsk A/S (Maersk, Baa1 review for downgrade) announced that it will become an integrated transport and logistics company and separate its oil and oil-related businesses via joint ventures, mergers or public listings. Maersk’s exit from its energy-related businesses is credit negative and prompted us to put the company’s ratings on review for downgrade because it will significantly reduce the company’s business diversification.
In 2015, the energy-related businesses contributed 52% of Maersk’s total EBITDA. Maersk has been engaged in a number of unrelated businesses that have buoyed its earnings. In addition to transportation and energy, the company had previously invested in banks and supermarkets. Maersk’s planned exit from the energy businesses will concentrate the company’s earnings in the volatile container-shipping sector, although the presence of APM Terminals (20% of 2015 EBITDA for the transportation segment) will provide a measure of stability.
Maersk’s new transportation and logistics business will encompass Maersk Line, the largest container-shipping company with approximately a 15% worldwide market share by volume; APM Terminals, an operator of primarily container terminals in 72 ports globally; Damco, a third-party logistics provider of supply-chain management and freight forwarding services; and Svitzer, a harbour towage operator. Maersk expects to integrate these businesses, which had previously operated independently, and offer digital solutions to improve product offerings and services to customers. The company estimates that its return on invested capital is likely to improve up to 2% over the next three years. Although the improvement clearly would be positive, it would not be sufficient to compensate for lost diversification benefits.
Freight rates in the container-shipping market have been challenged for most of 2016, and all container shipping lines, including Maersk Line, posted negative EBIT in the second quarter of this year. Even though container-shipping freight rates recovered slightly (and likely only temporarily) after the late August bankruptcy of Korea’s Hanjin Shipping (unrated), we expect Maersk Line’s business to continue to face negative pressure.
The energy-related business lines including Maersk Oil, Maersk Drilling, Maersk Tankers and Maersk Supply Service will be separated from the transportation and logistics company, individually or in combination, over the next 24 months through mergers, joint ventures or public listings, although partial ownership interests may be retained. The end markets for these businesses, particularly oil and drilling, have also been negatively affected by low oil prices (Maersk Oil was loss-making in the first quarter this year) and major exploration and production companies’ reduced capex spending. Although Maersk Drilling contributed 15% of total EBITDA to Maersk in 2015, based on signed contracts as of the first half of 2016, it expects contract coverage to decline to 56% in 2017 and 45% in 2018 from 73% in the second half of 2016, reducing its cash flow contribution to the conglomerate.
We expect that some of the negative effects of Maersk’s diminished diversification may be counterbalanced by the proceeds from the separation of the energy businesses. However, neither the timing nor the amount of such proceeds, if any, are known at this time. Maersk’s decision followed a strategic review that began in June. The company indicated that its aim as a transportation company is to maintain a strong capital structure and key financial ratios in line with an investment-grade rating, but did not elaborate on its specific targets.
Maria Maslovsky Vice President - Senior Analyst +44.20.7772.5502 [email protected]
NEWS & ANALYSIS Credit implications of current events
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Saipem Wins $430 Million in New Onshore Drilling Contracts, a Credit Positive Last Thursday, oil- and gas-focussed engineering, construction and drilling company Saipem S.p.A. (Ba1 stable) announced that it had been awarded $430 million in new contracts in its onshore drilling segment. The new contracts are credit positive because they add to Saipem’s €13.9 billion backlog, even though the oilfield services industry is stressed. The new awards emphasise the company’s strong customer relationships in key geographical areas that are showing some resilience in a stressed environment, such as Saudi Arabia.
Although the company won several new awards in the Middle East and South America, the majority of the $430 million of new contract wins relates to three-year extensions on 10 of the company’s rigs operating in Saudi Arabia. Saipem currently operates 28 of its around 100-rig global fleet with Saudi Aramco (unrated) in Saudi Arabia. In addition, Saipem currently has 30 operational rigs in Peru, Colombia, Bolivia and Chile, where the company also won contract extensions ranging from two to 24 months on a number of its rigs. It also won its first contract in Argentina. As a whole, these wins should help boost the company’s current low utilisation rate in South America, which we estimate at below 50%, mostly because of the company’s 25 idle rigs in Venezuela.
