Knock-On Effects From Global Macro-Economic Uncertainty Could Slow Deleveraging Prospects

Despite limited direct revenue exposure to Ukraine and Russia, ensuing inflationary challenges, rising wages for labor-intensive operations, high gas prices for distributors, and cyber risk for some information, payment, and technology service providers will remain key risks in 2022 and may slow the pace of deleveraging assumed in our ratings (see chart 3 and table 2). In response to market developments related to the Russia-Ukraine conflict, S&P Global Ratings recently revised its global GDP growth to 3.5% this year, a decline by 70 basis points from its previous baseline, as Europe's growth is hit hardest by the conflict. Similarly, we lowered our U.S. GDP expectation by 70 basis points to 3.2%. We expect seven rate hikes in total in 2022 (including a 50-bp hike), followed by four to five rate increases in 2023. Compounded with higher energy prices, Core CPI of 5.2% expected in 2022, we now think the U.S. economy faces a 20%-30% chance of recession in the next 12 months--up from our November assessment of 15%-20%. Financial markets have started to react. Higher benchmark rates and normalization of spreads, will likely end the historic run of favorable financing conditions. A rapid and volatile market repricing--affecting debt-servicing costs and funding access--would hurt lower-rated borrowers, in particular. While secondary-market spreads on corporate debt for our coverage of 169 rated companies in the sector (79% rated 'B' or below) remain historically narrow--they are widening steadily.

The Stable Rating Outlook Reflects Most Companies' Ability To Pass Through Higher Costs, But Recent Downgrades Suggest A Shift

Only about 5% of rated companies in the sector currently have a positive outlook, versus over 15% of the portfolio with a negative outlook which is higher than the U.S. corporate rated universe at about 11%. This trend has recently shifted to a negative bias, year-to-date, we downgraded five companies and upgraded two. Risks are weighted to the downside as persistently high inflation and tight labor markets will pressure profitability and in some cases revenues, as wages, overtime, and employee churn may outpace companies' ability to reset service contracts and fill open positions.

Chart 1

Chart 2

Key Sector Assumptions For 2022

Demand remains steady within the business and technology services sector, and we expect the sector to report mid-single-digit organic revenue growth in 2022 aided by increased market penetration, stable retention rates, cross-selling, and higher pricing for many companies. Companies will mostly pass inflationary cost pressures to the end customer by the end of the year, albeit intra-year earnings volatility is likely as price increases are gradually reset. We expect steady margins for several companies given the digitalization of their workflow/services and lower staffing requirements partially offset by inflationary pressure. Companies have also cut capital expenditure, but typically by only a moderate amount, and lower-rated companies have sharply cut M&A (although more highly rated companies have remained active). We see the risks to our baseline forecast as firmly on the downside. Rising geopolitical and central bank financial policy risks may result in unexpectedly higher levels of inflation and lower GDP growth versus our base case, which may result in boarder deterioration in credit quality across the portfolio particularly among the 'B' and 'CCC' rated category which make up 70% and 9% of the portfolio, respectively.

Chart 3

Outlook And Trends Are Mixed For Some Subsectors

The overall rating outlook for the sector remains stable due to strong demand for outsourcing non-core competencies, automation/digital transformation, and data/analytics. We expect facilities maintenance and distribution services to be most vulnerable to downside risks. Conversely, we believe the impact from these developments on the software, information services, and human capital management subsectors to be minimal or positive.

Table 1

Table 2

Distribution services

This subsector serves many end markets, with retail, energy, and discretionary-like segments hardest hit by the pandemic. Rising gas prices and wage inflation for distributors could negatively affect near-term operating performance. For distributors tied to the industrial, automotive, and energy end markets (such as PetroChoice Holdings Inc. and PSS Industrial Group Corp.) we expect operating performance to remain well below pre-pandemic levels as delayed customer spending and supply chain disruption hinder growth prospects. Given strong growth in the quick service and casual dining restaurant segments, we expect companies such as Double Eagle Buyer (d/b/a Restaurant Technologies) and BCPE Empire Holdings Inc. (d/b/a Imperial Dade) to report strong organic revenue growth over the next two years due to new customer wins, upselling services, and price increases.

