Macroeconomic Uncertainty, Persistent High Interest Rates Weaken Cash Flow Prospects For Several Companies

The U.S. economy continues to run too hot. Policy interest rates will likely need to go higher and stay there for longer to slow economic activity, weighing on cash flow for the business services sector over the next 12-18 months. Labor markets remain tight, although some cracks are emerging. We expect a growth slowdown in the U.S., and stagnation in the eurozone where risks are elevated and inflation remains sticky. (see "Economic Outlook U.S. Q3 2023: A Sticky Slowdown Means Higher For Longer", published June 26, 2023).

Higher interest rates for most issuers, inflationary challenges, rising wages for labor-intensive operations, high gas prices for distributors, and cyber risk for some information, payment, and technology service providers remain key risks in 2023 and 2024. This will weaken cash flow compared to 2022 for several issuers and slow the deleveraging assumed in our ratings on roughly 285 global business and technology services and insurance services companies (73% are rated 'B+' or below).

Despite Passing Through Higher Costs, Ratings Cushion Will Narrow

Our sector rating outlook bias (chart 2) is shifting increasingly negative, indicating a rising risk of downgrades due to higher interest rates and slowing economic growth. For instance, in North America, the negative bias (percentage of issuers with a negative outlook or on CreditWatch with negative implications) for business and technology services issuers rose to 19% at the end of May from 13% in October 2022, reflecting our expectation for greater pressure on margins and cash flow because of rising rates and deceleration in economic growth. This is slightly higher than the about 17% for U.S. corporates as a whole.

As the U.S. Federal Reserve aggressively hiked interest rates to curtail inflation, the cost of hedging rising interest rates correspondingly increased sharply. As a result, only about 50% of U.S. business and technology services issuers that we rate 'B' or 'B-' are hedged through interest rate derivative contracts. Furthermore, these hedges provide protection for an average of only 64% of the total notional value of outstanding debt, creating significant exposure to higher base interest rates. Coupled with recent limitations on the tax deductibility of interest expense, we believe higher debt service costs will challenge cash flow generation and liquidity improvement this year.

Since our last publishing in October 2022 we have taken 26 negative rating/outlook actions and 22 positive actions in North America. Because of higher interest rates and potentially lower EBITDA relative to our prior base case, we expect deterioration in credit quality and some refinancing risk, particularly in the 'B' (66% of the portfolio) and 'CCC' (6%) categories.

Within Europe, the Middle East, and Africa, our outlooks on 7% of companies we rate in the sector are positive, versus 10% with negative outlooks. Year-to-date rating actions have been more positive--10 versus only four negative actions--suggesting positive trading momentum since the worst of the COVID-19 pandemic and some issuers running more prudent balance sheets. We expect the eurozone will emerge from stagflation in the second to third quarters in 2023 because of disinflation and the first normal tourist season since the COVID-19 pandemic.

Chart 1

Chart 2

Debt Maturity Wall Could Trigger Quicker Downgrades To 'B-' And 'CCC+' For Issuers With Weak FOCF Prospects

Chart 3

Refinancing risks in the U.S. business and technology services sector will increase with rising cash flow pressure and upcoming debt maturities as over $57 billion of debt matures through 2025. Interest rates will remain high and uncertainty in financial markets will likely persist, complicating otherwise straightforward refinancing transactions.

Issuers we rate in the 'B' category are particularly exposed given large debt overhang, weaker earnings growth, and more narrowly focused businesses. Even those issuers that we expect to demonstrate more stable operating performance could struggle to refinance on economically acceptable terms. Downgrades toward the 'CCC' category will likely accelerate for issuers that we expect will struggle to refinance relative to those with improved prospects. Our assessment of refinancing prospects incorporates operating performance expectations, credit market conditions, banking relationships, potential to tap alternative financing sources including preferred equity or private credit, and ability to potentially sell the business at a valuation that would support debt repayment at par.

Even in cases with sufficient liquidity and minimal near-term debt maturities, persistently higher debt service costs could limit free operating cash flow (FOCF) generation while our longer-term view of capital structure sustainability contributes to ratings pressure. Furthermore, to the extent debt trading prices decline, we believe issuers are generally more likely to execute subpar debt exchanges that we could view as distressed and tantamount to a default. For instance, 44% of U.S. defaults so far in 2023 have been distressed exchanges. In addition, a significant portion of transactions in this space involved alternative sources of funding such as preferred equity or private debt. We've seen limited refinancing activity among 'B' and 'B-' rated issuers. However, a few such as Inmar Inc. have mitigated credit downside over the next 12 months by extending large 2024 maturities to 2026 and refinancing maturing debt with preferred equity to reduce cash interest expense. Ratings pressure could persist even for issuers that complete refinancing transactions if they don't comprehensively extend debt maturities.

