Elevated Interest Rates And AI-Focused IT Spending Remain Headwinds

We anticipate macroeconomic growth will be milder than expected as inflation remains sticky, which could leave interest rates elevated over the near term.   Despite the rapid and sizeable increases in the effective federal funds rate (rising by 525 basis points [bps]) since July 2023 to stem surging inflation, the U.S. economy has remained resilient and the Fed has yet to achieve its goal of reducing inflation toward its target level. Consequently, S&P Global economists now expect U.S. GDP will expand by 2.5% in 2024, before slowing to 1.7% in 2025, and anticipate the Fed will only reduce the fed funds rate by 125 bps by the end of 2025.

Higher-for-longer interest rates are a particularly material concern for U.S. tech issuers--especially those we rate 'B' or below--because the leverage levels of many of these entities exceed the corporate average (given their higher-growth profiles). Therefore, we expect these companies will continue to be negatively affected by their onerous debt interest burdens.

We expect lower-rated U.S. tech issuers will remain prudent in managing their expenses and preserving liquidity amid the gradually weakening macroeconomic backdrop. Many issuers have already delayed growth investments, cut costs, or shed valuable assets to reduce their debt burdens. However, despite these measures, we believe these companies will continue to face headwinds will persist as interest rates stay elevated over the near term and the growth environment remains challenging.

We forecast global IT spending will increase 8% this year, though we expect the additional spending will be highly skewed toward larger tech companies that focus on cloud and AI infrastructure.  We expect AI infrastructure providers, such as large cloud service providers and semiconductor manufacturers, will be the main beneficiaries of rising AI spending and anticipate the effect on smaller technology issuers will be far more measured. Furthermore, we expect these AI investments will not only come from budget increases but also re-allocations of budgets earmarked for traditional enterprise IT spending. This has already led to demand headwinds for many of the lower-rated U.S. tech issuers we cover that are not AI-focused. Therefore, we expect the growth profiles of this cohort will remain muted until IT budgets improve further or AI spending tapers off.

Rating Actions Among U.S. Tech Issuers Continue To Skew Negative

Negative rating actions exceeded positive rating actions among lower-rated U.S. tech issuers in the first half of 2024.  Negative rating actions continued to outpace positive rating actions (12 to 6) among the U.S. tech issuers we rate 'B' and below in the first seven months of 2024. High interest expenses and, in many cases, operational headwinds have remained the primary drivers of downgrades and negative outlook revisions so far in 2024. Many of these issuers, especially those overburdened with variable-rate debt, experienced accelerated cash flow deficits and liquidity pressures.

The issuers we rate 'B-' with negative outlooks merit more attention given their vulnerability to being downgraded into the 'CCC' category. The chart below details the rating transitions among the issuers we rated 'B-' with a negative outlook between Jan. 1, 2024, and July 31, 2024.

Chart 1

Some of these issuers generated negative cash flow almost entirely due to higher interest rates, despite maintaining stable operating and top-line performances. For example, Polaris Parent LLC (d/b/a Solera) increased its revenue by 7% during the fiscal year ended March 2023 and we forecast it will expand its top line by a further 3%-5% in fiscal years 2024 and 2025. However, we expect Solera's free operating cash flow (FOCF) to debt will be in the 0.4%-0.8% range in fiscal year 2025 and estimate its total available liquidity will decline significantly by the end of the fiscal year. This is because, despite significant cost-reduction efforts and temporary payment-in-kind (as opposed to cash pay) relief on its second-lien term loan, the company's debt service costs rapidly increased due to its nearly $8.3 billion of variable-rate debt. Therefore, the pace and magnitude of interest-rate relief could be a significant factor in our assessment of Solera's rating trajectory.

For other issuers, their cash flow deficits stemmed from a mix of elevated borrowing costs and operational challenges. For example, we revised our outlook on Project Leopard Holdings Inc. (d/b/a Tungsten Automation) to negative from stable in May to reflect its underperformance, which was largely attributable to a combination of high interest expense and headwinds arising from a recurring revenue transition.

With nearly $200 million of expected interest expense in 2024, along with reduced upfront cash collections due to its shift to subscription revenue, we anticipate Tungsten Automation will burn a nearly $30 million of free operating cash flow this year and expect it to utilize more than half of its revolver capacity to fund cash shortfalls. Our expectations for interest-rate relief, as well as the company's ability to successfully execute its recurring revenue transition, will be the key considerations for the rating going forward.

While Capital-Markets Activity Has Picked Back Up, Some Issuers Continue To Face Refinancing Risk

As the capital markets reopened in 2024, many of the U.S. tech issuers we rate 'B' and below seized the opportunity to extend their debt maturities, reprice to lower loan spreads, and--in some cases--upsize their term loan and revolver commitments. In the first six months of the year, nearly 30 issuers in this cohort initiated such transactions in the public debt markets. The vast majority of these issuers have experienced stable, or improving, business operations over the past 12-18 months. Therefore, we believe many of these companies did not need to refinance or reprice but rather did so opportunistically by taking advantage of the broader credit market recovery.

Chart 2

Conversely, the issuers we rate 'B-' with negative outlooks and lower were far less active in the capital markets in the first half of the year. While this cohort would have benefitted significantly from extending their debt maturities and reducing their loans spreads, we believe many were unable to refinance in the broadly syndicated markets or unable to do so at attractive terms, given their weaker credit profiles. Other companies, both stable and stressed, turned to the private credit markets to address their upcoming maturities during the first seven months of 2024. Despite the resurgence in refinancing and repricing activity, we fear that debt capital markets could become less amenable to some borrowers in the future than they are currently. As such, the threat of looming maturities remain a key risk for entities that have not yet refinanced.

