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Rating action

Scope Ratings GmbH (Scope) has today affirmed the BB-/Stable issuer rating of Duna Aszfalt Zrt. Scope has also affirmed the BB rating for the senior unsecured debt category.

The rating affirmation also takes into account the correction of previous calculation errors in some financial metrics. The errors related to the calculation of net interest, cash flow from operations and Scope-adjusted debt*. The errors were reviewed, and Scope concluded that the corrections had no impact on the ratings.

The full list of rating actions and rated entities is at the end of this rating action release.

Key rating drivers

Business risk profile: B. Duna Aszfalt's business risk profile remains constrained by its relatively small size in a European context and weak diversification, with its competitive positioning dependent on strong ties with the Hungarian government ¬– despite growth in Poland – to ensure continued operations at unchanged scale and profitability in its domestic market. However, good profitability levels and a record order book provide sufficient revenue visibility and headroom to counter increased competitive pressure.

Duna was able to grow in a declining market (construction output in Hungary down 5% YoY), with revenues rising to HUF 261bn (up 8% YoY) and EBITDA of HUF 50bn (up 55% YoY) in 2023, underpinning its position as the market leader in Hungarian motorway construction. The acquisition of Poland's Mota-Engil Central Europe (MECE) at the end of September 2024¹ makes it a visible player in its neighbouring country, reducing its dependence on the close relationship with the Hungarian government. The acquisition is seen as complementary, as it adds exposure to a similar type of activity (construction of roads and bridges), but also to property development (3% of combined gross margin in 2023).

While only 5% of revenues in 2023 were generated outside Hungary, this is expected to rise to nearly 30% by 2025, driven by the acquisition of MECE. The company expects an even higher share in the coming years, supported by contracts in either Poland or Romania and further acquisitions in Central and Eastern Europe (CEE). This would further improve geographical diversification, which is much needed given the diminishing business opportunities in Hungary with the major highways built or rehabilitated over the last two decades.

Diversification is still constrained by (i) the group's relatively high exposure to (small) civil engineering projects, where it generated around 90% of revenues in 2023 (around 91% in LTM H1 2024), (ii) its concentrated customer structure, with government-related projects (including municipalities) representing around 75% of its current order book, as well as (iii) its concentrated order book, with the top 3 projects representing 67% of its backlog at end-June 2024. Given the complementary nature of MECE's businesses, diversification in terms of segments, customers and projects is not expected to change significantly. All of this could lead to significant cash flow volatility in the event of project delays or cancellations, increased competition or looser government ties.

Duna Aszfalt's profitability improved in 2023, with an EBITDA margin of 19% (up 6pp YoY), largely due to lower subcontractor involvement as Duna was able to complete more work with its own resources. However, while MECE's order book is expected to provide further revenue visibility – in addition to Duna Aszfalt's backlog of HUF 800bn as of end-June 2024 (up 63% YoY), resulting in a backlog of 3.0x of average revenue over the last three years – it will have a dilutive effect on the group's margin^a. Further margin pressure that could be exerted in the future is related to (i) the possible need for Hungary to change its public procurement law², which could mean a higher level of competition in public tenders, and (ii) a resumption of negative volatility in raw material prices, as the company limits the hedging of input prices, with most materials (except steel) being purchased at spot prices. Given the increased downward pressure, EBITDA margin is expected to decline and hover around 10% for the next few years.

Financial risk profile: BB+. Duna Aszfalt's financial risk profile is supported by low leverage, high interest cover and adequate liquidity. It is constrained by a relatively weak cash flow coverage given the expected pressure on cash generation, compounded by the risk of higher volatility due to (i) the company's ambitious growth strategy, which is associated with execution and integration risk, as well as (ii) the chunkier order book.

Duna Aszfalt had an almost net cash position at the end of 2023, but this is expected to deteriorate due to the lower free operating cash flow and, most importantly, the company's investment plans to expand its reach to other countries and regions to counter the declining business opportunities in Hungary.

Margin dilution from recent and future acquisitions and the chunkier order book increase the risk of a more volatile top line, putting pressure on free operating cash flow in the coming years. This will only be partially mitigated by Duna's efforts to consolidate motorway contractors in CEE, which should lead to a more diversified order book, but also to higher execution and integration risk. Duna Aszfalt's consolidation efforts, with capex of around HUF 90bn in between 2024 and 2025, will lead to a significant increase in the company's debt to around HUF 55bn by the end of 2025. As a result, Scope expects the debt/EBITDA ratio to peak at around 3x in 2025.

Going forward, debt/EBITDA should remain between 2x and 3x but could come under pressure in the event of a major transformational acquisition or a massive contraction or delay in the execution of the company's order book beyond Scope's expectations, neither of which is expected in the short to medium term.

Funds from operations/debt is expected to decline to 30-45% in the coming years due to the expected increase in debt, partly as a result of the issuance of approximately HUF 33bn of debt to co-finance business expansion. Although the latter will be at a higher cost than the company's current financial debt (HUF 30bn bond with a fixed interest rate of 2.99%), the weighted average cost of debt is not expected to exceed the profitability margin of the operating business, thus protecting funds from operations/debt at the projected level.

