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November 30, 2021 | GSAM Connect

Credit Check-In: Capital Allocation Trends

Themes from third quarter earnings results were similar to those we discussed in our recap of second quarter earnings in August: normalization and the effects of inflation and supply chain disruption. This month, we discuss how those themes have evolved and how they are impacting capital allocation trends.

Normalization to 2019 Levels

“Normalization” – in terms of both corporate health and behavior – is our biggest takeaway from third quarter earnings. Both earnings and earnings before interest, taxes, depreciation and amortization (EBITDA) have recovered to 2019 levels for the majority of investment grade (IG) non-financial corporates; broader trends showed strong profit margins particularly for larger companies.

Balance sheet positions continued to improve from the levels during the height of the pandemic but capital allocation trends are starting to normalize: capital expenditure (capex) is at roughly 90% of 2019 levels and returns to shareholders are at around 103% of 2019 levels for the median US IG company.

High yield (HY) companies reported better-than-expected earnings for a sixth consecutive quarter, with overall guidance that was generally above or in line with consensus expectations, but momentum appears to be moderating. While stronger profit margins contributed to stronger overall third quarter earnings relative to expectations, there was greater variability across companies. The percentage of high yield companies that reported results below expectations was higher than previous quarters, with 20% missing EBITDA guidance in the third quarter. This compares with a 10% and 13% miss in the first and second quarters, respectively. 

Inflation and Supply Chain Disruption Persist

One caveat to this normalization is the current inflationary environment. While in August there was still some debate about the persistence of inflation and supply chain disruptions, most companies now acknowledge that both issues will last into 2022.

Over 20% of high yield companies guided to lower fourth quarter operating results as more management teams called out inflation pressures, challenges with raw material availability and supply chain disruptions, as items that will weigh on future results. Sectors experiencing the greatest headwinds include both consumer cyclical and consumer products, restaurants, retailers, and technology hardware.

However, corporate margins in aggregate remained relatively strong thanks to two underlying themes. First, companies are realizing their pricing power, which is strengthened by the combination of a healthy consumer, strong demand for goods and services and limited substitution effect due to supply chain issues. The other key driver of margins was the conversion of robust revenue growth to EBITDA, particularly for larger companies. The relative stability of corporate margins may be contributing to the widespread guidance from companies that they will continue to deal with inflation and supply chain issues at the operating level and as such, are not planning any changes to their operating models or capex strategies.

Capital Allocation and Corporate Behavior in 2022

After reporting strong profits, retaining solid profit margins and improving balance sheets, we think many companies will begin loosening some of their conservative practices of the last 18 months. Management teams are increasingly comfortable running businesses with a BBB credit rating, as opposed to an A rating, and with capital markets wide open, we expect to see more merger and acquisition (M&A) activity and other potential changes to corporate structures as companies seek ways to realize value.

Already, several conglomerates have announced break-ups to optimize capital structures and allow for more efficient capital allocation by eliminating the need for one business to subsidize the other. While size has been an advantage in terms of profit margins and credit ratings, we believe that capital restructurings are not necessarily negative for credit; in at least one case the company will use proceeds to reduce debt.

Some capital allocation trends remain more concerning; we continue to monitor areas of potential overinvestment. We highlight that utility companies could face high funding needs as they invest in the energy transition, though we believe management teams remain committed to retaining IG credit ratings. Utilities trying to avoid issuing more debt may either increase their hybrid issuance or engage in minority interest sales or outright divestitures.

Lastly, we note that share buybacks have once again been increasing as managements feel more confident. However, a potential new tax on share buybacks in the US may lead companies to return capital to shareholders through variable dividends instead. From a credit point of view, buybacks are not a positive development, but are preferable to dividends because they are more flexible.

Overheard at Goldman Sachs

Each month we feature quotes from our investment team, offering a glimpse into our investment views and what we are monitoring and analyzing.

“The word to describe the current corporate environment is ‘normalization’, though the inflationary environment may add some excitement.”

— Stephen Waxman, Head of the Global Investment Grade Research Team

Goldman Sachs Asset Management Forum | November 2021


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