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Rating action

Scope Ratings GmbH (Scope) has affirmed the B issuer rating on Hungarian gear manufacturer company Szabó Fogaskerékgyártó Kft. and changed the Outlook to Stable from Negative. Scope has also affirmed the B+ rating for the senior unsecured debt category, one notch above the issuer rating.

Rating rationale

The return to a Stable Outlook reflects the expected recovery in profitability, as measured by the Scope-adjusted EBITDA margin, to over 25% after a sharp decline in 2022 as well as the higher revenue expected in 2023-2024. A higher rating is still out of reach due to Szabó Fogaskerékgyártó’s weak business risk profile (assessed at B-) which reflects its weak market position and weak diversification in terms of both products and customers, which makes Szabó Fogaskerékgyártó very vulnerable to economic shocks. Additionally, Szabó Fogaskerékgyártó’s business nature entails a very low share of recurring revenue (mainly project orders with a short lead time of one to six months) and lack of aftermarket activities, which usually leads to low volatility.

The Scope-adjusted EBITDA margin declined from 34.5% in 2021 to 21.7% in 2022, driven by the sharp increase in material costs and the late conclusion of price negotiations to pass on higher material prices to customers in Q4 2022. An increase in staff costs by around 37% YoY also weighed on profitability. Revenue increased by about 37% in 2022, reaching HUF 2.4bn compared to HUF 1.8bn in 2021 but could not offset the lower Scope-adjusted EBITDA margin, resulting in a decline of Scope-adjusted EBITDA to HUF 527m in 2022 from HUF 612m in 2021.

Based on unaudited figures, 9M 2023 revenue increased by 27% YoY to HUF 2.1bn. This was mainly driven by higher volumes and price increases implemented in Q4 2022. EBITDA (unaudited) also increased to HUF 773m at 9M 2023 from HUF 276m at 9M 2022. In addition to higher revenue, EBITDA was supported by the improved gross profit margin (51.7% at 9M 2023 versus 32.1% at 9M 2022) thanks to the price increase implemented in Q4 2022 and the normalisation of the energy and raw materials markets. As a consequence, the reported EBITDA margin improved to 37% at 9M 2023 from 17% at 9M 2022.

For the full year 2023, Scope expects revenue of around HUF 2.8bn (up 15% YoY), which is in line with the company's forecast. Szabó Fogaskerékgyártó communicated to Scope that there have been no price increases in 2023, no increases are planned for 2024-2025, and growth should come from higher volumes and new customers. There is a risk of downward price adjustments due to falling raw materials prices and energy costs under the contractual agreements. Scope has learnt from its discussions with the company that downward price adjustments are not an issue at this stage. Overall, Scope expects 2024 revenue to increase by 5% YoY to around HUF 2.9bn.

In 2023, Szabó Fogaskerékgyártó increased its wages and salaries by an average of 15%, increasing the ratio of personnel cost to revenue to 15.5% at 9M 2023 from 14% in 2022. Given that the gross profit margin has improved beyond Scope’s expectations, Scope is revising its forecast for the 2023 Scope-adjusted EBITDA margin upwards from 21% to around 34%. This translates into Scope-adjusted EBITDA of around HUF 960m in 2023. Scope has factored in a relatively stable gross profit margin of around 51% in 2024 compared to around 52% assumed for 2023 (52% achieved as at 9M 2023). Scope assumes that personnel costs will continue to rise in 2024. However, Szabó Fogaskerékgyártó benefits from its relatively low ratio of personnel expenses to revenue, which is why the expected continued wage inflation will have relatively little impact on the company's overall profitability. Szabó Fogaskerékgyártó plans to move premises in summer 2024. Scope expects the costs associated with the move to hinder profitability that year. Overall, Scope has factored in a Scope-adjusted EBITDA margin of around 29% for 2024, resulting in a Scope-adjusted EBITDA of around HUF 855m.

Szabó Fogaskerékgyártó has indicated that it wants to start operating as a supplier to the automotive industry. According to Szabó Fogaskerékgyártó, the company is in advanced negotiations with automotive suppliers. While this strategic decision could boost revenue, it increases risk regarding the company's profitability in the long term as the automotive industry is characterised by standardised mass production and fierce price competition.

