- Deteriorating earnings and margins could impair credit quality in the next year as consumer pullback on spending and limited ability to pass through cost increases.
- Aggregates issuers are more resilient than those exposed to discretionary products and new construction due to more favorable outlook on nonresidential spending.
- Higher interest burden from exposure to floating-rate debt could pressure interest coverage metrics and tighten liquidity.
- About 50% of rated building materials issuers are rated in 'B' category, and 9% are rated 'B-', reflecting a high portion of sponsor-owned companies.
- Debt maturities appear manageable until 2027 due to proactive refinancing in last few years.
A deterioration of margins and earnings will impair the building materials sector's credit quality.
Under S&P Global Ratings' base-case forecast, tailwinds from increased home investment, heightened repair and remodel spending, and new homebuilding activity that began during the second half of 2020 are tapering off in 2023. We expect modest declines in revenue (about 5%-10%) and narrowing profit margins with EBITDA declining in the 10%-15% range for the rated building materials sector due to slowing demand for home repairs and construction. We also expect margins will be under pressure in 2023 as commodity, labor, and delivery costs remain constraining factors. While 95% of the outlooks in the rated portfolio are stable as of May 8, 2023, we expect a growing negative rating bias in the next year as the sector faces weaker earnings and higher financing costs.
Our U.S. GDP growth forecast still calls for a shallow recession, but increased credit tightening, stemming from recent events in the banking sector has increased downside risks to our forecast. We expect the prolonged effect of inflation and elevated interest rates to pressure consumer discretionary spending on remodeling and renovations, while a rapidly cooling housing market adds pressure to the top line.
Overall, we expect repair- and remodel-exposed companies to be relatively less volatile than those exposed to new housing. However, discretionary consumer spending levels could affect demand for some higher-value building products such as cabinetry and bath fixtures. Revenue across the portfolio has been generally strong in recent years, but we expect decelerating growth and flat to low-single-digit revenue declines for the sector with commodity-based companies falling more sharply. According to the LIRA Index (Leading Indicator of Remodeling Activity published by the Joint Center of Housing Studies by Harvard University), year-over-year expenditures for homeowner improvements and maintenance will post a modest decline of 2.8 percent through the first quarter of 2024. We also expect total housing starts to be about 1.2 million units in 2023, a decline from 1.6 million in 2022 as the housing market rapidly cools down in response to sharply higher mortgage rates.
Despite weaker demand from the consumer, we expect an increase in nonresidential spending from investments in infrastructure to temper some of the declines in the cyclical residential end market. Indeed, we think issuers with exposure to the aggregates segment will remain more resilient compared to those exposed to discretionary products and new home construction. The Biden administration's $1.2 trillion infrastructure bill from November 2021 includes investment in roads, bridges, water systems, electricity grids, broadband, and health care. We believe the bill will result in an uptick in nonresidential spending with the market reflecting federal investments modestly in 2024.
We expect interest rates will stay higher for longer, pressuring credit metrics as demand slows.
The recent turmoil in the banking system could tighten access to credit, adding to downside risk and chances for a worsening recession. However, none of our issuers appear to be overly exposed to regional or challenged banks. We continue to expect a shallow recession in 2023 followed by a period of slow growth. S&P Global economists expect the federal funds rate to peak at 5.00%-5.15% by May of 2023. While the Fed raised rates by 25 basis points (bps) in March, and we expect another 25 bps hike in May as they continue to tame inflation, the trajectory of further rate hikes remains uncertain. As prices begin to stabilize, we expect the first rate cut in mid-2024.
We expect rising interest rates to contribute to weaker cash flow credit metrics this year, including EBITDA to interest coverage, resulting in potential outlook revisions or downgrades in the next year if performance is weaker than we expect. About 50% of building materials issuers are rated in the 'B' category given the high level of private equity ownership, which generally have aggressive financial policies and highly leveraged capital structures. Our ratings at the 'B' and 'B-' threshold generally place a greater focus on liquidity and capital structure sustainability. Companies at the highest risk for a downgrade are those exposed to rising debt service costs while simultaneously facing slowing demand, supply chain challenges, and higher costs for other inputs that collectively threaten to constrain cash flow and render debt burdens unsustainable.
We expect a higher interest burden from exposure to floating-rate debt to pressure interest coverage metrics given there is limited hedging protection for variable-rate debt. As credit underwriting standards tighten, issuers with highly leveraged capital structures may face challenging refinancing conditions. Higher borrowing cost and tighter access to credit could strain liquidity for issuers facing near-term debt maturities.
