Ratings Cushion Across The Sector Will Narrow

With the long and variable lag of restrictive monetary policy, together with elevated inflation, our economists expect around 1%-2% GDP growth in the U.S. and Eurozone for 2025 and 2026.

The overall rating outlook for the sector remains stable due to strong demand for outsourcing noncore competencies, automation/digital transformation, and data/analytics.

We expect credit quality to deteriorate and some refinancing risk among the issuers we rate in the U.S. because of higher interest rates and potentially lower EBITDA relative to our prior base case, particularly in the 'B' and 'B-' (55% of the portfolio) and 'CCC' (8%) categories. About 25% of these issuers generated breakeven or lower FOCF as of the most recent trailing-12-month period, given higher-for-longer rates, absence of interest rate hedges, and elevated working capital growth investments with additional reliance under revolvers to meet lease and debt amortization payments. So far this year we have downgraded 12 issuers and upgraded five, in addition to 16 outlook revisions, balanced equally between negative and positive actions. Within Europe, the Middle East, and Africa, our outlooks are mostly stable, with positive outlooks on 3% of companies we rate and 3% negative.

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Higher Interest Rates And Maturity Walls Will Amplify Credit Stress For Weaker Issuers

S&P Global Ratings expects a first rate cut by the Federal Reserve in December 2024, with the terminal rate of 2.9% reached in the second half of 2026. For the Eurozone, we continue to forecast a quarterly cut in European Central Bank (ECB) rates until the deposit rate bottoms out at 2.5% in the third quarter of 2025.

Higher-for-longer base interest rates and a lack of rate hedging across the sector will pressure cash flow and liquidity for issuers we rate 'B' or below, (63% of the sector) in 2024 and 2025. Issuers we rate in the 'B' category are particularly exposed given large debt overhang, weaker earnings growth, more narrowly focused businesses, and unhedged interest rate obligations. For instance, we believe only about 35% of single 'B'-rated U.S. business services issuers are hedged through interest rate derivative contracts. Furthermore, these hedges provide protection for an average of only about 64% of the total notional value of outstanding debt. Therefore, only about 22% of the notional value of outstanding debt in the sector is protected by hedges.

Refinancing risks, especially for speculative-grade issuers, in the global business and technology services sector will increase with rising cash flow pressure and more than $82 billion of upcoming debt maturities through 2026.

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Table 1

Highly leveraged capital structures could complicate debt maturity refinancings among speculative-grade companies.   We expect we will continue to see PIK refinancing transactions as issuers seek cash debt service relief amid the current interest rate environment. Refinancing with payment-in-kind (PIK) securities can ease cash interest burdens and liquidity concerns, but potentially at the expense of longer-term capital structure sustainability. For more details refer to "PIK Refinancing: A Little Room To Breathe, Or One Step Closer To The Edge? Published Feb. 8, 2024" which covers over 25 global PIK refinancing transactions that occurred in 2023 and identifies the factors that distinguish companies rated in the 'B' category from those rated in the 'CCC' category.

Liability management transactions are likely as issuers look to pre-emptively address highly leveraged, unsustainable capital structures.  We expect to see more comprehensive liability management transactions even where liquidity is not immediately at risk to deteriorate. In addition, a significant portion of transactions in this space involved alternative sources of funding such as preferred equity or private debt. 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. We are likely to consider these transactions as distressed and akin to a default if the terms cause lenders to receive less value than initially promised. For instance, 56% of U.S. defaults so far in 2024 have been distressed exchanges.

Higher Rated Issuers Will Remain Resilient Though Financial Policy Remains A Wild Card Amid Rising Margin Pressure

Overall, for investment-grade issuers across global business services, our base-case assumes issuers will remain prudent and reduce leverage (on average) in 2024 and 2025, compared with the all-time peak in 2023 and in line with 2.0x-3.0x threshold for most investment grade issuers (see chart 4 below).

Despite tightened client budgets and elongated sales cycles, we expect steady revenue growth for most issuers rated 'BB+' or above as they remain committed to conservative financial policies.

Several issuers will likely prioritize cash flow for shareholder returns and M&A such as Broadridge Financial Solutions Inc., Automatic Data Processing Inc. (ADP), Cintas Corp., Kyndryl Holdings Inc., MSCI Inc., Fiserv Inc., and Verisk Analytics Inc. This could cause net leverage to increase modestly but remain within our ratings threshold given their healthy cash balances.

