The Long and Short
Finding value in ‘A’ credit
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The incremental yield available in moving from ‘AA’ to A’ credit is currently at historic highs and greater than moving from ‘A’ to ‘BBB’. That points to relative value in ‘A’ risk. One clear opportunity is to underweight Cisco Systems Inc. (CSCO – A1/AA-) and overweight Booking Holdings Inc. (BKNG – A3/A-). Both credits have strong net cash positions, providing for a ratings cushion should the economy go into recession.
The spread differential between the two credits in the 4-year part of the curve currently stands at 67 bp, exceeding the average pick-up of 54 bp to move down the ratings curve (Exhibit 1).
Exhibit 1. CSCO to BKNG LTM Comparison
Source: Company Reports; Bloomberg; APS
Cash is King
The trade idea largely revolves around the strong cash positions of both credits, which is fueled by their strong free cash flow generation. A net cash position is positive in a rising rate environment as it helps to alleviate the need to tap the public debt market at disadvantageous interest rates. Furthermore, it provides each credit with some ratings cushion in a macroeconomic downturn. While CSCO’s cash position is larger than BKNG’s (by roughly $5bn), BKNG benefits from a higher free cash flow/sales ratio. BKNG’s business is slightly less capital intensive that that of CSCO as BKNG’s capital intensity ratio stands at $1.67, versus $1.82 at CSCO. This enables BKNG to maintain a higher free cash flow/sales ratio, which is over 15 percentage points higher than CSCO’s.
Additionally, BKNG ended 2019 with cash and equivalents of $11.8 billion. While the company issued debt in 2020 to shore up liquidity, we note that it has repaid most of that debt while expanding its cash position nearly $2.5 billion. CSCO ended calendar 2019 with a cash position of approximately $27 billion and total debt of roughly $17 billion. CSCO’s cash now stands at $19.3 billion while total debt has been reduced by $6.5 billion over the same time period (Exhibit 1).
More Conservative Financial Policies Support BKNG
While both companies have witnessed deterioration in their stock performance this year, BKNG’s stock is down just over 26% year-to-date, relative to 34% at CSCO (at time of writing). However, CSCO has been more aggressive with shareholder remuneration relative to BKNG. While BKNG does not pay a dividend, the company returned 39% of free cash flow to shareholders via repurchases, on a LTM basis. CSCO, on the other hand, was unable to keep shareholder rewards within the confines of free cash flow. CSCO spent $14.6 billion on buybacks and dividends, despite only generating $12.8 billion in free cash flow. Management maintains a stated capital return policy of returning 50% or more of free cash flow to shareholders. Over the past 10 years, CSCO has returned an average of 102% of free cash flow to shareholders, versus 75% at BKNG.
Outlooks are Stable
Both BKNG and CSCO have stable outlooks on their ratings. BKNG’s stable outlook reflects the expectation for continued recovery in travel demands. We note that 2Q22 marked BKNG’s first quarter to exceed pre-pandemic revenue levels, with that quarterly trend expected to continue for the remainder of the year. Additionally, consensus estimates have BKNG generating $5.0bn of free cash flow for the year, relative to the $4.5bn generated in 2019.
CSCO’s stable outlook reflects the expectation to generate stable revenue and free cash flow through the current economic downturn while maintaining a net cash position. Should management become more aggressive with their financial policy by further increasing shareholder remuneration or by pursuing large M&A transactions that would push leverage into the 1.0x-2.0x area, the agencies would reconsider their current ratings. Given that CSCO has paid down debt over the past five years, leverage is comfortably below 1.0x. CSCO would need to increase debt by over $7 billion to bring leverage just over 1.0x.
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