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Report Card: Large Capital Goods Companies Are Positioning Themselves For A Post-Pandemic Recovery


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Report Card: Large Capital Goods Companies Are Positioning Themselves For A Post-Pandemic Recovery

The capital goods sector's credit quality has weakened during the course of 2020. The rating level has shifted down, and an 'A+' issuer credit rating is the highest rating awarded in the sector globally, with most companies rated 'B-'. Also the number of 'CCC' category ratings has increased, which points toward weakening credit quality at the low-end of the ratings scale. Defaults haven't amassed so far, but this can change if credit conditions don't improve rapidly and substantially next year. After peaking in March to May, downgrades in the sector have slowed significantly. Changes now are largely based on S&P Global Ratings' assessment of potential recovery paths and the timeframe of recovery for individual issuers, in particular for those falling within the investment-grade category. Though we expect conditions to remain on an upswing in the coming year, there's still significant risk as the pandemic continues to be the dominant force shaping the sector and overall economic development.

Chart 1


Highest Share Of Negative Outlooks Since The Financial Crisis

Our net outlook bias for the sector remains highly negative.  We've assigned negative outlooks or placed ratings on CreditWatch with negative implications on 45% of the sector. The region with the most negative outlooks and ratings on CreditWatch is the U.S. with more than 50%, followed by EMEA. APAC ratings have remained mostly stable. Because the U.S. and EMEA have a greater share of low speculative-grade ratings, where the pandemic's impact has worked its way through issuers' balance sheets fastest, a rising number of defaults next year is still possible.

The pandemic has caused overall sector credit quality to suffer and just about all industry players' credit metrics have weakened. This has prompted a high number of downgrades throughout the year, in particular during the first half. Rated sector players issued large amounts of debt during 2020 to secure liquidity during the pandemic, and we expect a significant portion of the debt to linger on balance sheets through 2021 and 2022. Nevertheless, we expect the current high negative outlook bias to start to unwind during the first half of 2021, should the economic recovery assumed in our sector base case start to materialize.

Chart 2


Low Speculative-Grade Issuers Are Most Vulnerable To Additional Downgrades

The composition of outlooks, indicating ongoing pressure on ratings, varies greatly according to rating level.   In the 'A' category approximately 80% of the global outlooks are stable, in the B category ('B+', 'B', 'B-') our outlooks are more than 50% negative, and in the CCC category ('CCC+', 'CCC', 'CCC-') more than 90% are negative. This indicates ongoing high pressure on ratings among the weaker rated entities, in particular at the very low end of the speculative-grade arena, despite the portfolio shift toward lower ratings through downgrades. In the lowest rating categories, issuers remain highly reliant on the fast recovery of their respective end markets. Most highly levered issuers in the 'B-' and 'CCC' categories face an elevated default risk due to liquidity issues and lack of access to financing on reasonable conditions.

Chart 3


Anyone Can Get The Virus, But The Severity Of Symptoms Vary

The pandemic's repercussions have hurt some segments of the sector more than others.   There's been a less pronounced weakening of credit quality for investment-grade issuers, and for the leading industry players the drop will be largely temporary, with a strong rebound of revenues and profitability next year. However, in 2020 we expect no large industry player to match the previous years' revenues. On average we expect revenues to be down by 8-10% and absolute EBITDA down by about 20% compared to 2019. Heavy equipment manufacturers have suffered most through pandemic-driven lockdowns and reduced end-market demand, and issuers with stronger, more diverse, technology- and service-driven business models have shown resilience and performed well compared with the general sector trend. Good positioning in Asian markets, led by China's rapid recovery to economic normality, has benefitted large global well-diversified issuers.

Debt issuance has increased in 2020 due to readily available liquidity and overall debt volume in the sector is now higher than in previous years. Large well-performing investment-grade sector issuers have used debt for refinancing or to shore up precautionary cash on their balance sheets, while continuing to generate free operating cash flow, unlike weaker performing issuers requiring additional financing to cover for cash bleed.

Also, in case of more traditional, equipment-driven but well-positioned, large manufacturers we expect a significant catch-up effect during 2021, when we expect economic activity to accelerate again. However, for this group of issuers performance improvement and ratings stability requires a more supportive economic environment over the next six to 12 months than for issuers that performed better than sector average in 2020.



