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Deleveraging Trend is Set to Pause for China’s Rated Corporates

Stocks Rocked the House Post Midterm Elections

How Management & Governance Risks and Opportunities Factor Into Global Corporate Ratings

Oil refining executives wary of RFS program despite falling compliance costs

Oilfield service majors to limp into 2019 as North America land market struggles


Deleveraging Trend is Set to Pause for China’s Rated Corporates

Rated Chinese companies will have trouble maintaining their deleveraging trend now that the earnings rally has faded. However, corporate spending appetite remains restrained, and Chinese authorities are committed to deleveraging for state-owned enterprises. That's according to a report S&P Global Ratings published today titled, "Slower Earnings Growth Drags On Deleveraging For Corporate China."

"We project that debt leverage for our rated portfolio of Chinese companies will increase slightly in 2018, reversing the downward trend in 2017," said S&P Global Ratings credit analyst Chang Li.

Earnings growth is decelerating after a commodities-fueled boost over the past two years, and amid generally tougher economic and financial conditions.

By our estimates, EBITDA will expand by 10% on average for our rated portfolio this year, down from a heady 25% in 2017. Among large sectors in our portfolio, property and mining drove the earnings recovery in 2017. For example, EBITDA jumped 41% in the property sector and 43% in the mining sector. However, EBITDA growth in these two sectors will shrink to 24% and 2% respectively in 2018.

China's deleveraging campaign has contributed to slower investment spending by local governments, supply-glut heavy industries, and property companies. This combined with a crackdown on "shadow banking" and rising U.S.-China trade tensions will lead to slower average revenue and profit growth in 2018.

Chinese authorities have recently begun to fine-tune their financial-risk reduction measures to support corporate financing. This comes amid rising stress and higher default rates, especially for private enterprises.

"We believe easing efforts could take pressure off some Chinese companies facing difficulties in refinancing their debt maturities, especially state-owned enterprises that rely on borrowing new funds to pay off old debt," said Mr. Li.

However, in our view, the most vulnerable borrowers, in particular private enterprises, will continue to face higher refinancing and default risk.

Overall, we have a modest negative net bias in our portfolio, due to deteriorating liquidity, especially for companies in capital goods, metals and mining, and local government financing vehicles.

As of July 2018, our list of "weakest links" and "fallen angels" within the China corporate portfolio has expanded slightly, to nine companies. Four of these companies are in real estate, reflecting this sector's heightened vulnerability to tightening liquidity and refinancing risk.

 



Stocks Rocked the House Post Midterm Elections

After the S&P 500 logged its 9th worst Oct. on record, losing 6.9%, it has bounced back 2.6% month-to-date through Nov. 9, 2018. Though the monthly returns for the eight Novembers following the historically bad Octobers were only positive twice – in 1978 (President Jimmy Carter midterm year) and 1933 – the fact there was a midterm election this year may help the chance of a solid rally if history repeats itself. Historically, the S&P 500 has been positive in most periods after the midterm elections.

In the months of Nov. and Dec. during historical midterm election years, the S&P 500 gained 14 of 22 times in Nov. and in 15 of 22 times in Dec. with a combined 2-month gain in 17 of the 22 midterm election year-ends. In percentage terms, the S&P 500 gained in 64% of midterm election Nov. months and 68% of the following month that when combined into a 2-month return resulted in gains 77% of the time. Also, the magnitude of the average gains in the 2-month period was 6.1%, more than the magnitude of the average loss of 4.1%.



How Management & Governance Risks and Opportunities Factor Into Global Corporate Ratings

Highlights

An assessment of management and governance is part of every corporate issuer rating.

We find that events of mismanagement and poor governance contributed to severe multiple-notch downgrades.

Notable cases of key personnel misconduct, bribery, data breaches, and corporate criminal behavior have been captured in our ratings analysis. We highlight some here.

In total there were 262 instances over a two year period where we reassessed our M&G score. Over 60% related to a negative reassessment, while the rest were positive.

S&P Global Ratings has completed a two-year review of how issues of management and governance (M&G) are reflected in our ratings. For that period, we found 77 cases where a revision of our view of management and governance factors led to rating changes, and a total of 262 cases where these factors were a part of the analysis and resulted in a change of our management and governance assessment.