For some others, such as DXC Technology Co., and Equifax Inc., and Sodexo S.A., leverage has increased to levels close to the current rating tolerance, but we foresee some improvement in operating performance and expect share repurchases to be curbed if necessary to maintain the rating.

We expect our portfolio of investment grade insurance brokers (Marsh & McLennan Cos., Aon, Willis Towers Watson PLC, Brown & Brown Inc., Arthur J. Gallagher & Co.) to continue to perform well with robust organic growth and steady margins boosted by a favorable insurance market backdrop, good new business and retention, and continued innovation in growth areas such as digital distribution, flood, cyber, and alternative capital. However, similar to other investment grade issuers across broader business services, we continue to expect these companies to offset any credit improvements from performance gains through debt-funded M&A and shareholder initiatives.

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The Credit Impact Of Megatrends Will Rise For Data And Technology Service Providers

AI remains credit neutral for most niche service providers and is modestly positive for tech service providers.   This is mainly because for more than 70% of issuers in the sector, there is limited potential to replace, transform, and regenerate human-work and digital processes in a way that would promise significant efficiency and productivity gains, higher revenue streams, and enhanced competitiveness. Even for labor-driven issuers, physical aspects (such as manned security, facilities maintenance) are unlikely to face secular pressure for the foreseeable future.

AI related initiatives will likely be a modest credit positive for most large IT-service providers (comprise under 20% of rated sector coverage), leading to accelerated revenue growth due to higher demand and investment to enhance longer-term competitiveness. Even for several technology service providers, large amounts of reliable, well-organized data are not yet available for fully automated generative AI solutions and hence presents a barrier that will limit broad adoption in our credit horizon. For more details refer "AI Will Gradually Reshape U.S. Tech Companies' Credit Quality", published April 8, 2024.

For customer experience focused service providers (5% of rated sector coverage), generative AI is also likely to shift competitive dynamics in a sector that has seen an abundance of offshoring to reduce labor costs. Despite longer term disruption risks, service providers could leverage AI to boost employee productivity, enhance the quality and lower the cost of services. This will help reduce the advantages enjoyed by offshore providers and potentially reducing pricing power industry wide.

For more details see "Credit FAQ: AI Bots Are Here, So How Will Customer Experience Outsourcers Cope?", published July 17, 2024.

Cyberattacks have had limited rating impact so far but some issuers remain vulnerable   Cyber risk remains an important credit factor as severity and frequency of hacks add vulnerabilities to data and technology service providers while providing opportunities for cyber-security providers. While not a material driver of credit rating actions to date, we note the rising nature of the threat of cyberattacks in terms of frequency and monetary impact. Material cyber incidents in our sector coverage have affected issuers, such as CDK Global Inc., Sitel Group SA, UKG Inc., Equifax, Rackspace Technology Global Inc., and ISS A/S, that process large amounts of data or provide critical technology services. So far, credit impact has been limited because of swift remediation efforts and access to cyber insurance in most cases.

Additionally, we believe financial data providers like MSCI and Fair Isaac Corp. (FICO), cross-border remittance providers such as TransNetwork LLC, payroll processor ADP and payment processors will incur higher IT security spending, higher cyber premiums, and compliance/legal costs to protect against higher customer churn/reputational damage.

Conversely, we view the evolution of cyber-related developments to be a modest credit positive for issuers like Escape Velocity Holdings Inc. (Trace3), World Wide Technology Holding Co. LLC, UST Holdings Ltd., Optiv Inc., Jacobs Solutions Inc., and Rackspace due to strong demand for cyber security technology software or consulting services providers. For more details, refer to "Cyber Risk Insights: Corporates Up Their Cyber Preparedness As Cyber Attacks Become More Widespread", published Oct. 25, 2023.