Sector Recovery By 2022, But COVID-19 Risk Remains Significant

We rate more than 200 issuers in this sector, giving us a good overview of the market, although geared toward large industry players. The aggregated forecast currently shows an average sales drop of about 8-10% and an EBITDA margin drop of 160 bps in 2020. This leads to an aggregated average absolute EBITDA decline of nearly 20%. The impact on each individual issuer will differ greatly depending on end market exposure and management's ability to cut costs fast. According to our aggregated sector forecast over the next 36 months, the absolute EBITDA level of FY2019 will be reached again by the end of FY2022.

We forecast most issuers' leverage will peak in 2020 and aggregate sector credit metrics to improve to pre-crisis level not before the end of FY2022. In this regard, our previous assessment from midyear 2020 remains in place. The improvement is driven by better financial performance and profitability in a post-COVID world, with corporate investment back on track and cost bases reduced by cost-containment measures, as well as somewhat lower debt levels.

Chart 6


Chart 7


As of today, there's a high level of uncertainty remaining for next year as long as the end of the pandemic is not firmly in sight. Most importantly, our sector base case includes the assumption of a widely available vaccine by mid-2021. From a sector standpoint, this is critical because a vaccine would greatly diminish the restrictions on activity and eliminate a key source of uncertainty hanging over consumption and investment--a new wave of manufacturing lockdowns and no perspective to returning to significant economic growth within the next year would dismantle business and investment confidence. In such a scenario, we would expect additional downgrades and a spike in speculative-grade company defaults.

Tier 1 Capital Goods Tier 1 Review

3M Co. (A+/Negative/A-1):

"…inability to reduce leverage could result in a downgrade." 

After a difficult second quarter, 3M has started to show signs of stability with slightly positive organic growth in the third quarter. While the growth in a difficult economic environment was positive, the end market performance was bifurcated, as opposed to a broad-based rebound. The company continues to make progress reducing leverage, but it remains high for the current rating level following its $6.7 billion acquisition of Aceility Inc. last year, which was largely financed with debt. The company's Consumer, Safety and Industrial, and Healthcare segments all grew organically in the quarter, while the Transportation and Electronics segment declined by 7.1% on the topline. 3M continues to demonstrate a strong ability to generate free operating cash flow and has suspended share repurchases for the time being, helping to keep leverage relatively stable. We still expect that 3M will be able to reduce leverage to the 2x range over the rating horizon, but an inability to do so could result in a downgrade. Potential liabilities and settlements associated with 3M's role in manufacturing and disposing of perfluoroalkoxy alkanes (PFAS) continue to weigh on the rating. However, we believe the coronavirus has delayed potential cash outlays associated with the chemicals. The multi-district litigation lawsuit in South Carolina, regarding 3M's role in manufacturing Aqueous Film Forming Foam (AFFF), which is a key milestone we are watching, was delayed until early next year. As a result, litigation charges and reserves have declined significantly relative to the prior year, which should help to support 3M's S&P Global Ratings' adjusted EBITDA margins. We continue to monitor potential liabilities and cash outflows related to the litigation and assess any further impact on 3M's credit measures, particularly as we expect elevated debt leverage.


ABB Ltd. (A-/Stable/A-2):

"Sufficient ratings headroom under new rating level and currently high financial flexibility." 

We recently lowered our ratings on ABB to 'A-/A-2' because we expect the group will fall short of our previous rating threshold of 45% in 2021 and 2022. The pandemic-led recession has hurt ABB's operations, in particular its industrial automation and robotics and discrete automation segments. Production cuts in general industry and the automotive sector have led to lower demand and project delays in the group's robotics and discrete manufacturing and industrial automation operations. With lower volumes and underutilization of capacity, profitability is currently under pressure and notably below the group's targeted medium-term margin profile. On the positive side, operating performance at the group's Motion and Electrification business areas have remained relatively resilient because this short-cycle business has greater exposure to more stable end markets like rail, utilities, and data centers. Overall, the group's revenue declined by more than 9% year over year in the first nine months of 2020, and the operational EBITA margin remained relatively unchanged at 10.9%, versus 11.5% a year earlier. This was thanks to the solid execution of its cost-savings program and solid profitability in the motion and electrification segment. We expect a gradual recovery of revenue, supported by an order backlog that is about the same size as the previous year. However, we don't expect revenue will return to pre-pandemic levels before 2022 because economic uncertainties remain. We now expect the group's revenue to decline by about 8% in 2020, and recover by about 4% per year in 2021 and 2022, in line with the broader pace of recovery in the capital goods industry. Reflecting the lower volumes, we expect the EBITDA margin to decline by about 100 bps to about 11% in 2020. On the back of higher volumes, better utilization, cost-saving initiatives, and elimination of stranded costs with the disposal of power grids, we expect the group's EBITDA margin to increase to about 13% in 2021 and to above 13.5% in 2022. We expect ABB to post FFO to debt of about 50% in 2020, which cannot be sustained. We expect the ratio to decline to 38%-42% in 2021-2022 on the high cash distributions to its shareholders via dividends and share buybacks.


