waive an event of default arising from its recent guilty plea in a federal antitrust investigation of price fixing in its Puerto Rico operations. The waiver request and plea agreement are credit negative because they are likely to lead to higher interest costs at a time when the company needs to refinance its more than $500 million of debt. The plea agreement, announced 24 February, includes a $45 million fine, payable over five years, which will trigger an event of default under the company¡¯s debt agreements. The settlement with the US Department of Justice, which is subject to court approval, would eliminate a risk that has weighed on Horizons¡¯ credit profile. According to the company, the agreement removes the prospect of additional charges related to its Puerto Rico or Alaska operations, and indicates it is not a subject of any DOJ investigation into ocean trade to Hawaii or Guam. Yet choppy waters lie ahead for the Charlotte, North Carolina-based ocean cargo shipper. Horizon warned it may fall out of compliance with a financial covenant as soon as 31 March because of weak volumes in its Hawaii operation, pricing pressures in Puerto Rico, and seasonally low demand from Asia. Higher fuel costs could further reduce demand for Horizon¡¯s fast trans-Pacific service. Along with the proposed antitrust settlement, these factors are weighing on liquidity and are likely to raise the yield that lenders will demand in refinancing negotiations. An inability to refinance in a timely manner at yields that will allow the company to meet its debt service and settlement obligations, without overreliance on its revolving credit facility, may lead to a rating downgrade.
3
MOODY¡¯S WEEKLY CREDIT OUTLOOK
7 MARCH 2011
NEWS & ANALYSIS
Credit Implications of recent worldwide news events
Kathryn Kerle Senior Vice President +44.20.7772.5403 kathryn.kerle@moodys.com
Sugar Conversion is Sweet for Suedzucker and Tereos
On 24 February, the European Commission (EC) decided to convert 500,000 tonnes of non-quota sugar to quota sugar for sale in the European Union (EU) in order to ease pressure on the EU sugar supply. The EC later this month will decide whether to remove import tariffs applicable to another 300,000 tonnes of raw or refined sugar. These actions are credit positive for Suedzucker (Baa2 stable) and Tereos (Ba3 negative), as each has a relatively large amount of non-quota sugar. Given the €150 per tonne price difference between quota and non-quota sugar, this amounts to a windfall of around €75 million in revenue for the European sugar industry, divided pro rata between producers according to their share of non-quota sugar stocks. In addition, the conversion will lower the companies¡¯ financing costs, as they can now sell sugar they would otherwise have had to pay to store. Contrary to the expectations of the EC, Europe is experiencing a sugar shortage. In 2009-10, Europe produced around 16.2 million tonnes and imported another 3.0 million tonnes. However, it consumed around 16.6 million tonnes and exported another 3.1 million tonnes during the same period. As a result, Europe drew down already low stocks, leaving net stocks of around 1.5 million tonnes, a very low level by historical standards. For 2010-11, production is likely to fall further while imports and consumption are set to remain the same. Even though exports will likely drop as well, we expect stocks to be drawn down more, to less than 1 million tonnes. Consumers can blame the shortage on rising consumption in emerging markets, which, coupled with poor harvests, have led to record prices for sugar. Over the past few years, several major sugar producing regions, notably Brazil and India, have had poor weather, resulting in diminished harvests. Although demand for sugar in developed countries has been flat or declining, it has risen steeply in less developed countries as incomes rise and diets change. Thus, demand has outstripped supply, fuelling sharp increases in price. Producers of cane sugar, which once sought to sell their sugar to Europe, are finding ready markets closer to home. Meanwhile, as a result of changes to the European sugar regime, production of European sugar is constrained. Quotas limit the amount of sugar produced for human consumption, while production of sugar for other purposes, such as the manufacture of ethanol, is not constrained by quotas. However, the price of non-quota sugar is significantly lower than that of quota sugar. As a result, many producers, particularly less efficient ones, produce quota sugar only. The underlying assumption of the new European sugar regime is that any shortfalls will be made up by imports of sugar from emerging markets, even though such imports are costly to transport and attract tariffs. But things have not worked out that way. Emerging market producers have found markets in their own backyards and so Europe has not drawn the expected imports. Consumers in countries such as Portugal, which does not have an indigenous sugar industry, are suffering as a result. In response, the EC decided to convert 500,000 tonnes of heretofore non-quota sugar to quota sugar. For firms such as Suedzucker and Tereos, both of which are efficient producers and have significant stockpiles of non-quota sugar, the decision represents a small windfall. They can now sell their excess sugar at relatively high prices, while avoiding the costs associated with financing it until next year, which should boost their revenues, earnings, and cashflows.
