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Rating action

Scope Ratings GmbH (Scope Ratings) has today affirmed the B+/Stable issuer rating of Hungarian construction company West Hungaria Bau Kft. (WHB) along with the B+ rating for its senior unsecured debt. 

Rating rationale

WHB’s business was impacted negatively at the beginning of the Covid-19 crisis in 2020 by material shortages, but those were quickly resolved and the company gained traction on the back of the health crisis. WHB received a contract for a container hospital, boosting revenues above its own expectations. In addition, it signed and fulfilled a large contract to expand prison capacity in Hungary, which was required of the Hungarian state to comply with EU prison regulations and avoid payment sanctions. Apart from minor extraordinary expenses related to protective gear (masks, disinfectants), the company’s costs were not affected by the crisis. WHB also did not have to use the credit moratorium or apply for employee wage subsidies. As a result, the company ended 2020 with strong operational performance, with construction-related revenues forecasted at HUF 78bn (versus Scope’s expectations of HUF 62bn) and EBITDA at HUF 12.8bn (versus the expected HUF 4bn). WHB, while pleased with the result, cautioned that the achieved margin is unsustainable, distorted by the delayed recognition of revenues from previous years.

During the year, WHB also expanded a maintenance facility at the Paks Industrial Park; previously the company had leased a facility and equipment. This is in light of ongoing maintenance contracts and expected new contracts with Paks2.

The company delayed its plans to fully acquire and control a multifunctional shopping centre and start its refurbishment in 2020, with acquisition now foreseen by mid-2021. Conditional to this purchase is the issuance of a HUF 10bn (roughly EUR 27m) bond in H2 2021 under the Hungarian National Bank’s Bond Funding for Growth Scheme, with an expected coupon of 3% and a maturity of 10 years, amortising after five years. Regarding the acquisition, Scope foresees a capex need of HUF 6bn for 2021 and HUF 4bn for 2022, which will lead to negative free operating cash flow.

The capex programme comes at a time when the company faces a short backlog that covers only 2021, during which Scope estimates revenues of HUF 66bn followed by HUF 45bn in 2022. EBITDA will follow suit with HUF 5bn in 2021 and HUF 2.5bn in 2022.

WHB’s business risk profile (affirmed at B) is supported by its historically above-average profitability and its domestic market position, which has translated into market visibility and moderate access to third-party capital and guarantees. The business risk profile is somewhat constrained by the company’s small overall scale in European construction, which lessens its ability to mitigate economic cycles, as well as by weak geographical diversification (mainly in Hungary), segment concentration, and dependency on government contracts. The short and concentrated backlog is somewhat mitigated by the investment grade counterparties. The book-to-bill ratio is volatile.

WHB’s four private owners are also its top management, and no independent board provides an oversight function. This is exemplified by the HUF 2bn interest-free loan granted to one owner (partially repaid at year end 2019). While we understand the family-owned nature of the company, an improvement in corporate governance would be positive given its growth in scale. Regulatory and reputational risks are negative ESG factors. We believe that WHB’s market position in recent years was gained through state tenders, which were secured thanks to the company’s established credentials on projects with state-owned companies. The company is now highly dependent on state tenders, which accounted for around 90% of total revenues in 2020.

The company’s financial risk profile (affirmed at BB-) benefits from the historically low debt levels and a cash cushion estimated at HUF 16.6bn (including restricted cash of HUF 4.2bn) at year-end 2020. The HUF 10bn of bond debt and the refurbishment of the multifunctional shopping centre will result in a significant need for capex and, in turn, negative free operating cash flow. WHB intends to increase dividend payouts from HUF 1.7bn in 2020 to HUF 5bn going forward (if covenant restrictions allow), which will take discretionary cash flow into deeply negative territory and render dividends to be funded by debt. In addition, the short contracted backlog creates uncertainties about future cash flows, which Scope reflects through a decreasing top line that trickles through to a decreasing EBITDA and interest coverage along with a gradual increase in leverage to 3.1x in 2022, with an increasing trend thereafter.