Including these new contract awards, the company has won approximately €6.0 billion in new business this year, which compares with the €6.5 billion it won in all of 2015. Moreover, these are the first significant contracts awarded in Saipem’s onshore drilling segment this year, increasing that segment’s revenue visibility for next year. Onshore drilling accounted for only 12% of Saipem’s €669 million in total company-adjusted EBITDA3 in the first half of 2016, but it is the company’s second most profitable segment, with a company-adjusted EBITDA margin of 28.6% for the same period.
Furthermore, the contracts were awarded against the background of a challenging oilfield services and drilling environment. We have a negative outlook on the oilfield services industry, and expect the industry’s EBITDA to decrease by 30%-40% in 2016, with no meaningful recovery in the next 12 months. However, we assume that the new drilling contracts in Saudi Arabia were signed at current market rates of slightly more than $30,000 per day, which remain unchanged compared with last year.
The new contracts also demonstrate Saipem’s strong relationship with its customers, especially in Saudi Arabia, where onshore drilling activity has shown more resilience relative to other regions. In July 2016, Saudi Arabia’s output of 10.67 million barrels of oil a day surpassed the previous production high of 10.55 million barrels a day in June 2015, according to OPEC submissions. And, as of August 2016, Saudi Arabia’s rig count had increased by 3% from a year earlier, compared with a global decrease of 30%, according to Baker Hughes Inc.
3 Company-adjusted EBITDA does not include write-downs of overdue receivables of €87 million in the onshore drilling business unit.
Sonia Kuderjava, CFA Associate Analyst +44.20.7772.5276 [email protected]
Douglas Crawford Vice President - Senior Credit Officer +44.20.7772.5215 [email protected]
NEWS & ANALYSIS Credit implications of current events
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Banks
Saudi Banks Will Benefit from Central Bank’s Latest Liquidity Support Last Sunday, the Saudi Arabia Monetary Authority (SAMA), the country’s central bank, announced that it would provide Saudi banks with about SAR20 billion ($5.3 billion) of time deposits on behalf of government agencies, and introduce seven-day and 28-day repurchase agreements. These moves follow prior deposit injections of approximately SAR12 billion since the start of the year and are credit positive for Saudi Arabia’s banks, which continue to face pronounced liquidity pressures as a result of recent deposit outflows, a consequence of depressed oil prices.
Since oil prices plunged in 2014, liquidity trends in the Saudi banking system have reversed.4 Instead of excess liquidity, reflected by customer deposit growth of 12.1% versus 11.8% growth in credit (defined as claims to the private sector, which include loans, advances and investments) between 2013 and 2014, Saudi banks have experienced the opposite trend in recent years: since 2014, average deposit growth has decreased to 1% versus credit growth of 9.5% (see exhibit). Liquidity has tightened even more since February 2016, when deposit outflows led to a 3.1% year-on-year contraction in total deposits as of 30 July 2016. Government deposits as of July 2016 were down 4.4% from a year earlier because funds were needed to help finance its large fiscal deficit, which we estimate at around 12% for 2016. Private-sector deposits also declined and were down 2.6% year on year as of July, adversely affected by government spending cuts and weakening economic growth. We expect Saudi Arabia’s non-oil GDP growth to be 1.6% this year and 2.4% in 2017, versus the 2010-16 average of 6.2%.
Saudi Commercial Banks’ Year-on-Year Change in Claims on Private Sector and Total Deposits
Source: Saudi Arabia Monetary Authority
SAMA’s SAR20 billion injection of time deposits adds to an approximately SAR12 billion provision that was extended as short-term deposits and loans to a number of banks earlier this year. These measures should help stabilize banks’ regulatory loan-to-deposit ratio for the next six months, which we expect to decrease 100 basis points to around 84% as of September 2016 from 85% in June 2016. Earlier this year, SAMA had increased its maximum loan-to-deposit ratio guidance to 90% from 85%.5
In addition, SAMA announced that it would now provide seven-day and 28-day repurchase agreements in addition to one-day repo agreements. When combined with a robust stock of liquid assets to total assets of
4 See Saudi Banks' Deposit Losses Tighten Liquidity, 4 July 2016. 5 As per SAMA’s definition, the loan-to-deposit ratio includes long-term borrowing in the denominator.