Key Sector Assumptions For 2024-2025

• Demand remains steady within the sector, and we expect median revenue grows about 6% to 7% (includes M&A) in 2024, aided by increased market penetration, stable retention rates, cross-selling, and higher pricing for most companies.
• IT services grows around 7%-9% in 2024 mostly on digital transformation, public cloud migration, and automation.
• Despite expectations for an interest rate cut in late 2024, S&P Global economists expect the rate to remain higher for longer and forecast the 30-year mortgage rate at 6.4% in the fourth quarter of 2024, declining to an average of 5.6% in 2025.
• Companies will mostly pass inflationary cost pressures to end customers by year end, although intrayear earnings volatility is likely as price increases gradually reset. As a result, we expect a year-over-year increase in EBITDA margins in 2024 for roughly 70% of issuers we rate given the digitalization of their workflow/services and lower staffing requirements, partially offset by inflationary pressure.
• Despite these factors, given the outsized impact of higher-for-longer interest expenses, we still expect about 41% of the issuers we rate to report year-over-year FOCF/debt declines in 2024 (chart 4).

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Global Outlook And Trends Are Mixed For Some Subsectors

Software; education, childcare, other media services; information services; human capital management; and consulting and professional services companies are most vulnerable to downside risks, while insurance and payment services providers will remain relatively resilient.

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Commercial services and supply chain

Results for most issuers in this subsector are highly correlated to U.S. employment levels, wage inflation, higher interest rates and secular headwinds for office services and corporate employee relocation. For instance, we believe Staples Inc. will face declining demand in core paper and printing products because the number of employees returning to the office has been lower than originally expected. The current interest rate environment will strain budgets for utility customers of issuers such as Asplundh Tree Expert LLC that may look to defer nonurgent work (both vegetation and infrastructure) in the interim. This leads to increased focus on implementing cost saving initiatives in areas such as fleet optimization and procurement.

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 will 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. These companies can delay growth-oriented capital expenditure (capex) 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 recently upgraded rated peer Elis S.A., which benefits from increasing outsourcing, especially in the less mature markets of Southern and Central Europe, and clients' increasing focus on hygiene and sustainability, alongside abating energy cost inflation and prudent financial policy.

For some nondiscretionary service providers such as Belfor Holdings Inc., its core business will grow over the next 12 months through higher job counts, increased demand for maintenance projects, and favorable pricing trends. Information storage providers such as Iron Mountain Inc. and Access CIG LLC should benefit from relatively stable organic volumes in 2024 and 2025, with strong retention rates and growth in digital solutions and secured IT asset disposal. We expect limited growth in EBITDA margins given increased labor and insurance expenses. Food service providers present a mixed picture as 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 or Compass Group PLC than for Elior Group S.A., which generates about 45% of its revenues in France.

Food service providers such as Sodexo S.A. or Compass Group are experiencing decelerating food inflation which, given their general ability to pass on cost inflation, is likely to slow their revenue growth. We continue to forecast moderate profitability enhancements for these companies, underpinned by volume growth and operating efficiencies.

Consulting and professional services

We expect mixed results for this subset depending on the impact of the tougher macroeconomic environment in the second half of 2024 on specific end markets. For instance, in the real estate end market, we expect home affordability challenges will persist. As a result, we forecast a more protracted period of weak mortgage origination volumes will have a negative impact on credit quality for issuers that depend on transaction volume, including CoreLogic Inc., Equifax Inc., Lereta LLC, Emeria Inc., and credit protection insurance broker Kereis SAS. Conversely, we expect real estate data and workflow software providers with more recurring subscription-based revenue models like CoStar Group Inc., and RealPage Inc. will continue to perform well despite lower home sale transaction levels.

For issuers such as Anywhere Real Estate Group LLC and RE/MAX LLC, credit risks related to the recent National Association of Realtors (NAR) settlement, hypothetical scenarios, and complexities in estimating commission income amid broader uncertainty are summarized in "Credit FAQ: Count, Cooperation, Compensation, And Commissions: Are Real Estate Brokerage Fortunes Tied To Agent Finesse?" published April 15, 2024.

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 and as large enterprise customers reduce their number of suppliers to a few trusted and scaled outsourcing partners. Countercyclical segments such as bankruptcy and restructuring consulting services should support demand for professional consulting services. On the other hand, demand for advisory services and M&A-related services should remain lackluster this year but will likely benefit from a more favorable capital markets environment as interest rates trend down. Finally, continued strong hiring trends by consulting companies could lead to margin suppression if demand were to slow down.

We believe IT consultancy companies such as Business Integration Partners S.p.A. and Devoteam Group SAS, will continue growing as they have built out technological capabilities to address secular growth trends including cyber security and digital transformation supporting the digitalization of the Italian public and private sectors, projects related to smart grids led by the global electrification trend, and the migration of IT systems to the cloud.

