A Midsize Hit, Compared To Manufacturing

The European building material and construction industries are suffering significantly this year due to the pandemic-induced recession but then gradually recover in 2021-2022. Still, we believe that the drop in sales should be less severe than manufacturing's (see chart 1). We note that, in several countries in Europe under temporary shutdown orders, construction activity has slowed or been suspended. Now that most governments are gradually opening up, construction is slowly resuming. We expect the recovery to be quicker in civil engineering and green residential renovation and slower in new residential construction and commercial construction.

• Cement production and consumption faced significant disruptions in those countries with mandated temporary shutdowns. We anticipate cement consumption to continue to be subdued in second-half 2020 and in 2021.
• Building products consumption has also declined due to weakened consumer confidence in face of increasing unemployment, which should hurt both building materials producers and distributors. In 2020, we anticipate subdued activity in both new building and renovation. Over 2021, a recovery should be visible in the renovation segment, also thanks to tax benefits that most governments have put in place to support the green residential construction industry.
• One segment is holding up: Civil infrastructure construction has a currently healthy order backlog, which has meant a quick return to production after the lockdown. However, due to social-distancing rules, the sector is not yet at full capacity. The pipeline for public infrastructure investment in Europe should support sustained backlogs in 2022 and beyond.

For most companies we rate, this means a revenue decline of between 15% and 20% in 2020, followed by a gradual recovery in 2021-2022. We anticipate that most companies' revenues will reach pre-pandemic levels only in late 2022. However, we highlight that our estimate has significant downsize risk, particularly if the domestic consumer recovery is slower than we anticipate and if public investments are delayed.

Chart 1

The Downturn Is More Severe In Western And Southern Europe

Construction and building materials are typically local businesses, that is, they depend on local production and demand. As such, business trends can differ significantly by country or region. This is currently evident, where the extent of the lockdowns in various European countries in March through May had a major impact on the reduction of construction activity. In fact, we observe a more pronounced drop in activity in Italy, Spain, and France, where the lockdown has been longer and more restrictive than in central, Eastern and Northern Europe. This also translates into a more pronounced drop of GDP in those countries (see chart 2). We forecast GDP in the eurozone to shrink by 7.3% in 2020, but the drop is higher in Italy (9.9%), Spain (8.8%), and France (8.0%) than in Germany (6%). In Poland, we forecast a GDP decline of 4%, significantly less than the average for the eurozone.

This corroborates the recent performance of building materials and construction companies. For example, Rexel posted positive growth in Scandinavia and Germany in first-quarter 2020 and the first two weeks of April, while sales in France and U.K. strongly contracted. Similarly, HeidelbergCement reported no or little volume decline from mid-March onward in Germany and Eastern Europe, but showed significant demand declines in Italy, France, and Spain.

Generally, we expect companies with significant concentrations of activities in Western and Southern Europe to report a weaker operating performance in 2020 than companies that are more geographically diversified or with activities largely in central and Northern Europe.

Chart 2

The Drop In 2020 Volume Is Roughly In Line With Trends During The Financial Crisis

We anticipate that the revenue decline for building material companies in 2020 will be on average between 15% and 20%, which is similar to what we observed in 2009 during the financial crisis (see chart 3). Within this segment, we anticipate a more severe revenue decline for cement producers, which had to stop production in those countries with mandated lockdowns.

We also anticipate about a 10%-15% revenue decline for our rated construction companies. This is more than in 2009, due to the production stoppage as a direct consequence of the lockdowns, but less than for building materials, reflecting rated construction companies' large exposure to civil engineering, which is suffering less than building construction, as well as geographical diversification outside Europe to regions less affected by the pandemic.

At the same time in 2020, we anticipate that EBITDA for building material companies will decline on average between 20% and 25%, and in few instances, over 30%. This is somewhat more severe than the revenue decline, due to the reverse effect of operating leverage, but better than in 2009, when it dropped by about 30% on average. The comparatively smaller decline in EBITDA in 2020 versus 2009 reflects companies' improved cost structure and lower selling, general, and administrative expenses. At the same time, we anticipate that the EBITDA decline for construction companies will be between 15% and 20%, which is moderately worse than the revenue decline.

