- The impact of COVID 19 and the sharp economic contraction will result in significant declines in revenue and EBITDA for capital goods companies in 2020, raising the pressure on credit quality in the sector.
- We have taken over 40 ratings actions in recent weeks and expect the negative rating bias to grow.
- The extent of the impact depends on end market exposures, with those facing weaker end market more vulnerable to downgrades.
- Speculative-grade issuers are more vulnerable to downgrades given their limited diversity of end markets and resulting cash flow and liquidity pressures. Investment-grade issuers, while not immune to downgrades, should face less ratings pressure given their more diversified business models, greater cushion in credit metrics, and enhanced liquidity positions.
Demand Destruction And Sharp Economic Contraction Adds Pressure To Already Pressured Credit Quality
S&P Global Ratings now forecasts a steeper global recession and expects global GDP to decline by 2.4% in 2020 but to rebound in 2021 with expected growth of 5.9% in 2021. We expect the U.S. to post a historic (annualized) contraction in the second quarter of 35% and full year 2020 GDP decline of 5.2%, though we expect a recovery in 2021 with 6.1% expected GDP growth (see "COVID-19 Deals A Larger, Longer Hit To Global GDP," published April 16, 2020). Although the capital goods sector serves a broad array of customers, we generally view it as cyclical and expect the economic contraction and reduced capital expenditures (capex) by key end markets to curtail demand for original equipment and, to a lesser extent, aftermarket parts. The collapse of oil prices will also hurt capital goods issuers with high exposure to the sector.
While we expect the service sector to be hit harder than the manufacturing sector, the Purchasing Managers Index (PMI) for the manufacturing sector returned to contraction territory, with March PMI decreasing to 49.1 from 50.1 in February and we expect the negative trajectory to continue.
Our outlook for the capital goods sector was already weak entering 2020 due to trade tensions and slowing economic growth. The rapid onset of COVID-19 added significant stress to a sector already facing headwinds. Given the challenging operating landscape, we have taken over 40 negative rating actions and the portion of ratings with negative outlooks has risen to about 31% from 19% at the end of 2019. By comparison, our negative bias stood at approximately 26% at the height of the 2016-2017 industrial downturn. While the 31% negative bias is high historically, this is still below corporate sectors that are more directly impacted. For example, over 65% of ratings in the oil & gas sector and 45% of rating in the auto sector have a negative bias as of March 31, 2020.
End-Market Strength Will Be A Decisive Credit Factor
While we expect all end markets to suffer under the economic recession, issuers with higher exposure to weaker end markets such as oil & gas, autos, aviation, construction, foodservice, material handling, auto, and to some extent metals/mining, will be more vulnerable given the dramatic decline in demand from these sectors.
Below are a few updates on these key end markets.
Oil & Gas
Oil prices have plunged, tied to oversupply and the standoff between Saudi Arabia and Russia. As a result, we expect capex related to the oil & gas sector to cut back substantially. We see the upstream segment facing the most pressure. Rig counts in North America declined by about 40% year over year and we do not expect a recovery in the near term. This will likely depress spending on oil & gas equipment. We expect significant capex declines, which could directly impact rated capital goods companies. For instance, ExxonMobil announced it was reducing capex by 30%.
We expect crude oil prices to remain weak this year due to a severe supply-demand imbalance, with West Texas Intermediate (WTI) averaging about $25 per barrel and Brent Crude about $30 per barrel this year.
|S&P Global Ratings' Oil And Natural Gas Price Assumptions|
|--New prices--||--Old prices--|
|Brent||WTI||Henry Hub||AECO Hub||Brent||WTI||Henry Hub||AECO Hub|
|2022 and beyond||55||50||2.5||1.5||55||50||2.5||1.5|
|WTI--West Texas Intermediate. AECO--Prices are rounded to the nearest $5/bbl and $0.25/mmBtu. bbl--Barrel. WTI--West Texas Intermediate. mmBtu--Million British thermal units. Source: S&P Global Ratings.|
Measures to contain the coronavirus pandemic have led many airlines to ground large portions of their fleets. The International Air Transport Association, IATA, projects that European air traffic could fall 46% in 2020 compared with 2019, assuming a very strict three-month lockdown, while we have assumed a drop in the range of 25%-35%.
