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Rising debt shapes Asean credit risk

Leverage is raising the risk of financial distress, corporate restructuring and default, especially if competition increases and growth slows.
Singapore: Debt accumulation has tripled between 2008 and the first quarter of 2014
Singapore: Debt accumulation has tripled between 2008 and the first quarter of 2014

How are Asean companies financing growth?
Asean companies are increasingly using debt to finance growth. Since the global financial crisis in 2008, we estimate that the 100 largest Asean companies have spent $295 billion on capital expenditure and acquisitions. They have also added close to $150 billion in debt from year-end 2008 to the first quarter of 2014. In fact, we estimate that total debt for Asean’s top companies has more than doubled during this period.

Companies in Asean have been experiencing a growing gap between cash inflows from operations, and outflows on capital spending, acquisitions and dividends. These outflows have been increasingly financed with debt.

Debt accumulation was particularly rapid for companies in the Philippines, with gross reported debt nearly tripling between 2008 and the first quarter of 2014, albeit from low levels. It almost doubled in Indonesia, Singapore and Thailand over the same period. (See chart.)

Are Asean companies heading toward a similar path as Chinese companies?
Debt-funded investment in Asean is reminiscent of the rapid debt-funded investment trends that we have seen in China. Although this may represent a growing risk, we believe that the credit quality of large Asean companies is generally stronger than their Chinese counterparts. The borrowing levels in China are also much higher than in Asean, and have grown much faster over the past five years.

Continuing investment by Asean companies has eroded their credit profiles since 2011, when growth in revenue and cash flow started to wane. These companies sailed through the 2008-2009 crisis relatively unscathed because of their low debt. But now, the next global financial “shock” or a scenario of lower growth in China could cause greater harm because of their higher debt levels. Rising leverage raises the risk of financial distress, debt or corporate restructuring, or default, especially if competition increases and growth slows.

How has rising debt affected the credit quality of Asean companies?
When comparing erosion in credit quality, we found significant differences in the debt tolerance and leverage levels of companies across the region. Geographically, we found that the companies we reviewed in Indonesia have a much more conservative balance sheet than companies in Singapore, Malaysia or the Philippines.

Will this debt-driven financing trend continue?
Yes, we anticipate that Asean companies will continue using debt to finance growth over the next two years. Consequently, we expect leverage to keep rising and credit quality to further deteriorate. With companies keen to maintain their market positions amid steady GDP growth in the region, we see no sign of a slow-down in capital spending and expansion.

What’s more, diminishing rates of return are enticing some Asean companies to lower capital costs by using more debt in their funding mix. We are also seeing that more and more debt is financing less and less growth. Returns on capital invested have declined by almost a third in 2013 from 2011 levels, suggesting that an incremental unit of investment is bringing less profit.

Growth in revenue and cash flow is also stalling, after peaking in 2011, largely because of increasing competition. Median revenue growth halved in Malaysia and Thailand and declined by a third in the Philippines, while median revenue for the companies we reviewed in Singapore declined in 2013 for the first time in six years.

Adding to pressure on debt is our expectation that capital expenditure and dividend levels will remain elevated. The gap will need to be financed somehow, and debt remains attractively priced.

Are you concerned about rising interest rates and liquidity?
We found that most Asean companies have enough earnings buffer to absorb the higher funding costs associated with a gradual increase in interest rates. Liquidity is generally not an immediate concern. We estimate that Asean’s top 100 companies have about $70 billion of debt maturing in the next 12 months, compared with almost $110 billion in cash balances.

Nevertheless, we view the indirect effects of a gradual hike in interest rates as being a larger threat for the interest-servicing capacity of Asean’s largest companies. Such effects may include slower GDP growth, weaker consumer sentiment, slower revenue growth and margin pressure. Foreign exchange fluctuations may also pose a risk to Asean companies. The direct and indirect effects of increasing interest rates may weaken the financial risk profiles of up to a quarter of the largest 100 companies we reviewed.

Will acquisition activity increase?
Growth patterns for Asean companies remain geared toward organic capital spending. However, we believe acquisitions will feature more prominently as companies seek to improve their international presence and counter stalling revenue and profits.

Spending on acquisitions nearly tripled between 2008 and 2013, with acquisitions now representing about 20% of total investment. Acquisitions in the region tend to be financed by debt, leading to higher credit risk. Companies take on the funding risk upfront, while the pay-off for an acquisition will only materialise once the acquirer has successfully integrated the asset. This M&A-related risk-reward pattern is different from the growth pattern resulting from typical capital expenditure, whereby cash outflows are more spread out over time and often are a better match to future cash flow generation.

Will Asean conglomerates continue to grow, especially in Thailand and the Philippines?
Conglomerates and their listed subsidiaries have been expanding rapidly in the region. In fact, we see conglomerates as a barometer for the region's economic potential because of their size and integration within regional bank and capital markets. In 2014, we have seen a number of large-scale acquisitions by Thai and Filipino conglomerates or their subsidiaries. We believe this trend will continue, provided external funding remains cheap and companies maintain good access to bank and capital markets.

On the negative side, acquisitions have generally been funded by debt and the balance sheets of some conglomerates, and especially of their subsidiaries, have been stretched by frequent transactions. The rapid growth is increasing the complexity of conglomerates, in particular when the conglomerate has numerous listed entities and acquisition debt is raised by private or unlisted companies. As a result, aggregate leverage levels of a group may be understated and group liquidity overstated.

The author of this article is Xavier Jean, CFA, Director Corporate Ratings, Standard & Poor’s Ratings Services. S&P’s study of top companies in Asean is available now.

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