Chart 3

The Recovery Should Be Quicker Than After The Previous Crisis

We believe the recovery of the construction and building material sector should be faster after the pandemic than after the financial crisis. We anticipate that most companies should reach pre-pandemic volumes in late 2022, whereas after the financial crisis, European construction output had declined until 2013 and only started on a path to recovery that ended in January 2020. It is worth noting that some European countries, such as Italy and Spain, have not yet reached pre-financial crisis construction volumes. In our view, a quicker recovery this time around reflects:

• The more rapid and effective fiscal stimulus taken in 2020 by both governments and the European Commission, which should support the currently healthy backlog in civil engineering, limit the reduction of employment, and allow for a recovery of consumer confidence in 2021.
• The European Central Bank's continued expansionary monetary policy, with continued low interest rates. This compares with a less effective monetary policy that the ECB adopted immediately after the financial crisis.
• Accelerated demand by households for sustainable products due to new tax incentives to support green building renovation.

Similar to after the financial crisis, we expect the rebound in residential building construction to center on renovation rather than new construction, also reflecting Europe's currently stationary demographic path. However, we highlight that our forecast has significant downsize risk, particularly if the recovery in consumer demand is slower than we anticipate or if public investments are delayed.

In our scenario, we believe the recovery will be uneven in the building material and construction sector. Those companies focused on innovative and energy-saving building products should benefit from a quick rebound, compared with traditional building products. As such, we expect companies to invest more than in the past to modernize their product offering with green and sustainable solutions to offer to construction companies. We also believe that large companies in the green building products segment have stronger balance sheets to sustain research and development costs to innovate their product offering. This imbalance may result into a new wave of consolidation and acquisitions, given that the market is currently highly fragmented.

Negative Rating Activity Has Been Largely Limited To Speculative-Grade Companies

Since the start of the pandemic, we have taken negative rating actions on about one-third of building material and construction companies in Europe, the Middle East, and Africa, largely revisions of outlooks to negative. The number and extent of rating actions in this sector are significantly less than in other sectors such as transportation and retail, hit by the pandemic. As of June 15, about 36% of ratings on EMEA building material and construction companies had a negative outlook or were on CreditWatch with negative implications, which indicates possibility of downgrades of more than one-third of the rated sector in 2020 and 2021.

Most of the rating actions we have taken were on speculative-grade companies, largely with ratings in the 'B' category. About 60% of our speculative-grade companies currently have ratings with negative outlooks or are on CreditWatch with negative implications. Those companies entered the crisis with high financial leverage following recent rounds of refinancing, which meant reduced rating headroom ahead of the downturn. Due to the reduction in EBITDA, we expect average adjusted debt to EBITDA for these companies to peak temporarily to above 7.5x in 2020, versus about 6.5x in 2019. In addition, most companies that we rate in the 'B' category are small, compared with investment-grade companies, and less geographically diversified, so more sensitive to the current downturn. For example, LSF10 Edilians (B/Negative/--) and Stellagroup (B/Negative) have been severely impacted by the consequences of the lockdown measures during two months in France, where they generate most revenues. Positively, we forecast most of the companies in the 'B' category will preserve positive but reduced free operating cash flow (FOCF) in 2020. All of them for the moment have adequate liquidity, as their debt refinancing is limited, have reduced capital expenditure for 2020, and enjoy some cash balance or committed credit lines. Companies also drew on their revolving credit facilities to secure immediate liquidity. We could downgrade companies in the 'B' category if they cannot quickly strengthen their credit metrics, if FOCF does not significantly improve in 2021 perhaps due to a harsher than recession than we anticipate, or if their liquidity position deteriorates. In addition, if losses from the pandemic are significantly higher than we expect, resulting in very high leverage with no expectation of swift recovery, we could assess some capital structures as unsustainable. In that situation, we believe the risk for distressed debt exchanges could increase and for that reason we could downgrade companies to the 'CCC' rating category. We anticipate that the number companies that could fall into the 'CCC' category to be limited.

