S&P Global Ratings is testing U.S. capital goods companies' credit ratios for a stress scenario, which could erode revenues and margins while elevated working capital drags on cash flow. Onshoring, energy transition, fiscal priorities, and a recovery in aerospace provide a solid baseload of demand for U.S. manufacturing, so our stress scenario is a purposeful departure from this favorable industry narrative. In total, our findings indicate about 20% of the U.S. capital goods portfolio are most at risk of a downgrade, because they are already over our downgrade ratio thresholds, and a stress scenario could worsen those ratios for another year. Another 20% of companies, potentially higher up the ratings spectrum, could face downward pressure in case of a steeper or longer downturn, but these credit stories would likely take until 2024 or 2025 to play out. About 60% of issuers' ratios would withstand our stress case comfortably in 2023 and 2024. In this report, we outline our findings.

Two Years Of Profit Recovery Provides A Buffer For Credit Ratios

Revenues and profits for U.S. capital goods manufacturers were stronger in 2022, with last 12 months (LTM) EBITDA up 5%-10% for the entire industry. We estimate aggregate S&P Global Ratings-adjusted debt to EBITDA will close out 2022 at 2.3x, slightly lower than 2.4x in 2021, even though companies used significant amounts of cash for capital investments and acquisitions.

Debt levels in U.S. capital goods were higher in 2022, up 13% since 2020 to $272 billion, and supported by commensurately good EBITDA growth. Nevertheless, this higher debt quantum could stretch leverage ratios portfolio-wide if earnings decline without a countercyclical boost in cash flow for debt reduction. We're already anticipating about 5%-10% downgrades in 2023 with our 15% portfolio-wide negative outlook bias, which is concentrated mostly among smaller speculative-grade companies.

Context is important: A one-notch downgrade for an investment-grade issuer is unusual, with only about 5%-8% of these issuers downgraded one notch in any given year (Default, Transition, and Recovery: 2021 Annual U.S. Corporate Default And Rating Transition Study May 11, 2022). For investment-grade credits, a one-notch downgrade likely incorporates a year or two of outlook horizon and some clear financial policy or strategic choices with the attendant changes in capital markets positions. A one-notch downgrade for a 'BB' category issuer is more frequent, and probably incorporates some combination of earnings volatility, persistent competitive pressure, and stretched credit ratios. A one-notch downgrade in the 'B' category is an emerging indication of capital structure strain, which could be critical as 2024 and 2025 maturities loom for 2017 and 2018 vintage leveraged buyouts (LBOs). Most companies with negative outlooks in U.S. capital goods are concentrated among the most highly leveraged issuers, which rely on the follow-through of acquisition revenue and profit synergies to improve earnings and leverage in 2023. The single 'B' category is characterized by narrow business models often exposed to discretionary end markets and relatively high debt usage.

We Have Identified Two Cohorts Of Relative Risk In U.S. Capital Goods

The sample of 45 capital goods companies we examine spans the rating spectrum and covers a breadth of activities, including the manufacture of industrial machinery and systems, heavy equipment, and electronic components; the distribution of these capital items; and equipment rental companies. This portfolio excludes aerospace and defense manufacturers specifically, even though many of these companies have significant exposure to that sector. The portfolio of capital goods issuers we rate in the U.S. amounts to more than $1 trillion of equity market capitalization and almost $300 billion of debt. We have identified two cohorts that face the highest relative risk.

Cohort 1: Stretched ratios now breach downgrade thresholds in 2023.  The 20% of companies that are above our downgrade thresholds today depend on some combination of higher earnings or debt reduction in the next year to strengthen credit measures despite economic headwinds. About half of these issuers already have a negative outlook, and they would be most exposed to downgrades if their business or financial fortunes don't improve this year in line with our base-case assumptions.

Table 1

Cohort 2: Less buffer now tests downgrade thresholds in 2024.  The 20% of companies that could breach our thresholds in a stress scenario would mostly begin with outlook revisions in 2023 if a downside emerges rapidly, with downgrades possible in 2024 or 2025. We'd probably need to see an unusually deep downturn in EBITDA of 20% that extends beyond 2023 for this group of credits to cross our downside ratio thresholds, which wouldn't happen until 2024 considering the generally good momentum today. Most of these credits have stable outlooks, so we would expect about a year of outlook revisions before downgrades if the stress scenario unfolds.

