Signs that the French company’s sliding credit performance should reverse were evident before GE launched a takeover bid, says Jon Brager, senior analyst at Hermes Credit.
Energised: Alstom credit surged after GE bid for its power-generation unit, ending three years of weak performance. But the cheap valuation of the energy and high-speed rail company, combined with management’s aim to lift its credit rating by raising capital, had already positioned it for a turnaround.
Fundamental blues: Lower demand for new power-plant capacity and less investment in rail networks had driven Moody’s Investor Service rating on Alstom to Baa3 (BBB-) from Baa1 (BBB+) in early 2011 with a persistent negative outlook. Weak Q4 2013 trading and expected negative cash flows this year saw it underperform the market, and especially its sector peers. By March, Alstom’s five-year CDS spread had progressively widened to more than 210bps year-to-date.
Trading target: Alstom is a “crossover” name: its bond clings to the investment-grade universe but its credit default swap (CDS) recently entered the iTraxx Crossover Index of the most liquid European high-yield CDS contracts. As a new entrant, it suffered as index-arbitrage traders exploited small differences between the index’s value and underlying constituents.
Turnaround potential: But the lights were far from going out. We believed Alstom could still generate positive returns for credit investors in a number of ways:
- Rerating: At 210bps, the market expected Alstom to be downgraded to junk. The company’s management, however, had plans to improve its creditworthiness by either raising €2bn through asset sales to reduce gross debt by 35%, issuing between €1-2bn of a hybrid bond, or carving out and potentially listing its train business for a minority stake to generate €1-1.5bn.
- Optionality: Its largest shareholder, Bouygues, had stated that it wanted to sell its 29% stake. This could be seen as negative, but a buyer or new ownership structure could deliver positive optionality to investors: an ownership shift could trigger change-of-control options and see bonds redeemed above par and simultaneously compress CDS spreads.
- Technical: Investors could have taken the other side of the index-arbitrage trade, which is usually a temporary phenomenon in the weeks before investors renew their index futures exposure. As these positions are “rolled forward”, spreads on new entrants narrow and realign with fundamentals. Late March would have been an opportune time to sell Alstom CDS and benefit from spread compression.
Fast change: In a matter of weeks, Alstom’s performance strengthened amid divestments, trading activity and GE’s takeover bid:
- Asset sale: On April 1, the company announced the sale of its steam auxiliary components business for €730m. Alstom had been heavily short-sold and its CDS tightened sharply from 210bps to 180bps.
- Trade fade: The index-arbitrage trade slowly diminished to further compress spreads on its CDS.
- Takeover offer: On Thursday April 24, GE offered €11.4bn for Alstom’s power-equipment unit. GE is rated Aa3/AA+ and its CDS trades at about 45bps. This takeover would strengthen Alstom’s credit profile.
- Rival bid: On Monday April 28, Alstom five-year CDS opened 100bps tighter at 90bps. Soon afterwards, Siemens, which is rated Aa3/A+, emerged as a rival bidder to GE.
- Beating consensus: Alstom’s preliminary results for financial-year 2014 showed that its sales, earnings and revenue beat analysts’ estimates while its net debt declined.
TBC: The story is still unfolding. The French government seeks more protection for employees in the event of a GE takeover, and Alstom has conceded that it lacks the scale to compete with both companies and emerging-market competitors. Today its five-year CDS trades at 87bps, 125bps tighter than 6 weeks ago. It may compress further: but investors who acted on earlier signs that Alstom’s credit performance would improve have captured most of the gain.
Compression sessions: the credit spread on Alstom CDS has narrowed as the company’s credit quality has improved