Higher Recession Risks And Rising Interest Rates Will Slow Deleveraging Prospects For Several Companies

As economic conditions worsen, we have generally lowered our forecasts for global GDP growth to 3.1% this year and 2.4% into 2023 and raised our inflation expectation. Risks around this baseline remain on the downside. Central banks are aggressively raising rates to fight inflation, and our belief is waning that such actions can avoid a sharp downturn. We now expect a mild U.S. recession in 2023, and a 50% chance for the eurozone. (See "Economic Research: Global Macro Update: Many Routes To The Bottom," published Sept. 28, 2022).

Higher interest rates for most issuers, ensuing inflationary challenges, rising wages for labor-intensive operations, high gas prices for distributors, and cyber risk for some information, payment, and technology service providers will remain key risks over the next 12 months into 2023. This will slow the pace of deleveraging assumed in our ratings (chart 1 and table 1).

Higher benchmark rates and normalization of spreads will likely end the historic run of favorable financing conditions. A rapid and volatile market repricing--affecting debt-servicing costs and funding access--would hurt lower-rated borrowers in particular. While secondary market spreads on U.S. corporate debt for 180 companies we rate in the sector (77% are rated 'B' or below) remain historically narrow, they are widening steadily.

Despite Passing Through Higher Costs, Ratings Cushion Will Narrow And Downgrades Could Increase

Within North America, only 8% of companies we rate in the sector have positive outlooks, versus 13% with negative outlooks, slightly lower than U.S. corporates as a whole at about 16%.

In 2022, we have taken 29 negative rating/outlook actions and 26 positive in North America. This trend has recently shifted to a negative bias, and we expect ratings cushion for numerous issuers (table 1) to deteriorate faster relative to their respective subsector (table 2 and 3) due to company/industry specific risks and/or a failed stress test by generating sustained negative free operating cash flow in 2023. Our stressed-case assumptions incorporate a 10% downside to EBITDA relative to our base case in addition to average benchmark rates approaching 4% by the end of 2023. In our stressed scenario, we expect persistent high inflation and supply chain and labor shortages will lead to further tightening monetary policy by the Federal Reserve (see "Global Credit Conditions Downside Scenario: Recession Risks Deepen", Oct. 12, 2022). This will reduce discretionary spending, raise cost of capital and ultimately pressure companies' profitability and free operating cash flow. Because of higher interest rates and potentially lower EBITDA relative to our prior base case, we expect deterioration in credit quality and some refinancing risk, particularly in the 'B' (68% of the portfolio) and 'CCC' (8%) categories.

Within Europe, the Middle East, and Africa, 5% of companies we rate in the sector have positive outlooks, versus only 1% with negative outlooks. Year-to-date rating actions have been more positive, suggesting that recovery from COVID-19 has prevailed over recession risks.

Table 1

Chart 1

Chart 2

Chart 3

Chart 4

Key Sector Assumptions For 2022-2023

Demand remains steady within the business and technology services sector, and we expect it to report mid-single-digit percentage organic revenue growth in 2022 aided by increased market penetration, stable retention rates, cross-selling, and higher pricing for many companies. Companies will mostly pass inflationary cost pressures to end customers by year-end, although intrayear earnings volatility is likely as price increases are gradually reset. We expect steady margins for several companies given the digitalization of their workflow/services and lower staffing requirements, partially offset by inflationary pressure. Several issuers also can quickly reduce idle capacity in their labor forces, which aids near-term earnings visibility. A few issuers, especially in the U.S., have also cut capital expenditure modestly to adjust for the lower backlogs or order delays. Lower-rated companies have sharply cut mergers and acquisitions (M&A), although more highly rated companies remain active. This also limits upside for several issuers' competitive positions with niches in highly fragmented sectors because they depend on inorganic growth to expand their breadth of offerings and geographic presence. Our stressed-case assumptions incorporate a 10% downside to EBITDA relative to our base case in addition to average benchmark rates approaching 4% by the end of 2023.