Table 1

Key Sector Assumptions For 2023

Demand remains steady within the sector, and we expect median revenue growth of about 5% in 2023, aided by increased market penetration, stable retention rates, cross-selling, and higher pricing for many companies. Companies will mostly pass inflationary cost pressures to end customers by year-end, although intrayear earnings volatility is likely as price increases gradually reset. Several issuers also can quickly reduce idle capacity in their labor forces, which aids near-term earnings visibility. As a result, we expect a year-over-year increase in EBITDA margins in 2023 for roughly two-thirds of issuers we rate given the digitalization of their workflow/services and lower staffing requirements, partially offset by inflationary pressure. A few issuers, especially in the U.S., have also cut capital expenditure modestly to adjust for the lower backlogs or order delays.

Despite these factors, given the outsize impact of higher interest expenses, we still expect about 57% of the U.S. issuers we rate to report year-over-year FOCF declines in 2023 (chart 4). Lower-rated companies have sharply cut mergers and acquisitions (M&A), although more highly rated companies remain active. Large bid-ask spreads between buyers and sellers and high interest rates continue to hamper M&A activity. This also limits upside for several issuers' competitive positions with niches in highly fragmented sectors because they depend on inorganic growth to expand their breadth of offerings and geographic presence.

Chart 4

Global Outlook And Trends Are Mixed For Some Subsectors

The overall rating outlook for the sector remains stable (albeit with an increasing negative bias) due to strong demand for outsourcing noncore competencies, automation/digital transformation, and data/analytics. Based upon our assessment of inflation and labor market risks, we believe distributors, facilities maintenance providers, and software and information services providers are most vulnerable to downside risks. Conversely, we believe the impact on companies providing education and publishing services, security and safety services, insurance services and payment services will be minimal. Lastly, 80% of sector issuers in the 'BB-' and 'B+' categories enter an uncertain macroeconomic environment over the next 12 months with lower leverage than the corporate average.

Chart 5

Distribution services

This subsector serves many end markets, with retail, energy, and discretionary-like segments most vulnerable to weakening GDP. Rising gas prices and wage inflation for distributors could impair near-term operating performance. For distributors tied to promotional products such as CB Poly Investments LLC and Halo Buyer Inc., we expect organic growth to remain challenged as customers and end users tighten their budgets. Given potentially slowing traffic in the quick-service and casual dining restaurant segments, we expect companies such as Double Eagle Buyer Inc. (d/b/a Restaurant Technologies) and BCPE Empire Holdings Inc. (d/b/a Imperial Dade) to face additional pressure in strengthening organic revenue growth in 2023, with higher reliance on new customer wins, upselling services, and price increases. The credit profile for highly leveraged distributors with limited product scope such as Imperial Dade have little room for execution missteps against potential cost pressures. On the other hand, we expect larger and significantly more diversified competitor Bunzl PLC to be resilient to the macroeconomic downturn, albeit with less pricing power, in 2023.

Facility maintenance

This subsector includes companies providing heating, ventilation, and air conditioning (HVAC), insulation, and other technical services. We expect recession risks to pressure revenues and earnings for building materials contractors persistently over the next 12-18 months given our forecast for a meaningful decline in housing starts, which will slow the build-up of new backlog. Homebuilding contractors this year continue to benefit from contracts signed before the rise in mortgage rates. In the first quarter of 2023, a large backlog of single-family and multifamily homes under construction remained. However, we expect revenue softness sooner because homebuilders may put projects on hold in uncertain macroeconomic times (see "How U.S. Building Material Contractors And Mortgage Servicers Are Navigating Market Volatility", published Oct. 20, 2022).

As a result, for national scale players including Installed Building Products Inc. and TopBuild Corp., we expect adequate rating cushion to weather modest near-term pressure on residential construction demand as long-term fundamentals support steady operating performance beyond 2023. Performance of some HVAC and refrigeration companies with lower ratings such as Legence Holdings LLC (formerly d/b/a Therma) and Saber Intermediate Corp. (d/b/a Service Logic) has been resilient with steady backlogs and margins, and margin performance in 2023 could improve if business mix shifts toward more profitable maintenance services. Conversely, profitability for operators such as CoolSys Inc. has lagged HVAC peers and will likely remain below peers in 2023 as price increases are mostly offset by rising input costs.

