Key Takeaways
- Cost inflation, rising interest rates, supply squeezes, and softening demand will stymie earnings and credit measures for Australian companies over the next two years.
- S&P Global Ratings expects refinancing for speculative-grade issuers to become more challenging and capital investment to moderate amid rising input costs and higher debt costs.
- Rising rates will affect REITs in particular whereas companies with pricing power and less discretionary demand, such as supermarkets, telcos and regulated utilities, will remain well placed.
Corporate Australia faces a stern test. Balance sheets are strong. And they will need to be because in the next two years the ride could get rough. Interest rates are rising to combat stubborn inflation linked to the recovery from the pandemic, supply chain problems and booming commodity prices. This is likely to slow the economy and reshape the operating and capital market environment of the past few years. Wage and other cost inflation, rising interest rates, supply squeezes, and softening demand will shackle earnings and credit measures.
Consumer Demand To Be Tested In The Months Ahead
We expect rising interest rates and elevated prices to dampen spending in the next 12 months as the Reserve Bank of Australia strives to reduce inflationary pressures. This will challenge the more discretionary parts of the retailing landscape, such as apparel and consumer durables.
The Australian consumer has shown remarkable resilience. Retail sales have continued their robust COVID-19 recovery in recent months (see chart 1). Low unemployment and elevated savings buffers have supported strong demand despite rising prices.
Chart 1
We expect the major supermarket retailers, Coles Group Ltd. and Woolworths Group Ltd., to be relatively well positioned. Rising costs and labor constraints will likely crimp margins, but absolute earnings and cash flow generation should remain healthy. Driving the solid performance: The supermarkets' exposure to largely non-discretionary expenditure, bargaining power, and an ability to adapt their sales mix to lower prices.
Wesfarmers Ltd. has some exposure to more discretionary retailing segments. However, its credit profile remains underpinned by its diversified business model, significant exposure to non-discretionary expenditure, and sizable headroom in its credit metrics.
Consumer appetite for travel has also returned but we anticipate some demand to moderate as interest rate rises bite. Airlines report that demand for leisure airline travel is already above pre-COVID levels and business travel is at 90% of pre-COVID levels. Domestic traffic through airports should, in our view, recover to pre-pandemic levels by early 2024, and international traffic by late 2025. This view underpinned our recent outlook revisions to stable from negative for the five Australian airports we rate (Southern Cross Airports Corp. Holdings Ltd., Brisbane Airport Corp. Pty Ltd., Adelaide Airport Ltd., Australia Pacific Airports Corp. Ltd. and Perth Airport Pty Ltd.).
High Energy-Related Commodity Prices To Persist Despite Slowing Demand
Elevated commodity prices remain a key support for the Australian economy. This is despite the easing of prices of some metals from their peaks in recent months. Thermal coal and liquified natural gas (LNG) prices remain high because of supply shortfalls, exacerbated by the Russia-Ukraine conflict.
Commodity prices should moderate, in our view, as the global economy slows. But supply constraints arising from Europe's bid to replace Russian supplies should prop up prices of energy related commodities, such as thermal coal and gas, in the next one to two years. This is supplying producers with ample cash flow. BHP Group Ltd., Woodside Energy Group Ltd., Santos Ltd. and others have reported surging cash flows. This is providing capacity for a mix of new investments, mergers and acquisitions (M&A), and shareholder returns. For example, Santos' Pikka Phase 1 project is proceeding to final investment decision and adds about US$1.3 billion (Santos' share only) to its existing committed capital expenditure pipeline.
Notwithstanding large growth pipelines across the commodity sector, rising costs, strict environmental approvals and supply chain constraints are likely to slow the rate of this investment as producers weigh these risks against potential returns.
For Fortescue Metals Group Ltd. and other iron ore producers, weaker demand from China--due primarily to their slowing property market--will drive iron ore demand and pricing. And, depending on the severity of the property market weakness, this demand could offset infrastructure spending stimulus. The robust balance sheets of the producers, including Fortescue, shield creditors against potential price declines.
Chart 2
High commodity prices and supply issues will also affect integrated electricity players. This together with poor plant availability and the closure of the Liddell plant in April 2023 could force up wholesale prices and fuel inflation across many industries. Unless plant availability improves, the integrated electricity companies face an erosion in the earnings of their core energy business. These companies include Origin Energy Ltd., AGL Energy Ltd., and EnergyAustralia Holdings Ltd.
Origin Energy failed to provide earnings guidance for fiscal 2023 (ending June 2023) because of uncertainty over fuel supply and energy market volatility. This is despite the large dividends Origin gained from its Australia Pacific LNG investment.
Infrastructure operators (such as rail, ports, toll roads) derive reasonable protection from their ability to pass through higher fuel prices and inflation to end consumers. Still, they may have to absorb increasing wage and insurance costs over the next 12-24 months. In the absence of extreme weather, Aurizon Group and Pacific National could benefit from improvement in export coal volumes because of strong demand from Asia. We expect the focus to remain firmly on cost savings and discreet capital investments as companies emerge from the restrained spending during the pandemic.