Atlas Copco AB (A+/Stable/A-1):

"…robust credit metrics despite dividend and acquisition." 

We expect the COVID-19 pandemic to lead to a decline in sales of about 8%-10% for Atlas Copco this year and EBITDA margin to decline to about 22%-23% under the significantly softer market conditions, from the very robust 25% in 2019. We expect weaker equipment demand, notably from the motor vehicle industry, as well as temporary plant closures to be the key factor behind lower profitability. Even in a global economic slowdown, we expect Atlas Copco to generate stable cash flow, supported by its flexible operating model and high share of aftermarket service operations. These factors should allow Atlas Copco to keep profitability among the highest of its global peers, even in softer market conditions. (EBITDA for the first nine months of 2020 stood at about 23.3%). We expect Atlas Copco to continue to keep its FFO to debt above 60% (it is currently around 90%), despite shareholder distributions and small to midsize bolt-on acquisitions. Acquisition spending is higher this year than we usually expect for the company, given the settlement of ISRA for about SEK11 billion. The group has also decided to resolve the second dividend payment, resulting in about SEK8.4 billion dividend outflow in 2020. Although this temporarily weakens Atlas Copco's balance sheet, we expect the group's strong cash flow generation to strengthen credit ratios over the coming quarters and the group to hold its leverage at below 1x Debt to EBITDA over the next 24 months.


Caterpillar Inc. (A/Stable/A-1):

"…faces challenging end markets In 2020, though its solid 2019 credit ratios provide a rating cushion." 

Although we believe challenging end-market demand conditions will significantly reduce Caterpillar's revenue and earnings in 2020, the company's credit measures should remain appropriate for the current rating. Specifically, Caterpillar's S&P Global Ratings' adjusted FFO-to-debt ratio was 117% as of the end of 2019--well above our 30% downside trigger--which provides the company with a healthy cushion to withstand a material slowdown in its construction, mining, and oil and gas end markets in 2020. Although Caterpillar has substantial fixed costs, its absolute margins should be higher than in prior downturns due to its relatively leaner cost base following its past restructuring actions. We expect Caterpillar to maintain its strong market position as the world's largest construction and mining equipment manufacturer, and a leading provider of diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives. The company maintains a broad product line and a global footprint that balances mature and higher-growth markets. However, the the group's credit measures can be highly volatile due to the high correlation of its business with the demand cycle. We continue to expect that Caterpillar will use substantially all of its free cash flow from its machinery, energy, and transportation business for dividends and share repurchases through the cycle.

  • Analytical contacts: Svetlana Olsha/Ana Lai
  • Issuer Research: Caterpillar Inc. Full Analysis, Dec. 3, 2020


CNH Industrial N.V. (BBB/Stable/A-2):

"We expect credit metrics to recover to meet the ratings thresholds in 2021."  

Due to the pandemic's impact on market conditions across all regions and segments, CNHI group revenues and EBITDA are expected to decline significantly in 2020. In particular, the margin erosion is significantly higher than the capital goods sector average. This development is driven by lockdowns and low demand especially hurting the Construction Equipment, Commercial Vehicle, and Powertrain segments. The main EBIT contributor for CNH is the Agricultural segment and this year we expect it to be almost the sole contributor of group industrial operating profit. CHNI's results in the third quarter were better than expected in terms of order intake and performance of the main agricultural business segment. Also, cash generation in the third quarter was better than expected with the group generating about $1 billion of free cash flow from industrial activities (compared to typical negative free cash flow in the third quarter of 2019), after heavily negative cash flow during the first half of the year. For the fourth quarter, we also expect a positive cash flow and the group to generate around neutral free cash flow from industrial activities over the full year 2020, and materially positive free cash including the group's captive finance activities. For 2021, we expect industrial FOCF to be positive; however, moderated by the likely needed inventory buildup relating to expected increasing production volumes. Overall, our forecast on credit metrics for CNHI's fiscal years 2020 and 2021 are considerably weaker than expected before the pandemic. In 2020, credit metrics will be weaker than our current rating threshold for CNH (of debt to EBITDA below 2x and FFO to debt above 45%). We expect credit metrics to recover to meet the ratings thresholds in 2021. The group paid no dividend in 2020 and we expect the group's conservative financial management to continue in order to meet requirements for an investment-grade credit rating.


