Corporate sector leverage: who has it easy now?

In the departing year, the corporate sector has been affected by factors such as increased geopolitical instability, a period of extremely high key interest rates, the need for significant restructuring of logistics chains, and the search for new markets. These and other trends have impacted all segments of the economy to a varying extent. In this research paper, ACRA gives its view on which industries will primarily face an increase in leverage next year and the sectors where the situation is more stable.

increased leverage

Real estate development: life on loan

The share of projects carried out using escrow accounts as of the end of Q3 2022 grew to 87%.

In absolute terms, developers’ unadjusted debt continued to grow in 2022 as the industry more actively transitioned to escrow account usage and gradually accumulated project debt under these accounts. As of the end of three quarters of 2022, the share of projects carried out using escrow accounts had grown to 87% compared to 71% as of the same period in 2021. The size of project debt has almost doubled (from RUB 2.23 tln to RUB 4.23 tln), while its coverage by funds in escrow accounts has gradually declined, from 112% for three quarters of 2021 to 92% for the same period in 2022.

The current government-subsidized mortgage program is expected to end at the beginning of 2023 (it may be extended, but a decision on this has not yet been made), which may result in a slowdown of sales next year. This, in turn, will lead to a further decline of coverage of project debt by escrow account funds and higher leverage for adjusted debt of real estate construction sector companies. However, the reduction of the level of coverage below 100% should not yet be considered a clear sign that developers have problems. In general, these companies do not benefit from maintaining surplus coverage of project debt. In addition, lower coverage may be partly due to higher use of project financing to purchase land plots (in the form of bridge loans that are converted to project financing when construction begins).

At the moment, the profitability of developers is at a historically very high level (the ratio of housing price indices to the producer price index in the housing construction sector is close to the record levels of 2007), which creates a certain safety buffer in the event of a price decline in the primary market as a result of the possible cancellation of subsidized mortgages mentioned above.

Retail trade: repackaged

Food retail has recorded consistently positive dynamics of sales, profitability, and leverage compared to last year, and on the back of the decline of the population’s real disposable wages there has been increased demand in the so-called hard discounter segment. Over three quarters of 2022, sales at Chizhik discount stores (owned by  X5 Retail Group¹) have increased by 19 times compared to the same period in 2021 — from RUB 1.1 bln to RUB 20.7 bln. This retail format is also being actively developed by other industry representatives — Magnit PJSC², O’KEY Group, and Lenta LLC³. Many companies have reduced their leverage amid continuing uncertainty: according to ACRA, by the end of 2022 the ratio of total debt to FFO before net interest payments will decrease from 2.3x as of the end of 2021 to 2.1x.

Although the situation in non-food retail has stabilized, it is generally less favorable. In view of the withdrawal of a large number of manufacturers from the market, many retail companies (for example, in the consumer electronics segment) had to quickly reorient their business models in favor of brands from Turkish, Chinese and other manufacturers. This led to a noticeable decline of total revenues, both against the backdrop of reduced demand, and taking into account lower prices for similar goods — according to ACRA’s estimates, total revenues in nominal terms will decrease by about 20–25% year-on-year in this segment.

Even despite a decline of revenues, some companies of the non-food retail segment were able to maintain profits at an acceptable level. The most difficult period, which required a complete restructuring of logistics chains and updating of procurement conditions, has passed. However, a general decrease of revenues and changes to contract terms (deferred payments for goods has been replaced by prepayment) required that companies finance their working capital and on average has increased leverage in the sector.

¹ ACRA rating AAA(RU), outlook Stable
² ACRA rating AA+(RU), outlook Stable
³ ACRA rating AA-(RU), outlook Stable

Machine building: not by imports alone

The 2035 development strategy of the machine tool industry aims to increase the level of localization of production to 70%.

Given the traditionally high share of imported products in machine building and its segments, as well as sanctions and foreign-owned companies exiting the market, domestic representatives of the industry must increase existing and create new production capacities, as well as develop modern technologies. First of all, this concerns the fund-creating industries, for example, machine tool building (imports in metalworking exceeded 50% as of the end of 2021).

