Given the weakening macroeconomic environment and the rapid interest rate increases to combat elevated inflation, S&P Global Ratings is providing a refresh of our commentary "Macroeconomic Uncertainties Matter More Than Rising Interest Rates To Low-Rated U.S. Tech" published in March to incorporate our latest assumptions. In just one quarter, the macroeconomic backdrop underpinning our analysis has significantly deteriorated. The U.S. GDP growth rate has slowed considerably this year, with a second-quarter contraction of 0.9% after a 1.6% drop in the first quarter. S&P Global economists' assessment of recession risk over the next 12 months is 40%-50%, compared with 20%-30% just one quarter ago.

Here are our updated stress test assumptions:

• We stress LIBOR/SOFR rate to increase to 350 basis points (bps) by year-end 2022 and rise by another 50 bps by year-end 2023.
• We assume reduced sales and higher operating costs leading to lower EBITDA by 5% for software and 10% for hardware companies.

These assumptions are hardly the extent of the challenges lower-rated tech issuers will likely face the next two years. However, we believe this is a good starting point to help identify those companies most at risk of negative rating actions, based on our current downgrade or outlook revision thresholds, holding all else equal.

It's not surprising this updated stress test resulted in a larger number of companies on our "watchlist." Here we share our expectations for the extent and the timing of such actions.

Negative Rating Actions Will Be A Matter Of How Many, Not If.

While demand for technology products and services has remained resilient in the early part of 2022, characterized by large backlogs and stable book-to-bill trends, it's also evident that consumer IT spending is now weaker and could spread to reduce enterprise IT spending as the waning macroeconomic environment leads to enterprise IT budget cuts and layoffs.

These negative credit factors will likely exacerbate the pressure placed on credit metrics from rapidly rising interest rates, which could prove significant to many debt-laden tech issuers with scant free cash flow (FCF) generation.

Some Companies Are More At Risk Than Others

Some tech companies are at higher risk of negative rating actions due to various factors like business size, debt outstanding, exposure to foreign exchange rate fluctuation, and supply chain and inflation risks.

High small to midsize businesses (SMB) exposure.  SMBs are usually the first to show signs of deterioration during an economic slowdown. Technology companies with high SMB exposure were relatively resilient during the pandemic, but this was largely in part to the substantial amount of government support provided to SMBs through several waves of stimulus packages.

Financial sponsor-owned companies.  Tech companies that have highly leveraged financial profiles and an aggressive acquisition strategy and are owned by financial sponsors benefitted from a long stretch of favorable business and credit conditions that allowed them to engage in debt-financed acquisitions and still generate positive free cash flow. However, as the macroeconomic backdrop worsens, coupled with rising interest rates, companies with a significant amount of debt outstanding, especially those that have recently gone through a leveraged buyout (LBO) or engaged in large-size acquisitions are particularly vulnerable. These companies will likely have to incur costs to achieve targeted costs savings in the face of a weaker business environment that typically places higher focus on liquidity preservation, which could comprise operational or financial goals.

Lower value-add providers.  Companies that operate in highly competitive marketplaces or have less brand value, such as those within the supply chain and are far removed from end consumers, are particularly vulnerable during economic slowdowns due to typically weaker margin profiles to absorb demand shocks. These companies generally have lower leverage or excess liquidity to compensate for the added business risk. Those that don't, could be vulnerable in a business downturn.

High growth trajectory/high investment requirements.  Companies with good longer-term growth prospects but have low or no free operating cash flow (FOCF) generation due to high investment spending may face rating pressure. Our ratings on these companies could be somewhat contingent on strong secular growth and a significant improvement in FCF generation over time. When faced with macroeconomic challenges and prioritization of liquidity preservation, opting for lower investments over a short period could jeopardize longer-term growth trajectories.

Fallout from foreign exchange, supply chain, And inflation risks.  Technology companies with overseas operations are likely to feel the increasing pressure from the strengthening dollar, which will likely drag down profitability if not fully hedged.

Transition to subscription-based business model from transactional.  Companies in the process of transitioning to a more subscription-based business model will likely experience additional challenges when compounded by macroeconomic headwinds. The move to a subscription model typically includes significant implementation costs and added operational risks for customers. We often see customers slow such transitions and, at the same time, delay any significant license purchases, hurting tech companies' FCF generation.

Recent Rating Actions Explained

So far this year, we have taken 18 negative rating actions on non-investment grade issuers (see table 1), far outpacing the 6 positive rating actions, with many of the negative rating actions being outlook changes, rather than rating downgrades. Of these 18 negative rating actions, hardware & semiconductor accounted for 7 (out of 47 total hardware & semi companies we rate) while software & services had 11 negative rating actions (out of 90). While software negative rating actions have outpaced hardware year to date, it is important to note that most of these software rating and outlook changes were triggered by aggressive financial policy actions rather than a fundamental weakness causing increasing leverage. We revise outlooks to negative when there is a greater than one-third chance of a downgrade. We envision more such actions within the next 12 months given the uncertainties associated with the macroeconomic environment and our expectation for tighter liquidity for weaker tech issuers.