Though much demand will be nondiscretionary over the next two years, we expect project pipelines to remain vulnerable to customers postponing large-ticket repairs such as roof replacements with smaller repair jobs. While we expect revenue growth in residential end markets to slow, we anticipate stable growth in the commercial end market. As a result, for service providers such as BrightView Landscapes LLC (its commercial segment accounts for about one-third of total consolidated revenues), margins will modestly improve in 2023 on higher volumes as fuel costs and supply chain disruptions subside and they can increase prices. On the other hand, we expect margin pressure to continue into 2023 for energy services company Veregy Intermediate Inc., which caters to academic and government end markets, with rising inflation and little ability to increase prices.

Overall, residential construction projects growth will likely drop by double-digit percents in 2023 as economic uncertainty and rising interest rates weigh on demand and elongated building cycles slow construction. Nonresidential construction should revert to growth in the mid-single-digit percent area in 2023 after declining in 2022. Delaying maintenance work often leads to other issues (leaks, breaks, and wear and tear) and more complex job orders, potentially aiding the pace of recovery in 2024.

Information services /payments

Companies with significant revenues tied to mortgage servicing face pressure over the next 12-18 months amid higher interest rates. Consumer credit bureaus such as Fair Isaac Corp. (FICO), Equifax Inc., and TransUnion capitalize on large datasets and analytics that support effective decision-making. They have executed well in recent years, with products that are well integrated into their clients' workflow systems. We continue to expect strong organic growth into 2023 to support modest deleveraging. Nevertheless, M&A have picked up, and debt-funded acquisitions (often with EBITDA multiples well above 20x) will likely slow deleveraging. We expect some software service providers such as Verint Systems Inc. to report earnings improvement and moderate tuck-in acquisitions to further its analytics, automation, and cloud-deployment capabilities. This should support midsize acquisitions funded with cash and debt to compete against larger and faster-expanding competitors.

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., MSCI Inc., and Experian Finance PLC will continue to benefit from solid recurring revenue mix and operating leverage. Ratings hinge mostly on financial policy and the commitment to keeping leverage at or below 3x while these issuers pursue acquisitions and/or buybacks. We also expect payment processors to continue investing in omnipayment software to service their large network of merchants, enterprises, and financial institutions through both organic and inorganic means.

Software services

We forecast FOCF will decline for 61% of U.S. software business services companies in 2023. While these companies generally benefit from recurring subscription-based revenue models that support earnings visibility, their very high debt burdens and limited interest rate hedging render them susceptible to the rising interest rate environment.

Outsourced business and IT services

Spending is highly correlated to global GDP, so a severe and lengthy recession in the U.S. could hurt tech companies' performance, more so in hardware than software services. Slower enterprise spending, potentially in reduced data center investments, would be a signal for the entire sector. A shallow recession, however, may only delay purchases rather than cancel them. We expect an above global GDP growth rate for the information technology (IT) services industry, about 4% revenue growth in 2023 (about flat compared to 2022). Demand remains strong in areas such as digital transformation, cloud migration, and automation. Large projects such as enterprise resource planning, software implementations, and consulting engagements were abundant in 2022, a continuing trend from 2021. These projects tend to have long implementation periods and involve development or modernization of both front-end application and back-end platforms and infrastructure across areas such as customer engagement, cloud, artificial intelligence, big data, analytics, and cyber security. As businesses embed more technology in their operating environments, IT services vendors will have a bigger role to play as trusted business partners, favoring those with the most digital expertise but also superior customer service.

Furthermore, hybrid work appears to be here to stay. IT services to help accelerate the shift from on-premises to a private and public cloud environment will be essential. We expect large vendors such as Accenture PLC to report mid-single-digit percentage growth in 2023, aided by strength in these areas. We anticipate more growth ahead in 2023, albeit at a lower rate, aided by clients' desire to increase productivity gains, especially in a still tight labor market with rising wage pressure. However, there are two big risks ahead: the ability to navigate labor supply challenges and significant contraction in IT budgets such that enterprises defer these large and capital-intensive projects, especially if priorities could be given to liquidity preservation in times of stress.

Similarly, after solid resilience through the COVID-19 pandemic, outsourced customer relationship management companies such as Teleperformance SE enjoyed strong commercial momentum through first half of 2023. We expect this to continue through 2023, with some pressure from small and midsize business clients for which the sales cycle might get elongated as they enter recessionary conditions. This likely will slow revenue growth over the next 12 months for highly leveraged issuers such as Unisys Corp. and Virtusa HoldCo Inc.

