Rating Methodology for Construction Equipment Manufacturers

Transcription

1 May 2016 This methodology note stands superseded. Refer to ICRA's website to view the updated methodology note on the sector. ICRA Rating Feature Rating Methodology for Construction Equipment Manufacturers This rating methodology explains ICRA s approach to assessing credit risk of construction equipment (CE) manufacturing companies. ICRA s portfolio of CE companies includes subsidiaries of global CE majors, homegrown CE companies and material handling equipment (MHE) manufacturers. This methodology is a guiding tool for understanding the parameters ICRA takes into consideration while rating CE manufacturers. Overview The Indian CE industry can broadly be divided into: a) Earth moving equipment such as backhoes, wheeled loaders, excavators, diggers, dumpers and dozers. Earthmoving equipment deployed in mining are of larger tonnage and horsepower than those used in construction and also include some specialised equipment and implements such as underground mining equipment, articulated dump truck, walking dragline and other tracked machines b) Material handling equipment such as pick-and-carry (PNC) cranes and aerial cranes c) Road building equipment such as compacters and motor graders d) Concreting equipment such as transit mixers ICRA s Risk Analysis Framework for Mobile Service Providers Within the various CE segments, backhoes and excavators in the earthmoving segment currently occupy a larger volume share of the Indian market; PNC cranes in the MHE equipment; and compactors in the road building equipment segment. While product diversity in the Indian market is fairly adequate, given its relatively nascent stage, demand currently leans largely towards general-purpose equipment as opposed to usage-specific or specialized equipment. The relatively smaller size of the Indian market has so far deterred global companies from investing in development of India-specific products or customising their global products to suit the Indian requirements. While smaller capacity equipment is manufactured locally, often with sizable import content, larger sized equipment continue to be imported. 1. Business Risk Assessment Demand cycle Product Portfolio; Dealer and Service Network; and Financing Support Scale and Competitive Position Order book and Inflows 2. Financial Risk Assessment Revenue growth Cost structure, forex risk and profitability Leverage and coverage indicators Adequacy of future cash flows

2 Tenure mismatches and Risks relating to Interest rates and refinancing Debt servicing track record Contingent liabilities and Off-Balance sheet exposures Event risk 3. Management Quality & Strategy Business Risk Assessment Demand cycle Construction and mining equipment are critical components for capacity enhancement and gross fixed capital formation in an economy. This correlation with capital investments, public and private, leads to significant cyclicality in demand for CE. While the overall CE industry is correlated with the economic cycle, demand for each of the four main product segments is broadly linked to different factors. Infrastructure investments including road building and construction activity in the country drive demand for road construction equipment and material handling equipment. On the other hand, real estate activity drives demand for concreting equipment while global and domestic commodity cycles and the government s mining policies determine the demand for mining equipment. Demand for CE is dependent on both large central government projects and State level investments plans along with budgetary funding availability. Understanding the momentum of projects announced and implemented in the State and the kind of equipment required is critical to forecasting demand. This apart, private investments in infrastructure and capacity enhancement also has a significant impact on demand for CE. A diversified portfolio could buffer short-term equipment specific demand slowdowns. Product Portfolio; Dealer and Service Network; and Financing Support Given the varied needs of different geographies and end use segments, an extensive product portfolio with a wide spread dealer network is a positive. ICRA also evaluates the CE manufacturer s product launch plans and investments in new product categories in the context of the competitive intensity and growth prospects for the category. Cost economical feature-rich products could help sustain customer interest and market share. Globally, disruptive technology leading to the launch of cutting-edge products has been a demand driver for a manufacturer. Given the relatively smaller scale and the price sensitivity of the Indian market at present, the products available in India currently lag the technology curve. While the demand for high-end products is low in the domestic market, creating a differentiated product with low life-cycle costing can be a market driver. Resale value of a product function of the brand strength, spares network and product quality is a market share determinant. Given the vast geography and customer dispersion, an extensive dealership and service network across the country is critical to ensuring market presence across various regions, which in turn can help in lowering revenue volatility given the various geography specific demand drivers. Also, local service network with ready availability of spare parts is critical for ensuring high uptime and hence predictable cash flows to equipment operators. The economics of operating a service network are generally better in case of mining equipment where a large volume of orders originate from a single location. A high base of installed equipment in turn leads to sizeable spare parts and service demand within a region. Consequently, demand for mining equipment is heavily dependent on the OEM s ability to provide quality service in specific geographic areas. Given that bulk of the CE market is financed, financing tie-ups by original equipment manufacturers (OEMs) plays a key role in driving demand for the equipment. Well-established brands usually find it easier ICRA Rating Services Page 2