We consider M&G factors explicitly in every corporate issuer credit rating. Our M&G criteria encompasses a range of factual and qualitative assessments that we apply and revise as necessary based in part on our in-person meetings with management as well as our understanding of how governance impacts credit quality more broadly.

This analysis looks at the universe of rated corporate entities and transitions of their M&G scores from July 2015 to August 2017. We have complemented the analysis of our scores with the application of a natural language processing technology highlighting some other notable instances of M&G factors considered elsewhere in the rating analysis. Finally, we have selected a number of past rating actions to illustrate our analysis of various governance factors.

This report is part of a series covering the impact of environmental, social, and governance (ESG) factors in our credit ratings. In October 2015, we published our first review of how environmental and climate factors affected our ratings between 2013 and 2015 (“How Environmental And Climate Risks Factor Into Global Corporate Ratings,” Oct. 21, 2015); last November we conducted our second (“How Environmental and Climate Risks and Opportunities Factor into Global Corporate Ratings – An Update,” Nov. 9, 2017). We then expanded the series to review social factors (“How Social Risks and Opportunities Factor Into Global Corporate Ratings,” April 11, 2018). These reports showed that environmental and climate factors contributed more frequently than did social factors over the same period, and that while environmental and climate factors affected ratings in a nearly even split of negative to positive, social factors were overwhelmingly negative in terms of impact on credit quality. We will continue to track how we incorporate ESG risks and opportunities into our credit analysis, and we plan to further report on how those factors may affect entities' creditworthiness.

Governance in Ratings Processes

Our view on management and governance could significantly influence credit factors other than solely the M&G assessment, such as a company's competitive position, its credit metrics, and our view of its financial policy, each of which, on its own merits, can have direct impacts on the issuer rating.

An effective management team may, in times of market duress, seek to balance the needs of debtholders with those of shareholders by making efforts to reduce leverage. By contrast, a management team could be excessively focused on pursuing debt-funded mergers and acquisitions (M&A); while growth is part of every company's strategy, it can become a governance issue if it involves excessive risk-taking or results from skewed management incentives causing a misalignment between management's interest and that of debt- or shareholders.

This illustrates another aspect of the governance analysis: while management can actively take actions that worsen credit quality, it can also fail to take actions that would support credit quality. This duality is part of the reason why management meetings, which are part of every rating, are of such importance. Management teams have a finite level of resources that can be dedicated to mitigating risk; our interactions with them indicate which are of the highest priority, and this selection can influence credit quality.

Relevance and definition

Sudden management and governance developments can often have an immediate or future impact on an issuer's creditworthiness, and weak policies or structures can often be red flags that herald adverse credit developments. Among actions and behaviors that could impact an M&G assessment are matters like:

 - Executive/board and auditor departures and changes (particularly when sudden, unexpected, and repeated) can herald changes in strategic direction, indicate management dysfunction, or presage accounting, legal, or regulatory problems or operational underperformance.
 - Delayed financial reporting or a qualified audit report can be a signal of underlying performance issues. Even if resolved, it often is accompanied by reduced access to capital.
 - Lack of in-depth involvement by the board and/or its owners of management's strategic plans or complex areas of operations reduces their effectiveness to oversee risks.
 - Badly-designed management compensation (with excessive focus on short-term results and pay-out) or ineffective compensation or audit committees can cause excessive risk-taking and/or damage the long-term sustainability of the company.
- The presence of activist investors. While their presence is not invariably negative for credit quality, they can also prompt or signal change in an issuer's strategic direction, risk appetite, and the potential for personnel changes to board and management, often at the expense of debtholders.

Our working definition for management and governance, as reflected in our M&G criteria, "encompasses the broad range of oversight and direction conducted by an enterprise's owners, board representatives, executives, and functional managers. Their strategic competence, operational effectiveness, and ability to manage risks shape an enterprise's competitiveness in the marketplace and credit profile.

"If an enterprise has the ability to manage important strategic and operating risks, then its management plays a positive role in determining its operational success. Alternatively, weak management with a flawed operating strategy or an inability to execute its business plan effectively is likely to substantially weaken an enterprise's credit profile."

Process and criteria

As shown in table 1, our M&G score is an amalgamation of assessments. We assess eight "Management" factors relating to strategy, risk management, and organizational effectiveness, each of which we score positive, neutral, or negative.

