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S& P's European building materials sector report predicts uncertain future
Standard & Poor's has published a commentary on the European building materials sector, which describes how the sector is wrestling with difficult and uncertain end markets, as well as increasing input and fixed cost inflation which are likely to persist for the next 12 - 18 months.
It does, however, report that light building product manufacturers are continuing to outperform heavy material producers. It singles out companies with exposure to renovation, remodelling and improvement as being able to continue to perform strongly as they are not as heavily exposed to the highly cyclical nature of the construction market and because they are also able to pass on cost increases more easily.
Nevertheless, S&P sees the credit quality outlook in the entire sector as relatively stable as most issuers:
* have already reduced their cost base substantially, which should allow them to weather an extended period of weak demand
* will maintain a very prudent approach to acquisition and capital spending, while a continuous focus on cash flow protection measures should allow them to maintain positive free operating cash flow
* are increasingly willing to prioritise the use of cash flow to reduce debt, thereby safeguarding their credit metrics
In S&P's opinion, building materials companies will need to look outside of Europe - particularly to Latin America and Asia Pacific - for respectable rates of economic growth.
As a consequence of its findings, S&P has pushed back its forecast for a recovery in the sector to 2014 (from 2013).
Even so, the company believes that credit quality among building materials companies that its rates in the region should remain broadly stable, as the majority of them have taken actions throughout the downturn to protect their cash flow and liquidity.
It says that the macroeconomic environment in Europe is worsening and it forecasts that GDP in 2013 likely to be flat for the eurozone (European Economic and Monetary Union) as a whole. Its outlook for the building materials sector echoes this view: it anticipates no improvement in 2013, with many markets continuing to deteriorate.
S&P says that first-half results from the sector for 2012 have been disappointing, but largely within expectations. Although the picture remains very mixed country by country, most of the major markets in Europe are exhibiting slow or negative growth, and the indications are that the second half of 2012 and 2013 will also turn out to be grim. In particular, its economists have revised downward their forecasts for the German market, which has propped up the results of many European building materials issuers throughout the recent downturn. In France - a market that has been surprisingly stable over the past few years - growth now appears to be in decline, and they are forecasting a level in the mid-single digits. Meanwhile, southern Europe is performing in line with their pessimistic expectations, with volumes continuing to fall by 25% - 30% in Italy, Spain, and Greece.
Recent-third quarter earnings statements confirm that European building materials companies are still struggling with tough end markets and declining volumes in Europe - conditions S&P believes are likely to persist for the next 12 - 18 months.
Outside of Europe, the situation appears brighter. The majority of rated building materials issuers headquartered in Europe are globally diversified groups, and many have substantial operations in the US, the Middle East, and Asia.
"We are cautiously optimistic about earnings growth from the U.S. While the picture state-by-state remains very mixed, even a limited uptick in US housing starts can have a significant effect on earnings, owing to the high degree of operating leverage provided by significant assets that have been producing limited--or even negative--earnings over the past few years.
In the Middle East and North Africa, sound demographic fundamentals should in S&P's opinion support a return to solid demand growth in the absence of further significant political upheavals in the region. The company also believes Asian and Latin American construction markets will continue to grow robustly, even if at a somewhat more subdued rate than the recent past.
Despite the difficult and uncertain end markets that S&P believes will persist for at least the next 12 - 18 months, along with increasing input and fixed cost inflation, it sees the outlook for credit quality in the European building materials sector as relatively stable. This is largely because most companies have already reduced their cost base substantially, which should allow them to weather an extended period of weak demand. It believes that most issuers will maintain a very prudent approach to acquisition and capital spending, while a continuous focus on cash flow protection measures should allow them to maintain positive free operating cash flow. It also believes that European building materials companies are increasingly willing to prioritise the use of cash flow to reduce debt, thereby safeguarding their credit metrics.
S&P's stable outlook for the building materials sector assumes reasonable pricing behaviour in 2013. Last year, pricing pressure affected many markets where high input cost inflation could not be recovered, leading to lower margins. In more fragmented markets such as Italy and the US, competition resulted in prices that were close to, or below, production costs. However, prices have recovered in most markets in 2012 and this, along with falling energy costs, has boosted EBITDA margins. Nevertheless, the company forecasts higher fixed and input costs in 2013 and assumes that successful price increases should recover a large proportion of these costs, albeit with a time lag.
However, recovery may prove difficult in the more fragmented markets, or those experiencing the sharpest declines. This is because S&P anticipates that such markets will be most exposed to harsh pricing competition. Although it doesn't anticipate any price wars (as was the case in Italy in 2010 and Germany in 2003), it could become difficult to pass on cost increases in these markets, resulting in weaker margins and potentially leading to pressure on ratings.
Encouragingly for the KBB industry, those companies with exposure to renovation, remodelling, and improvement should continue to perform strongly. Notable among this group are those S&P categorises as 'light product' companies, such as manufacturers and distributors of electrical equipment, sanitary fittings, and tools. The company views industry conditions for this sub-segment as generally more stable than the highly cyclical construction markets to which the producers of heavy materials (cement, aggregates, and concrete) are exposed. Light product manufacturers and distributors also tend to be able to pass on cost increases more easily than the more commoditised heavy material producers.
The ratings performance of light and heavy industry players over the downturn reflect these trends. Over the past year or so, S&P has upgraded three light product manufacturers and distributors.
16th November 2012