The development strategy of the machine tool industry until 2035 aims to increase the level of production localization to 70% and the total output of machine tool products in monetary terms to RUB 79.5 bln. This will require additional long-term borrowings and create conditions for higher leverage. The size of state support, mechanisms to reduce the cost of borrowing, and compensation of R&D expenses will play an important role in this.

MODERATELY INCREASED LEVERAGE

In 2022, against a backdrop of high prices for metallurgical products that is typical of the first half of the year, metallurgy and the extractive industry (excluding oil and gas) improved their year-on-year financial indicators, despite lower production (steel output for ten months decreased by 6.6% compared to the result for the same period in 2021). The fall of prices for steel products that took place in H2 2022 may continue into 2023; when coupled with forced production cuts in the industry due to export restrictions (which may amount to around 10%) this will probably lead to lower operational cash flows and profitability, which in turn will result in an insignificant increase of leverage. In general, the sector maintains its stable financial standing thanks to the ability to control most of the production chain — from extraction of raw materials to creation of finished products.

Aviation: choose a detour

In the outgoing year, this sector experienced a substantial fall in the volume of passenger and cargo transportation. This was due to the closure of the majority of routes for Russian airlines, the need to put together new equipment supply chains to service machinery, lower business activity, and other effects triggered by sanctions. In particular, ACRA expects the passenger traffic of the Moscow Aviation Hub to decline by 15–20% in 2022 and due to this, FFO before net interest payments may decline and leverage may rise slightly.

Electric power: towards a bright future!

It is expected that leverage will grow moderately in the industry, by 10–20%.

From January to September 2022, FFO before net interest payments and taxes in the sector decreased by 5–6%, and corresponding profitability fell by 1–2% amid a decrease in electricity consumption in a number of Russia’s regions. According to ACRA, this will continue in 2023. The industry can expect a moderate increase in leverage (10–20%), including due to the need to implement government objectives (for example, providing electricity to the project to expand the Eastern Polygon of Russian Railways JSC⁴ — Baikal-Amur Mainline 2) and the growth of company expenses outpacing income due to inflationary dynamics.

⁴ ACRA rating AAA(RU), outlook Stable

stable leverage

In the rail freight segment, the volume of freight transported is expected to decrease by about 5%, which is not a significant drop and will be fully compensated by tariff indexation and additional decisions on tariff policy in 2022. The passenger rail transport segment has become a kind of beneficiary on the back of problems in the aviation industry, so by the end of 2022, ACRA expects a 15% increase in passenger traffic compared to 2021. Given the above trends, one may expect stable performance of the sector companies in terms of FFO before interest payments and leverage in 2022 and 2023 versus 2021.

Infrastructure construction: song that helps us live and build

A number of major railway and road infrastructure projects that started several years ago are currently underway, but no new significant projects have emerged yet. Operating and capital expenses in all segments of the infrastructure industry are impacted by inflation. At the same time, most investment programs are flexible, and some of their components can be postponed to avoid critical cost increases in each reporting period.

As of the end of 2021, the infrastructure construction companies with credit ratings assigned by ACRA — State Company “Russian Highways” (Avtodor)⁵, Soyuzdorstroy JSC (AVTOBAN GC)⁶, AO PSF BALTIYSKIY PROEKT⁷, JSC “GC “EKS”⁸, and Trud JSC⁹ — had cumulative debt of about RUB 240–250 bln. The Agency believes that the amount of liabilities of companies in the sector with ACRA ratings will remain relatively stable in the medium term.

⁵ ACRA rating AA(RU), outlook Stable
⁶ ACRA rating A-(RU), outlook Positive
⁷ ACRA rating BBB(RU), outlook Stable
⁸ ACRA rating BBB(RU), outlook Stable
⁹ ACRA rating BB(RU), outlook Stable

Fertilizer production: harvest prospects

A drop in potassium fertilizer exports from Russia and Belarus led to a jump in prices in the global market: over the first ten months of 2022, average prices rose by 143%.