CRRC Corp. Ltd. (A+/Stable/-):

"…strong balance sheet and government support provide sufficient financial headroom." 

We expect CRRC's revenue and profit to recover in the next one to two years, after a pandemic-struck 2020. As COVID-19 has largely been contained in China, railway transport volume has been steadily picking up from the trough in the first quarter and rolling stock tendering that was delayed in the first half has gradually normalized since the third quarter. These should lead to recovery of railway equipment delivery as well as higher maintenance revenue from 2021. Additionally, the company's high rapid transit vehicle backlog on hand provides good revenue growth visibility for the next two to three years. We therefore estimate that CRRC's topline could grow by 5%-8% in 2021 after a 3%-8% dip this year, and its margin could recover to close to 2019 results as the pandemic disruption subsidies. CRRC's overseas business faces higher hurdles the next few years given rising global trade and geopolitical tension, but we believe the impact is manageable given its less than 10% export exposure. With the recently announced 2035 China railway development targets and the government's renewed focus on infrastructure construction, domestic industry fundamentals should remain supportive for the next few years, with CRRC the prime beneficiary thanks to its commanding market position. We expect CRRC to stay in near net cash position for the next 12-24 months given its solid cash generation ability as well as limited capital expenditure needs, because most of its customers are government-related railway and subway operators with low receivable risks and the company already has sufficient capacity build-up. CRRC's strong balance sheet and the very high likelihood of extraordinary government support provides sufficient financial headroom and continues to underpin its robust credit profile.


Deere & Co. (A/Stable/A-1):

"…we expect the company's FFO-to-debt metric will improve next year as demand gradually recovers." 

The stable outlook on Deere reflects S&P Global Ratings' expectation that although the company's credit measures have weakened this year, and FFO to debt could dip below 30% by the end of fiscal 2020 due to challenging end market conditions globally, we expect this metric will improve to above 30% next year as demand gradually recovers. We believe the weak macroeconomic environment stemming from the COVID-19 pandemic and uncertain farmer sentiment has delayed capital investment, which will weigh on agricultural and construction end markets in 2020. Still, an aging agricultural fleet and Deere's technological offerings should support an increase in agricultural replacement demand in 2021, as customers trade in older equipment for more technologically advanced and connected machines that can lower farmers' production costs. Similarly, although there's limited visibility into 2021 order activity, we believe that Deere's construction markets should begin to recover next year as nonresidential investment increases. Still, we have a cautious outlook on business investment and view intensifying trade tensions as a risk to our overall forecast. In light of the challenging market conditions, Deere is lowering its operating costs. The company has completed voluntary separation programs, is reducing selling, general, and administrative expenses, and curtailing certain research and development (R&D) expenses, which should help to mitigate the margin impact of lower volumes in 2020. We believe the company's liquidity remains strong, as the equipment operations raised over $4 billion of long-term debt to add incremental liquidity amid the uncertain operating environment. We expect the company to generate positive consolidated free cash flow in 2020, albeit below 2019 levels. Deere has a history of disciplined cash deployment, including curtailing share repurchases during market downturns, and therefore we expect the company will manage its share repurchases in the context of its operating performance and cash flow generation.


Eaton Corp. PLC (A-/Stable/A-2):

"We expect Eaton to make prudent financial policy decisions to maintain credit metrics and liquidity." 

Third quarter organic revenue was down about 9% with decremental impact on margins of about 25%. While overall operating trends continue to be challenging, Eaton showed a sequential organic improvement of about 16% compared to 2Q, which continues to support signs of recovery in most of its end markets. We expect its aerospace business will continue to be depressed with reduced commercial aircraft manufacturing volumes and aftermarket facing headwinds related to reduced flight hours. However, its largest Electrical Americas segment performed well with about 3% organic revenues growth supported by strength in residential, utilities, and data center markets.

While the magnitude and duration of the recovery remains uncertain, we expect Eaton to make prudent financial policy decisions to maintain credit metrics and liquidity appropriate for the ratings. While we expect some fluctuations in credit metrics, we expect Eaton to maintain adjusted debt to EBITDA within the 2x-3x range over the next few years. We also expect liquidity to remain sufficient with its $2 billion undrawn revolving credit facility and cash of about $429 million at the end of the September 2020 quarter and 2020 free cash flow expectation of about $2.5 billion.