Table 1

While it's no surprise that hardware companies would be of higher credit concern given their transactional business model, we refrain from applying overly conservative assumptions since the impact from business risk factors may not be uniform even for companies in the same industries. For example, NCR Corp., Diebold Nixdorf Inc., and VeriFone Inc. are subject to similar business risk factors given their exposure to payments hardware. All three companies reported record high backlogs. However, while NCR and Diebold suffered from dwindling profitability and large negative working capital swings draining cash, Verifone proved to be much more resilient than expected mainly because it had the foresight to enact price increases earlier in the year, offsetting much of the interim margin pressure.

On the other hand, Diebold's situation was particularly volatile, hurt by inflationary pressure and supply chain challenges that led to significant working capital swings. The company was a microcosm for the rapidly changing business environment that could affect other tech companies if a recession comes to fruition. We downgraded the company to 'CCC+' and placed the ratings on CreditWatch with negative implications on May 11, 2022. With significantly negative FOCF, Diebold will likely have to increase the use of its revolver, which matures in 12 months while also facing a significant debt maturity in 2023 when its $755 million first-lien term loan becomes due. Given the refinancing risk, we view a debt restructuring as a higher probability event over the next 12 months.

We also saw Avaya Inc.'s rating trajectory take a turn for the worse. The steep credit deterioration was the result of an already weak FCF profile, higher refinancing risk, management changes, business transition to a subscription model from a licensing model and going-concern uncertainties as assessed by its auditors. We lowered our rating on the company to 'CCC-' from 'CCC' with a negative outlook on Aug. 11, 2022, as a result.

Negative Rating Actions Highly Correlated To Macroeconomic Trends

The number of companies flagged by this new stress test is 22, double the count from our previous test conducted in March 2022 (see table 2 and 3). While incremental interest costs are clearly negative for credit quality assessments, it's less of a factor, in our view, relative to a potential difficult business environment when assessing heightened default risk faced by many lower-rated tech issuers. Our expectation for U.S. GDP growth is about 2% in 2022 and about 1.6% in 2023. However, in our downside case scenario, we could envision U.S. GDP of 1.7% in 2022 and negative 0.6% in 2023, as well as our global IT spending growth rate deteriorating to 1.1% in 2023, down from about 4% in our base case scenario. In such a stressed scenario, we anticipate a year-over-year sales decline in 2023 for many hardware and semiconductors companies, an overall flattish IT services spending environment, with discretionary IT spending hurt but offset by strategic growth areas within 5G, electric vehicle, data center, and cloud segments. Software revenue growth, while positive, will likely decelerate significantly to the low- to mid-single digit growth versus a high-single digit growth expectations in our base case scenarios.

We note that 19 of the 22 companies flagged are rated 'B-' or lower. Most of the 'B-' rated companies have modest to breakeven free operating cash flow and we believe that in a mildly stressed macroeconomic environment that will likely lead to EBITDA contractions, it is conceivable that some of these companies will generate negative FOCF that may result in negative rating actions. Investment-grade issuers or those in the 'BB' category aren't in scope as we believe these entities have sufficient cushion to manage a mildly stressed macroeconomic environment. However, should a recession lead to operating results materially worse than our expecations, we can envision rating pressure migrating to the 'BB' category.

Table 2

Table 3

Do We Expect More Downgrades To 'CCC'?

We believe a deep and lengthy recession would lead to more downgrades to the 'CCC' rating category. However, most of our lower-rated tech issuers can withstand a mild recession that we believe will merely delay rather than eliminate IT spending or lead to significant layoffs. As many of our 'B-' rated tech issuers are software companies with predictable revenue and FCF generation, we believe many of them will be able to navigate through the challenging macroeconomic environment with their ratings intact.

We've identified eight software/services companies at higher risk of negative rating actions because of several factors including low FOCF generation due to high-growth investments, stressed balance sheets with a large degree of leverage, as well as transitions to more subscription-based sales models. The element of uncertainty will likely be the main driver of outlook changes to negative over the next few quarters. Tech issuers that are most vulnerable to downgrades are those that require favorable operating environments in order to preserve credit metrics.

Fourteen of 22 companies identified by our stress test are hardware companies, which we believe are most vulnerable to business underperformance because of their revenue and cash flow variability. While we will continue to see lower FCF levels and higher leverage, a good portion of the companies on this watchlist don't face near-term debt maturities and may be able to weather the storm. We're not quite at the point of sounding the alarms with ubiquitous downgrades; however, we've have already seen companies like Avaya and Diebold take sharp tumbles and wouldn't be surprised to see a few more downgrades to the 'CCC' rating category if we enter into an environment that is worse than a mild recession.

This report does not constitute a rating action.