The fertilizers sector is one of the main beneficiaries of the current situation due to rising prices in the global market and a large discrepancy between domestic and external prices for raw materials. In view of declining exports of potassium fertilizers (mainly through the Baltic ports), the volume of fertilizer exports in physical terms is expected to decrease by about 10% by the end of 2022 versus 2021.

From January to October 2022, potassium fertilizer production decreased by 33.1% year-on-year, while nitrogen fertilizer production increased by 6%, and phosphate fertilizer production grew by 2.5%. As a result, total fertilizer production shrunk by 5.2%, while domestic demand increased by 7–10%. At the same time, reduced exports of potassium fertilizers from Russia and Belarus caused a price hike in the global market: in the first ten months of 2022, the average price increased by 143% compared to the average price for 2021 (according to the World Bank), which offsets drop in physical export volumes by a wide margin.

Nitrogen and phosphate fertilizer prices started rising back in 2021 amid a sharp increase in natural gas prices, and this trend continued in 2022. Over ten months of 2022, urea prices were up 51% from the 2021 average (after a 111% increase in 2021), and diammonium phosphate (DAP) prices were up 33% (after a 92% increase in 2021). Although one could expect a decline in prices for chemical products in the global market in the long term, they will still be above average cyclical levels for a long time to come, mainly due to the continuing natural gas shortage.

Oil and gas industry: easy game?

In ten months of 2022, the total volume of oil production in Russia, including gas condensate, amounted to 443 mln tons, which exceeds the volume produced in the same period of 2021 by 2.4%.

Despite the restrictions imposed on Russian oil exports and logistics difficulties, the country’s oil industry has managed to rather quickly recover physical production and supply after a decline in Q2 2022. The total volume of oil production in Russia, including gas condensate, amounted to 443 mln tons for ten months of this year, which is 2.4% higher than in the same period in 2021.

ACRA expects that by the end of this year, oil production and export indicators will be at least comparable with the level of 2021. At the same time, despite the growing discount of Urals to Brent (the average discount of Urals to Brent for ten months of 2022 was 22.4% compared to 4.2% in 2021), Urals prices have shown a noticeable increase in 2022. For example, the average Urals price was USD 79.6/bbl in ten months of 2022 compared to USD 67.5/bbl for the same period in 2021 (a 17.9% increase).

Higher global oil prices, with production and export volumes remaining at levels comparable to those of 2021, will ensure that the the financial performance of Russian oil companies improves. The unprecedented rise in gas prices, in turn, even amid declining pipeline supplies in physical terms, will enable gas companies to demonstrate exceptionally high revenue, EBITDA and profits by the end of 2022.

In 2023, it is likely that the financial performance of oil and gas companies will decrease somewhat due to a possible reduction of crude oil exports as a result of the European embargo on Russian oil and oil products, as well as due to a further reduction of pipeline gas exports following the shutdown of the Nord Stream pipelines. ACRA also assumes that a moderate decline of oil and gas prices will take place in global markets in the coming years. Nevertheless, the relative leverage ratios (debt/EBITDA, debt/FFO) of oil and gas companies are expected to remain at very comfortable levels.

Telecommunications: one has to pay more for communications

This industry is characterized by high capital intensity that requires permanent investments (the ratio of capital expenditures to revenues for telecom operators is traditionally one of the highest among all non-financial companies) and low elasticity of demand despite the indexation of tariffs. This will allow the sector to maintain revenues in 2023, without significant changes in leverage and coverage indicators

leverage is declining, but with some reservations 

IT: out of reach

Providers of various IT infrastructure solutions (data centers, cloud technologies, etc.) and Russian software developers have demonstrated growth of their operating and financial indicators relative to 2021 on the back of increased demand and prices for the services they provide since some foreign providers left the Russian market.

Given the growth of FFO before fixed charges and taxes while maintaining the target corporate debt structure at the current level, ACRA expects a certain reduction of leverage and improvement of coverage for major players. At the same time, due to continuing uncertainty, some small players may face difficulties in raising additional funds in the foreign market, which may have a negative impact on their liquidity profile.

At the same time, deteriorating access to new equipment and reduced capital investments will affect the quality of telecommunications and IT services over time and may subsequently lead to a technology gap.