Despite high interest rates, U.S. economic resilience has so far prevented the worst of outcomes, but a significant rebound for speculative-grade tech issuers isn't anywhere in sight.  The U.S. Federal Reserve remains committed to battling inflation while balancing its maximum employment mandate. The policy rate is currently 5.25%-5.5% following rapid and successive rate hikes since March 2022. Given the resilience of the U.S. economy, S&P Global economists have revised their forecast and we no longer incorporate a recession into our base case. However, the Fed has indicated it will keep interest rates high for longer, which will likely dampen economic growth, as reflected by our economists' below-trend growth (below 2%) assumptions for 2024-2026.

Strong U.S. GDP growth and consumer spending has not provided a significant boost to IT spending because tech companies are still experiencing longer sales cycles and often have excess inventory. Many tech companies face additional constraints due to the increasing focus on artificial intelligence (AI), which does not benefit semiconductor and software companies across the board, and continues to crowd out traditional IT spending. Still, it may take time for AI to be widely adopted and it's likely to result in higher costs upfront ahead of any potential returns, making the selection of AI winners and losers very difficult in this early stage.

We lowered our full-year forecast for global IT spending growth in 2023 to 2.2% in June from 3.3%, even though we no longer assume a recession.   The weaker IT spending outlook reflects a slow first-half 2023 performance and a more meager second-half year recovery than we previously anticipated, which will likely hurt lower-rated issuers the most. While the Fed may decide to cut rates in 2024 if inflation subsides, we still anticipate many U.S. tech issuers--especially those rated in the 'B' category or lower, with significant variable-rate debt outstanding--to be burdened by high interest payments amid a more challenging business environment. If rates fall faster than expected due to a considerably weaker economy, we worry the fallout from macroeconomic weakness would outweigh the overall benefits of lower rates.

More Downgrades Than Upgrades

Rating distribution of issuers rated in the 'B' category or below

We expect the negative rating and outlook trends to persist into 2024 for issuers rated 'B-' and lower, mainly due to high debt service burdens, deteriorating liquidity positions, and increasing refinancing risks.   We lowered the ratings or revised outlooks to negative on 21 tech issuers across the 'B' rating spectrum this year, outpacing the eight positive rating actions in the sector. We lowered ratings on seven tech issuers to 'CCC' from 'B-' and 12 tech companies currently have negative rating outlooks. The negative rating actions and outlook revisions indicate the extent of the downside pressure on lower-rated tech companies. Of the 21 negative actions, half were outlook revisions and the other half were downgrades. We typically revise our rating outlook to negative when we believe there is at least a one-in-three chance that we'll lower the rating on an issuer within one year. Year to date, we downgraded seven companies to 'CCC+' from 'B-', six of which were preceded by a negative outlook revision. While we generally aim to assign negative outlooks as precursors to downgrades, there are situations in which negative performance or event risk is significantly different from our base case such that downgrades can occur even when there is a stable rating outlook.

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The hardware and semiconductor sectors accounted for only three negative rating actions, while the rest occurred in the software and services segments. The negative skew toward software and services is symptomatic of the highly leveraged capital structures the companies put in place when the cost of debt was significantly lower and issuers were confident that they would sustain high recurring revenue and cash flow characteristics, which were generally true. However, the rapid increase in debt service costs were unexpected. We believe these issuers have limited financial flexibility to blunt any potential business deterioration and may be reliant on favorable capital market conditions if debt refinancing becomes necessary.

Interest Coverage Becoming More Important to Ratings

Our ratings are formed through a holistic view encompassing both business and financial risk factors, including debt to EBITDA, free operating cash flow (FOCF) to debt, interest coverage ratios, and liquidity positions. Between the global financial crisis in 2008 and early 2022, interest coverage metrics were less of a risk given the low cost of debt financing. Following the rapid interest rate increases over the past 18 months, interest coverage has become strained and will likely remain weak for many lower-rated tech issuers for at least the next year or two.

When assessing whether to lower ratings to the 'CCC' category, we not only focus on an issuer's near-term cash flow generation for debt service and whether its liquidity profile is adequate, but also the long-term business trajectory and sustainability of its capital structures. We recognize that many tech issuers have issued debt at favorable financing rates. When assessing the credit profile of these issuers, we incorporate in our forecasts the likelihood of higher interest costs as debt obligations become due and refinancing becomes necessary.