NEWS & ANALYSIS Credit implications of current events
9 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
around 25%, these repurchase facilities will allow banks to access short-term borrowing at a lower and more stable cost than available in the challenged wholesale markets. This will reduce their funding costs, which, as reflected in the three-month Saudi Interbank Offered Rate (SAIBOR) of 2.35% on 27 September, are at their highest since January 2009.
Although the majority of banks continue to rely on funding from non-interest-bearing deposits (around 63% of total funding as of June 2016), recourse to more expensive and confidence-sensitive wholesale market funding has increased in recent months to 7.9% as of June 2016 from 6.1% as of December 2015, commensurate with the contraction in total deposits available in the system. Despite the likelihood of continued pressure on banks’ cost of funding into 2017, these SAMA facilities should also support profitability.
NEWS & ANALYSIS Credit implications of current events
10 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
Insurers
Draft Capital Requirements for Canadian Mortgage Insurers Are Credit Positive Last Friday, Canada’s national banking and insurance regulator, the Office of the Superintendent of Financial Institutions (OSFI), published for comment draft guidelines on changes to capital requirements for mortgage creditor insurers. These new capital requirements, if implemented as drafted, would increase overall capital for Canada’s mortgage insurance industry and Canadian Crown corporation, Canada Mortgage and Housing Corporation (CMHC, Aaa stable), a credit positive.
The draft advisory provides a new standard approach for residential mortgage insurance that is more risk sensitive and incorporates new key risk and loss drivers including creditworthiness, remaining amortization, and outstanding loan balances.
The draft guidelines require a supplemental capital requirement for mortgages insured in Canada’s 11 largest metropolitan areas when those cities show indications of high house prices relative to income levels, similar to bank capital requirements introduced earlier this year. This supplemental charge will create a capital cushion for mortgage insurers’ exposures in cities whose housing markets have had rapid price appreciation, such as Vancouver, British Columbia, and Toronto, Ontario. We believe required capital for mortgages in these cities will increase.
Of the CAD1.6 trillion in outstanding Canadian mortgage debt, including home equity lines of the credit, almost half are covered by creditor insurance (see exhibit). This insurance is primarily sold either directly to the borrower, who is legally required under the Bank Act to obtain it if the mortgage’s loan-to-value ratio exceeds 80%, or lenders purchase the insurance on a portfolio basis as a liquidity and capital- management tool.
Canadian Mortgages with Borrower Insurance Almost half of all Canadian mortgages have borrower default coverage.
Note: Data are as of 30 June 2016, except for Genworth, which is as of 31 March 2016. Sources: Company data, Canada’s Office of the Superintendent of Financial Institutions, Statistics Canada and Moody’s Investors Service
CMHC 68%
Genworth 25%
Canada Guaranty 7%
Public Insurance Limit CAD600 billion
Private Insurance Limit CAD300 billion
Uninsured Mortgages52%
Jason R. Mercer, CFA Assistant Vice President - Analyst +1.416.214.3632 [email protected]
NEWS & ANALYSIS Credit implications of current events
11 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
The Canadian government limits its mortgage insurance guarantee to CAD900 billion, which is shared among only three entities. CMHC, which as a crown corporation with government agency status, effectively makes any policies it writes a direct contract with Canadian government. Under legislation, CMHC’s insurance-in-force is limited to CAD600 billion. The Canadian government also provides a 90% guarantee on the insurance in force of two private-sector insurers, Genworth (unrated) and Canadian Guaranty Insurance Company of Canada (unrated), in the event that one of them fails. This CAD300 billion guarantee is shared between the two insurers.
These and other recent actions by Canadian policymakers will assist in slowing rapid house price appreciation and corresponding mortgage growth, reducing the prospect of a sharp housing price correction that would increase credit losses at Canadian banks. Increasingly, elevated housing prices have driven up Canadian household indebtedness, a key threat to the stability of the Canadian banking system. Since 2008, Canadian policymakers have implemented a series of changes to the rules for government-backed insurance, including limitations on amortization, premium increases and elimination of specialized product offerings.
We do not believe this has any credit implications for Canadian banks that hold insured mortgages because their exposures to mortgage insurers are already backstopped by the Canadian government.
