U.S. lodging, leisure, and gaming were among the first sectors to suffer blows from the coronavirus pandemic back in February. With travel bans, stay-at-home orders, and restrictions on consumer activity, many issuers had to adjust to zero- to low-revenue and ongoing cash burn for most of the second quarter. As a result, we've downgraded more than two-thirds of the U.S. lodging, leisure, and gaming companies we rate and we currently rate 31% of issuers in the 'CCC' category or below (see chart 1).

Here, we summarize the rating actions we've taken to date and our view of the "new normal" given the potential for longer-term industry disruption. Additionally, with 36% of ratings still on CreditWatch, and another 54% with negative outlooks, we address some of the credit factors that could trigger additional negative rating actions, outlook revisions, or affirmations.

Chart 1

Investment-Grade Issuers On The Fallen Angel Cusp

U.S. lodging, leisure, and gaming investment-grade issuers haven't been immune to ratings pressure, with nearly 45% experiencing single- or multi-notch downgrades due to significant spikes in leverage in the face of steep revenue and EBITDA declines. Nearly all investment-grade issuers have raised debt in 2020 to provide average liquidity runways of 12-18 months in the event of prolonged disruption. While incremental borrowings have addressed immediate liquidity concerns, debt funding has come at higher prices, and will make it more difficult for issuers to restore credit metrics to pre-pandemic levels in the event of a slow and prolonged recovery.

As of June 30, the sector has had two fallen angels; that is, an issuer dropping from a 'BBB-' or higher investment-grade rating, to a 'BB+' or below speculative-grade rating. Currently, 67% of lodging, leisure, and gaming investment-grade issuers sit on the cusp of this category. Both fallen angels were in the cruise industry, with Royal Caribbean Cruises Ltd., dropping to a 'BB' rating from 'BBB-' and Carnival Corp. falling to 'BB-' from 'A-' over the course of several months. Both ratings are currently on CreditWatch with negative implications, indicating there's a likelihood we could lower the ratings further. We expect the remaining investment-grade issuers to have leverage well above our downgrade thresholds this year, with some experiencing negative EBITDA in the second quarter and very depressed levels for the year. These issuers' ability to reduce leverage below our downgrade thresholds in 2021--and maintain investment-grade ratings--hinges on a number of factors including, in some cases, the timing of property reopenings, a reversal of cash burn, and the pace of EBITDA growth and margin improvement.

During shutdown, many issuers implemented significant cost-cutting measures, converting fixed costs to variable by furloughing a large percentage of their workforce. While these actions have aided liquidity preservation, we expect they'll face many obstacles in bringing cost structures back in line in light of a slow and uneven recovery. Even if issuers can deliver appropriate service levels with lower fixed costs, which we believe is possible--and has contributed to year-over-year EBITDA growth for some companies for the past few weeks since reopening--sustaining these trends will be challenging. While pent up consumer demand could provide a temporary boost, issuers are reopening amid a global recession, ongoing social distancing measures, and potential lingering travel fears that might influence consumer discretionary spending.

Table 1

Against this backdrop, the natural question from market participants has been: What might prompt additional fallen angels and overall downgrades in this sector? We think most investment-grade issuers on the cusp of dropping into the speculative-grade catergory have minimal headroom against downgrade thresholds based on S&P Global Ratings' base case 2021 forecasts (see table 1). Additionally, overall we believe some issuers might be more at risk of future downgrades based on subsector exposure. For example, we believe the path for recovery for cruise operators is highly uncertain, based on the timing of resumed sailing that will likely be phased in over a multi-month period, pricing pressure, capital intensity, and social distancing measures that will reduce load factors on ships, potentially reducing profitability and cash flow. Lodging issuers, which make up the bulk of remaining investment-grade companies, also face various hurdles although a recovery in revenue per available room (RevPar) and occupancy is already underway in many markets. Accordingly, we'll continue to be forward-looking and could take additional rating actions over the coming quarters if the pace of recovery in the second half of 2020 is below our base case. Conversely, given our two-year outlook horizon for investment-grade ratings, if we believe recovery is sustainable and companies are in stride to reduce leverage near our thresholds, even if still slightly above by year-end 2021, we would likely affirm ratings.