We also assess seven "Governance" factors, which are each scored as neutral or negative. In a circumstance when a governance deficiency or deficiencies impairs the ability of the enterprise to execute strategy or manage its risks, can be labelled severe.

These 15 factors are aggregated into the management and governance assessment, which can result in a strong, satisfactory, fair, or weak score. The result of the management and governance score, combined with certain anchor ratings, can result in increase on that rating of up to one notch, or a decrease of two or more notches, as shown in table 2. Sometimes these adjustments are only triggered if we feel we have not already captured the benefits of strong management and/or governance in the business risk profile or financial risk profile.

Each of the seven governance factors is primarily concerned with the structures and systems a company has in place that govern how it operates strategically (or not) given the various regulatory, political, economic, social, and natural environments it operates in. The governance systems are ultimately in place to guide, advise, and at times intervene in management's actions and planning to ensure the company's growth and longevity. Unlike the management factors that can be scored positively, governance factors are scored neutral or negative, and serve as an overarching scoring indicator when the two are combined. The rationale is that management cannot manage to optimum performance if the governance structures and systems are not in place that allow them to do so. This is reflected in the criteria, which caps the overall M&G Score at fair with just one governance negative subfactor, even if there are many positives among the management factors.

Table 1



Oil refining executives wary of RFS program despite falling compliance costs

While the price of biofuel blending credits has fallen toward insignificance, the uncertainty surrounding the direction of U.S. biofuel policy has some U.S. refining executives looking to limit their company's exposure to an opaque market that they see as primarily driven by politics.

The Renewable Fuels Standard, or RFS, program, administered by the U.S. Environmental Protection Agency, requires U.S. refiners to blend an increasing volume of biofuels such as ethanol into the transportation fuels they produce each year, escalating to 36 billion gallons by 2022.

The EPA sets annual renewable volume obligations each year based on overall volume requirements and projections of domestic gasoline and diesel production.

Those companies that cannot meet the blending requirements must purchase credits, known as renewable identification numbers, or RINs, to meet their blending obligations.

After a Philadelphia refiner blamed the regulations for its bankruptcy, actions taken by the Trump administration have led the RINs market to plummet 84% year-to-date through Oct. 10, according to S&P Global Platts.

In April, a federal judge approved a settlement between the EPA and PES Holdings LLC that allowed the bankrupt refiner to shed a substantial portion of its RFS compliance obligations.

The EPA's granting of "hardship" compliance waivers to small refiners has benefited the broader refining industry.

Despite the reduced compliance burden, some refining executives are still wary of the policy.

CVR Refining LP President, CEO and Director David Lamp said during an Oct. 25 earnings call that the company had started blending B5, a blend of petroleum-based diesel containing 5% biodiesel, across all of its racks to increase internally produced RINs by 5% of its renewable volume obligation and that the company also has "several deals in the works" to reduce its RINs exposure.

"I would tell you that if I had a crystal ball, I could predict what RIN prices are going to be," Lamp said. "Frankly, I don't trust them. I don't trust the politics. I don't trust the law itself. ... And if they don't issue waivers like they did last year, I would say the price is going to go straight up, maybe not immediately, but … over time as the RIN bank goes away. I think it's kind of foolish to stick your head in the sand and say this issue is gone just because the RINs are cheap right now."

Lamp's comments come as the ethanol industry is in the midst of challenging the Trump administration's RFS waivers in federal court.

Some refiners continue to lobby for RFS policy changes, but during earnings calls they did not outline investments to mitigate the policy's effects.

"We're not fully where we think the market needs to go and where the administration needs to go as far as fixing the RFS problem, but we're continuing to work on it diligently," Marathon Petroleum Corp. Chairman and CEO Gary Heminger said during a Nov. 1 earnings call.

During the third quarter of 2017, Marathon said biofuel blending reduced the indicative gross margin of its refining business by $743 million, but a year later, executives declined to outline a specific benefit from lower RIN costs.

"We are not believers that RIN costs drive differential profitability within the refining system. We have a ... view that as RIN prices rise, it gets reflected in the crack, and on a net basis, the system is no better or worse off than where things are at. So I'm not sure we'd highlight an incremental benefit to the lower RINs costs," Marathon Senior Vice President and CFO Timothy Griffith said. "It certainly introduces a lot less noise into the market relative to what the real economic cracks are, but we would not identify any natural economic benefit in total to the system related to the lower prices."