NEWS & ANALYSIS Credit implications of current events
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Exchanges
CBOE’s Acquisition of Bats Is Credit Positive On Monday, CBOE Holdings, Inc. (unrated) announced that it had agreed to acquire Bats Global Markets, Inc. (Ba3 review for upgrade) for $3.2 billion. The purchase price consists of $2.2 billion in CBOE stock and $1.0 billion in cash. CBOE intends to borrow $1.65 billion to fund the cash portion and refinance Bats existing debt. The acquisition is credit positive for Bats because it will benefit from the combined entity’s greater revenue diversification and reduced reliance on transaction-based revenues compared with Bats as a standalone firm. We put Bats ratings on review for upgrade following the announcement.
CBOE plans to suspend its share repurchase program and focus on de-leveraging after the transaction’s completion. CBOE has a strong and stable track record of favorable operating margins and a history of organic growth driven by strong performance in several key offerings, most notably the firm’s index options and futures on proprietary products. CBOE has been successful in deploying the benefits of its operating leverage via sustained revenue growth and the successful management of a relatively predictable cost base.
Through acquisitions and a disruptive pricing model based on aggressive rebates, Bats has grown into a leading equities exchange in the US and Europe. Two transformative acquisitions of Chi-X Europe and Direct Edge helped Bats become a dominant player in the equities market. Bats also gained a substantial presence in the foreign-exchange market with the acquisition of Hotspot from KCG Holdings Inc. (B1 stable). Hotspot is a foreign-exchange execution venue in the highly fragmented institutional spot foreign-exchange market. US options is the only segment where Bats has been growing organically without acquisitions. The firm’s aggressive pricing in US options in particular has increased its market share to 10% in 2015 from 3% in 2011. The segment remained a small contributor to net revenues but has been a growing piece of the business as the firm has gained market share from other players, including CBOE.
This transaction will further consolidate the US options industry: Nasdaq, Inc. (Baa3 positive) recently acquired International Securities Exchange (ISE, unrated). Market share of the combined Nasdaq and ISE is roughly 37% of the US options market, while CBOE’s proposed acquisition of Bats would increase its market share to 37% from 27% (see Exhibit 1).
NEWS & ANALYSIS Credit implications of current events
13 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
EXHIBIT 1
US Options Market Share in 2015 Actual Pro Forma Combined Nasdaq/ISE and CBOE/Bats
Note: Combined market shares are based on 2015 full year data. BOX = Boston Options Exchange; MIAX = Miami Stock Exchange; ISE = International Securities Exchange. Sources: The Options Clearing Corporation and Moody’s Investors Service
Compared with peers, Bats has the highest proportion of net revenue from cash equity trading, a product category that remains subject to heightened competition and transaction-based revenue variability and regulatory risk from market structure reforms. Following this acquisition, the combined company will have a more diversified profile (see Exhibit 2).
EXHIBIT 2
Net Revenue Mix for the Combined CBOE/Bats Entity and Competitors as of 2015
Notes: Bats other trading = Global FX. Although exhibit is based on 2015 data, business line disclosures are not comparable. Data and Connectivity segment for CME includes revenues of $399 million from market data and information services and $86 million in access and communication fees. Listing and Other category for ICE includes $405 million in listing fees and $178 million in other revenues. For Nasdaq, Data and Connectivity includes $512 million in revenues from information services, $543 million from technology solutions and $239 million in access and broker service revenues, while Listing and Other includes $264 million of revenues from listing services. Sources: Company reports and Moody’s Investors Service
ISE12%
NASDAQ26%
CBOE27%
Bats10%
NYSE17%
MIAX6%
BOX2%
NASDAQ37%
CBOE37%
NYSE18%
MIAX6%
BOX2%
7% 12%
33%
13%
84%
50%
9%
3% 76% 47%
4%
8%
3%
15%
26%
62%
55%
21%34%
2%17% 13%
3% 2%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
CMEAa3 Stable
ICEA2 Stable
NasdaqBaa3 Positive
BatsBa3 Review for
Upgrade
CBOE (unrated) CBOE + Bats (unrated)
Cash Equity Derivatives Other Trading Data and Connectivity Listing and Other
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Sovereigns
Lebanon’s Weak Fiscal Performance During the First Half of 2016 Is Credit Negative Last Wednesday, Lebanon’s (B2 negative) Ministry of Finance published data showing a cash deficit of LBP2.9 trillion ($1.94 billion) for the 2016 first half, an 8.5% increase from a year earlier. The increasing fiscal deficit suggests that the government is having difficulty reining in expenditures amid increased interest payments for government debt and weak revenue performance, a credit negative.