  • Analytical contacts: Henry Fukuchi/Ana Lai


Emerson Electric Co. (A/stable/A-1):

"We expect the company to generate over $2 billion of free cash flow this year." 

Fallout from the pandemic severely impaired Emerson's businesses, like other industrials. However, we expect them to maintain good headroom in their credit ratios, notwithstanding a brief spike due to the $1.6 billion acquisition of OSI Inc. We expect leverage to come down closer to 1.5x by fiscal year-end 2021, supported by $300 million of restructuring actions taken by the company and a pull-back in share repurchases next year. Both their automation solutions and commercial and residential solutions segments saw sharp declines as the pandemic took hold and manufacturing ground to a halt in early fiscal Q3. However, commercial and residential solutions (CR&S) began to see a rebound in June, particularly as the hot weather precipitated stronger volumes in the North American HVAC (Heating, Ventilation, Air Conditioning) market, and broader DIY (do-it-yourself) initiatives spurred strength in tools and other home products. The residential business should continue to show some strength, and the re-opening of the economy should have its commercial segments following suit. Automation solutions' exposure to longer-cycle businesses than CR&S will have a longer time until recovery, particularly as it relates to the company's oil and gas end-market exposure. Lower global consumption of crude oil has significantly brought down oil prices and production volumes, leading the upstream industry to pull back on both operational and capital spending. We suspect maintenance spending should return; however, broader discretionary investments and production growth are unlikely to return until at least late 2021. We expect the company to generate over $2 billion of free cash flow this year, which has supported what we view as a strong liquidity position through the pandemic.


General Electric Co. (BBB+/Negative/A-2):

"A slow recovery in aviation will pressure credit metrics, but we expect improvement in 2021." 

General Electric Co.'s (GE) aviation businesses are being significantly affected by COVID-19 because the recovery in air traffic could be prolonged over several years. We expect the aviation segment to suffer a steep decline in operating performance in 2020 because travel restrictions and the economic recession caused a steep decline in commercial air traffic, hurting demand for original equipment and more profitable after-market services. Demand remain strong in the military segment, partially offsetting the steep decline in commercial aviation. GE Capital's aircraft leasing business, GECAS, also faces headwinds to earnings and cash flow in 2020 and could see an increase in delinquencies and defaults given the acute stress faced by the airline industry. Still, we expect GECAS, like other aircraft lessors, to fare better than the airlines amid the economic fallout from the pandemic given that aircraft lease payment obligations remain contractually valid, even if the planes are grounded, affording strong protection to aircraft lessors. GE's power, renewables, and health care segment should see a more modest decline and a quicker recovery than aviation. GE's power and renewable businesses are long-cycle businesses, and we expect demand to be less affected by the sudden-stop recession. Beyond the recession, we expect limited improvement in profitability in 2020 from power and renewables but this should reverse over time. The health care segment was more resilient and we expect a recovery in elective health procedures to drive improving revenue in the balance of 2020.

Significant cost initiatives and efforts to reduce working capital use should contribute to positive free cash flow in the second half of 2020. Liquidity remains strong, with a cash balance of $39 billion ($24 billion of which is industrial cash) and ample availability under its revolving credit facilities as of Sept. 30, 2020, and GE faces manageable debt maturities given recent refinancing transactions. We believe debt leverage will remain high with total adjusted debt to EBITDA exceeding 5x in 2020 due to the steep decline in profitability and significant cash burn in 2020, but we anticipate a moderate recovery in 2021 both in leverage and free cash flow. However, we anticipate a long and bumpy recovery given the challenges facing the aviation industry.


Hitachi Ltd. (A/stable/A-1):

"…increasing pressure as the company conducts significant investments and restructuring of its business." 

Hitachi has focused on stabilizing profits and cash flow through its diversified business portfolio, centered on information technology (IT) services, in our view. Nonetheless, we believe Hitachi's EBITDA will fall considerably in fiscal 2020 (ending March 31, 2021), dropping about 15% from the previous year to around ¥930 billion in fiscal 2020. The results of the first half of fiscal 2020 were more or less in line with our expectations. We assume fiscal 2021 EBITDA will only improve close to that of fiscal 2019, taking into account that a recovery in its mainstay IT service business would take time because the segment generally trails the overall economy, even on the back of earnings from the acquired power grid business from ABB Ltd.