The issuer rating benefits from a financial risk profile revised to BB+ from BB-. The two-notch uplift reflects the better-than-expected credit metrics in 2022 and the anticipated improvement in credit metrics following Scope’s improved expectation for Scope-adjusted EBITDA. It is also supported by Szabó Fogaskerékgyártó's unchanged debt reduction plans.

Scope calculates Scope-adjusted debt of HUF 2.5bn at end-2022, up from HUF 1.0bn at end-2021 due to the bond issuance of HUF 1.5bn under the Hungarian National Bank’s Bond Funding for Growth Scheme. Szabó Fogaskerékgyártó plans to reduce its financial debt by around HUF 530m by end-2024. Scope expects a decrease in Scope-adjusted debt to around HUF 2.2bn by end-2023 and around HUF 1.9bn by end-2024.

Leverage as measured by Scope-adjusted debt/EBITDA deteriorated to 4.7x in 2022 from 1.7x in 2021, driven by the increase in Scope-adjusted debt, as well as the decline in Scope-adjusted EBITDA. Based on its improved expectations for Scope-adjusted EBITDA and the company's deleveraging plans, which should lead to a lower Scope-adjusted debt in 2023-2024, Scope expects the Scope-adjusted debt/EBITDA ratio to improve to around 2.5x in 2023-2024.

The interest result was positive in 2022, supported by high interest income from investments in securities and the fact that the payment of interest on the bond only began in 2023. Scope anticipates that the interest result for 2023 will remain positive despite the start of interest payments on the bond. Scope notes positively that the impact of higher interest rates on Szabó Fogaskerékgyártó is limited as around 95% of Szabó Fogaskerékgyártó’s total debt was fixed coupon at end-2022. Overall, Scope expects a very strong interest cover of over 10x in 2024.

In 2022, Scope-adjusted funds from operations decreased slightly to around HUF 555m from HUF 574m in 2021, as an increase in interest income was unable to offset the lower Scope-adjusted EBITDA. In 2021, Szabó Fogaskerékgyártó initiated an investment programme in production capacities, which drove up investments and led to a negative Scope-adjusted free operating cash flow (FOCF) of HUF -264m in 2022 and HUF -529m in 2021. After 9M 2023, the unaudited FOCF was positive at around HUF 110m (around HUF -210m in 9M 2022, adjusted for the receipt of the subsidy), as higher EBITDA and a positive interest result compensated for the higher outflows of working capital and capex. The investment programme will last until 2024, thus capex is set to remain high in 2023-2024. Overall, Scope assumes Scope-adjusted FOCF to be positive in 2023 at around HUF 230m for 2023 and negative in 2024 at around HUF -820m.

The increase in Scope-adjusted debt has caused the Scope-adjusted funds from operations/debt ratio to fall from 55% in 2021 to 23% in 2022. Based on its upwardly revised expectations for Scope-adjusted EBITDA, Scope expects Scope-adjusted funds from operations/debt of above 30% in 2023-2024. The negative Scope-adjusted FOCF in 2021-2022 due to the investment cycle led to negative cash flow cover in those years. Scope assumes a volatile cash flow cover in 2023-2024: positive at around 10% in 2023 and negative in 2024.

As stated in the bond prospectus, Szabó Fogaskerékgyártó has limited the dividend payout to HUF 50m during the investment cycle from 2021 to 2023. The dividend payment of HUF 50m had already been made in 2023, and Scope has also factored in dividend payments of HUF 50m for 2024. Scope understands that Szabó Fogaskerékgyártó does not want to return to distributing all of the FOCF after 2024 but wants to use its cash to invest. Szabó Fogaskerékgyártó does not plan any capital transfer to its sole shareholder and its subsidiary in 2023-2025.

Scope considers Szabó Fogaskerékgyártó's liquidity and financial flexibility as ‘adequate’ as the significant cash inflows in 2022 led to very high cash reserves and the maturity structure is well balanced over the next few years.