Volatile Capital Markets To Temper M&A
We project rising capital costs and slowing growth to temper the rate of large-scale M&A. Private equity buyers, who are often the marginal price setters for M&A, face much higher debt costs and potentially lower funding capacity.
Computershare Ltd. acquired U.S.-based Computershare Corporate Trust in late 2021. Since then, rising interest rates have led its margin income to surge. We expect CSL Ltd.'s acquisition of Switzerland's Vifor Pharma AG to add 20% to group EBITDA in fiscal 2023 while its existing plasma business faces lingering COVID-related hits. Orica Ltd.'s acquisition of Axis should bolster its digital mining services platform and increase its market share.
On the sell side of the equation, Santos' proposed divestiture of its interest in a key LNG project in Papua New Guinea, if completed, will moderate the oil and gas producer's exposure to the country and consolidate its credit profile.
The infrastructure segment could see the focus shift to the local market for growth. APA Group has shelved its ambition to pursue growth in the U.S. market in favor of opportunities in the domestic market, particularly in the electricity segment. AGL Energy is exploring the next steps for its business units, while Hong Kong-based CLP Holdings is seeking partnership in EnergyAustralia or to invest in green growth opportunities. Also, Aurizon Group will look to divest its East Coast Rail coal haulage businesses in line with its undertaking to the competition authority.
REITs Well Positioned For Higher Rates--For Now
For the REIT sector, rising interest rates remain a risk to valuations, cash flows, and credit quality. However, the REITs we rate are relatively well positioned for the next 12 months. Long-dated debt, conservative interest-rate hedging profiles and contracted rental growth should help to protect their cash flow and earnings.
This contrasts with the prevalence of short-dated debt and limited hedging of many REITs leading into the 2008 financial crisis. Over the next two to three years, however, we anticipate higher rates will squeeze REITs' free cash flow generation and credit measures as interest rate hedges roll off.
Chart 3
Demand for prime office space in central business districts should hold up relatively well over the next few years. This is despite the structural change associated with online retailing and work-from-home trends. Space users are likely to migrate toward the higher-end and more environmentally friendly buildings owned by our rated REITs as their space demands reduce with hybrid work arrangements. Office rental levels may suffer as the market adjusts to this potential demand-supply imbalance.
The shift to hybrid working is also causing behavioral change in commuting. The switch from public transport to private vehicles for work travel supports demand for Transurban Group's toll roads.
Tenant demand for space in high-quality shopping centers, such as those owned by Scentre Group and Vicinity Centres, is proving resilient even as some retailers reduce their number of physical stores. Online shopping will continue to limit space demand from individual retailers, but we believe the better positioned centers will continue to evolve their tenancy mix and remain a gathering point for communities.
The surge in online retailing is maintaining demand for logistics space. Strategically positioned urban-infill sites help to mitigate supply-chain and distribution disruptions for retailers. Operators such as Goodman Group have benefited from this demand while companies such as GPT Group and Stockland Corp. Ltd. have increased capital allocation toward logistics assets.
The operating landscape continues to evolve. Rising rates, higher costs and a slowdown in demand will put a healthy Australia Inc. to the test. Companies with superior balance sheet strength, pricing power and nimble operating strategies will be best placed to deal with these multiple challenges.
Related Research
- Spark New Zealand To Balance Leverage With Growth Ambitions, Aug. 31, 2022
- Newcastle Coal Infra Junior Debt Upgraded To 'BB-'; Outlook Stable; Senior Debt 'BBB' Rating Affirmed; Outlook Positive, Aug. 29, 2022
- Wesfarmers Can Endure A Consumer Spending Slowdown, Aug. 26, 2022
- Costs To Weigh On Woolworths' Margins, Aug. 25, 2022
- Telstra's Restructure In Line With Growth Strategy, Aug. 25, 2022
- Food And Cost Inflation To Nibble At Coles' Margins, Aug. 24, 2022
- New Zealand Post's Kiwibank Divestment Deleverages Balance Sheet, Aug. 23, 2022
- Santos' Proposed PNG LNG Selldown Curbs Country Risk, Aug. 18, 2022
- CSL's Brighter Earnings Outlook To Support Deleveraging, Aug. 17, 2022
- Perth Airport Outlook Revised To Stable On Strong Growth In Traffic; 'BBB' Ratings Affirmed, Aug. 2, 2022
- Adelaide Airport Outlook Revised To Stable On Strong Growth In Traffic; Ratings Affirmed At 'BBB', July 28, 2022
- Brisbane Airport Corp. 'BBB' Ratings Affirmed, Outlook Revised To Stable On Firming Passenger Recovery, July 28, 2022
- Melbourne Airport Outlook Revised to Stable On Progressive Traffic Recovery; 'BBB+' Rating Affirmed, July 28, 2022
- Southern Cross Airports Outlook Revised To Stable On Strengthening Traffic Recovery; 'BBB+' Ratings Affirmed, July 28, 2022
This report does not constitute a rating action.
S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).
| Primary Credit Analyst: | Richard Timbs, Sydney + 61 2 9255 9824; richard.timbs@spglobal.com |
| Secondary Contact: | Paul R Draffin, Melbourne + 61 3 9631 2122; paul.draffin@spglobal.com |
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