Market Access Has Held Up, Even For Speculative-Grade Issuers

At the onset of the pandemic, we based many of the initial multi-notch downgrades, especially those to the 'CCC' category, on liquidity risks due to an abrupt shutdown in operations and subsequent negative cash flows (see chart 2). The high yield credit markets ground to a near halt in March, with only higher-rated issuers being extended costly financing with more stringent terms and conditions. This began to change in late March to early April as markets opened, with federal stimulus providing additional optimism and indirect support. Consequently, even some lower-rated 'B' category issuers successfully raised new debt funding. As of June 24, the sector has brokered more than $32 billion in new debt since the start of the pandemic.

Table 2

U.S. Leisure And Gaming New Debt Issuance Since March 1

Yields have varied widely across the U.S. lodging, leisure, and gaming segments depending on the subsector and company-specific circumstances (see table 2). Cruise operators, one of the hardest hit sectors, have seen the highest yields, with some investment-grade issuers having to provide security. For example, Carnival Corp. provided security for its three-year notes at a coupon of 11.5% when it was rated investment grade. While the company likely paid up given the debt issuance that occurred in early April as credit markets were just beginning to ease, peer Royal Caribbean Cruises Ltd. issued three-year unsecured notes with a coupon of 9.125% on June 5. This compares to five-year yields for 'BBB' and 'BB+' corporate bonds of 2.19% and 4.67%, respectively, as of June 17, 2020. Theme Parks such as SeaWorld Parks & Entertainment Inc. and some gaming operators have also raised costly secured debt to weather potential prolonged shutdowns. While issuance has helped to bolster balance sheets and stave off near-term bankruptcies, companies will be saddled with a significant amount of high-cost debt, depending on cash-burn rates, as they navigate recovery and the potential for years of lower revenues.

From a ratings perspective, despite the observed market access, we don't factor potential borrowings into our forecasts until transactions have closed. Additionally, while the consensus among health experts is that the pandemic may now be at, or near, its peak in some regions, with businesses reopening, we've mostly downgraded companies to the 'CCC' category if they lack sufficient liquidity to withstand a shutdown (e.g., zero incoming revenue) for at least the remainder of 2020, if not longer. This is because we believe the pandemic will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. Given the uncertain recovery path, the potential for a second wave of infections, and lingering fears that will keep limiting travel and consumer discretionary spending, we expect excess liquidity will remain a key ratings factor over the next year. Additionally, just because a company has raised incremental debt, doesn't mean we believe it will necessarily remain solvent. Even with sufficient liquidity, we might view a capital structure as unsustainable--and likely lower ratings to 'CCC+'--if we don't expect the company to return to positive cash flows or be able to refinance longer-term debt due to elevated leverage and eroded equity value.

Chart 2

Rating Actions To Come

As of June 30, we rated approximately 27% of issuers in the 'CCC' category (see chart 3), and by definition, they're more vulnerable over the next six to 12 months to conventional defaults or distressed transactions that we would view as tantamount to a default. Additionally, we rate approximately 17% of issuers 'B-', all of which have negative outlooks or remain on CreditWatch with negative implications. Based on these concentrations, while only 4% of issuers have defaulted or are currently in default, we expect these numbers to rise as the year progresses. We currently expect the U.S. trailing-12-month speculative-grade corporate default rate to rise to 12.5% by March 2021 from 3.5% in March 2020. Given that a 'CCC' category rating implies at least a one in two chance of eventual default, this would suggest a default rate of about 13%-14% for U.S. lodging, leisure, and gaming over the next year. While this is likely a high estimate because we believe some 'CCC' category issuers could reverse their fortunes, we expect default rates to approach corporate averages given the material fallout on these sectors from the pandemic and recession combined. These estimates include selective defaults, which could consist of credit amendments to defer obligations such as principal payments, interest payments, or excess cash flow sweeps, without offsetting compensation provided to lenders.

Chart 3

In the second half of 2020, ratings activity will also include a resolution of the approximately 36% of ratings remaining on CreditWatch with negative implications. We expect that some CreditWatch listings could extend modestly past the typical 90-day period as events continue to unfold. For those resolved, whether through an affirmation or downgrade, it's also likely rating outlooks could be negative reflecting continued uncertainty.