EBITDA interest cover remains strong, with a net interest income in 2023 thanks to substantial interest income on term deposits. Going forward, Scope expects EBITDA interest cover to decline to 7-10x due to (i) higher financial expenses amid Duna Aszfalt's partly debt-financed investment phase and (ii) lower interest income due to the corresponding cash absorption as well as declining deposit rates in Hungary over the next few years. This level of debt protection, however, provides good headroom for the increased volatility of expected future cash generation, thereby supporting the financial risk profile at its current level.

Liquidity: adequate. Liquidity is adequate and benefits from a backloaded debt maturity profile comprising a HUF 30bn bond with a bullet maturity in 2029. The group’s cash balances stood at HUF 31bn by end-June 2024. Marketable securities (such as shares in investment funds) of HUF 53bn as at end-June 2024 could enhance the group’s liquidity to some extent. Scope believes short-term debt and capex coverage will be adequate over the next few years given the long maturity of the bond and no other short-term financial obligations. New financing for acquisitions in CEE is expected to have debt maturities of around eight years, which will not affect short- to medium-term liquidity.

Scope highlights that Duna Aszfalt’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 30bn) if the debt rating of the bond stays below B+ for more than two years (grace period) or drops below B- (accelerated repayment within 90 days). Such a development could adversely affect the company’s liquidity profile. The rating headroom to entering the grace period is 2 notches. Scope therefore sees no significant risk of the rating-related covenant being triggered.

In addition to the rating-related covenant, other covenants include a maximum dividend payment of 30% of EBITDA if the rating deteriorates below B+.

Supplementary rating drivers: credit-neutral. Although supplementary rating drivers are credit neutral, Scope's assessment of the company's business and financial risk profile reflects regulatory and reputational risks (ESG factor credit negative), given (i) Duna Aszfalt's heavy reliance on government tenders, which have helped to build its market position and (ii) its lack of a tier one auditor despite its size and international expansion.

One or more key drivers of the credit rating action are considered an ESG factor.

Outlook and rating sensitivities

The Stable Outlook reflects Scope’s expectation of a successful integration of MECE’s operations into Duna Aszfalt, with a combined order book providing good revenue visibility for more than two years. The Outlook is based on a normalisation of credit metrics with debt/EBITDA of 2-3x and EBITDA interest coverage of above 7x. The Outlook further reflects increased volatility in cash generation due to (i) the chunkier order backlog, (ii) potential changes in Duna's competitive environment, and (iii) declining operating profitability, with acquired companies having a dilutive impact on Duna Aszfalt's currently good EBITDA margin.

The upside scenario for the ratings and Outlook is:

1. Improved diversification of the order book (customers, segments, geographies, projects) paired with debt/EBITDA maintained below 3.0x, which is considered remote at present

The downside scenarios for the ratings and Outlooks are (individually):

1. Debt/EBITDA of above 3.5x
    
2. Backlog of below 1x

Debt rating

Scope affirmed the BB rating for the senior unsecured debt category, which is one notch above the issuer rating and reflects an above-average recovery. The rating is constrained by the risk and possibility of an increase in senior secured debt if the issuer’s credit quality deteriorates (volatility of the capital structure and the proportion of senior unsecured debt).

The recovery calculation considers the HUF 30bn unsecured corporate bond issued under the Bond Funding for Growth Scheme of the Hungarian National Bank. Scope assumes that (i) the business plan will be executed with HUF 33bn of additional bank debt, in line with the group's plans; (ii) payables have a higher seniority; and (iii) advances received will have the same seniority as the bond. The recovery analysis is based on a liquidation value of HUF 104bn for a hypothetical default in 2026. This value is based on an appropriate haircut on the assets and reflects a liquidation cost of 10% on the assets.

Environmental, social and governance (ESG) factors

Scope deems regulatory and reputational risks to be a negative ESG factor. Scope believes that Duna Aszfalt’s market position in recent years was gained by winning state tenders thanks to the company’s well-established credentials on projects with state owned companies. State tenders account for around 70% of Duna Aszfalt’s backlog as at end-June 2024, which creates a high dependency.

Further, Scope would have expected the company, given its size, to use one of the tier one auditors or a firm that is part of an international network. However, Duna Aszfalt still relies on a small, local auditor with around 30 years’ experience, but limited market presence and reach, which raises concerns about the effectiveness and reliability of the audit going forward, given Duna Aszfalt’s recent growth outside of Hungary.

All rating actions and rated entities

Duna Aszfalt Zrt.

Issuer rating: BB-/Stable, affirmation

Senior unsecured debt rating: BB, affirmation

*All credit metrics refer to Scope-adjusted figures.

a. MECE's EBITDA margin has historically fluctuated between 5-6%

Rating driver references
1. 27 September 2024, Company news
2. 13 December 2023; European Commission – Questions and answers on Hungary: Rule of Law and EU funding

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 these Credit Ratings and/or Outlook, (General Corporate Rating Methodology, 16 October 2023; Construction and Construction Materials Rating Methodology, 25 January 2024), are 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 Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With the 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 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 these 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: Philipp Wass, Managing Director
Person responsible for approval of the Credit Ratings: Sebastian Zank, Managing Director
The Credit Ratings/Outlook were first released by Scope Ratings on 6 September 2019. The Credit Ratings/Outlook were last updated on 12 October 2023.

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, as well as a list of Ancillary Services and certain non-Credit Rating Agency services provided to Rated Entities and/or Related Third Parties.

Conditions of use/exclusion of liability
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