Given the sudden drop in air traffic demand, this will likely result in a dramatic decline for services, particularly for the commercial aviation sector. We recently revised the outlook on General Electric Co. (BBB+/Negative/A-2) due to its exposure to aviation services. We also recently downgraded Parker-Hannifin Corp. (BBB+/Negative/A-2) and maintained a negative outlook, in part due to its aerospace exposure. Parker-Hannifin closed on the acquisition of Exotic Metals Forming, a designer and manufacturer of components for engine and airframe systems, in the second half of calendar 2019.
Our autos analysts expect a material decline of light vehicle demand globally and this decline will be particularly severe in the second quarter of the year, only gradually recovering thereafter. We expect global light vehicle sales will likely decline by almost 15% in 2020 to less than 80 million units (versus 90.3 million in 2019). Given the large majority of global auto manufacturers have announced production shutdowns at most of their plants in Europe and the U.S, this will likely result in a cutback in orders from their supply chains. We continue to see pressure in the heavy and medium duty truck segment, which was already bracing for a sharp decline even prior to COVID-19 headwinds.
|We Are Further Lowering Our Global Light Vehicle Sales Forecast|
|% year-on year change|
|--Previous projections*--||--New projections*--|
|Rest of the World||(3)||0||(15)||6-8|
|Previous projections are as of March 5, 2020; new projections as of March 23, 2020. f--Forecast. Source: S&P Global Ratings.|
In late March, we lowered our assumptions for several metals for 2020-2022. Demand fundamentals for industrial metals have been weighed down since late 2019 by slowing economic growth in the U.S., China, and EU, particularly in the important construction and automotive sectors. On top of that, we believe the one-two punch of rapidly escalating coronavirus pandemic and the sharp drop in oil prices could cause demand to drop for some key metals in 2020. We expect producers to cut output and tighten inventory levels, resulting in reduction in capex.
|Revised Metal Price Assumptions Versus Previous Assumptions*|
|Revised assumptions (as of March 13, 2020)||Previous assumptions (Dec. 23, 2019)|
|Iron ore ($/dmt)||75||70||65||80||70||65|
|Hard coking coal (US$/mt)||150||160||160|
|Thermal coal (Newcastle, US$/mt)||65||70||70|
|*Ton--metric ton (1 metric ton = 2,205 pounds). Oz--ounce. Dmt--Dry metric ton.|
Supply Chain Disruption Is Restricting Capacity And Output
In addition to demand destruction, capital goods issuers are also facing supply chain disruptions. Government mandated closures of production facilities, slump in demand, as well as labor shortages are contributing to capacity reduction and restricting output. While operations in China have largely resumed as China has passed the first-wave COVID-19 peak and has gone some way to restarting its economy, disruptions have emerged in the U.S. and Europe, the Middle East, and Asia (EMEA). Industrial sector operating capacity is around 90% of normal levels in China as workers steadily return from their home provinces.
While supply chain disruptions could have some impact on operating performance, we expect these disruptions to be relatively short term and to have only a modest impact on most issuers. Issuers operating a diversified supply chain can better mitigate supply chain disruptions compared to those reliant on a limited number of facilities.
To mitigate the impact of the sudden revenue decline, issuers have implemented cost reduction measures such as workforce reduction or furloughing. Despite these measures, we still expect a significant erosion of profit margins given the relatively high operating leverage and capital intensity of capital goods businesses. Reduction in inventory, however, could result in some improvement in working capital that could support operating cash flow despite earnings decline.
Given the high level of uncertainty in the recovery, capital goods issuers could consider more permanent capacity reduction and more permanent labor cost reductions. In addition, although many capital goods issuers will curtail capex in the short-run, we think issuers will likely accelerate automation to their operations after the peak of the crisis subsides to enhance efficiencies in light of the disruption by COVID-19.
