Fitch Revises Outlook on InfraBuild to Negative; Affirms at 'BB-'

(The following statement was released by the rating agency) Fitch Ratings-Sydney-19 October 2020: Fitch Ratings has revised the Outlook on InfraBuild Australia Pty Ltd.'s Long-Term Issuer Default Rating (IDR) to Negative, from Stable, and has affirmed the IDR at 'BB-'. The agency has also affirmed InfraBuild's USD325 million senior secured notes at 'BB'. The Negative Outlook reflects Fitch's expectation that key steel end markets, particularly the Australian construction market, will weaken in 2H20 and 2021. It also reflects the uncertainty associated with the coronavirus pandemic's longer-term impact on the economy and the weakening of InfraBuild's credit metrics, highlighted by weakness in interest cover, driven by slowdown in construction and recycling markets. InfraBuild announced a number of strategic decisions in response to the pandemic, including a reduced headcount, site closures and growth capex deferral. We regard these decisions as prudent, but the large drop in earnings due to the pandemic and uncertain timing of a recovery in domestic steel demand has led us to forecast elevated total debt/EBITDA for the next 12-18 months. We rate the notes one-notch higher than the company's IDR on superior recovery prospects. The notes are secured by first-lien property and other assets, and second-lien account receivables and inventories. Our recovery analysis assumes that the company's asset-based lending facility will be fully drawn and it will have priority on the proceeds from the collateral. We treat InfraBuild's lease costs as operating expenses, in line with the change of our treatment of leases; consequently, we have changed our rating sensitivities to unadjusted metrics, from lease-adjusted. In addition, we have incorporated an interest coverage ratio into our sensitivities to capture the company's weakness in its operational leverage. Key Rating Drivers High Construction-Market Exposure: We expect weakness in steel sales volume and prices in the second half of the financial year ending June 2021 (FY21) due to InfraBuild's high exposure to the Australian construction market, which is experiencing low activity due to over-supplied residential apartments and delays in government-funded infrastructure projects. We also expect high unemployment and lower migration levels to delay a recovery in residential construction activity until late 2021. InfraBuild's EBITDA fell in FY20 due to pandemic-related weak steel pricing and under performance in its recycling division as experienced in line with the industry sector. This is likely to see leverage, measured by gross debt/EBITDA, rise to around 5x in FY21 and FY22, above the level at which we would consider taking negative rating action, before moderating towards historical norms in 2022 as conditions normalise. Rent Expense Weighs on Coverage: InfraBuild's high rent expense, partly stemming from its large distribution network, weighs on its coverage metrics and limits its cash flow flexibility, especially during market downturns. We forecast the company's coverage, measured as EBITDA/interest paid, to fall to 1.6x in FY21, from 2.4x in FY20. We believe the network supports InfraBuild's market share, but its fixed charges more than offset this benefit. However, we expect InfraBuild to maintain a sufficient liquidity buffer to cover its fixed charges over the next 12-18 months. Market-Leading Position: InfraBuild is Australia's sole EAF steel long product manufacturer and operates the country's second-largest ferrous and non-ferrous recycling business. Its strong market position has seen it maintain an around 63% volume share of domestic steel long products over the last decade, despite stiff competition from imports. This is helped by its flexible operation, reliable supply and broad product offering compared with imports. Furthermore, InfraBuild gained market share from the pandemic-related supply-chain disruption, in part, due to customer efforts to secure steady steel supply. Weak Cost Position, Small Scale: InfraBuild has a small-scale operation in terms of EAF production volume, at 1.4 million tonnes a year, and a weak cost position compared with peers in export markets. Profitability could come under pressure if low-cost producers, especially Chinese steel mills, increase export volume into Australia, although we do not expect this to occur in the short-to medium-term due to China's effort to reduce its steel-mill capacity and Australia's geographic isolation that results in longer supply lead time. In the domestic market, Fitch believes InfraBuild's cost position is competitive against imports after adjusting for freight, import tariffs and