We believe pressure on the ratings on Hitachi will mount if it fails to take measures to mitigate its financial burden. The company plans to invest heavily for growth despite the challenging operating environment. In May 2020, it completed a tender offer for Hitachi High-Technologies Corp. at a cost of about ¥530 billion, making it a wholly owned subsidiary. It also completed the acquisition of ABB Ltd.'s power grid business in July 2020 for about ¥704 billion. Accordingly, we estimate that the investments will likely weaken Hitachi's debt-to-EBITDA ratio of around 2.5x in fiscal 2020, from 1.1x in fiscal 2019. If the company continues to invest but cannot fund them through asset sales, and the prospects of a recovery in operating performance wane in the latter half of fiscal 2020 and thereafter, we think its debt-to-EBITDA ratio will likely stay above 2.0x. Given Hitachi's record of disciplined financial management, we expect it to take measures to ease the financial burden, such as selling assets to partially fund the investments. However, we believe the amount and timing of any asset sales is uncertain. Under such circumstances, the rating would come under stronger pressure.


Honeywell International Inc. (A/Stable/A-1):

"We expect Honeywell to maintain credit metrics and liquidity acceptable for the ratings." 

We expect overall operating trends to be weak in 2020 as the broad-based end-market softness continues to hinder revenue growth and earnings. While the safety and productivity solutions segment should perform well in mid-single-digits percentage area for 2020, the other segments will continue to be challenging. The repercussions from the pandemic continue to affect Honeywell's key end-markets, including aerospace, construction, and oil and gas. We are forecasting a consolidated 10%-15% topline decline in 2020 and we believe these underperforming end-markets remain challenged for the next few quarters. We expect the greatest impact will stem from its aerospace segment with sharp declines in deliveries of new commercial aircraft and aftermarket sales due to decreases in air travel. We expect the Performance Materials & Technologies (PMT) and building technologies segments will continue to be depressed but less significantly than aerospace. Nonetheless, we expect Honeywell to continue to maintain adjusted debt to EBITDA below 2.5x through 2021 and beyond despite the broad-based impacts of COVID-19 fallout hurting end-market demand. While its aerospace, PMT, and HBT segments will remain challenged during this pandemic, we expect that they should improve over the next few years--consistent with overall macroeconomic trends. We believe that the company could continue to engage in M&A during this downturn but would maintain liquidity and debt leverage that are appropriate for the ratings.


Komatsu Ltd. (A/Stable/A-1):

"…will recover its profitability in the next 1-2 years." 

We expect Komatsu will recover its profitability within the next one to two years, after a significant drop of 5 percentage points in EBITDA margin in fiscal 2020 (ends March 31, 2021) due to COVID-19 fallout and shrinking demands. We expect demand for construction and mining machinery products will remain significantly weak in its core markets such as South East Asia and North America. However, despite the difficult business environment, we expect Komatsu's EBITDA margins to recover to 12%-14.5% after a drop to 10% in fiscal 2020, remaining above its downside rating trigger of 11%. This is because we believe Komatsu's strong initiatives for reducing costs, reinforcing production and inventory management, and expanding high-margin businesses, such as sales of machinery parts and after-sales services will underpin its profitability and strengthen its resilience to downward earnings pressure. These efforts will mitigate the inherent susceptibility of demand for construction and mining machinery to economic conditions.

We expect Komatsu will maintain solid cash flow metrics for the next one to twoyears, with free operating cash flow of ¥90 billion-¥100 billion, thanks to its solid management of working capital and capex. Its debt EBITDA will recover to below 1x after a hike to 1.2x in fiscal 2020 due to a drop in EBITDA. We expect Komatsu will maintain adequate buffer for its downside rating trigger of 2.0x.


Mitsubishi Heavy Industries Ltd. (BBB+/Stable/--):

"…we believe measures to ease the financial burden, such as selling assets and reducing costs, is critical for maintaining the rating." 