Distribution services

Distribution services, logistics, delivery, and supply chain related service providers should benefit from growth in 2024 after recent troughs.

This subsector serves many end markets, with retail, energy, and discretionary-like segments most vulnerable when GDP is weakening. Volatile diesel/gas prices and wage inflation for distributors could impair near-term operating performance. However, for issuers such as Liquid Tech Solutions Holdings LLC, top line is fairly insulated from commodity prices as they pass most of these on to customers, though working capital can be very volatile. For distributors tied to discretionary promotional products such as CB Poly Investments LLC and Halo Buyer Inc., we expect revenue and earnings declines will moderate in 2024.

We have seen similar trends for distribution companies that are exposed to discretionary spend of telecommunication providers such as Eos Finco S.a r.l. We expect issuers in markets where fiber to the home (FTTH) penetration remains low, such as Germany or the U.K., will continue investing in the medium term. Yet, we anticipate 2024 will remain a challenging year for telco distributors with largely subdued demand.

Nevertheless, persistently high inflation will likely continue to challenge demand, limiting revenue and earnings recovery. 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 2024, with higher reliance on new customer wins, upselling services, and price increases. On the other hand, we expect larger and significantly more diversified competitor Bunzl PLC to be resilient to the macroeconomic slowdown, albeit with less pricing power.

After strong growth in the solar market in 2022 led to record orders we expect 2024 will be more difficult for distribution businesses exposed to the solar industry in Europe, such as Green Bidco S.a.r.l. Beyond 2024, we expect tailwinds for distribution companies exposed to the energy transition in Europe and globally thanks to supportive policies and ambitious goals that require significant investments that are expected to fuel future revenue growth.

Education childcare and other media services

We expect childcare operators in the U.S. and Europe will continue to see growth in the mid- to high-single-digits in 2024, driven by childcare supply constraints. In the U.S., low unemployment and market participants' ability to implement tuition increases will further support the sector. However, while we expect revenue to increase, we anticipate EBITDA will decline for many U.S. operators in 2024 as pandemic-related federal stimulus funding rolled off in September 2023. Further, we expect margins at European operators will remain pressured because of continued staffing challenges. Still, our overall outlook for the sector remains stable as we forecast companies will remain within our leverage thresholds over the next 12 months.

Facility maintenance

This subsector includes companies providing heating, ventilation, and air conditioning (HVAC), insulation, and other technical services. We expect low housing supply and strong demand will give U.S. homebuilders room to grow in the next two years. Better labor and material availability has resulted in shorter cycle times relative to pre-pandemic levels, enabling builders to prioritize returns through higher asset turns (see "U.S. Homebuilders Are Building On Improving Credit Quality", published June 3, 2024).

As a result, for national scale players including Installed Building Products Inc. and TopBuild Corp., we expect steady performance as pressure on revenue will subside in 2024. 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 retrofit and replacement project backlogs and strong demand across health care and energy solutions. We do not expect cash flow expansion as capex will be elevated in 2024 and 2025 as these issuers catch up on investments in their fleet of vehicles, which supply chain issues and chip shortages delayed. Conversely, profitability for operators such as CoolSys Inc. has lagged HVAC peers in recent years as price increases are mostly offset by rising input costs. These could be offset by potential EPA mandates regarding refrigerants, which will lead to more demand for system upgrades and replacements.

Though demand for large-ticket repairs such as roof replacements will be nondiscretionary over the next two years, we expect project pipelines to remain vulnerable due to customers postponing these projects. We expect revenue growth in residential end markets to slow, but growth in the commercial end market will remain stable. As a result, service providers such as BrightView Landscapes LLC will look to improve margins by aligning its sales force to its local branches, reintegrating core businesses, and focusing on higher quality and profitable businesses. On the other hand, we expect margin pressure to persist in 2024 for energy services company Veregy Intermediate Inc., which caters to academic and government end markets, as the company expands its salesforce to capture increasing demand in new markets including California and Texas, where regulation has made energy efficiency projects more affordable through government subsidies.

