Moody’s Investors Service has downgraded the issuer rating of auto industry supplier Continental AG to Baa2 from Baa1.
Concurrently, Moody’s downgraded the senior unsecured ratings of Continental and their subsidiaries Conti-Gummi Finance BV and Continental Rubber of America (CRoA). The short-term Prime-2 (P-2) ratings of CRoA were affirmed. The outlook on the ratings is negative.
“The rating downgrade to Baa2 ratings reflects the further deterioration in the operating environment for European automotive parts suppliers, the resulting pressure on Continental’s profit margins and financial metrics, as well as the company’s elevated distributions to shareholders”, said Matthias Heck, a Moody’s VP, senior credit officer and lead analyst for Continental.
“The negative outlook is driven by the current uncertainty facing the auto sector for 2020 and beyond. The spreading of Covid-19 across Europe that has led to weaker consumer sentiment could make it challenging for Continental to sustain leverage and cash flow metrics at levels required for a Baa2.”
Moody’s sector outlook on European automotive parts suppliers, first published 2 March 2020, remains negative.
It expects global light vehicle sales to decline by another 2.5% in 2020, following a decline of 4.6% in 2019. Additional risks relate to a global outbreak of the coronavirus and disruption of economic activity beyond the first quarter of 2020.
For the sector, Moody’s expects EBITA margins not to recover from already low 2019 levels, whilst environmental regulation, electrification and disruptive technologies (such as autonomous driving and digitalisation) represent additional challenges for the sector.
For 2020, Continental expects sales to reach EUR42.5bn to EUR44.5bn while it expects EBIT margins to erode further to 5.5% to 6.5%.
The erosion will come in particular from the rubber group, where margins will decline to 10% to 11% (from 12.4% in 2019).
In the automotive group margins will reach around 3% to 4%, after 4.4% in 2019. In 2019, Continental initiated an efficiency programme to reduce gross cost by approximately EUR500m from 2023. This will, however, only increase the group’s margins by around 100 basis points while requiring upfront costs of around EUR1.1bn. This implies that Continental’s EBIT margin will remain below 8% until after 2021 and hence position the company weakly in the Baa2 rating category.
More positively, Continental’s cash generation through 2019 remained decent, with free cash flow (FCF) after dividend remaining positive. For 2020, Continental expects a FCF (before M&A and dividend payments) of EUR0.7bn to EUR1.1bn. After management’s proposed dividend payment of EUR800m, this leaves FCF in a range or minus EUR100m to plus EUR300m, a low level considering the highly volatile sector environment and the potential of some further, albeit smaller, M&A transactions. Moody’s considers that Continental’s shareholder distributions have become more aggressive.
During 2012-2018, dividend payouts increased gradually from 24% to 33%. While this level was still balanced and in line with the sector average, the proposed payment for 2019, albeit somewhat lower than last year, is for a year with negative profits and increased debt levels.
At the end of December 2019, Continental’s reported debt increased to EUR7.6bn. On a Moody’s adjusted basis, including pension liabilities, gross debt amounted to approximately EUR12.5bn. This translates to an adjusted debt/EBITDA of approximately 2.5x. For 2020, the ratings agency expects Continental’s leverage to remain at around this level, due to ongoing margin pressure and despite some debt reduction due to bond maturities.
For 2021, Moody’s expects leverage to improve marginally within a range of 2.0-2.5x, including and excluding the proposed spin-off of Vitesco Technologies.
Continental’s Baa2 long term issuer rating takes into consideration the company’s (a) strong business profile as the third largest Tier 1 global auto supplier with revenues of over EUR44bn in 2019; (b) diversity across multiple business areas and product lines; (c) leading position both in tyres and industrial-facing businesses which reduces exposure to the original equipment (OE) automotive industry; (d) significant proportion of revenues from the replacement tyre aftermarket which is less cyclical than for original equipment sales; (e) excellent positioning to mitigate the disruptive trends facing the automotive industry and (f) relatively strong credit metrics with leverage (as measured by Moody’s adjusted debt / EBITDA) of 2.5x and retained cash flow (RCF) / net debt of 42% as of December 2019, and the maintenance of a good liquidity profile.
Nevertheless, the rating reflects as negative the company’s: (a) exposure to the cyclicality of the automotive industry; (b) high research and development (R&D) costs within the automotive business, albeit similar to peers; (c) exposure to volatile raw material prices and foreign exchange rates, (d) credit risks related to high shareholder distributions, including cash dividend payments and the proposed spin-off of Vitesco Technologies.
Environmental, social and governance (ESG) risks are relevant and have been reflected in Continental’s ratings. Some of Continental’s end products, especially in the area of powertrain (Vitesco Technologies), are negatively impacted by stricter environmental regulation of passenger and commercial vehicles and the trend towards electrification. This results in lower demand and profit margins for existing products and requires high research and development cost for new products.
Continental’s governance risks are moderate. As a stock market listed company, it provides good disclosure in terms of financial and sustainability reporting. The company’s financial policy includes the maintenance of good liquidity. The company has, however, become more aggressive in terms of shareholder distributions. Moody’s therefore considers the financial policy to be more in line with a Baa2 rating and expects, based on its public rating target, that the company would take measures to defend this rating if needed.
Rationale for negative outlook
The negative outlook reflects (i) risks related to the high cyclicality of the automotive industry, (ii) material short-term challenges regarding a global outbreak of the coronavirus and its risks on production, stability of supply chains and consumer demand for vehicles, and (iii) ongoing challenges in the automotive industry, such as electrification and disruptive technologies, which require ongoing high amounts of R&D spending and limit free cash flow generation. In this environment, it might be difficult for Continental to (i) maintain its debt/EBITDA (Moody’s adjusted) at a maximum of 2.5x, which is expected the Baa2 rating, (ii) improve EBITA margins (Moody’s adjusted) to at least 8% over the next 2-3 years, given the challenging sector environment and despite efficiency measures.
What could change the rating
Moody’s might consider downgrading Continental’s ratings to Baa3 in case of (1) an increase in leverage (debt/EBITDA) to above 2.5x for a prolonged period (2.5x as of December 2019); (2) the RCF/net debt coverage ratio falling below 30% (42% as of December 2019); (3) a failure to recover adjusted EBITA margin to at least 8% on a sustainable basis (as of December 2019: 7.4%); or (4) a deterioration in Continental’s liquidity profile.
The ratings could be upgraded if Continental was able to (1) demonstrate a sustainable Moody’s-adjusted free cash flow generation in excess of EUR1bn per annum, that would be applied to (2) a further debt reduction leading to a decline in Moody’s leverage (debt/EBITDA) of constantly below 2.0x; (3) achieve an EBITA margin (as defined by Moody’s) sustainably above 10%; and (4) an RCF/net debt above 45%.