May 24, 2016

SPLS’ Strong Cash Profile Merit Tighter Market Spreads Despite ODP Deal Collapse

Cash flows over operating obligations and strong liquidity profile, even after paying the ODP break-up fee, indicate that credit markets are overstating credit risk

Credit markets are materially overstating fundamental credit risk with a CDS of 262bps and a cash bond YTW of 4.369%, relative to an Intrinsic CDS of 105bps and an Intrinsic YTW of 2.569%. On the other hand, Moody’s is accurately stating SPLS’ fundamental credit risk, viewing the firm as a Baa2 credit in line with Valens’ fundamental IG4+ (Baa1) credit rating.

Incentives Dictate Behavior™ analysis highlights that SPLS’ compensation framework is favorable for debt holders. Management’s compensation metrics should drive them to focus on ROA’ improvement through margin expansion and asset utilization, while also encouraging top-line growth. Additionally, management is not well compensated in a change-in-control scenario, indicating that they are not likely to seek a sale of the company, limiting event risk for creditors.

SPLS equity is trading at a 16.3x V/E’, which is moderate relative to historical valuations. The market is expecting ROA’ to expand, with slight Asset’ shrinkage going forward. This indicates that in the aftermath of the failed ODP merger, the equity is likely fairly valued. However, if the firm cannot make fundamental improvements, equity downside may be warranted.

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