Heightened cyber security threats and awareness will likely increase IT budgets and support better deleveraging prospects for Escape Velocity Holdings Inc. (d/b/a Trace3), Tenable Holdings Inc., and Optiv Inc. on these trends. EBITDA and cash flow were lower in 2022 for many traditional value-added resellers because of a shortage of components and other supply chain issues. As a result, cash flow depends on customer negotiations to bill for partially completed jobs, generating cash flow even from delayed jobs. While we expect supply chain constraints to persist in the near term, these delays should ease modestly over time. This should improve cash conversion cycles and FOCF across the industry.

Commercial services and supply chain

We expect the structural shift in demand for office services and corporate employee relocation since the height of the pandemic to be ongoing headwinds. However, for companies such as Staples Inc. and Sirva Inc., we expect a sustained recovery supported by market share gains and headcount reductions. Similar cost cutting at providers of cleaning and laundry facilities management services, which are largely nondiscretionary, have shifted investments to digitize machines from scale-driven M&A. We anticipate wage and commodity inflation to place near-term pressure on earnings for U.S.-based laundry and linen rental service providers Spin Holdco Inc. (d/b/a CSC ServiceWorks) and WASH Multifamily Acquisition Inc. Our outlooks on these issuers remain stable. These companies can delay growth-oriented capital expenditure to preserve cash and leverage scale to offset inflationary pressures and improve cash collections as they continue to combat revenue declines in their more discretionary segments. On the other hand, we have a positive outlook on rated peer Elis S.A., which operates in less mature markets of Southern and Central Europe. It has negotiated price increases amid solid demand for linen rental services driven by expanding outsourcing and clients' increasing focus on hygiene and sustainability.

Nondiscretionary service providers such as Belfor Holdings Inc. and to a lesser extent W3 Topco LLC (d/b/a Total Safety) face rising cash flow pressures from elongated cash conversion cycles and elevated capital expenditure, respectively. Information storage providers such as Iron Mountain Inc. and Access CIG LLC should benefit from relatively stable organic volumes in 2023, with strong retention rates and growth in digital solutions and secured IT asset disposal. This has helped service revenues exceed pre-pandemic levels without a full recovery of traditional services (shredding, collection, etc.). We believe these companies will increasingly rely on acquisitions, price increases, and market share wins in their traditional businesses. They will also continue to invest in digital record management capabilities to position themselves as the industry shifts. Food service providers present a mixed picture. Although they all benefit from on-site volume recovery since the worst of COVID-19, the ability to pass through food and wage cost inflation differs across the industry, especially with country-specific contract features. Margin pressures may be more moderate for global players such as Sodexo S.A. or Compass Group PLC than for Elior Group S.A., which generates about 45% of its revenues in France.

Consulting and professional services

We expect mixed fortunes for this subset depending on the impact of the tougher macroeconomic environment in the second half of 2023 on specific end markets. For instance, we expect overall home resale volumes to decline about 15% year over year, resulting in recent credit pressure for U.S. residential real estate service providers such as Anywhere Real Estate Group LLC and RE/MAX LLC.

Similarly, volume growth could slow for fund administration and corporate services providers, but a high share of recurring services limits downside risk. We also expect minimal impact from a potential recession on legal, audit, tax, and accounting services companies such as WMB Holdings Inc. (d/b/a CSC) due to their nondiscretionary nature. Countercyclical segments such as bankruptcy and restructuring consulting services should support demand for professional consulting services.

Human capital management

Human capital management includes payroll and human resources software vendors, benefits administrators, background screening providers, and professional employee organizations that offer fully outsourced human resources services to small to midsize businesses. We see limited downside risks for these companies as high retention rates from stronger clients and the tight labor market supports operating performance and credit metrics.

Most industry revenue models are directly related to customers' employee counts or payroll volumes processed, which has positioned industry sales to benefit from high wages and low unemployment rates. While the labor market has cooled in recent months, job opening estimates indicate that labor demand remains elevated. We believe this will further the digital transformation of human resources to attract, reward, and retain employees. Global supply chain constraints and raw material inflation are not meaningfully affecting the subsector, although a modest rise in operating expenses in step with higher labor costs offsets revenue growth to some extent. Notably, for Automatic Data Processing Inc., HealthEquity Inc., and Minotaur Acquisition Inc., the rising interest rate environment has improved credit metrics due to favorable spreads earned on custodial assets and highly profitable net interest income on customer accounts.

