Credit Analysis – Relative Value of Bonds
In this article I will finish the credit analysis series. Check out the prerequisite to this article, about what steps I take before looking at relative value. Also check out my article on credit ratings.
I will skip an analysis of management as well as of covenants for simplicity, and will proceed to a relative valuation of credits. The purpose of this is to understand what debt investors look for in companies. If companies are appealing to debt investors they will pay less for debt in interest, and they can use this money on revenue generation, which will help their stock price. Also in uncertain times, strong creditworthy companies tend to perform well. A disclaimer, I am not a financial advisor and my comments should never be taken as financial advice. Investments come with risk, so always do your research and analysis beforehand. This analysis will be broken up into two sections, one discussing how each company compares as a credit, and another discussing definitions as well as explaining the metrics used in the analysis.
For this analysis I chose airlines with a similar credit rating for a closer comparison. I chose Alaska Airlines, United Airlines, Jet Blue, Spirit, and Allegiant. United is a much larger company than the others on the list, but I wanted to include it since it is one of the most popular airlines on Invstr. I have two charts displayed, one of fiscal 2019 and another of analyst expectations of 2021.
Starting off with profitability in fiscal 2019, Allegiant and Spirit take the cake, with Alaska close behind. Nothing unexpected came from looking at cash flow from operations except that only 11% of Spirit’s revenue is turned into cash, this makes Spirit the worst at generating cash in 2019. Due to one time expenses making free cash flows hard to compare, I will glance over it besides pointing out that Allegiant does have a negative free cash flow. Looking at 2021 expectations, revenue decreases anywhere from 21% in the cases of Spirit and Allegiant, and decreases up to 29% in the case of United. Low profitability does not surprise me, the only thing to note is United’s low margin.
Moving on to EBITDA after capex in 2019, a similar trend emerges, Allegiant cannot cover its interest if it does not lower its capex or cut other costs. This is an area for concern since cutting costs often means less revenue in the future. This positive feedback loop of cutting costs in order to pay interest, often leads to further cost cuts since cutting costs decreases revenue. Free cash flow compared to debt tells a similar story, for Allegiant, however again due to one time expenses, it does require digging deeper. Alaska Airlines stands out in this metric for the opposite reason, its free cash flow for 2019 is nearly equal to its total debt. This indicates a large capacity to take on more debt if needed. In 2021, United, Jet blue and Allegiant are expected to not have enough earnings to cover interest after capital expenditures. So again, they will have to decrease capex spending or take on more debt if earnings do not increase. In 2021 the companies will look more leveraged. With lower earnings and the same amount of debt, this is expected. For example United is expected to be 4 times leveraged in 2021.
The net debt/EBITDA in 2019 seems quite low, especially for such a capital intensive industry. When looking at the percentage of debt in the companies’ enterprise value, there is a correlation between high EV/EBITDA and low percentage of debt financing. In fiscal 2019 Allegiant stands out because it has the highest EV/EBITDA however it has a larger percentage of debt financing than Alaska Airlines. This is likely due to Allegiant’s best in class 28% EBITDA margin. Jetblue and United seem as if they should have close EV/EBITDA metrics, they have the same profitability and net debt/EBITDA. The difference in EV/EBITDA can potentially be explained by Jetblue’s more favorable maturity schedule. In 2021 all the firms have their EV/EBITDA increase, except Spirit’s which remains lower than the rest. This could be due to Spirit’s historically worse ability to turn revenue into cash.
Next looking at the liquidity analysis, as mentioned previously Jetblue has the most cash available relative to its maturities, which could explain its high EV/EBITDA. Allegiant seems as if it will not have much cash if any remaining after its 2020 maturity. To rectify this Allegiant will likely need to cut costs, raise new debt, and or sell assets. For simplification I have not projected cashflows out for these firms and thus for 2021 there is not a liquidity analysis. Alaska Airlines after Allegiant does have the most aggressive maturity schedule relative to cash, however it could easily raise more debt.