port-handling charges, as evidenced by the company's resilient domestic volume share. However, there is a risk of rising Chinese imports affecting InfraBuild's profitability, especially during times of weak Chinese steel consumption or if iron ore and coking coal prices become competitive against scrap. Derivation Summary Fitch assesses InfraBuild's rating as in line with other Fitch-rated 'BB' category EAF steel producers due to the company's integrated business model, flexible operating profile and leading market position in Australia. The ratings are constrained by InfraBuild's weak cost position, scale and high leverage. The ratings of InfraBuild are comparable with those of US-based Commercial Metals Company (CMC; BB+/Stable). CMC has better geographic and operational diversification due to its operations in the US and Poland, as well as its higher number of operating mills. However, InfraBuild's strong market position and long-term customer relationships offset its relatively weaker diversification. Both companies have vertically integrated business models, receive a premium over the import parity price and have similar absolute level site-operating costs. However, Fitch believes CMC's mini mill in the US benefits from strict tariff barriers and access to cheap electricity and scrap, which results in better margins and a lower threat from Asian imports. CMC's leverage metric, as measured by total debt/operating EBITDA, of around 3x is also around one turn lower than that of InfraBuild. These factors underscore the two-notch rating differential between the two entities. Brazilian-based Gerdau S.A. (BBB-/Stable) has better diversification, business scale and profit margin as well as lower leverage than InfraBuild, but InfraBuild's dominant domestic market position accounts for the three-notch rating differential between the two entities. Key Assumptions - Weak steel volume and prices due to volume contraction in Australia's construction market in 2020 and 2021. - EBITDAR margin improving to around 6.0% due to cost cutting initiatives, including savings from a continuous improvement programme and cost synergies from planned acquisitions (FY20: 5.4%). - Capex of around AUD35million in FY21 and FY22, then remaining at around 2% of revenue. - No dividend. RATING SENSITIVITIES Factors that could, individually or collectively, lead to positive rating action/upgrade: - Total debt/EBITDA below 4.5x for a sustained period (FY20: 4.0x) - EBITDA/interest paid above 2.0x for a sustained period (FY20: 2.4x) Factors that could, individually or collectively, lead to negative rating action/downgrade: - Fitch may downgrade the ratings if the above positive sensitivities are not met Best/Worst Case Rating Scenario International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579. Liquidity and Debt Structure Adequate Liquidity: InfraBuild's next significant debt maturity is in October 2022, consisting of a AUD250 million asset-based lending facility. We expect the company to have adequate liquidity from its undrawn asset-based facility and cash on the balance sheet of AUD365 million to meet short-term requirements. We expect InfraBuild to rely on refinancing to address its long-term debt maturities. We believe it should be able to manage its refinancing needs due to its sizeable unencumbered property assets. REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. ESG Considerations Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg InfraBuild Australia Pty Ltd.; Long Term Issuer Default Rating; Affirmed; BB-; Rating Outlook Negative ----senior secured; Long Term Rating; Affirmed; BB Contacts: Primary Rating Analyst Leo Park, Associate Director +61 2 8256 0323 Fitch Australia Pty Ltd Suite 15.01, Level 15 135 King Street Sydney 2000 Secondary Rating Analyst James Hollamby, Associate Director +61 2 8256 0347 Committee Chairperson Vicky Melbourne, Senior Director +61 2 8256 0325 Media Relations: Peter Hoflich, Singapore, Tel: +65 6796 7229, Email: peter.hoflich@thefitchgroup.com Leslie Tan, Singapore, Tel: +65 6796 7234, Email: leslie.tan@thefitchgroup.com Additional information is available on www.fitchratings.com Applicable Criteria Corporate Rating Criteria (pub. 01 May 2020) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10120170) Corporates Notching and Recovery Ratings Criteria (pub. 14 Oct 2019) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10090792) Sector Navigators - Addendum to the Corporate Rating Criteria (pub. 26 Jun 2020) (https://www.fitchratings.com/site/re/10125796) Applicable Model Numbers in parentheses accompanying applicable model(s) contain hyperlinks to criteria providing description of model(s). 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