Lebanon’s persistent and high fiscal deficits are a key credit constraint. The first-half 2016 result implies that the full-year deficit will reach around LBP6.4 trillion ($4.28 billion), or around 8.1% of GDP, up from our earlier forecast deficit of 7.8% of GDP. We expect the general government debt burden to increase to 130.7% of GDP by year-end 2016 from 126.5% of GDP in 2015, instead of 130.4% of GDP as of year-end 2016 that we expected when we affirmed Lebanon’s rating in June. Given the country’s relatively low 1%-2% growth, we estimate that the authorities would need to decrease the fiscal deficit to 4.3% of GDP to stabilise Lebanon’s debt-to-GDP ratio, all other things equal.
The deterioration in fiscal performance primarily results from higher interest payments on government debt, which absorb 47% of government revenue. Compared with a year earlier, interest payments on government debt increased 8.6% to LBP3.5 trillion ($2.33 billion) in the first half of 2016. Although interest rates on government securities have remained low and stable since 2012 at 5.4% for one-year local-currency treasury bills, the issuance volume has increased amid higher deficits. In June 2016, gross general government debt (excluding debt owed to public entities) was LBP101.3 trillion ($67.23 billion), up from LBP95.7 trillion in June 2015 and LBP73.0 trillion at year-end 2010.
Meanwhile, the Lebanese authorities have sought to extend debt maturities, in line with the Ministry of Finance’s debt management strategy. We estimate that the average maturity on government debt (excluding Paris Club loans) rose to 4.6 years as of June, from 4.3 years as of year-end 2015 and 2.8 years at year-end 2010. Although longer-term securities limit liquidity risks by lowering gross borrowing requirements, they carry higher interest rates.
Excluding interest payments, the government’s primary surplus actually increased 4.2% to LBP746 billion ($495 million) in the first half of 2016. Lower oil prices helped moderate fund transfers to utility company Electricité du Liban (unrated), which in the first half of 2016 decreased 46.7% from the year-ago period to 5.3% of expenditures. Increases in other expenditures were moderate, except for health expenses, which the refugee crisis inflated and donor support only partly compensated (see Exhibit 1).
NEWS & ANALYSIS Credit implications of current events
15 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
EXHIBIT 1
Change in Lebanon’s Revenues and Expenditures on a Six-Month Rolling Average as a Percentof GDP
Source: Lebanon’s Ministry of Finance
Weak revenue performance also contributed to the growing fiscal deficit. Tax revenues increased 2.6% year on year to account for 77% of total revenue, down from 83% in 2010 (see Exhibit 2). Over the past few years, tax revenues have remained stable because of a narrow tax base and continued delays with reforms, including the removal of value-added tax (VAT) exemptions on gas and oil that were introduced in 2012 and broader VAT reforms. As a result, the government has become increasingly reliant on volatile non-tax revenue to finance expenditure growth, a credit negative.
EXHIBIT 2
Lebanon’s Tax Revenue versus Interest and Other Expenses
Sources: Lebanon’s Ministry of Finance and Moody’s Investors Service
In the absence of consensus around economic and fiscal reforms, the fiscal deficit is likely to slowly return to pre-2009 levels. Not a single budget has passed since 2005, and current expenditures crowd out capital expenditures. Although liquidity is solid in the domestic banking system, rising deficits will gradually erode investor confidence.
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
2009
- D
ec20
10 -
Feb
2010
- Ap
r20
10 -
Jun
2010
- Au
g20
10 -
Oct
2010
- D
ec20
11 -
Feb
2011
- Ap
r20
11 -
Jun
2011
- Au
g20
11 -
Oct
2011
- D
ec20
12 -
Feb
2012
- Ap
r20
12 -
Jun
2012
- Au
g20
12 -
Oct
2012
- D
ec20
13 -
Feb
2013
- A
pr20
13 -
Jun
2013
- A
ug20
13 -
Oct
2013
- D
ec20
14 -
Feb
2014
- Ap
r20
14 -
Jun
2014
- Au
g20
14 -
Oct
2014
- D
ec20
15 -
Feb
2015
- Ap
r20
15 -
Jun
2015
- Au
g20
15 -
Oct
2015
- D
ec20
16 -
Feb
2016
- Ap
r20
16 -
Jun
Revenue Expenditures
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
2010 2011 2012 2013 2014 2015 2016F
Tax Revenue Non-tax Revenue Interest Payments Other Expenditures
NEWS & ANALYSIS Credit implications of current events
16 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
US Public Finance
Atlantic City, New Jersey’s Impending Technical Default Is Credit Negative Last Monday, Atlantic City, New Jersey (Caa3 negative), Mayor Don Guardian announced that the Atlantic City Municipal Utilities Authority (B3 negative) had agreed to purchase Bader Field from the city for more than $100 million. The mayor added that the purchase constitutes the monetization of the authority as called for by previous legislation, and therefore, the state would not seize the utility as it is entitled to under the terms of the bridge loan from the State of New Jersey (A2 negative). The state has yet to comment on Mr. Guardian’s plan, but on 22 September, it informed the city that it was in violation of the covenants on its bridge loan and had until 3 October to cure the default.