Chart 5

Global Outlook And Trends Are Mixed For Some Subsectors

The overall rating outlook for the sector remains stable (albeit with an increasing negative bias) due to strong demand for outsourcing noncore competencies, automation/digital transformation, and data/analytics. As global GDP weakens and the U.S. enters a recession, we believe companies that generate high-quality revenues will be best positioned to maintain credit quality.

Recently, we reassessed the revenues for each company by analyzing the mission-critical nature of service, revenue type (transaction versus contracted), renewal rates, and diversification (customer and end market). Combined with our assessment of inflation and labor market risks, we believe distributors and facilities maintenance providers are most vulnerable to downside risks. Conversely, we believe the impact from these developments on software, information services, security and safety, and human capital management will be minimal. Lastly, several issuers in the 'BB-' and 'B+' categories enter the U.S. recession with low leverage and higher free operating cash flow (FOCF) to debt than the corporate average.

Table 2

Table 3

Distribution services

This subsector serves many end markets, with retail, energy, and discretionary-like segments hardest hit by the COVID-19 pandemic and most vulnerable to weakening GDP. Rising gas prices and wage inflation for distributors could impair near-term operating performance. For distributors tied to promotional products such as CB Poly Investments LLC and Halo Buyer Inc., we expect operating performance to remain challenged as enterprise marketing spending declines and supply chain disruption hinder growth prospects. Given slowing growth in the quick-service and casual dining restaurant segments, we expect companies such as Double Eagle Buyer Inc. (d/b/a Restaurant Technologies) and BCPE Empire Holdings Inc. (d/b/a Imperial Dade) to face additional pressure in strengthening organic revenue growth in 2023, with higher reliance on new customer wins, upselling services, and price increases. We expect distributors with well-balanced end-market and geographic exposure such as Bunzl PLC to be resilient to the macroeconomic downturn and take advantage of clients' increasing focus on hygiene and sustainability.

Facility maintenance

This subsector includes companies providing heating, ventilation, and air conditioning (HVAC), insulation, and other technical services. We expect recession risks to pressure revenues and earnings for building materials contractors into 2023 as the housing market cools and they run through record high backlogs. Homebuilding contractors continue to benefit from contracts signed prior to mortgage rates rising. We believe the number of homes under installation plus permitted starts suggests about 12 months of backlog at the current pace of completions. However, we expect revenue softness sooner because homebuilders may put projects on hold in uncertain macroeconomic times ("How U.S. Building Material Contractors And Mortgage Servicers Are Navigating Market Volatility", published Oct. 19, 2022).

As a result, for national scale players including Installed Building Products Inc. and TopBuild Corp., we expect adequate rating cushion to weather modest near-term pressure on residential construction demand as long-term fundamentals support steady operating performance in 2023. We expect working capital usage even as growth rates diminish in 2023. For instance, TopBuild also holds greater-than-typical inventory partly because the supply of fiberglass, the most common type of insulation, remains constrained. Performance of some companies with lower ratings, such as Legence Holdings LLC (formerly d/b/a Therma) and Saber Intermediate Corp. (d/b/a Service Logic), has been resilient. We expect strong top-line growth in 2022 due to large acquisitions and ongoing demand for commercial air filtration, HVAC, and refrigeration services across end markets including mission-critical facilities (such as hospital, government, and education buildings). Conversely, operators such as CoolSys Inc. and Thermostat Purchaser III Inc. (d/b/a PremiStar, formerly Reedy) have already reported deteriorating EBITDA margins and likely to remain depressed through 2023 due to supply chain disruptions and high labor and fuel costs into 2023.

Though a large portion of the demand is nondiscretionary over the next two years, we expect project pipelines to remain vulnerable to customers postponing large-ticket repairs such as roof replacements with smaller repair jobs. New construction projects will decelerate to the mid-single-digit percentage in 2023 and nonresidential and residential investment will likely drop by double digits as economic uncertainty and rising interest rates weigh on demand and elongated building cycles slow the pace of construction. Delaying maintenance work often leads to other issues (leaks, breaks, and wear and tear) that can result in more complex job orders, potentially aiding the pace of recovery in 2024.