3 to arrange financing tie-ups for its dealers and consumers at favourable terms. The resale value of the equipment also drives the availability of financing. Scale and Competitive Position The Indian CE market is dominated by few large OEMs in each product category. The past five to six years have witnessed the entry of several new players also, mostly joint ventures and subsidiaries of global majors. Import threat from established Chinese manufacturers has also heightened over the past decade, more so as domestic demand for equipment in China has fallen. Ability to establish and sustain market share in an evolving competitive landscape requires a strong product and deep pockets to fund market penetrative strategies, given the strong incumbents. JCB, the first entrant in the Indian backhoe market, continues to maintain its market dominance with over 70% share in the high volume backhoe segment. Similarly, BEML Limited has been the market leader in high tonnage mining trucks for a long period. Technology, distribution network and a long-standing presence in the market drive share of business. A strong competitive position leads to revenue stability and pricing flexibility. An analysis of the competitive landscape, movement in market share and threat of imports, help understand the level of price and product competition. Understanding the customer profile (single user owner, first-time buyer, small and large fleet owners) for any particular product category indicates the customer diversification; granularity and quality of orders; and the possible volatility in order flow. The target customer profile dictates the marketing strategies devised by players to drive demand. Order book and Inflows Heavy equipment orders are usually characterised by advances from the customer to support order execution. Large orders also have sufficient lead-time, allowing for effective ordering for raw material and production planning. Customised orders also have advances built into the contracts. The ability to demand advance payments is an indication of the market position of the OEM, and advances help meet working capital requirements, replacing borrowings. An analysis of the order book of the OEM serves as an indicator of its potential revenue growth and profitability. Financial Risk Assessment Revenue Growth Scale of operations, revenue growth and sustainability are important parameters that reflect the overall market strength and operating leverage a manufacturer enjoys with respect to its industry peers. Scale lends well to effective cost absorption and requisite capital allocation to profitable segments, particularly during the deep downtrends the CE industry experiences. A healthy scale of operations is an indicator of staying power, flexibility in the market for deploying timely pricing strategies and access to the capital and financial markets. Cost Structure, Forex risk and Profitability The CE industry witnesses significant variation in profitability through an industry cycle. Commodity price volatility and the ability to successfully pass on or absorb fluctuations can have a material impact on an OEM s profitability. A price undercutting strategy by any player to gain market share could lead to a discount war, which would have a more detrimental impact on high cost manufacturers. Procurement strategies and optimal level of backward integration in the supply chain allows for better asset efficiencies and retention of profit margins. Owing to the high operating leverage, higher asset sweating also drives profitability. ICRA Rating Services Page 3