We believe Mitsubishi Heavy Industries (MHI)'s operating performance and credit metrics in fiscal 2020 will be hit the most among the APAC tier 1 capital goods companies. We lowered our rating to 'BBB+' from 'A-' on MHI on Feb. 19, 2020, reflecting our view that a further delay in development of SpaceJet, a small passenger jet, is likely to keep development costs at a significantly high level, as well as the negative impact stemming from the COVID-19 pandemic particularly on industrial products, such as forklift trucks and turbo chargers for automobiles. Amid mounting challenges in the commercial aircraft business globally, in October 2020, MHI revealed its plan to freeze the development of SpaceJet, which we consider positive for near-term credit quality. However, the weaker economy is likely to lead to more pressure on industrial products and commercial aircraft business (other than SpaceJet) than we had previously assumed. In response, the company is reducing costs, including in its thermal power generation systems business, which faces a drop in orders. It has also enhanced its management of engineering projects. Despite these measures, we expect the EBITDA margin to fall below 7% in fiscal 2020, with slow recovery in fiscal 2021.

In addition, MHI will incur heavy working capital in fiscal 2020, leading to a substantially weak debt-to-EBITDA ratio (above 5x temporarily) in fiscal 2020. Given MHI's record of disciplined financial management, we expect it to take measures to ease the financial burden, such as selling assets or streamlining businesses. Nonetheless, we will consider a downgrade if the EBITDA margin does not stay comfortably above 6%, or if we believe the debt-to-EBITDA ratio will exceed and remain above 3.0x.


Mitsubishi Electric Corp. (A+/Stable/A-1):

"…will come under increasing pressure if customers' appetite for capital expenditure and a recovery in auto production remain sluggish." 

Mitsubishi Electric has a well-diversified business portfolio that has generated relatively stable profits. Even so, the pandemic hit its earnings severely. We believe pressure on its ratings will mount if the profit recovery of its industrial automation business remains sluggish from the dampened appetite for capex and a weak recovery in auto production. The industrial automation business generated around 30% of consolidated EBITDA in fiscal 2019 (ended March 31, 2020). After considerable fall in the company's EBITDA in fiscal 2020--despite significant cost reduction efforts--by about 20% from the previous year to around ¥375 billion, we assume its earnings in fiscal 2021 will improve to just below the fiscal 2019 level, supported by an economic recovery in line with our GDP forecasts. The recovery will also be underpinned by increased demand in parts of the factory automation business, such as 5G, semiconductors and lithium-ion batteries. Nevertheless, we expect the EBITDA margin to only improve to 11% in fiscal 2021, near our downside trigger.

We expect Mitsubishi Electric to maintain its very sound financial base, with its debt-to-EBITDA ratio remaining at 0.1x-0.2x in the next one to two years. The company is likely to maintain a net cash position on a reported basis and has a publicly stated policy of financial discipline with limited dependence on debt as it pursues growth. In addition, we expect Mitsubishi Electric to take a conservative approach to shareholder returns, keeping dividend levels at a manageable level.


Schneider Electric S.E. (A-/Stable/A-2):

"Resilience in the crisis, but ratings headroom is consumed by acquisitions." 

We affirmed our 'A-/A-2' ratings and stable outlook on Schneider Electric in August 2020 after the groups announced it will acquire OSIsoft through its consolidated subsidiary AVEVA Plc. On a consolidated basis, we estimate this transaction to add $3.0 billion of net debt to Schneider's balance sheet. Together with the completed €1.4 billion RIB Software transaction and €1 billion related to the pending acquisition of L&T, which we also expect to close by the end of the year, the transaction has now fully consumed the rating headroom, which existed at the beginning of the year.

Schneider Electric has shown resilience in the current crisis and we expect its performance to during the second half of the year to make up for most of the lost sales and EBITDA during early 2020. Although its topline declined during the first half of 2020 by 12.3%, compared with the same period in 2019, EBITDA margins declined only modestly, by 120 bps. Cash flow generation during the first half of 2020 remained strong, and free cash flow generation increased by 15% compared with the same period in 2019. For the full year, we expect a sales decline of less than 8% compared to 2019, and an adjusted EBITDA margin of 16.5% compared with 17.3% in 2019, which is a better performance than the expected sector investment-grade average. Schneider's operations bounced back fast after the initial lock-down phase supported by China's strong recovery. APAC is a very important regional market for Schneider with approximately 30% revenues share.

Overall, we anticipate that Schneider Electric's ratio decline will prove temporarily, with leverage around 2.5x in 2020 reducing to about 2.0x in 2021, and FFO to debt at about 30% in 2020 and recovering to more than 35% in 2021 as a result of cash flow generation and the group's announcement to put its share-buyback program on hold until further notice. Thresholds for the current rating are FFO to debt of above 30%, debt to EBITDA of not higher than 2.5x, with prudent financial management and comfortable liquidity.