4
MOODY¡¯S WEEKLY CREDIT OUTLOOK
7 MARCH 2011
NEWS & ANALYSIS
Credit Implications of recent worldwide news events
Sabine Renner Assistant Vice President - Analyst +49.69.70730.752 sabine.renner@moodys.com
Multiple Sclerosis Drug Rejection Is Credit Negative for Merck
Last Wednesday, Merck KGaA (Baa2 stable), the German pharmaceuticals and chemicals group, announced that the US Food and Drug Administration (FDA) has not approved Cladribine, its oral treatment for multiple sclerosis (MS), in its present form. In a so-called ¡°complete response letter,¡± the FDA requested further information on the safety risk and overall benefit-risk profile of the drug, either through additional analysis or further studies. Cladribine was the only major drug remaining in the company¡¯s late-stage pipeline displaying a high revenue potential over the next one to two years. However, the news regarding Cladribine is mitigated by the company¡¯s strong operating performance and a deleveraging effort, whose pace is well ahead of our expectations and therefore has no ratings impact. Non-approval in the US follows a negative opinion by the Committee for Medicinal Products for Human Use (CHMP) in the European Union (EU) earlier this year, which led Merck to withdraw its marketing authorisation application for the drug. While Merck has said it intends to follow up with the FDA to clarify the next steps regarding Cladribine, even in the best-case scenario (i.e., the drug eventually wins approval), the FDA¡¯s action further delays the product launch in the US. Consequently, this setback is likely to impact Merck¡¯s cashflow, which otherwise would have benefitted from incremental cash streams from 2011 onwards. Competition is intensifying in the market for MS drugs. Novartis AG (Aa2 negative) has already won approval from the FDA for Gilenya, its competing oral treatment for MS, and the CHMP has recommended that the EU regulator approve the drug, ensuring Novartis first-mover advantage. In addition, several of Merck¡¯s rivals have experimental MS drugs in their late-stage pipelines that may come to market in 2012-13. These new treatments, together with Gilenya, will have a negative impact on Rebif, Merck¡¯s existing intravenous MS blockbuster with revenues of €1.7 billion. However, given the complexity of switching drugs for existing MS patients, we expect this effect to be gradual. In our view, the recent setbacks with Cladribine, together with the non-approval of Erbitux for non-small cell lung cancer, may lead Merck to consider strategic initiatives, such as alliances or in-licensing of promising molecules, aimed at strengthening its late-stage pipeline. The non-approval of Cladribine should not hinder the company¡¯s deleveraging efforts following the acquisition of Millipore in 2010, as the company has benefited from a strong uptick in revenues and operating profits in the past year and from proceeds from the disposal of two non-core businesses announced in the fourth-quarter 2010.
5
MOODY¡¯S WEEKLY CREDIT OUTLOOK
7 MARCH 2011
NEWS & ANALYSIS
Credit Implications of recent worldwide news events
Francois Lauras Vice President - Senior Credit Officer +44.20.7772.5397 francois.lauras@moodys.com Victoria Maisuradze Vice President - Senior Credit Officer +7.495.228.6067 victoria.maisuradze@moodys.com
Partnership Is Credit Neutral for Total, Credit Positive for Novatek
French integrated oil and gas company Total SA (Aa1 stable) last Wednesday announced that it signed agreements to purchase a 12% stake in Russia¡¯s OAO Novatek (Novatek, Baa3 stable), the world¡¯s largest independent gas producer, and to join Novatek¡¯s Yamal liquefied natural gas (LNG) project as a strategic partner. The proposed transactions are credit positive for Novatek. Combined with the CEPSA sale announced in February, the Novatek purchase will leave Total¡¯s credit metrics largely unchanged. The agreements are in line with Total¡¯s strategic objective to redeploy capital towards long-term access to strategic reserves and growth areas, while accelerating sales of non-core assets, and should be beneficial in the long term. In particular, Total will acquire a 20% stake in the Yamal LNG project, which includes the construction of production, storage, and loading facilities for LNG to be sourced from the South-Tambeyskoye field. As of 31 December 2010, the field had proved and probable reserves of 802 billion cubic metres of natural gas and 31 million tons of gas condensate, according to Novatek. Last month, Total announced the sale of its 49% stake in CEPSA for €3.7 billion ($5.1 billion), which offsets the $4 billion that Total is to pay Novatek¡¯s two main shareholders for the initial 12% stake in the Russian company. The deal with Novatek allows Total to increase its stake in the company to 15% within 12 months and 19% within three years. Based on our