Table 2

Some credits in these two cohorts have temporarily high debt for strategic transactions, and some are experiencing an earnings lag after financing a large cyclical working capital swing. Also, our scenarios don't incorporate a variety of credit-defensive actions from issuers in a downturn, which should mute the ratio deterioration and downgrade pressure. Finally, any downside scenario would likely incorporate the countercyclical release of a shockingly large working capital investment in 2022. For a credit-by-credit breakdown of our stress scenarios, see Appendix: U.S. Capital Goods Stress Test Output.

Table 3

Once-in-a-lifetime cost rises and supply disruptions revealed good pricing power

Most U.S. capital goods companies drove their prices sharply higher through the first three quarters of 2022 to cover record input costs and boost profits. Our cohort of capital goods issuers probably grew revenue 8%-10% in 2022, which is more than 3x the 10-year revenue compound annual growth rate (CAGR) of 2.6%. However, we still downgraded several smaller companies in 2022 due to unmitigated cost increases, higher leverage, and tighter liquidity.

The FRED Producer Price Index (PPI) Manufacturing was up 17% in 2022, the fastest increase in generations (see Chart 1). By comparison, the PPI Manufacturing rose an average of only 2% from 1987-2020, because input costs had been contained by trade, technological advancements, overcapacity and easy pricing for commodity inputs, and a progressively lower cost of capital. Although the PPI All Commodities is now receding from near-record levels, the index has been up 15%-20% for almost 18 months. This mirrors historic bouts of inflation like the commodities "supercycle" of 2006-2008 (when PPI was up 17%), the oil shock 50 years ago (1972-74, 20+%), postwar reconstruction (1946-47, 35%), and an epic 40% price swing in 1917-1920 in the wake of a global pandemic. Those four waves of inflation all ended with commodity price collapses and recessions. S&P Global economists now believe there is a high likelihood of a mild recession in both the U.S. and eurozone in 2023.

Chart 1

Credit Stress Will Depend On Business Model, Competitive Strength, And Financial Cushion

Among the subsegments we cover, capital goods manufacturers will likely face the most credit stress because of typical profit pressures from higher fixed costs, demanding suppliers, price-sensitive customers, exposure to discretionary end markets, and competing substitutes. As such, we are focusing on order intake in 2023, which is holding up despite deteriorating economic indicators. Typically-good cash conversion has slowed with higher working capital, and issuers will need to sustain pricing on high-cost 2022 inventory to preserve margins as the economy weakens. Further, manufacturers' fixed costs might prove sticky this cycle, owing to higher labor retention to preserve skills and production capacity.

Distributors could continue benefiting from tight product availability and high prices for goods in our stress test, with a bit of working capital and logistics cost relief from softer volumes. Also, reduced investment for growth could conserve cash in a weaker economy. That said, lower comparable sales per location and elevated operating costs would pressure top-of-cycle profits for these lower-margin industrial distributors.

Equipment rental companies, which are generally better insulated from rising costs than manufacturers, have enjoyed a surge in profits under conditions of equipment scarcity. Higher rental rates and utilization, elevated margins on equipment parts and sales, and some constraints on outlays for new equipment have all combined to fuel a cyclical boost in earnings for equipment rental companies. Our stress scenario appears to be only a moderate credit downside for rental companies, partly because of persistent supply constraints for equipment manufacturers. On the other hand, rental companies often exhibit the industry's widest revenue volatility, so an economic slowdown could overwhelm a good secular trend of renting versus buying. Further, rental companies are consuming cyclically strong cash to grow ambitiously, planning to add billions of dollars of equipment to their fleets amid elevated prices for new assets while consolidating this fragmented sector through acquisitions. Lower rental activity from a broad-based slowdown in construction could pressure gross profits somewhat, but the real test in a downturn for distributors and rental companies might be sticky selling, general, and administrative (SG&A) costs for labor, services, and logistics, as well as debt usage for growth.

Key Stress-Case Assumptions For U.S. Capital Goods

Owing to the breadth of businesses in capital goods, we ran credit-by-credit stresses in late 2022 with a generic set of downside assumptions to gauge sensitivity to a downturn in 2023 and 2024. Our economic forecasts indicate negligible (0.1%) real GDP decline in 2023 and slow growth of only 1.4% in 2024 ("Economic Outlook U.S. Q1 2023: Tipping Toward Recession," Nov. 28, 2022). More important, perhaps, is that our economists expect back-to-back years of decline in equipment investment and nonresidential construction in the U.S.