Lower-rated building materials issuers with high exposure to floating-rate debt or upcoming debt maturities face increasing downgrade risk.
We currently have nine ratings (or 15% of the rated building materials sector) at the 'B-' level. We believe these ratings face increasing downgrade risk given the potential for weaker operating results and cash flow pressure, in addition to narrowing credit cushions relative to downgrade triggers. Given their highly leveraged capital structures with expected average debt to EBITDA of 8x in 2023 and 2024, their capital structure may become unsustainable in a downturn where performance is more pressured than we anticipate. A large percentage of the capital structure is comprised of floating-rate debt, which could pressure credit metrics in the next 12 months given currently higher interest rates and limited hedging of rate exposure. However, there are no meaningful debt maturities over the next two years as many of our issuers rated 'B-' refinanced their capital structures and took advantage of lower interest rates in the past few years. As a result, maturities are pushed out, with maturity walls starting in 2027 with about $6.8 billion due 2027 and $6.9 billion due 2028. While we view the liquidity of issuers rated 'B-' as largely adequate, we see downside risk in free cash flow generation. As operating performance weakens, some issuers may face thinning covenant cushions. Still, with reduced investments in working capital due to slower conditions and deflating commodity costs, these companies could generate better free cash flows and support liquidity in the near term.
We therefore expect most of our 'B-' issuers will maintain stable outlooks over the next 12 months given limited refinancing risk, adequate liquidity, and despite modest pressure on operating performance and high exposure to floating-rate debt. Still, we will continue to monitor building material issuers' performance in a slower economic growth landscape, especially leading up to debt maturities for refinancing.
|Building materials companies outlooks|
|Companies rated 'B-'|
|Company||Outlook||Downside Scenario||Upside Scenario|
|Stable||We could lower our rating if: we viewed the company's debt load to be unstainable, as characterized by leverage near or above 10x EBITDA, EBITDA to interest meaningfully below 2x, or negative free operating cash flow; inflationary pressures or a U.S. recession caused demand for kitchen and bath cabinetry to drop substantially; or the company's financial sponsor's dividend policy is far more aggressive than currently anticipated.||Although unlikely given current debt levels, we could upgrade ACProducts over the next 12 months if: leverage falls below 6x of EBITDA with management's and the sponsor's intent to maintain this ratio; price increases are higher and occur more quickly than we anticipate; and capacity streamlining results in meaningful cost savings.|
Apex Tool Group LLC
|Stable||We could lower the rating if: commercial construction declined or input costs increased, resulting in EBITDA so low that debt leverage rose above 9x and EBITDA interest coverage moved closer to 1x; we viewed the company as vulnerable and dependent on favorable business, financial, and economic conditions to meet its financial commitments; or the issuer's financial commitments appeared to be unsustainable in the long term, but the issuer might not face a credit or payment crisis in the next 12 months.||We could raise the rating if: the company were able to reduce S&P Global Ratings-adjusted leverage metrics to below 7x and maintain interest coverage above 2x on a sustained basis; and we believed there would be commitment to maintain leverage at or below that level.|
CP Atlas Buyer Inc.
|Stable||We could lower the rating if: we view its capital structure as unsustainable, exhibited by S&P Global Ratings-adjusted leverage rising above 8x or EBITDA interest coverage trending toward 1x; (This could materialize in a severe downturn such that demand for the company's products drastically declines or higher-than-expected input prices cannot be passed on, compressing margins for a prolonged period.) or the company maintains an aggressive financial policy, for instance, using debt to fund additional distributions or acquisitions and thereby deteriorating leverage to over 8x on a sustained basis.||We could raise the rating if: demand conditions are better than expected such that higher earnings and margins improve S&P Global Ratings-adjusted leverage to under 6x; and the financial sponsors commit to maintaining leverage below 6x permanently.|
|Stable||We could lower the rating if: we viewed the capital structure as unsustainable, exhibited by S&P Global Ratings-adjusted leverage deteriorating toward 10x, EBITDA interest coverage trending lower than 1x, or free cash flow turning negative; (This scenario could materialize if demand slowed down faster than expected or higher-than-expected input prices that could not be passed on compressed margins by more than 300 basis points.) liquidity weakened because of tighter covenant headroom; or the company maintained an aggressive financial policy--for instance, using debt to fund distributions or acquisitions--thereby keeping leverage elevated.||Although unlikely, we could raise the rating over the next 12 months if the company outperformed our base case scenario, resulting in S&P Global Ratings-adjusted leverage of below 6x, and we believed the financial sponsors were committed to maintaining it at this level.|
LBM Acquisition LLC
|Stable||We could lower the rating if: we view the capital structure as unsustainable, exhibited by S&P Global Ratings-adjusted leverage deteriorating toward 10x, EBITDA interest coverage trending closer to 1x, or free cash flow turning negative; (This could occur in case of a severe recession, drastically slowing down demand for the company's products or compressing adjusted EBITDA margins to below 8%.) or the company continues pursuing large debt-funded acquisitions or dividends that result in deteriorating credit measures.||We could raise the rating if: the company outperforms our base-case scenario such that S&P Global Ratings-adjusted leverage improves to below 6x, and we view it to be sustained, even in a potential housing downturn; and we believe financial sponsors are committed to maintaining it at this level.|
Park River Holdings Inc.