Atlantic City’s impending technical default is credit negative for it and indicates a disconnect between the city council, mayor, and state. The impending default was caused by political gridlock because the city was unable to conditionally dissolve the Atlantic City Municipal Utilities Authority by a 15 September deadline. The city has requested that the state waive the event of default and believes that it is on the verge of announcing a full-scale plan to address its financial issues.
In August, when Atlantic City agreed to the terms of a state bridge loan for up to $73 million, the city agreed to numerous conditions, including provisions making the Municipal Utilities Authority and Bader Field collateral for the loan. In the loan covenants, the city specifically agreed to pass an ordinance conditionally dissolving the authority by 15 September. The dissolution was not to take effect unless the city defaulted on its other obligations under the agreement. The city failed to pass the ordinance and was subsequently informed by the state that it was in violation of the covenant.
If the city does not cure the default by 3 October, the state has the right to demand immediate repayment, seize the collateral (i.e., Bader Field and the Municipal Utilities Authority) and stop advancing the rest of the bridge loan. Ignoring, for the moment, the funds from the proposed sale of Bader Field, the city does not have sufficient funds to immediately repay the $62 million already received from the state. Furthermore, unless the state continues to disburse additional funds from the bridge loan, or releases the Atlantic City Alliance and investment alternative tax funds owed to the city, it is highly improbable that the city will be able to make its 1 November $9.4 million balloon payment (see exhibit).
Atlantic City, New Jersey’s Monthly Debt Payments for the Rest of 2016 Debt payments peak in November 2016.
Date Payment Amount Security Enhancement
1 October $69,942 2012 Pension Obligation General Obligation Bonds AGM
1 November $9,362,311 2012 Tax Appeal General Obligation Bonds; 2012 Tax Appeal General Obligation Bonds - Taxable
AGM
1 December $2,331,175 2013 Tax Appeal General Obligation Bonds; 2013 General Obligation Bonds
None
15 December $4,777,527 2011 Tax Appeal General Obligation Bonds AGM
Notes AGM = Assured Guaranty Municipal Corp. Source: Atlantic City, New Jersey
NEWS & ANALYSIS Credit implications of current events
17 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
Many of the city’s loan-repayment challenges would be addressed if the proposed sale of Bader Field were to go through. Certainly, $100 million would be sufficient to repay the state and cover debt service. Nevertheless, the proposed sale raises many questions. As of the end of 2015, the authority had $7.9 million in unrestricted cash and investments, meaning it would need to borrow nearly the entire sum pledged. Given the authority’s low rating and its connection to Atlantic City, market access is uncertain. Even if the authority were to have market access, borrowing $100 million would increase debt by a factor of seven, raising the question of how the authority would pay for this debt – assuming the plan went through, which is far from certain. Even the figure of $100 million is questionable: in an auction earlier this summer, the largest bid received for Bader Field was only $50 million, undermining the proposed valuation.
Although Mr. Guardian stated that this plan would likely resolve the technical default, it would require close collaboration between the state, city, and authority. Although the mayor, authority, and city council president appear to support the plan, approval is still required from the city council and state.
NEWS & ANALYSIS Credit implications of current events
18 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
Court Rules Kentucky Governor Must Release University Funds, a Credit Negative On 22 September, the Commonwealth of Kentucky (Aa2 stable) Supreme Court ruled that Governor Matt Bevin does not have the authority to withhold funds appropriated to public universities. The ruling is credit negative for the state, proximately because it will face pressure to release $18 million of funds appropriated to universities, and ultimately because executive authority to unilaterally reduce appropriations is a credit-positive governance attribute. To the extent that this ruling inhibits that authority, Kentucky’s governor will find it harder to manage difficult budget scenarios without legislative cooperation.
