Strong Macro Recovery, Good Trends Should Improve Tech Issuers' Creditworthiness

Declining numbers of COVID-19 cases and robust fiscal stimulus should power a strong macroeconomic recovery and drive good broad-based performance across the sector. This will likely lead to more reversals of negative rating actions related to the macro weakness caused by the pandemic and may help other companies achieve higher ratings. In fact, we have had more positive rating actions than negative ones since July 2020. Good trends are in place for the sector, including accelerating digital transformation and cloud adoption, rollout of the first generation of 5G smartphones with network spending to follow, the recovery in the auto and industrial end markets, and a PC market that is showing strength in first-quarter 2021. The industry is working through supply constraints and low inventory, which should support good pricing power. We expect companies to continue pursuing acquisitions, specifically among software companies seeking to broaden product capabilities and add cross-selling opportunities, as well as semiconductor companies looking to diversify their product portfolios and capture scale efficiencies to gain a competitive edge. Credit markets will likely be open to support mergers and acquisitions (M&A), but we also see large public issuers willing to use equity for transformational deals as long as valuations are high. For our full view for global technology in 2021, see our report, "Industry Top Trends 2021: Technology," published Dec. 10, 2020.

Early-Stage Companies' Credit Market Access Is Increasing

We see credit markets continuing to open up to early-stage companies that have above industry-average growth but limited histories of positive EBITDA and cash flow. Recent examples in U.S. tech are security software provider Crowdstrike Holdings Inc. ('BB+/Stable'), customer engagement platform Twilio Inc. ('BB/Stable'), and data analytics company Cloudera Inc. ('BB-/Stable'), which have all received new ratings during the past four months. Cloudera raised funds for share repurchases, while Crowdstrike and Twilio sought to opportunistically boost liquidity. Examples from Asia include super app platforms Grab Holdings Inc. ('B-/Stable') and Meituan ('BBB-/Stable'). These companies can achieve these ratings despite limited track records of positive EBITDA and cash flow because we believe their competitive positions are durable, despite numerous niche challengers and threats from large incumbents. Additionally, many of these issuers are pivoting to focus more on profitability and cash flow, with ample liquidity cushion. The trend began with early stage stars Netflix Inc., Tesla Inc., Uber Technologies Inc., and WeWork Cos. LLC (see our report comparing these issuers, "Fast Starters: Will Netflix, Tesla, Uber, And WeWork Keep Pace?," published Feb. 19, 2020). Now, we see that trend expanding to the next tier of companies, which credit markets have traditionally viewed as too speculative. We also think the stigma of raising debt for early-stage companies is waning, and we expect more to access credit markets for low-cost capital in 2021 and beyond, many of which will come from U.S. tech. For more details about how we assess these companies, see our report, "What Factors Drive Ratings For High-Growth, Early-Stage Companies Like Tesla And WeWork?," published Dec. 3, 2018.

Differentiated, Efficiency-Delivering Products Support Consistent Creditworthiness

Chart 1

As of Jan. 29, 2021, we rated 203 issuers within our U.S. tech corporate ratings team. The rating distribution is pyramid-like: More than half of the ratings are in the 'B' category, and each successively higher category has fewer ratings. Only 25% of ratings were investment grade (IG). Eleven issuers had ratings in the 'CCC' category, reflecting our view that their capital structures are unsustainable and that their default risk is elevated. The 'B' category is particularly large because of the high number of companies acquired by private equity in leveraged buyouts (LBOs) that typically carry leverage of 7x or higher.

Chart 2

Our rating outlooks have a more negative skew than normal: 12% of ratings have a negative outlook, up from 8% in January 2020, owing to lingering stress from the COVID-19 pandemic. Nevertheless, most of our ratings have stable outlooks, reflecting mission-critical, productivity-enhancing offerings for enterprises, increasing electrification in key markets such as auto and industrial, and the increasing quantity of data created across an increasing number of applications. In addition, more than half of our ratings are in the 'B' category: They are frequently on companies with capital structures that are maxed out but have durable, cash-generative businesses such as software, therefore limiting downgrade risk.

