The downgrade is driven by the risk that credit metrics are expected to come under pressure amid mounting headwinds including inflationary supply-side pressures, decreasing gross profit margins, increasing leverage and an overall unsupportive macroeconomic mid-term outlook for the construction sector. KÉSZ’s good competitive positioning and solid contracted backlog remain supportive factors.
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Scope Hamburg GmbH (Scope) has downgraded the issuer rating of Hungarian construction company KÉSZ Holdings Zrt. (KÉSZ or KÉSZ Group) from BB/Stable to BB-/Stable. Based on an assigned senior unsecured debt category rating of BB the debt instrument ratings for the HUF 11bn and the HUF 22bn senior unsecured bonds were affirmed at BB.
KÉSZ Group’s business risk profile, assessed at BB-, is mainly driven by the inherent exposure to the cyclical and competitive construction industry in Hungary and higher-risk CEE countries, as well as the limited geographical diversification and high revenue concentration within the domestic construction sector (>90%). Furthermore, Scope expects that mounting inflationary pressures, building material supply disruptions and the currently dampened macroeconomic mid-term outlook will contribute to shrinking profit margins within the construction sector. Overall, we expect KÉSZ’s long-term operating profitability to develop at only modest levels (expected Scope adjusted EBITDA margin c. 7%), also in comparison with other Hungarian peers.
The expected slowdown in the construction industry follows a dynamic, in our view unsustainable, 2021/22 post-COVID recovery where marked-wide contracted volumes had increased substantially due to catch-up effects, but also fuelled by state-incentives (subsidy schemes, VAT cuts, public procurement). KÉSZ’s record high revenues were up by 40% YoY in 2021 (HUF 166.6bn) and are forecast to reach c. HUF 190bn (+14% YoY) in 2022. Side-effects of the Russia-Ukraine war such as building materials shortages, rising costs for materials, labour, energy or for prefabricated structures, capital outflows (HUF devaluation) or rising interest rates all contribute to the expected slowdown in our view. GDP growth is projected to slow to 2.5% in 2023 while the labour market is expected to remain tight, continuing to put upward pressure on real wages. A major risk is that a combination of stronger wage growth and continued high energy/commodity prices could aggravate inflation expectations and tighten monetary policy in our view.
On the other hand, KÉSZ’s rating level remains supported by the long-established market position (among top four in Hungarian construction) and KÉSZ’s vertically integrated business model with a high potential for further expansion. The market position is underpinned by a reputable project portfolio, an international presence in the CEE region and a high degree of independence from external subcontractors due to own resources covering the whole construction and civil engineering supply chain. Scope thinks that KÉSZ’s long-pursued vertical integration strategy provides barriers to entry while creating strategic benefits for accessing raw materials, skilled labour, new markets and more profitable and complex tenders.
KÉSZ’s rating level is further underpinned by a solid order backlog comfortably covering around 1.4x of annual sales, but comprising some notable concentrations risks as the top ten customers account for more than 80% of contracted volumes (top 3: > 60%). Overall, Scope highlights the very long track record of largely stable gross margins which indicates generally good project execution and cost management skills as well as adaptable operations. Besides the high exposure to domestic general construction activities, we note KÉSZ’s efforts to continuously expand into other segments and regions (e.g. energy, facades, real estate development) which is likely to benefit our diversification assessment looking forward. For example we note that the concentration of domestic general construction within KÉSZ’s order book has decreased to around 60% (2021: 80%), while the total contracted volume increased by 28% (YoY).
KÉSZ Group’s financial risk profile, assessed at BB-, mainly reflects our expectation that the amount of Scope-adjusted debt is set rise in order to finance the significant investment budget and build-up of working capital ahead. Overall, KÉSZ has a history of solid credit metrics and fairly stable current- and turnover ratios. After the 2021 first-time issuance of two corporate bonds (HUF 22bn+11bn), however, Scope-adjusted debt more than doubled, but KÉSZ Group could keep Scope-adjusted debt/Scope-adjusted EBITDA at around 3x (2020: 2.3x) thanks to a surge in operating profits. The proceeds are mainly earmarked to accelerate the group’s expansion into real estate development (residential, office, industrial), to fund the expected build-up in inventories (construction work in progress), to refinance parts of bank debt and to invest into other activities (e.g. renewables, facade construction).
Within Q4 2022, KÉSZ is heading towards a third large bond issuance (c. HUF 16bn) to fund the development of two large residential real estate projects based in Romania and Serbia respectively. This will temporally drive up leverage to levels exceeding 4x Scope-adjusted debt/EBITDA with the potential to decrease to below 3x once the recent substantial expansionary investments begin to materialize (expected from 2024/25). We treat these expectations with caution as we think that esp. residential projects pose increasing development risk and cluster risk for profit generation. Our net debt calculation is based on the assumption that c. 8% of total assets will remain accessible as available cash sources (equal to the volume reported before attraction of growth financing via bonds).
Overall, Scope is confident that KÉSZ Group is capable of achieving its medium-term targets based on the fairly solid contracted backlog providing good visibility (c. 1.4x of annual sales). Scope-adjusted EBITDA margin, however, will stay slightly below average over the near-term at around 7.0% (2021: 8.5%) in our view, while we expect interest coverage to fall to below 7x (2021: 11.8x) after full recognition of annual interest payments on the bonds. Free operating cash flow coverage (FOCF/Scope-adjusted debt) is subject to higher volatility which stems from larger-scale projects with a higher concentration of cash flow sources and their higher pre-financing (working capital) requirements. From 2022 FOCF will turn negative reflecting the high working capital needs to fund KÉSZ’s grown real estate project pipeline and envisaged investment expenditures following the substantial inflow of bond proceeds.