Weak cash flow generation is here to stay for another year or more.   We anticipate over half 'B-' rated tech companies will see no better than breakeven or even negative FOCF generation over the next 12 months. Many companies have anticipated higher interest burdens for longer and have implemented cost-savings plans, including reductions in force. These actions are often prudent when expectations for a difficult macroeconomic environment lies ahead. Still, there may be limits to wringing out costs without notable impact to a company's growth trajectory or workers' morale. Companies may also consider asset sales or debt restructurings, which could be viewed as having negative credit implications depending on the totality of the circumstances.

For example, GoTo Group Inc., a provider of collaboration and identity management solutions, was downgraded to 'B-' from 'B', with the outlook maintained as negative. Since the leveraged buyout (LBO) in the third quarter of 2020, GoTo has underperformed expectations due to various factors including weaker demand for its heritage online collaboration offerings, sharp declines in profitability, and being victim to a cybersecurity incident, all of which led to much weaker credit metrics. Although GoTo has adequate liquidity and isn't threatened by near-term debt maturities, its financial position, with roughly $335 million of S&P Global Ratings-adjusted EBITDA, is burdened by a sizable variable-rate first-lien term loan of $2.1 billion and more than $270 million of interest expense that would lead to another year of negative free cash flow generation and a debt-to-EBITDA ratio of about 9.2x at the end of 2023. Uncertainties remain related to its financial and operational burden resulting from any restructuring actions and impact from the security breach incident.

Low-rated issuers are usually viewed as those who depend upon favorable business, financial, and economic conditions to meet debt commitments. The expectation of only modest economic growth over the next few years may temper many enterprise and consumer IT budgets and would disproportionately affect those whose products or service offerings are not deemed mission-critical.

Prevailing market trends show that inflation is declining, albeit at a slow pace, which could eventually lead to a lower federal fund rate. A lower rate could help spur IT spending, as well as lower the interest burden of many low-rated tech issuers. We are cognizant that any help from the Fed lowering interest rates may be accompanied by generally weaker business environments. In such a scenario, we find tech issuers that are better positioned to maintain pricing power to be better insulated from such deteriorating business conditions. In 2020-2022, many tech companies faced little resistance from customers when passing along higher costs due to supply chain constraints and strong end demand. Companies such as Verifone Systems Inc. and NCR ATMCo LLC, for example, were able to protect their margins through pricing hikes the past couple of years. However, we believe supply chain constraint is becoming less of a headwind and IT spending growth is not anticipated to be robust any time soon. As such, we believe it will be more challenging for tech issuers to grow their top lines, protect margins and, possibly, face difficulties with timely cash collections when dealing with small to midsize businesses (SMBs).

Refinancing Woes On The Horizon

As debt maturities draw near, refinancing and debt restructuring risks add to rating pressure.   Most of our U.S. tech issuers don't have large near-term maturities within the next 12 months. However, refinancing risk is growing for many. We've observed that current capital market conditions are less receptive for issuers that are saddled with high debt leverage and have weak cash flow generation.

Having substantial debt maturities within 12 months is not an automatic precursor to a negative rating action. For example, we maintained our 'B-' on Project Alpha Intermediate Holding Inc. (d/b/a Qlik), provider of business intelligence solutions, with a stable outlook, even though it had a $2.4 billion first-lien term loan due April 2024. We believed the company would be able to address its debt maturity given its good operating performance with high recurring revenue and positive FOCF generation supported by a strong cash position. On Nov. 2, 2023, we raised our issuer credit rating on Qlik to 'B' from 'B-' and removed the rating from CreditWatch with positive implications and assigned a stable outlook to reflect the successful execution of its refinancing transaction and its improved projected credit metrics following the recent Talend acquisition.

On the other hand, when we're less certain about a company's ability to refinance debt maturities, whether the debt is becoming current or not, it could lead to a negative rating action.   Liquidity deterioration is an increasing risk for 'B-' issuers. Weak free cash flow generation over the past year has led to deteriorating liquidity positions for many 'B-' rated issuers, leaving them more vulnerable to business underperformance and other unforeseen situations. We view liquidity to include available cash, investments, or revolver capacity.

Cardinal Parent Inc. (d/b/a Zywave), provider of insurance distribution software, has shown how a highly leveraged capital structure has become a major concern for many issuers facing the compounding effects of higher interest rates and increasing liquidity risks. On Oct. 26, 2022, we affirmed our 'B-' rating on the company and revised the outlook to negative from stable, highlighting its weakening credit metrics, particularly negative free cash flow stemming from higher rates and increasing investments to fund its growth pipeline. However, at the time, the company still had adequate liquidity to navigate under the difficult conditions. Almost one year later, on June 9, 2023, the risk of a near-term liquidity crunch and further financial underperformance led us to downgrade the company to 'CCC+', with a stable outlook. At the time of the downgrade, Zywave had only $22 million of total liquidity compared to $93 million the previous year.