Facility maintenance

This subsector includes companies providing HVAC (heating, insulation, ventilation, and air-conditioning) and other technical services. For national scale players like Installed Building Products Inc. and TopBuild Corp., we expect ongoing near-term residential construction demand and long-term fundamentals to support solid operating performance over the next 18 months. Performance of some companies with lower ratings, such as Refficiency Holdings LLC (d/b/a Therma) and Saber Intermediate Corp. (d/b/a Service Logic) has shown resilience and we expect strong top-line growth in 2022 from ongoing demand for commercial air filtration, HVAC/R services across end markets including mission-critical facilities (such as hospital, government, and education buildings). Conversely, operators such as CoolSys Inc. and Thermostat Purchaser III Inc. (d/b/a Reedy) have already reported deteriorating profits, and we believe that margin expansion opportunities in the subsector are limited because of high labor expenses. We think supply chain disruptions and material input-cost pressures will likely drag profitability in 2022. Though a large portion of the demand is nondiscretionary over the next two years, we expect project pipelines to remain vulnerable to customers postponing large-ticket repairs like roof replacements that they can defer with smaller repair jobs. New construction projects could see a deceleration in 2022 as economic uncertainty and elongated building cycles slow the pace of construction. Delaying maintenance work often leads to other issues (leaks, breaks, and wear and tear) that can result in more complex job orders.

Commercial services and supply chain

Until workplaces fully reopen, the structural shift in the post-pandemic demand for office services and corporate employee relocation could continue to hamper profitability for companies like Staples Inc., Sirva Inc., and KCIBT Holdings L.P. Cleaning and laundry facilities management services, which are largely nondiscretionary, have shifted investments to digitize machines from scale-driven M&A. While we anticipate wage and commodity inflation to represent near-term pressure on earnings for laundry service providers Spin Holdco Inc. (d/b/a CSC ServiceWorks) and WASH Multifamily Acquisition Inc., these companies can leverage their procurement efficiency, which stems from their sufficiently large scale to offset these pressures as they continue to grow revenues. Non-discretionary service providers such as Belfor Holdings Inc. and to a lesser extent W3 Topco LLC (d/b/a Total Safety) should benefit from a stable operating profile despite rising input costs, as the majority of work is conducted on a cost-plus markup basis. Information storage providers such as Iron Mountain Inc. and Access CIG LLC should benefit from relatively stable organic storage volumes in 2022, with strong retention rates and growth in digital solutions and secured IT asset disposal that has helped exceed service revenues compared to pre-pandemic levels without a full recovery of traditional services (shredding, collection, etc.). We believe these companies will increasingly rely on price increases and market share wins in their traditional businesses as they continue to invest in digital record management capabilities to position themselves as the industry shifts.

Human capital management (HCM)

These providers are particularly sensitive to decreases in economic activity and employment levels. Our outlook of stable to positive for companies in the subsector reflects our view that the tight labor market will on balance provide a tailwind for operating performance and credit metrics. The HCM subsector includes payroll and human resources (HR) software vendors, benefits administrators, background screening providers, and professional employee organizations (PEO) that offer a fully outsourced HR solution to small to midsize businesses. Most industry revenue models are directly related to payroll volumes processed, or to customer's employee levels which positions industry sales to benefit from rising wages and declining unemployment rates. Job opening estimates indicate labor demand remains elevated; we believe this will further accelerate hiring and the digital transformation of HR to attract, reward, and retain employees. Global supply chain constraints and raw material inflation are not likely to affect the sector; however a modest rise in operating expenses in step with higher labor costs could offset positive revenue growth trends.

Consulting and professional services

We expect this subset of companies to maintain stable client retention and steady creditworthiness in 2022 following robust performance in 2021. Revenue growth has broadly remained positive, including companies with high exposure to increasing regulatory requirements supporting the adoption of energy-efficiency programs (for instance CRCI Longhorn Holdings Inc. (d/b/a CLEAResult) and KAMC Holdings Inc. (d/b/a Franklin Energy). We think these companies will likely encounter inflation-related margin challenges in 2022 despite permanent cost cuts during the pandemic, as annual contracts with set pricing may limit their ability to pass on increasing costs to customers. For residential real estate based service providers such as Realogy Group LLC and RE/MAX LLC, we expect the U.S. housing market transaction volume to slow in 2022 given rising mortgage rates and historically low inventory.