Chart 3

Software is the biggest segment because of the large number of companies acquired by private equity. They make attractive targets because of the mission-critical nature of their products, high switching costs and risks, high recurring revenue, and good cash flow because of low capital intensity. Because they make for good LBOs, software companies make up the bulk of the 'B' rating category. The semiconductor segment includes many companies with strong market positions and differentiated products based on advanced technologies, but they are few in number because small and midsize companies with good products tend to be bought out because of the scale efficiencies and portfolio diversification they bring to acquirers. The hardware segment comprises several mature companies being challenged by the shift to the cloud, and some, such as the printing companies, are in secular decline. Payment processors, information technology service providers, and internet-based companies make up most of the services segment.

The Pandemic Prompted Negative Rating Actions, But Tech Is Bouncing Back

Table 1

In 2020, we took action on 107 U.S. tech ratings, and 64% of those actions were negative. This compares to 70 rating actions in 2019, 56% of which were negative. The increase in negative actions was a result of the stress from the COVID-19 pandemic. A greater proportion of the rating actions were outlook changes in 2020 because they represented a disproportionate share of pandemic-related rating actions.

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Chart 5

We took 41 negative actions as a result of pandemic-induced macro weakness, of which 17 have been fully or partially reversed. Several more may still be reversed, reflecting the fact that the effect of the pandemic was not as bad as feared. Most companies saw a dip in second-quarter 2020, followed by a full or partial recovery in the second half of the year. Some companies, such as Dell Technologies Inc. and Plantronics Inc., have provided solutions that facilitated the transition to working from home, while software companies have maintained resilient performance because of the mission-critical nature of their products and high recurring revenue. The durability of many of these companies surprised us and reinforced the creditworthiness of the sector. For example, we lowered our 2020 PC unit growth forecast to negative 9% in March 2020, but PC units will likely have grown 13% after the final tally. Likewise, we revised our semiconductor industry revenue growth forecast to negative 6% in March 2020; revenue grew 5%, which supported strong PC, gaming console, and smartphone cycles, and benefited from tight supply at year-end that has persisted. We expect semiconductor market growth in the mid-single-digit percent area again in 2021.

Ratings In The 'B' Category Were More Volatile; IG Ratings Were More Stable

Table 2

Despite representing about half of outstanding U.S. tech ratings, companies with ratings in the 'B' category accounted for 65% of our rating actions in the sector. This compares to the IG group, which made up 11% of rating actions while representing 25% issuers. We actioned about half of the companies in the 'B' category, while only actioning one-quarter of IG companies. In addition, two-thirds of the actions in the 'B' category were negative, while actions were more evenly balanced in the IG space. 'B' category companies are typically smaller and have higher leverage, which means that small changes in absolute EBITDA can have a substantial effect on credit metrics. These companies are also more likely to be owned by private equity sponsors who drive more frequent financial policy actions (i.e., M&A and leveraged dividends). Thus, small M&A targets can have a large relative effect on the balance sheet. We attribute the relative stability of IG ratings to companies that generally have stronger business profiles with more durable competitive moats and broader product diversification, larger capacity for M&A, and broader stakeholder bases, which value more conservative and consistent financial policies.

We Upgraded More Companies On Strong Software And Semiconductor Trends, As Well As Equity Offerings

Table 3

We upgraded 23 companies in 2020 versus 18 companies in 2019 (table 1), an interesting result given the macroeconomic stresses the pandemic created. This demonstrates the resilience of the software and semiconductor segments, which said nine upgrades a piece. For several companies, we took a more constructive view of the business. We upgraded KLA Corp. and its peer Lam Research Corp. because we believe that the wafer fabrication equipment sector has become less volatile because of broadening end-market demand for semiconductors and the consolidation among manufacturers. Also, Advanced Micro Devices Inc. (AMD) has made significant share gains against much larger rival Intel Corp., earning it several upgrades over the past couple of years, including one to IG last month. Examples in software include Cadence Design Systems Inc. and PTC Inc., which showed strong execution through the pandemic because of differentiated products and strong recurring revenue. Others, such as ON Semiconductor Corp., delivered strong operating performance, strengthening credit metrics to the point that justified an upgrade.