From a credit perspective, the $18 million sum is trivial. Kentucky’s annual revenues exceed $10 billion, and an $18 million onetime item is not material. Nor would $18 million make a dent in its pension plans, which are underfunded by $31 billion on an actuarial basis and by $41.3 billion on a Moody’s-adjusted basis. As for universities, the funds in dispute are 0.27% of $6.6 billion of annual expenditures.
What is not trivial is a potential limit on gubernatorial powers to reduce spending without legislative collaboration, which our US states methodology expressly considers a governance weakness. Without such a power, states are less capable of quickly adjusting to revenue shortfalls or unexpected spending increases. Conversely, states whose executives can unilaterally cut spending mid-year can swiftly modify their spending to better align with revenue or other trends.
Upon taking office in fiscal 2016 (which ended 30 June), Mr. Bevin ordered a 4.5% spending cut across the board for executive branch departments, intending to use the savings to deposit additional money into the state’s underfunded pension plans. The governor in April reached an accord with eight of the state’s nine universities instead for a 2% reduction, equal to about $18 million.
Kentucky’s attorney general sued, arguing that the governor lacked authority to instruct recipients of legislatively appropriated funds not to spend the money. Last week, the Supreme Court agreed and ruled that the governor cannot impede spending authorizations that the legislature enacts. The court’s ruling applies only to universities; the governor was able to cut spending across other executive departments.
According to a National Association of State Budget Officers report, 33 states give their governors the power to withhold appropriations from executive branch departments (see exhibit). An additional nine confer the power to withhold appropriations from all three government branches.
Dan Seymour, CFA Assistant Vice President - Analyst +1.212.553.4871 [email protected]
NEWS & ANALYSIS Credit implications of current events
19 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
Gubernatorial Authority to Withhold Appropriations from Executive Branch Agencies by State Some Gubernatorial Authority to Withhold Appropriations from Executive Branch Agencies
Authority to Withhold Appropriations from All Three Branches No Such Authority
Alabama Alabama Alaska
Arkansas Connecticut Arizona
California Indiana Delaware
Colorado Minnesota Florida
Connecticut Mississippi Illinois
Georgia Missouri Kentucky
Hawaii North Dakota Michigan
Idaho South Carolina Nebraska
Indiana Virginia New Hampshire
Iowa New Mexico
Kansas North Carolina
Louisiana Ohio
Maine Oklahoma
Maryland South Dakota
Massachusetts Texas
Minnesota Utah
Mississippi Wyoming
Missouri
Montana
Nevada
New Jersey
New York
North Dakota
Oregon
Pennsylvania
Rhode Island
South Carolina
Tennessee
Vermont
Virginia
Washington
West Virginia
Wisconsin
Source: National Association of State Budget Officers
NEWS & ANALYSIS Credit implications of current events
20 MOODY’S CREDIT OUTLOOK 29 SEPTEMBER 2016
Such powers do not always look the same. Some governors can reduce expenditures whenever they want, while others can only reduce appropriations under certain circumstances, such as a revenue shortfall. Kentucky is in this second category: the court ruled that the law does give the governor the authority to cut appropriations if there is a budget shortfall of 5%, but Kentucky’s revenues outperformed in 2016 and the state ran a surplus. (To be clear, the authority to cut spending in the event of a 5% budget shortfall is still a very helpful feature of Kentucky’s governance profile.)
Executive ability to reduce spending comes in handy. The governor of Kansas (Aa2 negative) reduces spending each year to adjust to the state’s chronic revenue shortfalls, and the state’s credit quality would likely be worse without these actions. The governor of Mississippi (Aa2 negative) reduced the state’s budget this year to offset a $57 million accounting error. And in Alabama (Aa1 stable), proration, or forced spending cuts to balance the budget, has helped stabilize the state’s finances through prior economic cycles.
The alternative to such measures is often to draw down rainy-day funds. For example, in difficult years in which it has not declared proration, Alabama has instead drawn on financial reserves to avert or lessen the need for midyear budget cuts.
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