Finally, we can compare the secured bonds of Alaska Airlines, United Airlines, Jet Blue, and Spirit. I chose secured bonds because all four companies have comparable securities. I left out Allegiant because their only debt was a term loan B. The largest spread per unit of leverage based on earnings from 2019 and expected earnings from 2021 is Alaska Airlines. Spirit and United follow closely in 2019, however Spirit is expected to have a larger spread per unit of leverage in 2021. Based on just these factors I like Alaska and Spirit as well. Looking at yields, the story is the same, Alaska and Spirit have the highest yields. Jet Blue has a very safe maturity schedule, however it does have a higher debt load relative to its peers on a debt/EBITDA basis. In addition, the yield on Jet Blue’s 2032 2.75 is much lower than the bonds mentioned previously. United is a large company, with obvious access to the capital markets which is a plus, the concerning thing is that Untied is expected to be the hardest hit by Covid of these peers. Since these bonds are all secured, a typical part of this analysis would be to verify asset coverage, or what assets the debt is secured against in case of bankruptcy. I believe I do not have access to this information, however if I am wrong please let me know. Thus not having this information, I could not say for certain one bond has a stronger relative valuation than another. However, based on just the raitos, Alaska’s 2027 4.8 secured bond and Spirit’s 2030 3.375 secured bond are more attractive than Jet Blue’s 2032 2.75 or United’s 2032 2.7 secured bonds.
Definitions and explanation of the table used
The framework I used allows for a quick and easy analysis of a company’s ability to pay back debt. It is important to note that much more goes into this than just financial ratios. However by using financial ratios you can understand some critical metrics that are being looked at. Companies that are expected to pay back debts outperform those that are not, especially in market regimes like the one caused by Covid. Starting from the top, you want to see how much a revenue company brings in to gauge the size of the operation and to later determine profitability. I use EBITDA to compare earnings more fairly, so the way the company finances operations as well as ownership of assets is irrelevant. Operating cash flow does not include things like non-cash expenses, so it is a measure of how good a company is at bringing in cash. If a company cannot bring in cash, but has profits on paper in other metrics, these profits are not useful. Finally free cash flow measures how much cash a company has expenses including capital expenditures, and changes in working capital. Essentially free cash flow measures how much cash a company has to pay dividends and creditors. The issue is that one time expenses can make results incomparable, so when using free cash flow it is important to look at a trend.
The financial statistics section provides insight into the capital structure of the company. Coverage measures how many times a company’s earnings can cover interest payments. It is also useful to look at how many times earnings after capital expenditures can cover interest. If a company cannot cover interest after replacing assets, it is likely in some trouble. The next section then takes a look at different tranches of debt. Bank debt I classify as the revolvers, term loan As, term loan Bs and anything in between. Finally net debt is total debt taking away cash. The purpose of analyzing the breakdown of a company’s debt is to see how many turns of leverage has been issued in and ahead of each tranche of debt (leverage is debt/earnings, so 1 turn would look like 100/100, 2 turns would look like 200/100, ect.). The less leverage your tranche has, and the less leverage the tranche’s that are senior (get paid before you in bankruptcy) have, the better. Analyzing the leverage of each tranche is a way of measuring risk, since the higher the leverage the more money that must be paid back to others before your tranche can get paid in bankruptcy. The final two metrics use are the percentage of debt financing in a company, and earnings relative to the total value of the firm, respectively.
Next, I created an amortization table. This looks at a company’s mandatory debt repayments year by year. Especially when airlines have negative free cash flow it is important to note how much money airlines will be obligated to pay in the coming years. Using cash, any undrawn revolvers, and any lines of credit, we can compare the firms’ liquidity to their obligations. The numbers in red indicate when the companies’ current liquidity will no longer be able to cover obligations. The capitalization table is a breakdown of claims on each company to get to total enterprise value.
The final table is the most interesting personally and is an relative valuation of the debt of each company. The coupon is the semi-annual interest payment you would receive on a $100 portion of the debt. The maturity is when the principal amount must be repaid. For more information on credit ratings check out my article about credit ratings. The price is the price per $100 the bond is trading at. Yield is simply the rate of return if held to maturity, re-investing the coupons at the same rate of return. Yield is more complicated than this, but think of it as the rate of return for now. Spread, simplified is the difference in yield between treasuries and the bond. Finally spread per unit of leverage is simply the spread divided by leverage. The larger the spread per unit of leverage the better.