Table 1

For example, VeriFone Systems Inc. has a $2 billion term loan due August 2025 that it has yet to address. The company's operating performance suffered over the past 12 months due to ongoing end-market weakness and customer de-stocking headwinds. We expect muted revenue, in conjunction with its high interest expense, will lead the company to generate a $64 million cash flow deficit this year. Therefore, we revised our outlook on Verifone to negative in April.

Considering VeriFone's recent performance headwinds, we are unsure whether it will be able to refinance its upcoming debt maturity. If the company continues to face performance challenges and demonstrates limited refinancing progress over the near term, negative rating action could be warranted.

Similarly, QBS Parent Inc. has $337 million debt due in 2025 that it has yet to refinance. Due to spending headwinds in its core oil and gas end markets in 2023, we revised our outlook on the company to negative to reflect our weaker performance expectations. However, in contrast with VeriFone, QBS improved its operational performance in recent periods and we expect it will increase revenues and generate positive cash flow in fiscal year 2024. Although we rate the company 'B-' with a negative outlook largely because of its upcoming maturity, we are less concerned with its ability to refinance its upcoming debt maturities than we are for VeriFone due to QBS' stronger recent performance. Nonetheless, we believe the company will continue to face refinancing risk until it successfully addresses its upcoming maturity.

Some Stressed Issuers Are Engaging in Liability Management Exercises (LMEs) Or Restructuring Activities

Some of the issuers that have experienced material deteriorations in their business and declining valuations have considered undertaking LMEs. LMEs have become more frequent in recent years due to the rise in popularity of covenant-lite credit agreements. Under these exercises, financial sponsors evaluate and pursue options to manage their portfolio companies' debt without having to initiate costly and disruptive bankruptcy proceedings. In these cases, the portfolio companies would need to secure the consent of a majority of lenders to amend their loan terms, often at the expense of the nonconsenting lenders.

Another kind of LME involves using the flexibility in loan terms to transfer assets outside the reach of existing lenders through unrestricted subsidiaries. These assets would then become unencumbered and could be used as collateral for new debt.

S&P Global Ratings generally views LME transactions as tantamount to a default because the lenders typically receive less than they were originally promised. Therefore, we would likely view these issuers as having selectively defaulted on the affected debt. In 2024, four of the U.S. tech issuers we cover engaged in LMEs or restructurings. (see Table 2)

Table 2

We Expect Lower-Rated And Highly Leveraged Issuers Will Continue To Face Negative Ratings Pressure

Our expectations for the tech issuers we rate 'B' or below over the next 12 months remain largely unchanged from the beginning of the year. We anticipate these companies will continue to face ratings pressure because of the lack of a material improvement in the underlying interest-rate and macroeconomic environment. In addition, lower-rated issuers tend to be much more sensitive to fluctuations in interest rates and macroeconomic conditions than their higher-rated peers.

While we anticipate that the proportion of issuers generating positive cash flow will improve this year due to the numerous cost actions they have implemented, we do not believe that the magnitude of the changes in their cash flow will be sufficient to support a material rise in positive rating actions. Accordingly, we anticipate that a more outsized improvement among the issuers we rate 'B' and below will be delayed until at least early 2025, when the Fed's rate cuts begin to take hold and borrowing costs become less prohibitive.

Chart 3

As high rates and muted IT spending persist, we believe that certain issuers will be more vulnerable to negative rating actions than others. For example, some issuers with generally resilient businesses that benefit from sticky customer relationships (due to the mission-critical nature of their enterprise software offerings) and consistently increase their top-line revenue have encountered profitability headwinds due to elevated interest expenses. Although we view these issuers as having stronger credit quality than their similarly-rated peers--and thus believe they are less likely to face negative rating actions over the near term--we still expect they will face persistent ratings pressure until borrowing costs decline.

On the other hand, we view issuers that have experienced both deteriorating cash flows and varying degrees of operational challenges more negatively. These are companies that, like the issuers discussed above, cash flow headwinds following the rate hikes in 2023 but also struggled to grow their businesses. Macroeconomic uncertainty, inventory de-stocking headwinds, and general end-market softness were the primary reasons for the operational difficulties among this group, which led them to report flat or even declining revenue. The weaker revenues further exacerbated the cash flow deficits for these companies, which--in many cases--led them to draw on their revolvers. However, the overall liquidity of the entities in this group remained mostly adequate. Ultimately, given the combination of both operational and interest-expense headwinds, we expect this group to be at greater risk for negative rating actions over the near term.

Lastly, we believe the issuers facing the greatest risk for negative rating actions are those that have encountered severe operational and financial challenges. Unlike the other cohorts, the companies in this group experienced particularly material declines in their revenue, cash flows, or both, leading to an outsized reliance on revolver borrowings and diminished liquidity. These issuers may require external intervention--such as rate cuts or equity injections--or an otherwise favorable market environment to avoid negative rating actions over the near term. We also include companies with significant near-term maturities in this group. Given our expectation that the capital markets were open and amenable in the first half of the year, we fear issuers that have yet to refinance their 2025 maturities may miss the chance to do so if market conditions worsen. We also consider the possibility that some of the issuers with near-term maturities may have been entirely unable to refinance, given their recent underperformance, and will continue to make limited refinancing progress until their performance recovers.

Table 3