Outsourced business and information technology (IT) services

We expect growth in the subsector to outpace global GDP at about 5% revenue in 2022, following an increase of 8% in 2021 due to a sharp uptick in workloads as their clients navigated through the pandemic. Large projects, such as enterprise resource planning (ERP), software implementations, and consulting engagements returned in 2021 after delays. We saw large IT services vendors such as Accenture experience double-digit revenue growth in these areas. A significant backlog reflects a heightened need for digital transformation projects and a lack of labor supply both onshore and offshore. We expect this trend to continue through the first half of 2022 and estimate that the Russia-Ukraine conflict is unlikely to have a material impact on financial performance in 2022 based on limited direct exposure.

As the pandemic highlighted the importance of remote work, businesses show the need to make structural changes to enable a hybrid work environment. This leads to more work orders and engagement with IT services vendors to redesign operating environments, optimize usage of private and public cloud infrastructure, as well as application modernization, and automation. We expect these projects to span across multiple phases because implementation periods tend to be long and involve the development and modernization of both front-end applications and back-end platforms across areas such as customer engagement, cloud, artificial intelligence, big data, analytics, and cybersecurity. Additionally, heightened cyber security threats and awareness will likely lead to higher IT budgets. Escape Velocity Holdings Inc. (d/b/a Trace3), Tenable Holdings Inc., and Optiv Inc. are those that saw revenue growth benefiting from these trends. However, looming risk in 2022 will be their ability to navigate labor supply challenges while utilization, attrition, and wages are high. Operational excellence will likely reside with those that can attract and retain skilled workers and pass on high service costs.

Information services/software/payment

The outlook for this subsector is stable to positive with predictable revenues and further EBITDA margin expansion opportunities. Credit risk factors include balancing the use of free cash flow toward debt reduction and shareholder returns which have accelerated. Large providers including Fidelity National Information Services Inc., Fiserv Inc., Global Payments Inc., and MSCI Inc. will continue to benefit from solid recurring revenue mix and operating leverage. These companies do not have any direct exposure to Russia or Ukraine. We also expect payment processors to continue investing in omni-payment software solutions to service their large network of merchants, enterprises and financial institutions through both organic and inorganic means.

Consumer credit bureaus such as Fair Isaac Corp. (FICO), Equifax Inc., and TransUnion capitalize on large datasets and analytics that support effective decision-making and they have executed well in recent years. They have solutions that are well integrated into their clients' workflow systems, and we continue to expect strong organic growth in this sector in 2022. We expect FICO's entrenched scores business to grow 10%-15% due to future price increases targeted toward insurance, health care, and international end markets. Nevertheless, M&A activity has picked up, and debt-funded acquisitions (often with EBITDA multiples well above 20x) are likely to slow the pace of deleveraging. We expect software service providers such as Verint Systems Inc. to report solid revenue and gross profit growth with cloud-based solutions adoption and this should support an acquisitive growth strategy funded with cash and debt to compete against larger and faster-growing competitors.

Security and safety services

This subsector includes private security, cash-in-transit, alarm monitoring, and prison operators. We expect the global security installation and servicing market to grow faster than GDP in the 5% area. In our base case, U.S. labor and global supply chain risks are unlikely to significantly affect gross margins in 2022, however we expect this to be a larger issue for companies such as Allied Universal Topco LLC. Being the third largest employer in the U.S., the tight U.S. labor market has hurt the company's employee turnover and increased nonbillable overtime wages after having benefited in 2020 from COVID-19 screening services, lower wage pressures, and higher unemployment rates. Additionally, several factors supported organic growth over the past two years for some segments. For example, residential alarm providers benefited from lower attrition levels (as move-related disconnects declined), fiscal stimulus, the support of residential and commercial owners in paying their ongoing monitoring fees, and the increased deurbanization and work-from-home trends. These companies, which typically generate relatively low free operating cash flow due to the large capital expenditures needed for customer acquisition, also recorded better cash flow dynamics as the industry adopted third-party financing models. For instance, APX Group Holdings Inc. (a/k/a Vivint) was able to generate positive free cash flow in recent periods and we expect this to continue in 2022 as it approaches scale required to drive sustainable cash flows despite annual customer attrition. On the other hand, Monitronics International Inc. (d/b/a Brinks Home Security) continue to face liquidity risks with nearing debt maturities. Some of these companies will likely pursue aggressive debt-funded M&A that will elevate leverage levels and constrain free operating cash flow.

Related Research

• Economic Outlook U.S. Q2 2022: Spring Chills, March 29, 2022
• Global Macro Update: Preliminary Forecasts Reflecting The Russia-Ukraine Conflict, March 8, 2022