Credit gloom remains for corporate Canada

S&P report

The credit quality of Canadian companies is in a tough position, and not just because of continued drags in commodity prices and bloated balance sheets, according to a new report by Standard & Poor’s.

According to S& P, the net negative outlook bias for Canadian companies has risen from about 2 per cent i n December 2014 to ap- proximately 17 per cent as of June this year.

Foreign exchange headwinds, after two years of a weakened Canadian dollar, have also contributed to weaker financials among companies overall, the report found.

While the energy and natural resource sector continue to be the most at risk due to pricing challenges, the ratings agency said that the spree of mergers and acquisitions in the utilities sector in late 2015 and early 2016 has led to a strain on corporate credit that could last two years.

“Although these purchases had business risk profiles similar to existing assets, their cost and the financing structures that were put in place to buy them have placed a strain on credit metrics,” said credit analyst Madhav Hari, in the agency’s midyear outlook for Canadian corporates. “We don’t see any significant additional acquisitions as companies allow credit metrics to come back in line with historical levels.”

However, S& P also says that investor- owned utilities could be outliers of this trend, looking for acquisitions in order to satisfy the shareholders with dividend growth. One thing that could challenge these utilities is regulatory regimes, which the report says “will continue to challenge the utilities to find efficiencies from both an operational and capital perspective ... This task will become more acute as governments move to policies that favour more environmentally friendly generation, which will increase the cost of power as well as customer rates.”

Generally, S&P anticipates that low interest rates and limited avenues for domestic growth will make for incentives for debt- funded M& A in certain mature sectors beyond utilities, including retail, telecommunications, and railroads.

The report adds that, because of higher debt levels, funding risks could have an impact on lower-credit-quality companies. Notably that pertains to companies that have exposure to currently volatile commodity prices or that rely heavily on discretionary consumer spending — that means specialty retailers, consumer products and business service companies.

The corporate oil and gas sector, unsurprisingly, faces the most challenging shortterm outlook, according to the report. Forecasting a US$40-US$50 price for West Texas Intermediate and a US$ 3 price for natural gas, the agency said it anticipates annual cash flow for many companies to remain well below the levels needed to support their current ratings. That could mean a spate of downgrades in the months to come, which could heavily impact borrowing costs, as about one-third of rated Canadian oil and gas companies have already been assigned negative outlooks. Speculative grades of ‘B’ and ‘ triple-C’ represent 47 per cent and 11 per cent of the companies S& P rates in the sector in Canada.

Low natural resource prices have also affected public borrowing, with the provinces of Alberta and Saskatchewan both being downgraded in recent months.

The metals and mining industry, too, is likewise in a difficult position with price volatility and 40 per cent of the companies the agency rates with negative outlooks. “Lower prices led to deterioration in our estimate of issuer credit measures ... In certain instances, liquidity and the viability of capital structures emerged as significant concerns,” wrote Hari.