Commercial services and supply chain

We expect the structural shift in demand for office services and corporate employee relocation since the height of the pandemic to be ongoing headwinds. However, for companies such as Staples Inc. and Sirva Inc., we expect a sustained recovery supported by market share gains and cost-saving initiatives. Cleaning and laundry facilities management services, which are largely nondiscretionary, have shifted investments to digitize machines from scale-driven M&A. While we anticipate wage and commodity inflation to represent near-term pressure on earnings for laundry and linen rental service providers Spin Holdco Inc. (d/b/a CSC ServiceWorks), WASH Multifamily Acquisition Inc., and Elis S.A., these companies can leverage their procurement efficiency, which stems from their sufficiently large scale to offset these pressures as they continue to increase revenues.

The outsourcing trend will continue to support cleaning and integrated facility services providers' activity when cost savings and hygiene are an increasing point of focus. Nondiscretionary service providers such as Belfor Holdings Inc. and to a lesser extent W3 Topco LLC (d/b/a Total Safety) should benefit from a stable operating profile despite rising input costs, as most of the work is conducted on a cost-plus-markup basis. Information storage providers such as Iron Mountain Inc. and Access CIG LLC should benefit from relatively stable organic volumes in 2022, with strong retention rates and growth in digital solutions and secured information technology asset disposal that has helped exceed service revenues compared to pre-pandemic levels without a full recovery of traditional services (shredding, collection, etc.). We believe these companies will increasingly rely on acquisitions toward industry consolidation along with price increases and market share wins in their traditional businesses. They will also continue to invest in digital record management capabilities to position themselves as the industry shifts. Food service providers present a mixed picture. Although they all benefit from on-site volume recovery since the worst of COVID-19, ability to pass through food and wage cost inflation differs across the industry, especially with country-specific contract features. Margin pressures may be more moderate for global players such as Sodexo S.A. or Compass Group PLC than for Elior Group S.A., which generates about 45% of its revenues in France.

Human capital management

These providers are particularly sensitive to decreases in economic activity and employment. The U.S. labor market remains healthy, however recent August job openings and layoffs indicate the tight market is beginning to loosen. With the federal funds rate moving from near zero in early 2022 to over 4% by early 2023, we expect wage inflation to normalize only by the second quarter of 2024. Our outlook of stable to positive for companies in the subsector reflects our view that the tight labor market will on balance lift operating performance and credit metrics. Human capital management includes payroll and human resources software vendors, benefits administrators, background screening providers, and professional employee organizations that offer fully outsourced human resources services to small- to mid-size businesses.

Most industry revenue models are directly related to payroll volumes processed or to customers' employee counts, which positions industry sales to benefit from rising wages and declining unemployment rates. Job opening estimates indicate labor demand remains elevated. We believe this will further accelerate hiring and the digital transformation of human resources to attract, reward, and retain employees. Global supply chain constraints and raw material inflation are not likely to affect the sector, although a modest rise in operating expenses in step with higher labor costs could offset revenue growth trends.

Consulting and professional services

We expect this subset of companies to maintain stable client retention and steady creditworthiness in 2022 following robust performance in 2021. Revenue has broadly increased, including companies with high exposure to increasing regulatory requirements supporting the adoption of energy-efficiency programs, for instance CRCI Longhorn Holdings Inc. (d/b/a CLEAResult). However, execution challenges at KAMC Holdings Inc. (d/b/a Franklin Energy) indicate the ability to pass on increasing costs to customers could get challenging. Franklin's energy-efficiency program revenue, which spans both the services and products segments, has some contracts based on fixed fees or performance with limited price escalators. As a result, we expect profitability challenges to persist for the remainder of 2022 into 2023 despite permanent cost cuts during the pandemic.