Liquidity is expected to remain adequate. Following the issuance of bonds, the group’s currently adequate financial flexibility rests on strong cash sources (30 Jun 2022: HUF 24.9bn), unutilised overdraft facilities (31 Jul 2022: c. HUF 3.0bn of which c. 65% EUR denominated), no major near- or medium-term debt maturities and an overall good standing in credit markets, demonstrated by solid relationships with banks and a high investor appetite for the two 2021/31 corporate bonds. Expected negative FOCF caused by the planned working capital build-up and capex expansion 2022/23 is well covered by the 2021/22 bond proceeds which benefits Scope’s near-term liquidity assessment.
No drivers in this credit rating action are considered as ESG-related factors with a substantial impact on the overall assessment on credit risk.
Outlook and rating-change drivers
The stable outlook reflects Scope’s expectation that the group is able to maintain a solid operational track record backed an adequate contracted backlog and based on strategically important near-term investments in accordance with the business plan. The outlook also incorporates Scope’s expectation that the group will maintain a prudent financial policy, notably in terms of dividend payments and expansionary investments, helping to move Scope-adjusted debt/Scope-adjusted EBITDA towards 4.0x over the next two years.
A negative rating action could occur if short-term liquidity were to worsen or if Scope-adjusted debt/Scope-adjusted EBITDA exceeds 4.0x on a sustained basis. This could be triggered by i) adverse developments in net working capital tying up more liquidity than anticipated; ii) an operational development leading to a substantial reduction of contracted backlog, profitability and cash flow levels; or iii) continued debt-funded business expansion activities.
A positive rating action is seen remote at present but may be warranted in the case of significant growth in KÉSZ Group’s size, improved geographic diversification (including outside CEE region) and an extended contracted backlog to more than 2x of annual sales. At the same time, we would expect an improvement in operating profitability to >10% Scope-adjusted EBITDA while Scope-adjusted debt/EBITDA stays below 2x on a sustained basis, which could be due to much lower working capital needs.
Long-term and short-term debt ratings
In 2021 KÉSZ Holdings Zrt. has issued two series of senior unsecured bonds under the Hungarian National Bank’s Funding for Growth Scheme (HUF 22bn – ISIN: HU0000360466 and HUF 11bn – ISIN: HU0000360870). Both series are structured as partially amortising balloon notes with a term of 10 years. Partial repayment begins from 2026 with a balloon payment of 50% at maturity (2031). Coupons are fixed and payable on an annual basis. Proceeds are being mainly used to fund the group’s business development and expansion projects. For Q4 2022, the group plans to issue a secured bond (HUF 16bn, 7 years) collateralised by a 80% public surety guarantee provided by the state of Hungary.
Scope’s recovery analysis for senior unsecured debt follows a hypothetical default scenario and is based on an assumed liquidation of KÉSZ Group’s assets, as Scope assumes the sum of the companies subsidiaries, assets and project pipeline to be of a higher value than the group as a whole. Scope’s view is driven by the relatively high level of vertical integration represented by individual companies that form part of the group. Based on our recovery analysis, Scope expects an ‘above average recovery’ for the company’s senior unsecured debt category, resulting in a BB debt instrument rating for KÉSZ’s series of senior unsecured bonds (one notch above the underlying issuer rating).
Stress testing & cash flow analysis
No stress testing was performed. Scope Hamburg performed its standard cash flow forecasting for the company.
The methodologies used for these Credit Ratings and/or Outlook: (Corporate Rating Methodology, 15 July 2022; Construction and Construction Materials Rating Methodology, 25 January 2022) are available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Scope Ratings GmbH, Scope Ratings UK Limited and Scope Hamburg GmbH apply the same methodologies/models and key rating assumptions for their credit rating services. Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Basic Principles for Assigning Credit Ratings and Other Services 8 June 2022’, published on https://scopehamburg.com/seiten/SH_Basic_Principles_July_2022.pdf. Historical default rates of the entities rated by Scope Hamburg can be viewed in the ‘Credit Rating Transition and Default Study ’ at https://scopehamburg.com/seiten/Default_Study_2022_Scope_Hamburg.pdf. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): https://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Hamburg’s definitions of default and Credit Rating notations can be found at https://scopehamburg.com/seiten/SH_Basic_Principles_July_2022.pdf. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.
Solicitation, key sources and quality of information
The Rated Entity and/or its Related Third Parties participated in the Credit Rating process.
The following substantially material sources of information were used to prepare the Credit Ratings: public domain, the Rated Entity and Scope Hamburg’s internal sources.
Scope Hamburg considers the quality of information available to Scope Hamburg on the Rated Entity or instrument to be satisfactory. The information and data supporting the Credit Ratings originate from sources Scope Hamburg considers to be reliable and accurate. Scope Hamburg does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlook and the principal grounds on which the Credit Ratings and/or Outlook are based. Following that review, the Credit Ratings were not amended before being issued.
These Credit Ratings and/or Outlook are issued by Scope Hamburg GmbH, Ferdinandstraße 29-33, D-20095 Hamburg, Tel +49 40 60 77 81 200.
Lead analyst: Matthias Peetz, Senior Analyst
Person responsible for approval of the Credit Ratings: Werner Stäblein, Managing Director
The Credit Ratings/Outlook were first released by Scope Hamburg or its predecessor on 17 March 2021. The Credit Ratings/Outlook were last updated on 26 October 2021.
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.
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