Whichever direction biofuel policy takes, other refiners are investing in renewable fuels because they see them as a long-term part of the global fuel mix.

"If you step back and look at ethanol, it's going to be in the gasoline pool for a long time, and it's a core part of our strategy," Valero Energy Corp. Vice President of Alternative Fuels Martin Parrish said during an Oct. 25 earnings call. "We see corn ethanol as the most competitive source of octane in the world."

On Oct. 11, Green Plains Inc. announced it would sell three of its ethanol plants to Valero.

Parrish expects that growing U.S. ethanol exports and slowing domestic production growth will lead to improved margins for Valero's renewable fuels business, which the company recently decided to expand.

Valero executives pushed back on the notion that their decision to invest in renewable fuel production was related to the Trump administration's proposal to allow year-round sales of E15 — gasoline blends containing 15% ethanol — which the oil industry has vowed to fight in court.

"[It's] going to take a couple of years for that to work its way through the courts before you get a final answer [on its legality]," Valero's senior vice president of public policy and investor relations, Jason Fraser, said Oct. 25. "Put yourself into the shoes of one of those retailers who's got to spend money to be able to offer E15. You're going to spend money with the risk of having stranded capital because in a couple of years, the court may void [the rule]."



Oilfield service majors to limp into 2019 as North America land market struggles

Diversification helped oilfield service majors navigate through a difficult third quarter in North America land markets, but analysts see more downside risk for the sector in the last quarter and persistent challenges into 2019.

Bottlenecks in the Permian basin limited exploration and production in the prolific basin, impacting third-quarter earnings across the oilfield services sector.

Customer activity weakened during the third quarter as takeaway constraints in the Permian limited production growth, Schlumberger Ltd. CEO Paal Kibsgaard said during the company's Oct. 19 earnings call.

Halliburton Co. CEO Jeffrey Miller said Oct. 22 that the North America land market presented challenges in the third quarter amid a combination of off-take capacity constraints and customer budget exhaustion that led to less demand for its completion services.

Analysts said that the diversification of services offered by the two leading oilfield services companies sheltered them from larger negative impacts to quarterly earnings.

Schlumberger and Halliburton's international businesses performed well in the third quarter but could face challenges early in 2019.

Kibsgaard said Schlumberger's revenue from its international business, excluding Cameron, was up 4% sequentially to $4.6 billion in the third quarter. The strength of international markets, where the company expects "flattish" revenues in the fourth quarter, should outweigh any further challenges in the North America land market, the CEO said.

Halliburton saw international revenue in the third quarter climb 5% sequentially to $2.4 billion, and Miller said he is excited about the international markets in 2019. "It's a bit of a mixed bag in the sense that there are going to be markets like Asia-Pacific and Europe, Africa, Eurasia, that, in my view, may recover more so, pretty strongly on a percentage basis, just given where they started," Miller said. "But there's other parts of the market, all in Middle East, that have been fairly resilient throughout the downturn."

On its third-quarter call, Halliburton guided fourth-quarter earnings per share to a range of 37 cents to 40 cents, "well below consensus of 48 cents," analysts with B. Riley FBR said in an Oct 24 note. The company based its outlook on the collective impact of bottlenecks and budget exhaustion not only in the Permian, but also the Marcellus/Utica and DJ Basin. Schlumberger's Kibsgaard said its North America land revenue and earnings per share will be down in the fourth quarter, and the level of the decline will be a function of how severe the shutdowns are going to be in November and December.

The reasons for the headwinds in North America around takeaway issues and budget constraints were well understood by the market, but the pace of declines implied by the guidance from the two industry leaders likely caught some by surprise, said West Carlyle, an analyst with Evercore ISI. "The fact that the industry will see extended breaks with some starting before Thanksgiving mean that customer activity levels will decline for the last six weeks of the year and makes visibility challenging with pricing and utilization falling in the spot market," he said in an Oct. 22 note.

Halliburton expects these challenges to ease through 2019. In addition to a Permian re-acceleration, Halliburton expects to see bullish budgets for the Eagle Ford, Bakken, Marcellus/Utica and DJ Basin. FBR agrees with Hallburton management's view "of the transient nature of and resolution timing of the challenges," analyst Thomas Curran said Oct. 24.