Debt with payment-in-kind (PIK) features may provide some liquidity relief if allowed under existing credit agreements. For example, Solera Parent Holding LLC, provider of insurance claims software, agreed with its second-lien lenders to convert its cash interest to PIK interest for two quarters beginning May 31, 2023. It then returned to cash interest payments. This cash-pay to PIK agreement provides the company with more financial flexibility to execute its growth and cost-optimization plan. We viewed Solera's election of the PIK feature as opportunistic rather than distressed because we didn't envision any near-term payment default scenario or conventional insolvency. Additionally, second-lien lenders also received an increase in margin, which we view as adequate compensation for consenting to the terms. While these types of deals could provide near-term headroom, they also increase total debt load and force companies to quickly grow into an expanding capital structure, leaving Solera and similar companies with limited flexibility if it were to encounter further unexpected business challenges.

On a Positive Note…

Some 'B-' rated issuers have outperformed our expectation over the past year. For example, we viewed business intelligence software provider Project Alpha Intermediate Holding Inc. (d/b/a Qlik) as being at risk of a negative rating action in late 2022 when it was rated 'B-' with a stable outlook. Since then, Qlik made progress in its integration and realized business and cost synergies from its merger with Talend, which we expect will boost EBITDA generation and margins over the next few years. Qlik also announced that it will seek a $200 million revolving credit facility (RCF) and $2.4 billion first-lien term loan to refinance existing debt. We view these developments to be favorable from a credit perspective and we raised our rating on the company to 'B' from 'B-' on Nov. 2, 2023, and removed the rating from CreditWatch with positive implications and assigned a stable outlook..

Another example would be Delta Topco Ltd.(d/b/a Infoblox), provider of IT automation and security services, rated 'B-' with a stable outlook at the end of 2022. It had debt leverage of over 13x and negative free cash flow in 2022 and since then, the company's business performance improved, including better profitability and declining leverage, which provided some relief to its credit profile. While Infoblox's issuer credit rating remains 'B-' with a stable outlook, the company has mostly completed its shift to subscription on new business and its focus on higher recurring revenues will make it a more predictable business while increasing headroom under its current rating.

Earlier this year, we also considered the risk of a negative rating action to be higher for Starfish Holdco LLC (d/b/a Precisely), provider of data integrity solutions, rated 'B-' with a stable outlook, because of its high leverage of over 12x as well as its muted growth trajectory in an uncertain macroeconomic environment. Since then, the company's leverage has declined to the mid-10x area and we expect it will continue to trend lower as expense controls and cost synergies from acquired companies support its EBITDA growth and modest FOCF generation in 2023, lowering the risk that we could consider its capital structure to be unsustainable at it its current 'B-' rating.

Speculative-Grade Issuers Remain Vulnerable

Still, we do not expect significant credit profile improvement in tech issuers rated 'B-' or lower.  We believe the Fed's monetary policies will likely be effective in cooling the economy and clamping down inflation over the next few years. This could lead to interest rate cuts beginning some time in 2024, which will likely provide relief in interest burden for many of our lower-rated tech companies. In such a scenario, we would be most interested in how tech companies will fare in a below-normal macroeconomic growth environment. We expect those issuers that provide mission-critical products and services to be better positioned to weather challenging business conditions. Conversely, we would view those companies with offerings that are considered discretionary or who serve SMB customers and tend to have limited IT budgets as more vulnerable to typical patterns such as longer sales cycles or customer attrition in a weaker business climate.

For perspective, at the end of 2022, we had 10 issuers rated 'B-' with negative outlooks. Of these companies, we lowered the issuer credit ratings to 'CCC' on four of them. Currently, we have 12 tech issuers rated 'B-' with negative outlooks, reflecting our view of a greater than one-third chance of a downgrade. We acknowledge that many lower-rated issuers have not previously had to face the challenges of high interest burdens, limited capital structure flexibility, and weakening business conditions all at once. As such, we believe our negative rating bias over the past 18 months will continue.

Below, the heatmap identifies U.S. 'B-' rated technology companies that we believe are most likely to face a negative rating action within the next 12 months.