Lower Rated Issuers Will Face Greater Ratings Pressure
We have taken 43 rating actions in the capital goods sector in 2020, of which 41 were downgrades. The number of rating actions accelerated in March as we expect the impact from COVID-19 and the steep decline in economic activity to pressure operating results in 2020. The rating actions were mostly in the 'B' category and decidedly negative, with downgrades of mostly one notch and outlook revisions to negative. The high proportion of negative rating activity reflects our expectations of material deterioration in credit metrics as our revised forecast include sizable revenue declines in 2020 due to lower demand, margin compression, as well as lower cash flows and liquidity concerns such as refinancing risk or thinning financial covenant cushion.
The Growing Number Of 'CCC' Ratings Highlights Increasing Default/Distressed Restructuring Risk In The Next Year
We expect defaults to rise in the next year as the number of issuers in the 'CCC' category has risen sharply to about 12% of the rated portfolio in the capital goods sector compared to 5% at the end of 2019. The expected higher defaults for capital goods is in line with our expectations for ratings performance in nonfinancial corporate borrowers. Given the extent of the economic contraction, oil collapse and capital markets volatility, this will likely mean a surge in defaults, potentially reaching a double-digit speculative-grade default rate for nonfinancial corporates in the U.S. over the next six to 12 months. Our expectations for increased defaults includes debt restructurings that we deem distressed. Generally, issuers rated 'B-' or lower are the most exposed to risks of distressed exchange or debt restructuring, which would qualify as a default under our ratings definitions.
Large, Diversified Industrials Are Better Positioned To Withstand A Sharp Economic Downturn
We expect most investment-grade large, diversified industrials issuers to withstand near-term pressure and repair credit metrics in 2021. For example, Caterpillar Inc. (A/Stable/A-1) has a healthy cushion under its credit metrics to withstand a material slowdown in its construction, mining, and oil & gas end markets that will significantly reduce its revenue and earnings in 2020. Caterpillar's S&P Global Ratings-adjusted funds from operations (FFO)-to-debt ratio was 117% as of the end of 2019, which stands well above our 30% downside trigger.
Still, eight of the 24 investment-grade ratings have negative outlooks or are on CreditWatch negative to reflect the downside risk from an uncertain recovery in 2021. We also expect some cases of investment-grade ratings falling into speculative grade (fallen angels). For instance, we lowered the rating on Hillenbrand Inc. to 'BB+' from 'BBB-' because we believe the company's deleveraging following its recent acquisition of Milacron Holdings Corp. will now take longer than we previously expected due to a contraction in economic activity.
|Investment-Grade Non-Stable Outlooks|
General Electric Co.
Otis Worldwide Corp.
The Heico Cos. LLC
Westinghouse Air Brake Technologies Corp.
- An Already Historic U.S. Downturn Now Looks Even Worse, April 16, 2020
- Credit FAQ: Airlines And Airports Worldwide Confront An Unprecedented Plunge In Traffic And An Uncertain Recovery, April 6, 2020
- COVID-19 Will Batter Global Auto Sales And Credit Quality, March 23, 2020
- Metal Price Assumptions: Oil Prices And The Coronavirus Dulls Demand For Most Metals, March 16, 2020
- S&P Global Ratings Cuts WTI And Brent Crude Oil Price Assumptions Amid Continued Near-Term Pressure, March 19, 2020
This report does not constitute a rating action.
|Primary Credit Analyst:||Ana Lai, CFA, New York (1) 212-438-6895;|
|Secondary Contacts:||Henry Fukuchi, New York (1) 212-438-2023;|
|Trevor T Martin, CFA, New York (1) 212-438-7286;|
|Svetlana Olsha, CFA, New York (1) 212-438-1467;|
|Michael Tsai, New York + 1 (212) 438 1084;|
No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.
Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.
To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw or suspend such acknowledgment at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.
S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process.
S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.
Any Passwords/user IDs issued by S&P to users are single user-dedicated and may ONLY be used by the individual to whom they have been assigned. No sharing of passwords/user IDs and no simultaneous access via the same password/user ID is permitted. To reprint, translate, or use the data or information other than as provided herein, contact S&P Global Ratings, Client Services, 55 Water Street, New York, NY 10041; (1) 212-438-7280 or by e-mail to: email@example.com.