The Path Back To Normalcy

As various states continue to enter Phase 1 reopening, we examine what the recovery path back to "normalcy" could look like for U.S. lodging, leisure, and gaming companies. While some subsectors might benefit from near-term pent-up demand, given these subsectors have been hit hard by the pandemic and related fallout, we believe there's the potential for longer-term structural changes that could have a lasting impact on issuer credit quality. This could include properties that never reopen, permanent or prolonged supply and demand imbalances, and disruption to operations that could hurt profitability. As a result, for many subsectors, we believe it could take two to three years for credit metrics to return to 2019 levels (see chart 4).

Lodging

Following an unprecedented blow to lodging from COVID-19-related restrictions on movement and travel, we think the path to recovery in hotel demand will be slow over multiple years. However, it has already begun across much of the world. Occupancy has reportedly reached 40% for some chains in China from low-single digits earlier this year, and occupancy in the U.S. has likely climbed to more than 40% for June after bottoming out at 25% in April. The recovery path in Europe has been and may remain slower. There's a growing consensus that travel activity may recover in a sustained way faster in China and the U.S. because they're primarily domestic travel markets with a relatively small percentage of inbound international travel. By contrast, Europe relies on overseas travel to a larger extent. Since the pandemic began in the U.S., the economy, midscale, and extended-stay segments have outperformed the industry, and the upper upscale and luxury full-service segments have underperformed the industry. We assume this divergence continues at least through the second quarter and probably through much of the third quarter. We believe leisure travel will recover first, business transient second, and group business third because of potential lingering concerns about gatherings and social-distancing norms.

We assume U.S. RevPAR drops 40% to 50% in 2020, with recovery in the upscale full-service segment (which typically generates substantially higher RevPAR than the overall industry) significantly later in the year. As long as the economy recovers according to our base case forecast and travel resumes in the second half of this year and into 2021, we estimate next year's U.S. RevPAR could increase 50% to 60% but remain about 20% below 2019 RevPAR. We believe RevPAR outside the U.S. will perform at the high end of the U.S. assumption this year and next.

During the recovery period starting in the second half of this year, lodging companies will manage the cost base in a manner that achieves breakeven at lower occupancy rates than its hotels historically operated because guests may demand lower service levels, particularly food and beverage or any high-touch point service, for a prolonged period. For example, we've heard a number of U.S.-based lodging companies state that an economy or midscale select-service hotel could break even somewhere around 30% to 35% occupancy (depending upon average daily rates [ADR]), and these lower-price segments have already cleared that hurdle in recent weeks in the U.S. We assume 2020 RevPAR in upper upscale and luxury full-service segments declines at the high end of the range and 2021 RevPAR increases at the high end of the range. EBITDA generated by a hotel owner will be more sensitive to RevPAR declines and will fall more than a manager's and franchisor's in 2020, but could also recover faster (on a percentage basis) next year because of operating leverage.

Recovery in hotel owner profitability will also be highly sensitive to the pace of improvement in ADR in 2021. As a result of these assumptions, 2021 EBITDA for lodging companies could be anywhere from 20% to 40% below 2019 EBITDA. Even if the global economy and travel recover in sustained manner, we believe lodging revenue and EBITDA would only return to 2019 levels in 2022 at the earliest, and probably only for some.

Gaming

After the COVID-19 pandemic led to the closure of all casinos in the U.S., nearly 80% of casinos have reopened as of June 24. As casinos reopen, they're often required to limit the number of visitors as well as gaming capacity, including turning off adjacent slot machines and reducing the number of seats at table games to spread out patrons. Additionally, many casinos are reopening with limited amenities. In many gaming markets, we believe capacity limitations may not lead to lower gaming revenue because casinos' historical peak utilization rates were below these limits in many markets. We think the U.S. recession, high unemployment, changes in the customer experience, and lingering fear around being in enclosed public spaces for prolonged periods because of the virus will have more of an impact. Nevertheless, to accommodate reduced capacity and possibly volatile demand, we expect operators to slowly bring back cost structures, including taking a measured approach to labor and marketing.

