Mid-market corporates less resilient with clear winners and losers

SYDNEY, AUSTRALIA, Monday, 5 June, 2017 – The financial health of mid-market corporations in Australia has softened, according to new data from Equifax, the global information solutions company and the leading provider of credit information and analysis in Australia and New Zealand.

Despite the softer outlook, corporates are primed to withstand a slowing economy, with lower costs and strong balance sheets, although some sectors and states remain vulnerable.

Weak commodity prices have reduced cash flows, particularly in the mining sector. This has caused a more uncertain outlook in Queensland and Western Australia.

The Equifax Mid-Market Risk Index (MMRI) measures the risk of financial failure across a portfolio of more than 30,000 businesses. The index reflects credit scores and ratings assigned in any given year relative to the index year (2005).

The index is a leading indicator of trends in external administration of Australian corporates, and has historically provided advanced warning of turning points in the credit cycle.

The MMRI of 98[1] for the 12 months to December 2016[2] is down -0.5 from the previous year, when the Index recorded a value of 98.5. This reflects the declining conditions in the financial flexibility, profitability and capitalisation of local mid-market businesses.

Despite the decline, the Index shows a significant recovery from the historical low of 93.8 in 2009 in the aftermath of the GFC. In the context of the Index, an MMRI value below 95 may point to the risk of a corporate downturn.

Brad Walters, Head of Ratings Services, Equifax, said the decline in overall credit quality could be attributed to several causes, including weakening activity in construction, and the growing divergence between the mining states, and, New South Wales and Victoria.

“The latest MMRI shows that we have seen a turning point and that mid-market businesses are less resilient. More specifically, the decline in private capital investment, capital inflows, weak commodity prices and currency fluctuations have contributed towards sectoral weaknesses in mining and manufacturing,” Mr Walters said.                                                               

“The weakening outlook for construction is also a major risk factor. Over the last year, strong growth in the demand for residential and commercial construction has masked a structural decline in engineering. Construction activity has now fallen for six consecutive quarters, and recent attempts to cool the housing market by regulators and policymakers may cause activity to fall further,” Mr Walters added.

“This year there are clear winners and losers. Construction, mining, and manufacturing are all looking weaker, with healthcare and transport looking more positive. Both transport and healthcare have benefitted from increased demand, lower costs and stronger balance sheets,” said Mr Walters.

In the last MMRI, the healthcare sector held a negative outlook. However, legislative changes, consolidation in the sector and increased pricing power has meant the sector now has a positive outlook.

Across sectors, there are variations in risk profiles:

• The construction industry outlook is negative. Order books remain strong, but industry revenue growth is plateauing. Activity is expected to decrease further over the next 18 months as a result of the continuing vacuum following the resources boom. Liquidity is stable but not as strong as other sectors, and leverage is set to increase over the next year. There is also mounting pressure on profitability and margins from increasing competition, lower win rates, compromised pricing to secure work, and wage-related pressure.                                                                                                                                
• Healthcare encountered negativity last year, but now has a positive outlook. The consolidation of smaller service providers, leading to larger scale businesses, modest system growth and stronger pricing underpin the revenue recovery for the sector. Last year, operating cash flow was affected by the rapid decline in margins and investment in the cutting of long-term costs. Cash flows in the sector are now expected to strengthen as businesses reap the benefits of a lower cost base. Surplus operating cash and disciplined capital measures support lower and more sustainable levels of leverage.
   
• Transport saw improvements to move from a stable to positive outlook. Revenue has stabilised against a backdrop of higher volumes of Australian commodity exports and increased domestic activity. Profitability has been supported by the gradual reduction of costs. Increasing supply volumes has resulted in greater capacity utilisation which will support margins and cash flow over the next year. Leverage is continuing to decline, with disciplined capital measures driving borrowing down to a more sustainable level.
   
• Manufacturing faces several headwinds. Sector revenues are in structural decline. The exit of smaller – and more vulnerable – business explains a rise in like-for-like revenue, but margin growth in the sector is muted. A high labour cost base, stagnating labour productivity and limited capital investment are contributing to structural weakness in the sector. Liquidity in the sector is stable, and leverage has decreased following industry consolidation (particularly in the automotive supply chain) with the rationalisation of production facilities and the repayment of debt.
   
• Weak commodity prices and higher leverage threaten the outlook of the mining sector. Commodity production volumes increased in 2016, but prices remained weak until the second calendar half of 2016. Higher prices for iron ore, coal and oil, from a temporary rebalancing of demand and supply, may provide the sector with respite over the short-term, but this is expected to be temporary. Aggressive cost cutting has protected margins, and also strengthened liquidity, but leverage is increasing.                                                                                                                           

The full report can be accessed here: http://www.equifax.com.au/sites/default/files/Mid-Market-Risk-Index-2017.pdf