Insurance services

This subsector includes companies that predominantly service the insurance sector, including brokers, claims and warranty administrators, and insurance cost containment providers. Revenues are generally tied to underlying insured exposure trends, which in most lines such as commercial property and casualty insurance continue to benefit from rising insurance pricing as carriers seek rates to contend with a rising loss costs trend. Additionally, in contrast to many other service sectors, continued above-trend inflation is providing a boost for many credits, as it increases insured values on various lines of coverage, ultimately translating to higher commissions and fees. Given the large variable expense base of many insurance servicers (as most broker producers are compensated on the revenue they generate), the top line boost from inflation is more than offsetting the expense hit from heightened cost pressures, though companies with more salaried staff or a greater proportion of fixed cost base face greater inflation-related pressures.

Factoring in these continued market tailwinds, we expect healthy organic revenue growth and margin trends across most of the industry over the next year, despite the potential shallow recession and economic weakening that could modestly soften insurance demand. Organic growth will be supplemented by a robust M&A pipeline that has continued given market fragmentation and strong appetite for insurance service-related assets. Trends of course will vary by company and subsector. We believe insurance brokers, the largest subset among sector companies we rate, will fare the best given the generally stickiest revenue streams, a factor that has resulted in a history of generally solid performance during prior downturns. Conversely, the greatest pressure will likely be felt by warranty administrators, which tend to have more concentration in discretionary products with greater ties to consumer spending and supply chain disruption.

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 expand faster than GDP, in the 5% area. In our base case, we anticipate benefit from improving labor availability over the next 12 months, with declining nonbillable overtime and turnover. Moreover, normalizing working capital flow should enable good cash generation this year for companies such as Allied Universal Topco LLC. The third-largest employer in the U.S., Allied's elevated working capital needs, deferred payroll tax payments, and higher-than-normal pension plan contributions led to significant cash flow deficits in 2022 while tight labor availability hindered profitability.

Additionally, several factors supported organic growth over the past few years for some segments. For example, residential alarm providers benefited from lower attrition (as move-related disconnections 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 FOCF due to the large capital expenditure needed for customer acquisition, also recorded better cash flow as the industry adopted third-party financing models. Over the next 12 months backlogs in commercial segment and improvement in residential subscriber attrition could offset macroeconomic headwinds including lower consumer discretionary spending.

Security services providers face mixed fortunes depending on service offerings and scale. Global provider Securitas AB is likely to benefit from the integration of security products, price increases, and the ongoing shift toward the technology to support deleveraging prospects. In the U.S., high subscriber-acquisition costs have plagued the smart-home industry, preventing meaningful free cash flow generation. To combat this, larger players such as NRG Energy Inc., Google LLC, and State Farm Group have made investments to combine sales channels and cross-sell incremental products and services. We expect debt reduction more from disciplined financial policies and group support as opposed to meaningful EBITDA growth, such as in our recent upgrades of ADT Inc. and Vivint. For Vivint, despite the upgrade on close of its acquisition by NRG, we expect slightly better free cash flow in 2023 and 2024 but believe NRG will use it to help service its own debt. For ADT, we expect credit measures to improve following the company's publicly announced plan to deleverage and our forecast of earning growth. At the extreme end, Monitronics International Inc. (d/b/a Brinks Home Security) filed for bankruptcy in May 2023 mostly with an unsustainable capital structure and large free cash flow deficits because of higher interest expense and high customer acquisition costs to achieve subscriber growth and retention targets. Overall, in this subsector, we expect limited use of debt-funded M&A over the next 12 months that elevate leverage and further constrain FOCF.

Prison operators The GEO Group Inc. and CoreCivic Inc. will improve credit metrics toward our rating upgrade thresholds in 2023 and 2024 as prison occupancy rates increase from pandemic-era lows. We expect the expiration of the Title 42 federal emergency health law and other COVID-19-related regulations that suppressed prison populations during the pandemic to improve margins and cash flow. That said, uncertainty around the timing and amount of any legal settlements or penalties relating to labor litigation limits ratings upside in the industry.

Related Research

• Economic Outlook U.S. Q3 2023: A Sticky Slowdown Means Higher For Longer, June 26, 2023
• Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain, June 26, 2023
• Industry Top Trends 2023: Technology, Jan. 23, 2023
• What Rising Interest Rates Could Mean For U.S. Business And Technology Services Companies Rated 'B' And 'B-', Jan. 18, 2023
• How U.S. Building Material Contractors And Mortgage Servicers Are Navigating Market Volatility, Oct. 20, 2022