Following record-breaking volumes in 2021, residential real estate-based service providers such as Anywhere Real Estate Group LLC and RE/MAX LLC face a housing recession given high mortgage rates and price increases in 2022. Similarly, volume growth could slow for fund administration and corporate services providers such as TMF Sapphire Midco B.V., but a high share of recurring services limits downside risk. Finally, we expect low impact from a potential recession on audit, tax, and accounting services companies due to their nondiscretionary nature. Demand for professional consulting services should be supported by countercyclical segments such as bankruptcy and restructuring consulting services.

Outsourced business and information technology services

Spending is highly correlated to global GDP, so a severe and lengthy recession in the U.S. could hurt tech companies' performance, more so in hardware than software services. Slower enterprise spending, potentially in reduced data center investments, would be a signal for the entire sector. A shallow recession, however, may only lead to delayed--rather than cancelled--purchases. Large projects, such as enterprise resource planning, software implementations, and consulting engagements remain solid in 2021 and 2022 after delays in 2022. We expect large information technology services vendors such as Accenture PLC to report mid-single-digit percentage growth in 2023 aided by strength in these areas. Similarly, after demonstrating solid resilience through COVID-19, outsourced customer relationship management companies such as Teleperformance SE have enjoyed strong commercial momentum through first half of 2022. For all these businesses, a significant backlog reflects a heightened need for digital transformation projects (that tend to be faster expanding and higher margin) and a lack of labor supply onshore and offshore. We expect this trend to continue through 2023 and some pressure from small and midsize business clients for which the sales cycle might get elongated as they enter recessionary conditions.

Because the pandemic highlighted the importance of remote work, businesses found they needed to make structural changes to enable a hybrid work environment. This led to more work orders and engagement with information technology vendors to redesign operating environments, optimize usage of private and public cloud infrastructure, application modernization, and automation. We expect these projects to span multiple phases because implementation periods tend to be long and involve the development and modernization of front-end applications and back-end platforms across areas such as customer engagement, cloud, artificial intelligence, big data, analytics, and cyber security. Additionally, heightened cyber security threats and awareness will likely increase information technology budgets. Revenues increased for Escape Velocity Holdings Inc. (d/b/a Trace3), Tenable Holdings Inc., and Optiv Inc. on these trends. However, over the last 12 months, a dearth of certain components has delayed their ability to complete jobs. Since firms typically cannot bill the customer and collect cash until the job is finished, this is temporarily hurting free cash flow. Looming risks in 2023 will be their ability to navigate labor supply challenges while utilization, attrition, and wages are high.

Information services/software/payment

The landscape for this subsector is stable to positive with predictable revenues and further EBITDA margin expansion opportunities. Credit risk factors include balancing the use of free cash flow toward debt reduction and shareholder returns, which have accelerated. Large providers including Fidelity National Information Services Inc., Fiserv Inc., Global Payments Inc., MSCI Inc., and Experian Finance PLC will continue to benefit from solid recurring revenue mix and operating leverage. The ratings on most of these issuers hinges mostly on financial policy and the commitment to keeping leverage at or below 3x while they pursue acquisitions and/or buybacks. We also expect payment processors to continue investing in omnipayment software to service their large network of merchants, enterprises, and financial institutions through both organic and inorganic means.

Companies with significant revenues tied to mortgage servicing face pressure over the next 12-18 months amid rising interest rates. Consumer credit bureaus such as Fair Isaac Corp. (FICO), Equifax Inc., and TransUnion capitalize on large datasets and analytics that support effective decision-making. They have executed well in recent years. They have products that are well integrated into their clients' workflow systems, and we continue to expect strong organic growth in this sector into 2023. For instance, Equifax's year-to-date non-mortgage verticals (including U.S. verification for talent, government, and consumer lending) have increased revenues in double-digit percentages. We expect this to continue into 2023. We expect FICO's entrenched scores business to rise 10%-15% due to future price increases targeted toward insurance, health care, and international end markets. Nevertheless, M&A activity has picked up, and debt-funded acquisitions (often with EBITDA multiples well above 20x) will likely slow the pace of deleveraging. We expect software service providers such as Verint Systems Inc. to report solid revenue and gross profit growth with cloud-based solutions adoption. This should support an acquisitive growth strategy funded with cash and debt to compete against larger and faster-expanding competitors.