4 Given the lack of local sources for several key inputs like undercarriage parts and special steel, import content in the Indian CE industry is high, exposing players to forex volatility. Since several of the Indian CE manufacturers are subsidiaries/joint ventures of global OEMs, bulk of the critical technology components come from the parent, in return for which the manufacturer also pays a royalty. The major international billing currencies for Indian CE manufacturers are Yen, USD and the Euro. ICRA takes into consideration the hedging policy of the entity towards mitigating such foreign currency risks and the impact of adverse movement in foreign exchange rates on its cost structure. Leverage and Coverage indicators ICRA assesses the ability of a manufacturer to generate healthy cash flows to reinvest in the business and meet its debt servicing obligations in a timely manner. Leverage ratios are an indicator of the degree of financial flexibility an entity enjoys in terms of its ability to raise funds from alternative sources in times of financial stress. Such flexibility is reflected in the entity s gearing (Total Debt-to-Tangible Net worth) and Total Debt-to-Operating profit before Interest, Depreciation and Amortisation (OPBITDA) multiple. A strong Total Debt-to-EBIDTA multiple is a credit positive as it reiterates the ability of the manufacturer to service its debt obligations, fund growth opportunities and improve its competitive position without being overly reliant on external sources. High leverage leads to significant stress during cyclical downturns. The entity s ability to contain its leverage and thereby its future interest expenses and repayment obligations to levels comfortably serviceable during times of low accruals are critical to the rating. However, the extent to which an entity can leverage its balance sheet is subjective and is determined primarily by the philosophy of the management. The interest coverage indicator reflects the entity s ability to service the cost of external borrowings after meeting all operating expenses. It is an important rating consideration as a weak EBDITA-to-interest multiple indicates the entity s inability to generating adequate operating profits to meet its interest and may signal a default risk. Debt-Service-Coverage ratio (DSCR) indicates the entity s ability to service its interest and repayment from cash flows generated from the business. Strong free cash flows indicate the ability of an entity to fund investments; pursue organic and inorganic growth opportunities; and make timely debt repayments. Financial policies are key rating inputs that help in evaluating the risk appetite of the management and its impact on the performance of the manufacturer. Adequacy of Future Cash Flows ICRA ascertains the adequacy of cash flows to meet future repayment obligations and capital investment requirements. Since the objective of the rating exercise is to assess the debt servicing capability of the entity, ICRA draws up projections of the likely financial position of the entity based on the expected movement in operating performance factoring in capital expenditure and investment requirements as well as upcoming debt obligations. ICRA also looks at the funding requirements of the entity and the funding options available. Undrawn lines of credit, ability to rollover lines of credit cost-efficiently and drawingpower backed buffer in working capital limits are credit comforts. Ratios are adjusted for unencumbered cash to take cognisance of the liquidity buffer. Retained cash flowsto-debt is an indicator of cash available for reinvestment in the business and servicing of repayment obligations, after interest payouts, working capital adjustments and taking into consideration shareholder interests through dividends. Tenure Mismatches, and Risks Relating to Interest Rates and Refinancing Large dependence on short-term borrowings to fund long-term investments can expose a manufacturer to significant re-financing risks, especially during periods of tight liquidity. The ratings factor in the existence of adequate buffers of liquid assets/bank lines to meet short-term obligations and the extent to which the entity could be impacted by interest rate movements on such borrowed funds. Debt Servicing Track Record ICRA Rating Services Page 4