Infrastructure service providers will continue benefitting from end-market tailwinds. Companies like Infragroup Bidco S.a.r.l. or Eleda Management AB, which provide installation and maintenance services to multiple end markets across power distribution, water and sewerage, roads, telecom and datacenters, will show earnings growth underpinned by high and counter-cyclical investment needs in the critical infrastructure segment, and increased environmental demands and regulatory requirements. Similarly, multi-technical service providers like Spie S.A. have strong order backlog benefitting from the demand for energy-efficient refurbishments.

Human capital management

The human capital management (HCM) sector should see growth in 2024 despite a softening labor market. HCM 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. Prospects can vary depending on service mix, and we think payroll processors and benefits administrators are well positioned as opposed to background screening providers and talent recruitment software platforms that are more exposed to a slowdown in hiring.

Despite ongoing rebalancing in the labor market, we think payroll processors and benefits administrators will remain resilient as unemployment rates remain subdued and wage growth continues at a healthy pace of 3.5%. Those providers that are well diversified by end market and geography like ADP, TriNet Group Inc., Tempo Acquisition LLC (Alight), and Ascensus Group Holdings Inc. should remain insulated in the event of an economic downturn. However, more narrowly focused providers like EP Global Production Solutions LLC (Entertainment Partners) and Cast & Crew LLC are more exposed to industry-specific risk factors.

Companies with more direct exposure to new hiring trends, including background checkers First Advantage Holdings LLC and Genuine Financial Holdings LLC, temporary staffing companies like Adecco Group AG and Auxey Bidco Ltd. (AMS) as well as recruitment software providers like ZipRecruiter Inc. face more revenue volatility given their more transactional revenue models. Still, these providers generally benefit from a more variable cost base that can contract with transaction volumes to protect cash flow and liquidity.

Higher interest rates provide a tailwind for companies with business models that provide interest income on client funds including ADP and Health Equity Inc. For these issuers, the higher interest rate environment will support credit metrics due to favorable spreads earned on custodial assets and highly profitable net interest income on customer accounts.

Information services

Amid a prolonged period of higher interest rates, we see continued pressure on credit quality for consumer credit bureaus like Equifax and TransUnion LLC. Our negative outlooks in the sector reflect the impact of higher interest rates weighing on the mortgage market and reducing bank lending activity.

However, we see better prospects for providers with revenue models less directly exposed to mortgage volumes like FICO. This is because most of its demand stems from its dominant market position with financial services customers which has allowed it to make favorable pricing changes over the last year. The extended slowdown in real estate end markets driven by higher interest rates also pressures property-focused data and analytics providers like CoreLogic. We believe CoreLogic has enough liquidity to weather the downturn until interest rates drop and origination activity accelerates in 2025. However, ratings could face more pressure if mortgage rates do not drop over the next two years as we expect.

We expect more stable performances from information services companies that we view as less directly exposed to end markets affected by interest rates. These include investor communication solutions provider Broadridge, insurance analytics provider Verisk, and index and analytics provider MSCI, who should all see steady demand translate into 6%-8% revenue growth, modest margin expansion, and leverage maintained in the 2x-3x area over the next 24 months.

Payment processors

All the large providers will continue benefitting from solid recurring revenue and operating leverage. Most are focusing on value-added software solutions to expand share of wallet, enhance customer stickiness, and grow in adjacent markets beyond traditional payment processing and core banking solutions.

Ratings hinge mostly on issuers' financial policies and their commitments to keep debt leverage within certain ranges. Leverage for the investment-grade payment companies Fidelity National Information Services Inc., Fiserv Inc., and Global Payments Inc. are at or above the high end of our ranges for the respective ratings, which does not leave much cushion for an economic downturn or other adverse events. However, these companies have high margins and robust free cash flow. Limiting share repurchases would give them significant deleveraging power if needed. In addition, their products are typically mission critical and they tend to generate a good amount of revenue from nondiscretionary sources. Notably, merchant acquiring industry revenue still grew during the Great Recession and rebounded quickly following the initial downturn during the COVID-19 pandemic in 2020.

Ratings risk stems mostly from large acquisitions that take them outside their policy ranges for an extended period. We expect these issuers will be active in making acquisitions, but fortunately we believe moderately sized tuck-ins will be the norm. Our ratings on the large payment companies allow for the flexibility to periodically spike leverage above our downgrade thresholds for larger acquisitions, as long as we believe they will reduce leverage to appropriate levels within 12-24 months.   