Chart 4

The vast majority of investment-grade companies have stable outlooks. That's because they entered the crisis with solid balance sheets, due to strong operating and financial performances in 2019, combined in a few instances with the benefit of timely asset disposals. As such, they increased their rating headroom, which is helping them face the current downturn (see chart 5). We anticipate that FFO to debt should significantly weaken in 2020 and drop to about 30%, which nevertheless is significantly better than in 2009.

Chart 5

Most large investment-grade companies still display strong liquidity and some have successfully tapped the bond market in past few months to increase their cash balances. For example, in April 2020 HeidelbergCement issued a €650 million bond with a five-year maturity and a yield to maturity of 2.6%. Similarly, in March 2020 Saint-Gobain issued a dual tranche €1.5 billion bond issue consisting of €750 million tranche with three-year maturity and 1.75% coupon and a €750 million tranche with a 7.5-year maturity and 2.375% coupon. More recently, ACS, Actividades de Construccion y Servicios SA issued a €750 million bond with a five-year maturity and 1.375% coupon.

Over next few quarters, we cannot rule out negative rating actions on European large building material and construction companies if the recession is harsher than we anticipate or if they adopt aggressive financial policies before credit metrics recover, for example as a result of large debt-funded acquisitions or high shareholder remuneration.

Large Companies Have Quickly Adapted Their Financial Policy

Most large companies in the building materials segment have cut or postponed their dividends, and those with share buybacks in place have suspended them. For example, Compagnie de Saint-Gobain will not pay a dividend in 2020 given the uncertainty about the impact and duration of the pandemic and review its shareholder return policy by the end of the year. HeidelbergCement will distribute a dividend of €0.60 per share to shareholders, down from €2.10 in 2019. In April, CRH announced its decision to postpone its share buyback program until further notice; the company instead paid a cash dividend of €0.63 per share.

We estimate that aggregate shareholder remuneration of the largest building material companies has halved to less than €3 billion in 2020, down from about €6 billion in both 2018 and 2019. However, total remuneration remains above the level we observed during the 2009 financial crisis. We also note that most large groups are refraining from spending money for sizable acquisitions during the pandemic and most have cut investment capex planned in 2020. This reflects companies' increased focus on cash preservation, which is a key supporting factor for the ratings. In our view, financial policy is among the key potential drivers of future rating actions on large companies. If they turn back to more aggressive policies, embrace significant debt-funded acquisitions or higher shareholder remuneration before their credit metrics have recovered, they may put their current ratings at risk.

Chart 6

Related Research

• Hestiafloor 2 (Gerflor) Rated 'B'; Outlook Negative, May 21, 2020
• Spanish Construction Group ACS And Subsidiary Hochtief Affirmed At 'BBB/A-2' Amid Recession; Outlook Stable, May 20, 2020
• Shutter Manufacturer Stellagroup Outlook Revised To Negative On Economic Impact From COVID-19; 'B' Ratings Affirmed, April 30, 2020
• Nordic Materials Distributor Quimper (Ahlsell) Outlook Revised To Negative On Likely Weaker Demand; 'B' Rating Affirmed, April 30, 2020
• CRH PLC, April 29, 2020
• Tile Manufacturer Edilians Outlook Revised To Negative On Economic Impact From COVID-19; 'B' Ratings Affirmed, April 21, 2020
• Spain-Based LSFX Flavum (Esmalglass-Itaca-Fritta) Outlook To Negative On Economic Impact From COVID-19; Affirmed At 'B', April 21, 2020
• German Building Materials Maker Xella Outlook Revised To Negative On Weaker Revenue Prospects; Affirmed At 'B+', April 17, 2020
• HeidelbergCement Outlook Revised To Stable From Positive On Effects Of COVID-19 Pandemic-Induced Recession, April 9, 2020
• Salini Impregilo SpA 'BB-' Ratings Placed On CreditWatch Negative On Disappointing Operating Cash Flow, March 24, 2020
• Luxembourg-Headquartered Neptune Holdco S.a.r.l. (Armacell) Rated 'B'; Outlook Stable, Feb. 24, 2020