Scope highlights that Szabó Fogaskerékgyártó’s senior unsecured bond issued under the Hungarian National Bank’s Bond Funding for Growth Scheme has a covenant requiring the accelerated repayment of the outstanding nominal debt amount (HUF 1.5bn) if the debt rating of the bond stays below B+ for more than two years (grace period) or drops below B- (accelerated repayment within 10 days). Such a development could adversely affect the company’s liquidity profile. The rating headroom to entering the grace period is zero notches. Given the limited rating headroom, the company must at least maintain its current credit profile to avoid triggering the rating-related covenant.

There is a key person risk (ESG factor) as the entire management of the company rests with the CEO Ferenc Szabo, the 100% sole owner of Szabó Fogaskerékgyártó Kft. and his son Krisztian Szabo, the executive vice president. Scope's rating therefore reflects the improved financial risk profile to a lesser extent than the unchanged weak business risk profile, as the company could prove vulnerable to structural changes in management on top of external factors.

One or more key drivers for the credit rating action are considered ESG factors.

Outlook and rating-change drivers

The Stable Outlook reflects the faster-than-expected improvement in Szabó Fogaskerékgyártó’s profitability, supported by the normalisation in commodity markets and the higher prices agreed in Q4 2022, which has led Scope to revise upwards its expectation for the Scope-adjusted EBITDA margin to above 25% in 2023-2024. It also reflects Scope’s anticipation of higher revenue in 2023-2024, which, together with better profitability, should lead to improved leverage as measured by Scope-adjusted debt/EBITDA of around 2.5x in 2023-24.

A rating upgrade is remote at this stage but would be possible if the company improved its diversification, particularly with regard to customers and/or grew while keeping its leverage low.

A negative rating action could result from Scope-adjusted debt/EBITDA staying at around 4x, e.g. caused by EBITDA margin pressure from rising material or personnel costs or increased financial debt. It could also result from weaker liquidity or the loss of a major customer.

Long-term debt rating

In line with the issuer rating, Scope has affirmed the B+ rating for senior unsecured debt, one notch above the issuer rating, based on an ‘above average’ recovery prospect in the event of a default.

In February 2022, Szabó Fogaskerékgyártó issued a HUF 1.5bn bond under the Hungarian National Bank’s Bond Funding for Growth Scheme with a tenor of 10 years, amortisation of the notional amount by 10% annually over 2027-2031 with a 50% bullet repayment in 2032, and a 5.5% fixed interest rate coupon payable annually. Proceeds from the bond were supposed to be used for investments in a new production hall and logistics centre and to develop the production structure with an automated warehouse structure. The remaining debt comprises bank debt and financial leases. Bank loans are secured by pledge on some selected machines, lorries and cars.

Scope assumes that Szabó Fogaskerékgyártó will reduce its bank and lease debt by around HUF 730m by YE 2025 in line with its business plan and the investment programme will be executed as planned with no additional bank debt or other senior-ranking financing ahead of the bond.

In 2022, Szabó Fogaskerékgyártó received a HUF 1bn state subsidy to finance its investments. Scope has ranked the repayment obligation for subsidies at the simulated point of default senior to the claims on the prospective bond.

Scope also assumes an increase in property, plant and equipment compared to end-2022 due to the ongoing investment programme.

Scope’s recovery analysis uses the liquidation value in a hypothetical default in 2025 of HUF 2.4bn. This value is based on a haircut on the assets and reflects liquidation costs of 10%. The haircut also assumes the receivable from the parent, used to refinance the acquisition debt, would become non-recoverable in the event of payment default.

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

Methodology
The methodology used for these Credit Ratings and/or Outlook, (General Corporate Rating Methodology, 16 October 2023), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Rated Entity and/or its Related Third Parties did participate in the Credit Rating process.
The following substantially material sources of information were used to prepare the Credit Ratings: 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 the 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 Ratings and/or Outlook and the principal grounds on which the Credit Ratings and/or Outlook are based. Following that review, the Credit Ratings and/or Outlook were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlook are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlook are UK-endorsed.
Lead analyst: Gennadij Kremer, Associate Director
Person responsible for approval of the Credit Ratings: Sebastian Zank, Managing Director
The Credit Ratings/Outlook were first released by Scope Ratings on 31 January 2022. The Credit Ratings/Outlook were last updated on 21 December 2022.

Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest disclosures related to the issuance of Credit Ratings.

Conditions of use/exclusion of liability
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