If the company's properties reopen with limited capacity and amenities, we believe it will staff them accordingly and slowly increase its labor pool as additional capacity and demand warrants. We also expect operators to be judicious with their promotions and marketing initially, especially if capacity is limited. Additionally, many of the amenities like buffets and entertainment venues that remain closed are often lower margin, if profitable at all. This could result in some margin expansion, at least temporarily, even in the face of potentially lower revenue. However, operators may still face hurdles managing their expense base due to uncertain and potentially volatile demand.

Regional gaming markets should recover first, because customers typically live within driving distance of the properties. Also, regional casinos may benefit from customers staying closer to home this summer and limited other available entertainment offerings. Las Vegas will likely be slow to recover, because it relies heavily on air travel, international visitation, and conventions and group meetings. About half of Las Vegas visitors fly to the market, which raises the trip's cost and could have consumers avoiding the destination because of lingering travel fears due to the virus. Furthermore, we expect airlines to reduce capacity because of lower demand resulting from the pandemic, which could make it harder for visitation to recover quickly given our view that lower airlift into the market may persist for some time. Additionally, international visitors comprise about 20% of total visitation, and lingering travel restrictions along with reduced airline capacity may impair their ability to visit. Moreover, about 15% of visitors travel to Las Vegas to attend a convention or group meetings. We believe cancellations of conventions and group meetings have primarily focused on this year, and that bookings for next year and beyond remain intact for now. However, a combination of factors including potential lingering restrictions on the size of gatherings, lower corporate travel budgets, and corporate travel restrictions could impair this segment, which is important for Las Vegas midweek business, for an extended period.

We believe leisure travelers will be the first to return to Las Vegas, and that group business will take longer to resume. Overall, social distancing and other health and safety measures to curb the spread of COVID-19 will likely hurt the comprehensive experience in Las Vegas and could make it less desirable to visit at least for a while. This is because there will be fewer gaming positions at tables, fewer amenities open and those open will have reduced capacity, and limited entertainment, nightlife, and sports options. We believe customers visit Las Vegas for the overall entertainment experience and not just as a gambling destination. Thus, the lack of these entertainment amenities and the potential for reduced energy across resorts because of restrictions could make it less appealing to customers temporarily.

Cruise

There is a very high degree of uncertainty around when and how cruise operators will resume operations in 2020 and what ports and destinations will be available to them. We expect cruises will remain suspended through the seasonally strong third quarter given Cruise Line International Association's (CLIA) statement that its ocean-going cruise line members would voluntarily extend the suspension of cruise operations from U.S. ports until Sept. 15, 2020. This is beyond the July 24 expiration of the current no-sail order issued by the U.S. Centers for Disease Control and Prevention (CDC). Extended travel restrictions, like Canada's ban on cruise ships through October, could limit the number of available ports and itineraries and lead some cruises to remain suspended into the fourth quarter. In order to resume operations, we believe cruise operators will need to liaise with government and health authorities in various jurisdictions on screening and other health and safety protocols they intend to implement to resume operations safely. When they do resume operations, we believe cruise operators will slowly reintroduce their ships into service, which will somewhat limit capacity and potentially better align supply and demand. We believe it could take multiple months for operators to bring all their ships back into service, and that the COVID-19 pandemic could accelerate the removal of capacity, especially older ships, from their fleets and delay the delivery of new ships on order.

When operations resume, we expect that demand for cruises may remain soft due to lingering consumer fears around travel and cruises stemming from the ongoing coronavirus pandemic and weaker consumer discretionary spending resulting from the global recession. This will likely result in pricing pressure. We expect cruise yields in 2021 could be 10% to 20% below 2019 levels because of expected weaker demand and the utilization of future cruise credits. Customers whose sailings were cancelled and did not request a cash refund received future cruise credits in excess of what they spent or onboard credits. We also expect operators will implement social distancing and other health and safety measures on their ships to reduce the risk of spreading the virus. We believe these social distancing measures will reduce available occupancy on ships. Reduced available passenger capacity days from lower occupancy combined with lower assumed yields will likely reduce cruise operators' profitability and cash flow in 2021, especially since the large cruise operators have historically sailed with more than 100% occupancy.