Insurance services

Insurance services companies' performance should remain resilient as naturally sticky revenue streams and continued, though abating, insurance market tailwinds mitigate slowing economic growth. This subsector includes companies that predominantly service the insurance sector, including brokers, claims and warranty administrators, and insurance cost containment providers.

Insurance brokers, by far the largest subset of the portfolio, remain best positioned. The subsector has demonstrated strong organic growth in recent years, with revenues benefitting from inflation-driven exposure unit growth and high insurance pricing increases as insurance carriers respond to rising losses. Notwithstanding, we are starting to see signs of price moderation in commercial lines (the predominant focus area of our rated broker portfolio), with the Council of Insurance Agents and Brokers (CIAB) reporting that nearly all lines recorded premium increases in the first quarter of 2024 that were flat or down from the previous quarter. With industry tailwinds still present but starting to abate, we expect broker organic growth rates to start declining from industry highs though remain favorable in the mid-single-digits or better. We expect stable to slightly positive margins in 2024 and beyond due to operating leverage and benefits from efficiency initiatives, mitigated by gradual declines in fiduciary income and continued restructuring costs.

For the remainder of the portfolio (our rated nonbrokers), we expect growth will continue to widely vary based on product suites and company-specific factors. However, the market backdrop will provide revenue opportunity despite sluggish economic growth and payroll as companies continue to fill white space in their respective niches. While easing inflation should help wage and cost pressures, ongoing industry factors like price competition, new client/contract implementation, and technology/systems investments, should keep margins steady.

Outsourced business and IT services

IT services had a slow start in the first half of 2024 with headwinds from macroeconomic conditions, notably budgetary constraints, which remain drivers of sales cycle elongation, cost controls, and vendor consolidation. While these headwinds persist, customer interest in and exploratory efforts around potential AI use cases have served as a demand catalyst for our large issuers for projects related to cloud adoption, data cleansing, workforce productivity, modernizing enterprise business processes, and enhancing data security.

For the remainder of 2024, we expect IT services providers to remain cautious with their overall IT spending budgets while capitalizing on demand for these client services, especially for customers that can longer postpone refresh activity for complex solutions tied to digital transformation. Improving demand trends for consultant services related to technologies have bolstered our views around demand stabilization and spending expectations for the year, relative to our initial expectations. This is evident for large service providers like Accenture PLC which expects its consulting business to return to growth this quarter, Kyndryl which is successfully scaling its consulting offering and CDW Corp., which expects low-single-digit gross profit growth for 2024 with modest recovery in the second half of the year. We expect firms with consulting arms focused on digital transformation to experience a quicker recovery than other pockets of IT services, which will need to see engagements mature and transition beyond design to implementation phases.

Software services

Our outlook on software has softened modestly as enterprises have become more cautious in their investment amid slowing macroeconomic growth. Additionally, some enterprises have reallocated budgeted IT spend from software into AI-related projects. Nevertheless, we still expect software spending will grow 10% in 2024, a modest downward revision from our 11% forecast from December 2023.

Still, we forecast FOCF will decline for 53% of rated U.S. software business services companies in 2024. 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 their cash flows susceptible to the rising interest rate environment. Subscription-based revenue models generally support earnings visibility, however elongated sales cycles could challenge revenue growth.

Security and safety services

This subsector includes private security, private prison operators, alarm monitoring, and cash in transit. In our base case, we anticipate benefits from improving labor availability over the next 12 months due to slower rates of inflation. Along with continued normalization of working capital flow, this should enable sustained positive annual FOCF especially for labor-intensive security and safety services companies such as Atlas Ontario LP (dba Allied Universal).

Prison operators The Geo Group Inc. and CoreCivic Inc. should benefit from an increase in demand from the U.S. Immigration and Customs Enforcement agency (ICE). A spending package signed in March 2024 provides ICE with funding for 41,500 detention beds through September 2024, a modest increase compared with current utilization we estimate at about 38,000 beds. However, a change in the U.S. regulatory regime or continued increases in illegal Southwest border crossings could result in a significant increase in ICE demand in 2025 and 2026, which could accelerate rating improvement for GEO and CoreCivic.