FBR revised Halliburton EBITDA and earnings per share outlooks for 2018 and 2019 from $4.4 billion, or $1.98, and $5.3 billion, or $2.65, respectively, to $4.3 billion, or $1.86, and $4.8 billion, or $2.27, and set their 2020 outlook at $5.9 billion, or $3.32. Evercore analysts lowered Halliburton 2019 earnings per share estimate to $2.00, while CitiGroup analyst Andrew Scott said the bank lowered first-quarter 2019 earnings per share estimate for Halliburton to 39 cents and fiscal year 2019 to $2.04. A double-digit decline in fracking activity drove the bank to "take a hatchet" to its fourth-quarter earnings per share outlook to 37 cents to 40 cents, while the international business should be up modestly, Scott said.

Schlumberger said the company's international businesses would see 10% top-line growth in 2019 with national oil companies leading the charge on spending and the fastest growth rates for Latin America, sub-Saharan Africa and Asia. It also expects a continued climb in deepwater drilling activity, following an expected 8% rise this year, as well as help from pricing improvements.

FBR lowered its 2018 and 2019 EBITDA and EPS outlooks for Schlumberger from $7.53 billion, or $1.73, and $9.3 billion, or $2.55, to $7.22 billion, or $1.72, and $9.30 billion, or $2.45, on the net costs and disruptive impact of the company's broad, rapid rig mobilization internationally. For 2020 EBITDA is forecast at $10.60 billion, or $3.32 per share.

Curran said Schlumberger's third-quarter earnings call and annual sell-side roundtable reinforced the firm's thesis that outside of North America, the company is pivoting from a focus on investing and mobilizing to executing and harvesting. This "rest of the world," or non-North America land market, makes up 70% of Schlumberger's revenue. FBR expect Schlumberger to generate "a robust 2018-20 [free cash flow] trajectory and to return meaningful portions of it to shareholders."

Baker Hughes a GE company made strides developing its international presence to compete with the larger names in the international markets and said in its Oct. 30 earnings call that its smaller exposure to North America land fracking helped shield its earnings in the third quarter.

Jefferies analysts said Oct. 9 that Baker Hughes has plausibly gained a little share in oilfield services with non-North American market revenues flat in the first half compared to the second half of 2017, when compared with Halliburton and Schlumberger. "We don't doubt that [Baker Hughes] is pricing aggressively as it explicitly targets market share, although it feels far more consistent with peers' behavior through cycles than not," Jefferies said.

Jefferies lowered its 2019 earnings per share outlook for Baker Hughes to $1.45 from $1.65, and trimmed its 2020 estimate to $2.15 from $2.65. "That said, we model just under $4 per share in 2022 with the assumed later cycle contribution and assuming about 40% incrementals," the analyst said. Guggenheim Securities analysts said they expect all four of Baker's segments to contribute to growth in 2019 that should drive 11% and 29% growth in revenue and EBITDA, respectively.

For National Oilwell Varco Inc., its rig systems business suffered third-quarter losses as customers limited spending to only the most essential items in the third quarter, as a shrinking commodity price and subsequent activity decline led customers to limit capital spending.

Analysts with Tudor, Pickering Holt & Co. said Nov. 7 that during National Oilwell Varco's analyst day on Nov. 6 the company offered "some quantitative color" on its 2019 and three-year outlook. Amid "lots of assumptions," fiscal-year 2019 EBITDA was bracketed in $1.0 billion to $1.3 billion range, while Tudor Pickering Holt & Co. said its range was already around the midpoint, "which could be more like $1.8 billion to $2.5 billion a few years down road."

Barclays analyst David Anderson maintained National Oilwell Varco with an Equal-Weight and lowered the price target from $44 to $40. Raymond James analyst Praveen Narra maintained the company with an Outperform and lowered the price target from $55 to $45, and CitiGroup analyst Scott Gruber maintained National Oilwell Varco with a Neutral and lowered the price target from $48 to $40.

While the market remains challenging right now, the underlying trends still look positive for 2019, the Evercore analysts said. "Customer budgets will reset in 2019 with a backdrop of stronger commodity prices especially compared to where they entered 2018. The DUC count continues to rise which provides a backlog for demand when it gets worked down. Lastly takeaway capacity will expand and customer urgency will come back. Also the international recovery continues to emerge," the analysts said.