estimates, we expect Total to have sufficient financial flexibility to accommodate the transactions without compromising its credit metrics, taking into account dividend payments and budgeted capital expenditures of $20 billion. That assumes the timely execution of the various asset sales already announced by the group and a gradual sell-down of its remaining 5.5% stake in sanofi-aventis (A2 stable), currently worth $5.5 billion. Novatek will benefit from the agreements with Total in a number of credit positive ways. For one, Total will gain a seat on Novatek¡¯s board, which will strengthen Novatek¡¯s corporate governance by bringing in the expertise of a major international player in the industry. The deal will also solidify Novatek¡¯s strategic alliance with Total, with which it is jointly developing the Termokarstovoye field, another large gas field in Russia. Furthermore, Novatek will benefit from Total¡¯s technical expertise and funding support, which are essential to developing the vast resources in the South-Tambeyskoye field. The deal will also necessitate a valuation of the Yamal LNG project, which will provide greater transparency into its cost. In 2009, Novatek produced 215 million barrels of oil equivalent and generated total revenues of $2.8 billion. The Total-Novatek deal is the latest example of deepening cooperation between flagship Russian oil and gas companies and global majors. In January, BP (A2 stable) and OJSC Oil Company Rosneft (Rosneft, Baa1 stable) struck a strategic alliance to explore and develop hydrocarbon resources on the Russian Arctic continental shelf. Rosneft also signed partnership agreements with Chevron Corporation (Aa1 stable) and Exxon Mobil Corporation (Aaa stable) to develop several blocks in the Black Sea in 2010 and 2011, respectively. Although credit positive, the strategic partnership has no ratings impact for Novatek, as it will not generate immediate financial benefits. However, it will enhance the platform for further growth and international knowledge exchange, which are important for the implementation of strategically important large-scale projects.
6
MOODY¡¯S WEEKLY CREDIT OUTLOOK
7 MARCH 2011
NEWS & ANALYSIS
Credit Implications of recent worldwide news events
Gretchen French Vice President - Senior Analyst +1.212.553.3798 gretchen.french@moodys.com
Accounting Problems Raise Risk at Weatherford
On 1 March, Weatherford International (WFT, Baa2 stable) disclosed the discovery of material errors relating to income taxes in its financial statements. The oilfield services and drilling company will have to adjust its 2007-10 financial statements by around $500 million, which has negative credit implications for the Switzerland-based company. The errors raise questions about WFT¡¯s company-wide controls and how effectively it is managed on a systems and administrative basis. Under a worst-case scenario, WFT risks financial reporting covenant violations that may speed up its debt-repayment obligations. WFT acknowledges that its reporting problems stem from inadequate staffing and tax expertise, poor review and approval practices relating to income taxes, and inadequate processes to reconcile income tax accounts effectively. Most of the discrepancy, about $460 million, came from an error in determining the tax consequences of intercompany accounts. The company plans to solve this problem by year-end 2011 by hiring more staff with tax expertise for several departments, providing additional training, and by enacting new processes and controls. Although WFT¡¯s management believes it has already completed much of the testing of its tax reporting calculations, the company says it still needs more testing time before it can file its 10-K for 2010 with the US Securities and Exchange Commission (SEC). The SEC has granted a 15-day filing extension for the company, which must now file its annual 10-K report by 16 March. If WFT fails to file by the new deadline, it will violate the reporting covenants under its bond indentures, starting a 90-day cure period during which it must either file its 10-K or seek another extension from the SEC. If WFT cannot do any of these, its indenture trustees will then have the option of accelerating WFT¡¯s payment obligations. Corporate tax-reporting problems are not unusual, and generally amount to a relatively benign ¡°material weakness¡± under Section 404 of Sarbanes-Oxley. For WFT, the accounting errors are noncash and will have no impact on key credit ratios. Even so, the company¡¯s success in addressing its accounting issues related to income taxes will remain an open question until it resolves this weakness and files its 10-K. More generally, the discovery of the errors reflects another example of the challenges WFT has faced as a result of its aggressive growth strategy. WFT has expanded both organically and through acquisitions,