|Stable||We could lower the rating over the 12 months if: we view the capital structure as unsustainable, exhibited by S&P Global Ratings-adjusted leverage deteriorating back toward 10x, EBITDA interest coverage remaining below 2x, or free cash flow turning negative; a severe downturn such that demand for the company's products drastically declines, compressing margins by more than 100 bps, or forecast earnings synergies are not realized; or the company maintains an aggressive financial policy such as funding distributions or acquisitions, keeping leverage elevated.||Although unlikely over the next 12 months, we could raise the rating if: earnings are stronger than our base-case scenario, resulting in S&P Global Ratings-adjusted leverage lower than 6x, and we expect the company will maintain this level; the company achieves the targeted synergies faster than expected and has a higher-than-expected pass-through cost; and the financial sponsors commit to maintaining leverage below 6x.|
Sabre Industries Inc.
|Stable||We could lower the rating if: the company's liquidity deteriorated such that liquidity uses exceeded sources and we viewed a covenant breach under its revolving credit facility to be likely, and we came to view Sabre's capital structure as unsustainable; or Sabre's S&P Global Ratings-adjusted EBITDA interest coverage were to be sustained below 1x and S&P Global Ratings-adjusted debt to EBITDA were to be sustained above 12x without a path toward improvement.||We could raise the rating if: S&P Global Ratings-adjusted debt to EBITDA trends toward 6x, an unlikely event over the next 12 months given high debt as of Jan. 31, 2022, which would imply a 60% increase in EBITDA generation in 2023; we believe sponsor Blackstone is committed to maintaining a more conservative financial profile; and increased scale results in over $1 billion of sales, with EBITDA margins sustained in the low- to mid- teen percent range.|
SRS Distribution Inc.
|Stable||We could lower the rating if: we believe its financial commitments appear unsustainable in the long term and anticipate it will depend upon favorable business, financial, and economic conditions to meet its financial commitments; (For instance if SRS reports lower-than-expected S&P Global Ratings-adjusted EBITDA margins of well below 10%, which causes it to sustain S&P Global Ratings-adjusted leverage of more than 9x or EBITDA interest coverage trending toward 2x. This could occur if its demand slows or it faces elevated inflation that it is unable to pass through to its customers, causing its margins to decline.) or the company maintains an aggressive financial policy, including pursuing large debt-funded acquisitions, such that its S&P Global Ratings-adjusted leverage remains above 9x on a sustained basis.||We could raise the rating if: the company's EBITDA improves such that it maintains S&P Global Ratings-adjusted leverage of 5x-6x; and SRS and its financial sponsors commit to maintain this improved level of leverage.|
Cook & Boardman Group LLC (The)
|Stable||We could lower the rating if: liquidity continues to deteriorate such that its covenant cushion tightens further; we view the capital structure as unsustainable, exhibited by S&P Global Ratings-adjusted leverage deteriorating further such that EBITDA interest coverage approaches 1x or free cash flow remains negative; or the company pursues large debt-funded acquisitions or dividends that result in leverage trending higher than our base-case assumption.||We could raise the ratings over the next 12 months if Cook & Boardman outperforms our base-case assumptions such that it decreases and sustains S&P Global Ratings-adjusted leverage below 7x; the rebound in commercial construction occurs faster than we anticipate such that EBITDA increases 8%-9% from our base-case assumption; and the company directs free cash flows toward debt reduction over acquisitions.|
|Source: S&P Global Ratings.|
This report does not constitute a rating action.
|Primary Credit Analysts:||Tennille C Lopez, New York + 1 (212) 438 3004;|
|Nidhi Narsaria, Englewood + 1 (303) 7214666;|
|Ana Lai, CFA, New York + 1 (212) 438 6895;|
|Secondary Contacts:||Maurice Clark, New York + 212-438-0029;|
|Mckall Mattis, Englewood +1 3037214121;|
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