Generally, we pushed organic revenue down 5% for investment-grade issuers in 2023 and 0% in 2024, which would represent a fast decline in revenue from the currently robust high-single-digit run-rate. This would also represent the low end of the historical range for a downturn, so we're on the lookout for a drop in orders during 2023 that could portend a more severe downturn. At the same time, we assumed a 50 basis point (bps) decline in gross margins each year with steady-to-rising SG&A costs depending on our expectations for volumes and cost makeup for each issuer. We assume good pricing power mostly mitigates still-high input costs that persist in an economic downturn, so that revenues drop less than most cycles, but enough to erode profits. These assumptions generally pushed EBITDA down about 10% year-over-year for investment-grade issuers. For speculative-grade issuers, we pushed revenue down 10% in 2023 and 0% in 2024 and stressed gross margins by 100 bps over that period, also keeping SG&A at least steady to drive EBITDA down 15%-20%, highlighting the higher volatility of profitability that we expect in these issuers.

We assume working capital measures remain elevated owing to the combination of larger inventory safety buffers and still-high input costs. Our assumptions for lower revenue still enable some countercyclical cash flow from lower working capital, but less than most cycles. Many of these issuers benefit from fairly low capital expenditures (capex) and good cash conversion, but we assume that capex remains steady year-over-year owing to the follow-through of investment plans from 2022. We assume dividends for most issuers remain fixed and that share buybacks adjust with trailing free cash flow.

Sharply higher interest rates could chill demand.

Demand for capital goods stems from interest-sensitive capital budgets and operating expenditures in a range of public and private sectors. Capital goods is a mature, cyclical industry, and revenues for the S&P 500 Capital Goods index have grown about 29% in the last decade, or a CAGR of about 2.6% since 2012. Industrywide revenues tend to stagnate or drop when economic conditions weaken, especially if interest rates rise or input costs fall. We assume the industry follows a similar late-cycle revenue and profit pattern that could lag interest rate increases and headline GDP changes by about a year, which could stress credit ratios in 2023 or 2024 (see Chart 2). In the 15 years since the financial crisis in 2007-2008, revenues and gross margins have both dropped about every four years after cycling up for 3-4 years; the industry is entering its third year of sharp improvement. In each of those recent downturns (2009, 2014, 2019, and 2020), either interest rates were rising or commodity prices dropped. Today, both are occurring sharply. More broadly, S&P Global Ratings research indicates that revenues dropped 5%-15% in the nine recessions since the 1950s, with a corresponding drop in EBITDA margin of 10%-20%, so our stress test basically replicates a normal downturn off a recent cyclical peak

Chart 2

Data from S&P Capital IQ over the last 30 years of cycles provide some benchmarks for revenue and profit performance in a downturn. These examples are not entirely representative of the U.S. portfolio, and the actual performance is obscured by factors like transformational changes. Nevertheless, each of these credit stories aligns well with the peak-to-trough volatility expectations embedded in our Industry Risk criteria. ("General Criteria: Methodology: Industry Risk," Nov. 19, 2013)

Table 4

Base Case For U.S. Capital Goods 2023-2024

Manufacturing onshoring, energy transition, and government investments support demand

Sharply higher interest rates and high costs for equipment counterbalance cyclical and secular tailwinds and could drag on public and private investment decisions in 2023 and 2024. The U.S. Inflation Reduction Act and CHIPS and Science Act combine to bolster multiyear capital spending on items like solar panels, wind turbines, semiconductor foundries, and battery plants. Even so, we remain watchful about revenue growth from new orders in 2023 even with large backlogs intact in late 2022.

Our aggregate corporate forecasts indicate that global capex could increase about 3% in 2023 and flatten in 2024. On the other hand, S&P Global economists forecast a 1% decline in real equipment investment in 2023 and 2024, coming off a cyclical peak in 2021 of 13% and about 6%-7% in 2022. The latest 'flash' purchasing managers index (PMI) data from S&P Global indicates that the fall in business activity softened to the slowest in three months, as manufacturers and service providers signaled moderations in their respective downturns. The headline U.S. PMI Composite Output Index registered 46.6 in January, up from 45.0 at the end of 2022. Also, input costs are falling, so the 2022 catalysts for higher prices and high-single-digit organic revenue growth have flattened.

Chart 3

APPENDIX: STRESS TEST OUTPUT

Appendix Table