5 The debt servicing track record of the entity forms an important rating consideration. Any history of past delays or defaults in meeting interest and principal repayment obligations reduces the comfort level with respect to the entity s future debt servicing capability and willingness. ICRA also factors in the ability of the entity to honour its debt obligations during period of seasonal and cyclical stress. Contingent Liabilities and Off-Balance Sheet Exposures ICRA relies on the entity s audited financial statement to analyse its financial performance. The likelihood of devolvement of contingent liabilities/off-balance sheet exposures and the financial implications of the same are evaluated. ICRA also looks at the quality of accounting practices followed by the entity based on interactions with the Statutory Auditors as well as by studying the Auditors Report and other Notes to Accounts disclosed by the entity in its Annual Report. Some of the key factors looked at include: auditor qualifications with respect to internal control systems and asset liability mismatch; contingent liabilities and other off-balance sheet items; and the method of revenue recognition and depreciation policy of the entity in comparison with industry peers. Event Risk ICRA also recognizes the possibility of events, such as unrelated diversification; mergers and acquisitions; business restructuring, asset sales and spin-offs; capital restructuring; and litigations, which could have a material impact on the credit profile of the entity. Strength of promoters, Management Quality and Corporate Governance In addition to the business and financial risk analysis, all debt ratings incorporate an assessment of the quality of the issuer s management. The assessment of the credit profile of an entity factors in the commitment of the management to the entity s day-to-day operations. The participation of professional management and the constitution of Board (number of promoter vs. independent directors, background of each director) and their participation in strategy formulation, besides the entity s adherence to legal and statutory compliance requirements is also factored in. Usually, a detailed discussion is held with the management to understand its views on past performance as well as its future plans & strategies and the outlook on the industry. Some of the points assessed are: Experience of the promoter/management in the industry Commitment of the promoter/management to the entity Risk appetite of the promoter/management and risk mitigation plans Management s past success in introducing new projects and managing changes in external environment Management s plans on new projects, acquisitions, expansion, etc Considering that most of the large CE manufacturers in India are subsidiaries or joint ventures of global majors, the global parent s commitment to the Indian market and to the Indian entity being rated are critical. Parent support in the form of access to new technology, supply of components, beneficial credit terms and equity infusion has supported several of these manufacturers during cyclical downturns. Consequently, the Parent s financial and operational strength, its strategy and commitment to the Indian operations are of importance. In case of joint ventures between global OEM and Indian entities, the relative strengths brought by the partners to the JV, their commitment and willingness to fund growth are key monitorables. Development of substitutes to a JV, either through a wholly owned subsidiary or an alternative manufacturing location in nearby geographies could affect the Indian entity s future prospects. In case of a joint venture, equal commitment from both partners and a common strategy are critical. Other Factors Other factors, which cut across industries, considered while rating the issuer include regulatory framework; group support and usage of the issuer s funds to support group companies; ability and willingness of the ICRA Rating Services Page 5

6 group and management to lend support to the issuer in the event of required capital infusion and openness of the management to sharing information. Periodic interactions with the management helps estimate the possibility of the management s tendency to deviate from its philosophy in times of stress. Summing Up ICRA s credit ratings are a symbolic representation of its opinion on the relative credit risk associated with the instrument being rated. This opinion is arrived at by following a detailed evaluation of the issuer s business and financial risks, its competitive strengths, it s likely cash flows over the life of the instrument being rated and the adequacy of such cash flows vis-à-vis its debt servicing obligations and other funding requirements. ICRA s approach to rating CE manufacturers also incorporates the evaluation of various business profile parameters such as an assessment of the manufacturer s market position, product portfolio, distribution network as well as the management strategy for maintaining financial performance through the economic cycle and its overall approach towards investment and growth. Quantitative factors coupled with the management s policy and risk appetite help ascertain the adequacy of future cash flows to service debt obligations in a timely manner. ICRA Rating Services Page 6

7 ICRA Limited CORPORATE OFFICE Building No. 8, 2 nd Floor, Tower A; DLF Cyber City, Phase II; Gurgaon Tel: ; Fax: info@icraindia.com, Website: REGISTERED OFFICE 1105, Kailash Building, 11 th Floor; 26 Kasturba Gandhi Marg; New Delhi Tel: ; Fax: Branches: Mumbai: Tel.: + (91 22) /53/62/74/86/87, Fax: + (91 22) Chennai: Tel + (91 44) /9659/8080, / 3293/3294, Fax + (91 44) Kolkata: Tel + (91 33) / / / , Fax + (91 33) Bangalore: Tel + (91 80) /4049 Fax + (91 80) Ahmedabad: Tel + (91 79) /5049/2008, Fax + (91 79) Hyderabad: Tel +(91 40) /7251, Fax + (91 40) Pune: Tel + (91 20) /95/96, Fax + (91 20) Copyright, 2016 ICRA Limited. All Rights Reserved. Contents may be used freely with due acknowledgement to ICRA. All information contained herein has been obtained by ICRA from sources believed by it to be accurate and reliable. Although reasonable care has been taken to ensure that the information herein is true, such information is provided 'as is' without any warranty of any kind, and ICRA in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness or completeness of any such information. Also, ICRA or any of its group companies, while publishing or otherwise disseminating other reports may have presented data, analyses and/or opinions that may be inconsistent with the data, analyses and/or opinions presented in this publication. All information contained herein must be construed solely as statements of opinion, and ICRA shall not be liable for any losses incurred by users from any use of this publication or its contents.