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William Hoffman

While the latest round of quarterly earnings showcase a range of headwinds facing US leveraged credits, investors are drawing the positives as companies in many instances have avoided the worst case scenarios forecast earlier in the summer.

Corporate earnings had been expected to take a significant down swing as the economy shrunk for the second quarter in a row, inflation continues to rise and consumers appear to pull back on spending.

And yet, while a strong labor market is a costly challenge for employers, it’s also supporting consumer appetite for travel and services, putting an optimistic spin on earnings in certain sectors.

Tech companies such as Uber are demonstrating they can turn the profitability switch on, energy companies are using this period of high commodity prices to pay off debt through bond buybacks and tender offers, and travel and leisure companies including cruise lines, hotels, and casinos show continued demand for services.

“It's been pleasantly surprising,” one portfolio manager said. “Even companies that missed on their earnings — it wasn't terribly shocking.”

One of the trends investors are watching closely this quarter is margin deterioration as inflation eats into profits.

Foot-wear company Crocs and athletic-wear company Under Armour saw this to some degree, although Crocs also reported record revenues and in Under Armour’s case the company pointed to an increased promotional advertising budget.

Uber turned cash flow positive for the first time by increasing prices that were passed onto consumers. The company reported an adjusted EBITDA margin of 1.3% up from negative 2.3% during the comparable quarter last year.

“It’s not a surprise to see some margin deterioration with just how relentless inflation has been on so many levels, but we would like to see companies pass through the majority of costs,” one buysider said. “If they're not able to do that, then it might say something about demand levels and the macro economy in general.”

With gas prices high and bonds trading well below par, energy companies are taking the opportunity to buy back their bonds at a discount.

In the second quarter, the West Texas Intermediate peaked at around $122 per barrel (although this month it has come back down to below $90) and some energy companies are using that extra cash flow to delever.

Diamondback Energy in its Q2 earnings report on Monday disclosed that it repurchased $337m of the principal amount from its senior 2026, 2029 and 2031 notes at 95% of par for $322m.

Likewise, Matador Resources used free cash flow to repurchase $158m of outstanding senior notes on the open market, reducing its outstanding bonds to $892m from $1.05bn.

“It's definitely a smart use of cash flow,” one investor said. “If the company can pay down fixed rate debt at around 80 cents on the dollar or better they should definitely do that, it’s a good use of dollars.”

Other energy companies such as Antero Resources and Murphy Oil announced cash tender offers and will pay a premium to take out bonds before the first call date.

“Energy exploration companies are generating tremendous amounts of free cash flow in the current commodity price environment,” said Bryant Dieffenbacher, research analyst and portfolio manager at Franklin Templeton. “They saw the volatility of the last couple of energy default cycles, so even if it means tendering for debt that’s not callable for a while they need to get their absolute levels of debt down and protect their balance sheets.”

Companies outside of the energy sector also see opportunities to reduce debt in this environment.

Bonds from printing company Cimpress are trading at around 83 cents on the dollar and management explained during its latest earnings call that it’s weighing bond buybacks against maintaining a higher cash balance for extra liquidity during these uncertain times.

“We can buy back our bonds in the open market and from a tactical perspective, we have the mechanisms to execute that if we were to decide to allocate capital there and we’re not limited in terms of our debt covenants,” Sean Quinn, chief financial officer at Cimpress, said during the earnings call. “We agree from a returns perspective that repurchasing our bonds or share repurchases at these levels we believe have attractive returns.”

Gaming credits and cruise lines continue to benefit from pent-up demand for travel and entertainment coming out of the depths of the pandemic.

High-yield travel technology company Sabre even showed steady improvement in air and hotel bookings, despite the company losing some of Expedia’s North American business. The company announced a new $400m term loan B on Tuesday to refinance part of its existing 2024 term loan, with commitments due August 9.

Royal Caribbean continued to report net losses but said it returned to positive operating cash flow during the quarter, as well as guiding for increased bookings next year at higher prices. The story was similar for Carnival, which reported earnings in late June.

“Obviously the cruise lines have taken on a significant amount of debt, a lot of it coming at a pretty high coupon,” the investor said. “So they are going to have to really prove out cash flow to just refinance their high-interest cost, and then maybe in 2025 they can talk about delevering.”

Gaming credits are also bouncing back from the pandemic.

Boyd Gaming’s pricing performance over the last month (9fin)

MGM Resorts reported quarterly adjusted EBITDAR (which accounts for rent costs) of $825m, which is up 197% versus 2Q 2019 levels. Caesars Entertainment’s second quarter adjusted EBITDA is up over 200% from 2019 levels to $547m. And Boyd Gaming reported $327m EBITDAR, which is up 57% over 2019 levels.

One buysider said margins have improved in the gaming sector because during the pandemic companies cut back on promotional amenities such as free buffets and drink service and never brought them back as customers returned.

“The casinos realized that maybe they don't need all these frills that ultimately cut into the bottom line — people really are just there to gamble,” the buysider said. “So you've seen margins expand significantly, specifically in the regional gaming operators.”

Of course it’s not all rainbows and sunshine.

Bed Bath & Beyond was downgraded to the triple-C rung last month following poor guidance from its annual shareholder meeting, and one portfolio manager noted other retail names as an area of concern.

Earnings for Gap, Nordstom, and L Brands (which owns Bath & Body Works and Victoria’s Secret) are still slated for later this month and could underperform significantly compared with the high growth rate they all experienced during the pandemic last year.

“Bath & Body Works did really well during Covid, but do we think that’s sustainable? No,” the portfolio manager said. “We think there are fundamental challenges in retail and we’re managing that by staying in higher quality names, we want to avoid lower rated credits and more leveraged balance sheets.”

There is also some pressure in healthcare, where Community Health Systems reported a $200m drop in its adjusted EBITDA to $253m. Encompass Health displayed similar trends as EBITDA fell by $38.7m to $240m on the quarter.

But there’s divergence with Tenet Healthcare and HCA outperforming the sector.

“The general theme is that the recovery in demand for rural healthcare services seems to be trailing urban and suburban hospitals,” said a second portfolio manager. “Labor issues also continue to be a big issue in the healthcare sector, a lot of staff left the industry during Covid, so now hospitals are bidding up labor costs.”

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