Residential alarm monitoring providers like ADT and APX Group Holdings (dba Vivint) have generated better FOCF in recent years. In 2024 and 2025, we expect sustained higher recurring revenue per subscriber due to increased product attach rates. Traditionally in the U.S., high subscriber-acquisition costs have prevented meaningful free cash flow generation. To combat this, they have entered into partnerships with larger players such as NRG Energy Inc., Google LLC, and State Farm Group to combine sales channels and cross-sell incremental products, particularly around the fast-growing area of proactive risk detection and prevention through camera and video analytics and services. This will likely support sustained improvement in FOCF conversion. Over the next three to five years, we expect changing consumer preferences for integrated home security monitoring and smart home solutions will increase the complexity of these solutions, supporting product cross-sell initiatives and growth in per-subscriber revenues and EBITDA margins. Furthermore, lower attrition (as move-related disconnections declined) and the increased deurbanization and work from home trends should continue to support demand.

Global security and guarding provider Securitas AB is likely to experience significantly slower revenue growth in 2024 due to falling inflation levels in North America and Europe. Nevertheless, Securitas will benefit from high single-digit technology and solutions growth, which complements or substitutes manned guarding services. This should be accompanied by increasing profitability from the realization of synergies with Stanley and easing labor costs.

The organic growth of cash management companies, including Prosegur Cash S.A. and recently rated Loomis AB, is underpinned by increasing outsourcing of cash management services by financial institutions and retailers. Despite the increasing proportion of digital payments, the cash logistics market continues to expand as a result of overall growth in the economy. This is reinforced by inflation as well as automation and digitalization trends, which facilitate the creation of new, smart solutions. Yet, Prosegur's earnings were severely affected by the adverse impacts of FX stemming from the company's meaningful exposure to Latin America, particularly Argentina, given its hyperinflation and currency devaluation. We expect it to moderate in 2024, but rating headroom has tightened consequently.

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.

Value-added resellers

Value-added resellers (VAR) are poised to capitalize on IT industry tailwinds. However, prospects vary depending on scale and customer and product mix.

Despite macroeconomic uncertainty, organic revenue growth rates should trend well for most VARs, IT solutions providers, and hardware resellers given durable tailwinds in technology consumption. We think the growing complexity of IT environments will increasingly require multi-vendor solutions, and we expect vendors themselves will increasingly rely on IT solutions providers to reach a highly fragmented group of customers who often do not know what they need.

Still, product and customer mix are key determinants for credit quality. We see stronger growth prospects for IT solutions providers like World Wide Technology Holding Co. LLC, Insight Enterprises Inc., and Presidio LLC which serve blue chip customers and focus on in-demand IT services in areas like cybersecurity, automation, digital transformation, artificial intelligence, and cloud. Conversely, those providers with more exposure to small-to-midsize business (SMB) customers and a high product focus on less in-demand areas like legacy hardware could see slower improvement in credit metrics and more volatility through the business cycle. Loosening supply chains have improved inventory turns and cash flow and liquidity across the sector. However, the impact of macroeconomic pressure on IT spending is a key consideration, especially for those providers with higher customer exposure to SMBs and their less reliable IT spending behaviors.

We expect a return to growth in 2024 as customers increase IT spending year on year, and demand recovers from a weak first half.

For issuers such as World Wide Technology, revenue expansion will continue to slow toward the 4%-6% as key customers (especially telecoms) defer capex amid rising macroeconomic uncertainty. But credit downside could be limited despite the macroeconomic uncertainty, since most issuers have not seen order cancelations or customers moving to other providers. Despite a normalizing supply chain environment, we forecast inventory levels will continue to increase modestly through mid-2024 to support demand.

Related Research

• Economic Research: Q3 2024 Global Economic Update: The Policy Rate Descent Begins, June 26, 2024
• AI Bots Are Here, So How Will Customer Experience Outsourcers Cope?, July 17, 2024
• Credit FAQ: Count, Cooperation, Compensation, And Commissions: Are Real Estate Brokerage Fortunes Tied To Agent Finesse?, April 15, 2024
• AI Will Gradually Reshape U.S. Tech Companies' Credit Quality, April 8, 2024
• PIK Refinancing: A Little Room To Breathe, Or One Step Closer To The Edge?, Feb. 8, 2024
• Cyber Risk Insights: Corporates Up Their Cyber Preparedness As Cyber Attacks Become More Widespread, Oct. 25, 2023