Insurance services

This subsector includes companies that predominantly service the insurance sector, including brokers, claims and warranty administrators, and insurance cost containment providers. Revenues across the portfolio are generally tied to underlying insured exposure trends, which in most lines such as commercial property and casualty insurance continues to benefit from favorable insurance pricing as carriers seek rates to contend with a rising loss cost trend. In addition to keeping insurance pricing firm, inflation increases insured values on various lines, which ultimately translates to higher commission and revenues for brokers. We believe the benefits of favorable insurance pricing and inflation will more than outweigh any top-line pressures related to an economic slowdown, particularly given that most insurance service revenue streams are nondiscretionary (consumers are often required to purchase insurance by law, boards, and counterparties, etc.). Accordingly, we expect healthy organic revenue growth trends across most of the space over the next year, supplemented by a robust M&A pipeline that has continued given market fragmentation and strong demand for insurance service-related assets.

In terms of bottom-line performance, a tight labor market and wage pressures in a largely people-driven business, in addition to continued creep-back in travel and entertainment expenses as the pandemic subsided, create modest expense headwinds. But a large variable expense component (as most broker producers are compensated on the revenue they generate), continued operating leverage, and efficiency enhancements will likely result in a relatively stable margin trend over the next year.

Trends of course will vary by company and subsector. We believe insurance brokers, the largest subset among sector companies we rate, will fare the best given the generally stickiest revenue streams, a factor that has resulted in a history of generally solid performance during prior downturns. Conversely, the greatest pressure will likely be felt by warranty administrators, which tend to have more concentration in discretionary product with greater ties to consumer spending and supply chain disruption. Notwithstanding, favorable attachment points, more focus by sales representatives on warranty sales, and diversification into ancillary products somewhat mitigate the macroeconomic headwinds.

Security and safety services

This subsector includes private security, cash-in-transit, alarm monitoring, and prison operators. We expect the global security installation and servicing market to expand faster than GDP, in the 5% area. In our base case, U.S. labor and global supply chain risks are unlikely to significantly affect gross margins in 2022, however we expect this to be a larger issue for companies such as Allied Universal Topco LLC. Being the third-largest employer in the U.S., the tight labor market has hurt employee turnover and increased nonbillable overtime wages after benefiting in 2020 from COVID-19 screening services, lower wage pressures, and higher unemployment rates.

Additionally, several factors supported organic growth over the past two years for some segments. For example, residential alarm providers benefited from lower attrition (as move-related disconnections declined), fiscal stimulus, the support of residential and commercial owners in paying their ongoing monitoring fees, and the increased deurbanization and work-from-home trends. These companies, which typically generate relatively low FOCF due to the large capital expenditure needed for customer acquisition, also recorded better cash flow dynamics as the industry adopted third-party financing models. For instance, APX Group Holdings Inc. (a/k/a Vivint) generated positive free cash flow in recent periods. We expect this to continue in 2022 as it approaches scale required to drive sustainable cash flows despite annual customer attrition. On the other hand, Monitronics International Inc. (d/b/a Brinks Home Security) continues to face liquidity risks with nearing debt maturities. Some of these companies will likely pursue aggressive debt-funded M&A that elevate leverage and constrain FOCF. Securitas AB increased leverage above 4x in 2022 with its debt-funded acquisition of security business Stanley, triggering a downgrade to 'BBB-'.

Appendix

Table 4

Table 5

Table 6

Table 7

Related Research

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