Liquidity is adequate, with unrestricted cash exceeding short-term debt even if free operating cash flow turns further negative. Given the long maturity of the prospective bond, upcoming short-term maturities are likely manageable for the foreseeable future.

Outlook and rating-change drivers

The Outlook for WHB is Stable and incorporates Scope’s view of the company’s high transformation risk in 2021, when its government contracts will be completed and need to be replaced with new contracts not known of as of today. Thus, a strong decline in Scope-adjusted EBITDA is anticipated for 2022 to HUF 2.5bn, leading to weakening credit metrics with a Scope-adjusted debt/EBITDA ratio of around 3.1x. Furthermore, the Outlook incorporates a successful placement of a HUF 10bn bond in H2 2021 to finance the acquisition, related costs and the refurbishment of a multifunction complex in western Hungary. The project should benefit recurring EBITDA in the medium term but will result in significant capex and opex in the short term. Additionally, Scope expects dividend payouts to be in line with current covenants, at a maximum of 50% of net operating income.

A positive rating action is remote but may be warranted if the company can increase visibility on revenues beyond the next 12 months, helping to keep Scope-adjusted debt/EBITDA below 2.5x. This could be driven by i) an improving order backlog, benefitting from a higher granularity of customers and more complex projects extending respective execution periods; and ii) a successful revamp of the multifunctional complex that supports cash flow beyond Scope’s current expectations.

A negative rating action could occur if Scope-adjusted debt/EBITDA increases over 3.5x on a sustained basis or if liquidity worsens. This could be a function of adverse operational developments with reduced profitability and cash flows, or dividend payouts that are higher than company policy. The latter could happen if i) customers delay payments significantly; ii) the company becomes exposed to the non-recoverable cost overruns of its projects, or iii) guarantees are drawn.

Long-term and short-term debt ratings

The rated entity plans to issue a HUF 10bn senior unsecured corporate bond under the Hungarian National Bank’s Bond Funding for Growth Scheme. The planned bond has a 3% coupon and is amortising after five years with a tenor until 2031. Proceeds from the bond are earmarked for financing the capex to acquire, refurbish and operate a multifunction complex in western Hungary encompassing a mall, a hotel and a stadium.

Scope’s recovery analysis is based on a hypothetical default scenario occurring at year-end 2022, which assumes outstanding senior unsecured bond debt of HUF 10bn in addition to the existing debt positions. An ‘average recovery’ is expected for the company’s unsecured debt, resulting in a B+ rating for this debt class (the same as the issuer rating).

Stress testing & cash flow analysis
No stress testing was performed.Scope Ratings performed its standard cash flow forecasting for the company.

Methodology
The methodologies used for this credit rating(s) and/or rating outlook(s) (Corporates Rating Methodology: European Construction Corporates, 15 January 2021; Corporate Rating Methodology, 26 February 2020) are available on https://www.scoperatings.com/#!methodology/list.
Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The credit rating was not requested by the rated entity or its agents. The rating process was conducted:
With Rated Entity or Related Third Party Participation                        YES 
With Access to Internal Documents                                                     YES
With Access to Management                                                               YES
The following substantially material sources of information were used to prepare the credit rating: public domain, the rated entity and Scope Ratings internal sources.
Scope Ratings considers the quality of information available to Scope Ratings on the rated entity or instrument to be satisfactory. The information and data supporting Scope Ratings’ credit ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the credit rating action, the rated entity was given the opportunity to review the credit rating and/or outlook and the principal grounds on which the credit rating and/or outlook is based. Following that review, the credit rating was not amended before being issued.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The credit rating and/or outlook is UK endorsed.
Lead analyst Thomas Faeh, Executive Director
Person responsible for approval of the credit rating: Philipp Wass, Executive Director
The credit ratings/outlooks were first released by Scope Ratings on 28 January 2020. 

Potential conflicts
Please see www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
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