Siemens AG (A+/Negative/A-1+):

"Solid performance during the pandemic, but ratings headroom is limited due to M&A." 

This past August, we revised the outlook to negative on our 'A+' ratings on Siemens AG after the company has announced the acquisition of Varian Medical Systems (VMS), a global leader in radiation technologies, for $16.4 billion. The company will finance the transaction via a capital increase at Siemens Healthineers and the issuance of about 7.5 billion in debt. In combination with the spin-off of Siemens Energy, VMS is a further step in Siemens AG's Vision 2020+ strategy for a higher-margin and less-volatile earnings profile. Given the partly debt-financed acquisition of VMS, spin-off process of Siemens Energy and operating headwinds from the pandemic-led global recession, ratings headroom is limited over the next 12 months.

During the pandemic Siemens has shown resilient performance thanks to its less cyclical segments mobility, Healthineers, and smart infrastructure. With the release of its fourth quarter results (Sept. 30) Siemens has outperformed our base case thanks to its strong cash generation in Q4. We now estimate that FFO to debt will be around 45% in FY2020 compared with 40% to 42% expected previously, down from 100% in FY2019. Primarily due to the spin-off of Siemens Energy, revenues have dropped by about 34% to €56.4 billion, like for like revenues were down 2%, and EBITDA margin improved to about 14.3% from 13.2% in FY2019. For fiscal 2021, we expect revenue growth of about 3.0% to 4.0%, with a topline of around €58 billion and improving EBITDA margin to about 15.2%. Both growth and margin improvement are supported by the acquisition of VMS (which we include on a pro forma basis), the global economy's recovery, and the execution of its large order backlog in Mobility. Combined, these factors translate into significant free operating cash flow of about €5 billion. With the cash-out from the acquisition of VMS, we estimate FFO to debt to decline to 39% to 42% in FY2021, falling temporary short of our threshold for the 'A+' rating. We expect that shareholder remuneration, in particular, share buybacks, will be carefully matched with FOCF to ensure deleveraging and FFO to debt of more than 45% by fiscal 2022.


Toshiba Corp. (BB/Positive/B):

"…if Toshiba the EBITDA margin stays above 7.5% amid challenges, we would consider an upgrade." 

Even in this difficult and competitive market, under the shadow of the pandemic, the company's core infrastructure and energy businesses are likely to remain less susceptible to the volatile economy. The EBITDA margin was about 8% in fiscal 2019 (ended March 31, 2020), up from 4.5% on the previous year. Stable performance in its mainstay infrastructure business and cost-reduction efforts helped the margin. The debt-to-EBITDA ratio, a key financial indicator, was about 1.6x, better than we had assumed. Supported by the company initiative to reduce costs and promote structural reform, we believe the profitability is likely to remain relatively stable in the next one to two years despite the pandemic and recessions. We expect the company's EBITDA to decline only 10%, and it will maintain its EBITDA margin around 8% in fiscal 2020.

Although the company will continue to make aggressive investments for growth, which will increase the debt burden and weaken its major financial ratios, the worsening of the ratio will be limited to a certain range, in our view. The company has made some progress in enhancing its governance. Still, we think its record is insufficient to determine the certainty of disciplined financial management. We will consider an upgrade if we see more likelihood that the EBITDA margin stays above 7.5% consistently, while the debt-to-EBITDA ratio remains below 3.0x. We may also consider an upgrade if the enhancement of governance strengthens business performance and stabilizes financial management.


This report does not constitute a rating action.

Primary Credit Analysts:Tuomas E Ekholm, CFA, Frankfurt + 49 693 399 9123;
Ana Lai, CFA, New York + 1 (212) 438 6895;
Makiko Yoshimura, Tokyo (81) 3-4550-8368;
Secondary Contacts:Tobias Buechler, CFA, Frankfurt + 49 693 399 9136;
Svetlana Olsha, CFA, New York + 1 (212) 438 1467;
Trevor T Martin, CFA, New York + 1 (212) 438 7286;
Michael Tsai, New York + 1 (212) 438 1084;
James T Siahaan, CFA, New York + 1 (347) 2131346;
Taishi Yamazaki, Tokyo + 81 (3) 45508770;
Chloe Wang, Hong Kong + 852-25333548;
Mikaela Hillman, Stockholm + 46 84 40 5917;
Marta Bevilacqua, Milan + (39)0272111298;
Maria Vinokur, Madrid + 44 20 7176 3727;
Henry Fukuchi, New York + 1 (212) 438 2023;

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