The cruise industry benefits from a high level of repeat customers--approximately two-thirds of cruise passengers are repeat cruisers. We expect cruise operators will focus first on these loyal guests who have experienced cruises before and understand the brands and value proposition. We believe it will be more difficult to convince first-time cruise passengers to sail given the negative publicity the industry has faced this year. Nevertheless, it will likely take cruise operators many years to recover to pre-pandemic cash flow and credit measures because of the industry's capital intensity. Despite the weak operating environment, operators have committed ship deliveries over the next few years and while there may be some shipyard delays, operators will take delivery of contracted new ships as they're completed and incur the corresponding ship-level financing. Planned ship orders will materially slow recovery in credit measures because capital expenditures for new ships, even if there are some delays, will likely exceed EBITDA for many operators potentially through 2022. New supply in the face of ongoing weak demand could also hurt occupancy and yields.

Fitness Operators

Gyms are reopening in June in many states in the U.S. South, Midwest, and West, including California, depending upon whether various municipalities have reached the conditions of reopening. We believe gyms will be one of the last businesses to reopen in New York. Capacity limitations and distancing requirements differ from state to state, and we believe only a portion of members will initially be confident returning to the gym safely. In addition, the anticipated steep recession and high unemployment will likely cause many people to cancel gym memberships, at least for a while until the employment picture improves. As a result, we believe most gyms that reopen will ramp up revenue slowly over the next few months and next year. During closures, we believe fitness companies that have remained solvent incurred reduced labor costs and paid debt service, and deferred most or all of rent to preserve liquidity. As gyms reopen, fitness companies will restart paying rent and increase labor costs to service members and comply with increased cleanliness standards. Nevertheless, profitability and cash flow will likely be negative for several months after reopening.

Furthermore, one of the largest branded gym systems, 24 Hour Fitness Worldwide Inc., is reportedly permanently closing a significant number of gym locations. While we don't know yet whether other large systems will also permanently close some gyms, it seems plausible some will and the stock of traditional gyms in the U.S. could be substantially reduced possibly for several years. These headwinds have already caused two rated fitness companies to default: Equinox (selective default under our criteria) and 24 Hour (missed debt service payment and bankruptcy filing). Town Sports has indicated its intent to file bankruptcy soon. All currently solvent fitness companies are rated in the 'CCC' category or below because current liquidity is insufficient to cover current and anticipated rates of cash burn even under a reopening and gradual recovery scenario. As a result, we currently assume the fitness sector generates revenue in 2021 that is 20% to 30%, and EBITDA in 2021 that is 30% to 40%, below 2019 levels. We could lower these estimated ranges in coming months depending upon the number of gyms that permanently shutter.

Theme Parks

While a number of theme parks have opened, or have plans to open shortly (e.g., Disney's Shanghai park [May 11], Six Flags Frontier City in Oklahoma [June 5], Universal Orlando [June 5], SeaWorld Orlando [June 11], and Walt Disney World [July 11 and July 15]), we believe that theme parks' path back to normalcy will be much slower than global GDP. When current stay-at-home restrictions are eased, local and national governments may still impose social-distancing restrictions or even capacity-utilization limitations on public venues. We also believe many consumers will continue to be wary of attending theme parks, or other large public gatherings, until either a COVID-19 vaccine is available or the true nature and/or risk of COVID-19 is better understood. For theme parks to begin to return to normalcy, consumers will likely need to believe they won't be exposed to the virus while visiting the parks. This may be somewhat easier for outdoor theme parks, than for indoor activities. For companies like Disney and Comcast, whose theme parks are mainly destination attractions, they'll likely recover more slowly than regional theme parks due to lingering travel-related concerns. Regional theme parks, on the other hand, could benefit from pent-up demand, accessibility by car, and limited required planning as an alternative to other leisure activities.

A lengthening of the economic recession beyond our base forecast could further impair consumer discretionary spending, which would likely delay the return to normalcy. Given the slow and potentially uneven recovery in attendance and revenues, theme park operators face the additional challenge of bringing cost structures back online. It's likely that operating costs will come back more uniformly than revenues resulting in lagging financial metrics. Accordingly, we're forecasting a gradual ramp-up in theme park attendance over the next three years, notwithstanding a potential re-emergence of the pandemic. As a result, we believe theme park revenues may decline by well over 50% in 2020, and will, despite strong growth, still be below 2019 levels in 2021 (we forecast regional theme parks will be about 10% lower while destination theme parks will be 15%-20% lower). We believe theme park revenues will only return to 2019 levels in 2022, at the earliest.