We upgraded seven companies in 2020 because of positive financial policy actions, up from just one in 2019. This reflected receptive equity markets that allowed four companies to go public through IPOs--ZoomInfo Technologies Inc., Shift4 Payments Inc., Nuvei Corp., and Corsair Gaming Inc.

Negative Actions Focused In Hardware Because Of Volatile Demand, Cloud Migration, And Product Obsolescence

Of the nine negative rating actions we took because of weak operating performance (excluding COVID-19-related actions), six were in the hardware segment (chart 4). This reflects our expectation for tough operating conditions and lack of demand visibility, enterprise customers shifting workloads from on-premises to the cloud, concentrated customers who have pricing power, and product obsolescence. Examples include Corning Inc., which experienced volatile demand in its display and optical markets; CommScope Holding Co. Inc., whose large wireless network customers cut back spending to preserve capital for spectrum auctions; and Xerox Holdings Corp., whose printing products face secular headwinds.

We also took several negative actions on payment companies because of our expectations for very weak transaction volumes in second-quarter 2020. However, those volumes came back strongly in the second half of the year, supported by fiscal stimulus and a return of some normal activity aided by loosened restrictions in the summer and fall. We fully or partially reversed three of those actions as a result, and more may follow.

One rating action unrelated to business trends was our downgrade of Oracle Corp. after it raised $20 billion in debt following the start of pandemic stress in the U.S. in March. The debt raise portended continued share buybacks in excess of cash flow and caused Oracle's leverage to exceed our 2x downgrade threshold. The outlook remains negative because we are uncertain about whether the company will curtail buybacks and maintain leverage below our next downgrade threshold of 2.5x. We view Oracle as the exception rather than the rule because Board Chairman and Chief Technology Officer Larry Ellison is unique in his combination of voting power and willingness to leverage the balance sheet for shareholder returns.

Pandemic-Related Macro Weakness Replaced Shifting Product Trends As The Primary Reason Ratings Fell Below The 'B' Category

In 2020, eight companies fell below the 'B' category, signaling that we viewed their capital structures as unsustainable with increased default risk. The predominant reason was the stress caused by the pandemic, which was different than the prior year when the predominant reason was loss of product relevance. For example, two companies in the payments space, Transact Holdings Inc. and Priority Holdings LLC, faced pressure because of falling transaction volume. Cvent Inc., a provider of event planning software, delivered very good performance prior to the pandemic, but it operates in a space that the pandemic hit particularly hard. Electronics For Imaging Inc. provides differentiated industrial printers, but cutbacks in capital spending hurt its sales.

This compares to 2019, when five ratings fell below the 'B' category. These downgrades were more defined by market trends shifting demand away from the companies' products. These included Lexmark International Inc., which provides printing products; 4L Technologies Inc., which sells remanufactured printer cartridges; and Riverbed Parent Inc., which provides wide area network (WAN) optimization products that are losing share to software-defined WAN products that include optimization features.

Large M&A Didn't Cause Downgrades Because Companies Used Equity

When examining rating actions from 2020, it's important to consider the rating actions that didn't occur. Several companies that made large M&A transactions avoided downgrades because of the acquirers' significant use of equity, such as AMD's pending acquisition of Xilinx, Analog Devices Inc.'s pending acquisition of Maxim, and Salesforce.com Inc.'s pending acquisition of Slack. Usually, we see companies opt for cash or debt financing because equity financing could dilute shareholder value. We think these cases point to risk sharing between the acquirer and the target. A frothy equity market also makes targets so expensive that it is untenable to complete transformational acquisitions with significant cash but also provides acquirers with a rich currency--a friendly situation for creditors.