CDS improvement for retailers to fade in 2012

January same-store sales for the majority of retailers, released last week, were about even with middling expectations. Later this month, fourth-quarter 2011 earnings will roll in for the sector.

Consumers did spend more in 2011, but the recovery was modest at best. High unemployment persists and consumers have become more discriminating amid a heavy promotional climate. The retail sector and its respective credit-default swaps are likely to be stable in 2012, though they are likely to show a decrease in improvement relative to 2011 or 2010.

January is typically a month marked by heavy clearance selling, and the period is likely to see further drag based on the warmer-than-usual temperatures across most of the United States.

Seasonality plays a large role in retail profitability; therefore retail credit default swaps’ spread performance will likely exhibit the same feature. The second half of the year is key, due to the back-to-school season, which typically lifts margins, and peak holiday periods, which account for the bulk of profitability.

Operating fundamentals, liquidity and downward ratings actions are among the factors that have adversely affected retailers’ CDS

The retail sector has faced significant headwinds over the last several years. Weakness in the macroeconomic environment has weighed on the consumer: wealth erosion, job stability, pressure stemming from the housing market, evolving demographics, and a low savings rate have all affected consumer spending habits in general. The euro zone debt crisis has cast a shadow as well.

Operating fundamentals, liquidity and downward ratings actions are among the factors that have adversely affected retailers’ CDS. Company-specific responses to shifting conditions have, in some cases, facilitated marked improvement in these credit profiles, while others continue to lag.

Deleveraging, suspension of share repurchases and dividends, cost cutting — including on capital expenditures — layoffs, inventory management and refinancing via credit facilities were among the measures retailers used to compensate for an increasing lag in same-store sales and the growing deceleration in earnings per share and income.

Fallen angels

Department stores Macy’s and JCPenney both undertook these types of initiatives after being downgraded to junk status in 2008 or early 2009. These so-called “fallen angels” saw their respective CDS move wider amid a forced sell-off of cash instruments, as the companies’ bonds were disqualified from various US credit indices.

Macy’s five-year CDS was a highly distressed 974bps in November 2008. In the space of a year, it sharply compressed to 263bp and currently is around 110bp. It was able to gradually reestablish itself as high grade, and a “rising star” of corporate credit by focusing on meaningful debt reduction, improvement of its free cash flow, and bolstering liquidity via credit facilities. Cost cutting, paring down capital expenditures and curtailing dividends all helped it gain investment grade status. It is now rated BBB- / Baa3 / BBB- . Moody’s upgraded the name in January.

For JCPenney, however, the transition to investment grade has been more elusive. It is rated BB+ / Ba1 / BBB- . Whereas Macy’s curtailed share repurchases to shore up cash, Penney came under intense shareholder activist pressure. It adopted a poison pill, but eventually bought back shares. It also eliminated its catalog business, which heavily pressured margins.

In the third-quarter 2011, its comparisons to peers turned negative, with expectations of further erosion. Profits are anticipated to suffer as it used heavy, costly promotions to boost sales.

Penney has a new CEO, and its newly unveiled transition program has been widely hyped. Strategic changes, aggressive job cuts and an increase in 2012 capital expenditure bode for intermediate volatility for the retailer, which also makes it an unlikely ratings upgrade candidate.

In comments on January same-store sales, Fitch said, Penney “continues to disappoint and is likely to face significant earnings pressure with fourth-quarter negative comps of estimated negative 1.0% to 1.5%.

“Fitch also anticipates leverage to remain higher than peers in the mid-3.0x range as it undergoes its transformation before potentially trending lower to the lower-3.0x range in 2013.”

Penney recently stated it would no longer report monthly statistics, but gave a profit warning for the fourth-quarter of 2011.

Upbeat on JCPenny

While analyst opinion varies, most are upbeat on Penney’s forthcoming growth initiatives, but somewhat heistant from a credit perspective.

Bank of America Merrill Lynch in a January 26 report said significant challenges remain. The bank said that the retailer’s transition is “focused on driving value by improving operations and relationship with the customer, not by employing financial tactics. Management believes it can save US$900m on annualized Selling, General & Administrative spending over the next four years, which it plans to reinvest to further improve store performance. Management noted that it continues to discuss its financial policy with its Board of Directors and does not currently have a credit rating or leverage target.

However, Chief executive Ron Johnson did acknowledge that, while the turnaround plan is self-funding, the company ’wants a strong balance sheet’ and will continue to evaluate opportunities to strengthen its financial profile. Absent a clearly stated financial policy, ratings upside is limited, in our opinion.”

Penney’s CDS dropped to 179bp in November 2009 from 698bp in November 2008. After the drop, it climbed into the high 200s and is presently nearby 300bp.

RadioShack’s 5-year CDS rose from 367bp in November 2008 to 500bp in November 2011. Currently 5-year is in the 950s to higher, while net notional amounts have declined to three-year lows

Another retail name suffering amid volatility is RadioShack. The company has seen senior management come and go, while earnings per share and income have deteriorated. Leverage is at higher levels than in recent years. Liquidity has been deemed adequate, but the company recently warned that fourth-quarter 2011 will fall well short of consensus due to underperformance in its shift toward postpaid business. The postpaid segment of mobile phone service has also punished its gross margins. RadioShack has suspended its share repurchase and dividend as opinion has turned cautious.

RadioShack’s 5-year CDS rose from 367bp in November 2008 to 500bp in November 2011. Currently 5-year is in the 950s to higher, while net notional amounts have declined to three-year lows.

Sears Holdings, rated B3/CCC+, is trading at the most distressed levels in this field of retailers. The surge in CDS has been accompanied by a sharp increase in net notional amounts of protection outstanding, according to DTCC data, after Sears warned on fourth-quarter 2011 earnings.

Ratings actions followed, and pressure to its credit facilities was revealed after CIT Group said it would stop offering factoring services to vendors supplying Sears. Unlike its peers, Sears has not yet adopted any credit enhancing mechanisms, and has talked about but not executed non-core asset sales for years. It has shown interest in emphasizing its online presence, but is yet to embark on a strategy.

Five-year CDS for Sears Roebuck is 1,800bp. In November 2009, the same CDS was at 426bp and in November 2010, it was just 298bp. In mid-January 2011, CDS peaked at 2,415bp. Going forward, the macroeconomic environment remains mixed.

Lackluster earnings

The focus away from credit-enhancing deleveraging to a shareholder-friendly pattern is likely to slowly undermine built up liquidity in these names and augment the potential for event risk. Past drivers of improved performance are likely to wane, such as individual store-specific credit card income growth.

Upcoming fourth-quarter 2011 earnings are anticipated to be lackluster, particularly after profit warnings from Sears Holdings, RadioShack and JCPenney. Credit metrics are likely to come under some pressure, even as the cost of goods scales back somewhat, while merger and acquisition activity is expected to remain subdued. CDS spread compression in outperforming names such as Macy’s is unlikely to continue its sharp spread contraction, particularly after recently restarting its share repurchase program. Macy’s spreads are likely to offer attractive relative value, however.

Underperformers such as JCPenney, RadioShack and Sears synthetic are all subject to bouts of volatility amid their individual risk and will probably see spreads jostled to wider wides, especially as synthetic liquidity in general also undergoes a change.