Fitch Downgrades Wijaya Karya to 'BB-'/'A(idn)'; Places on Rating Watch Negative

(Fitch Ratings - Singapore/Jakarta - 10 Sep 2020)--Fitch Ratings has downgraded Indonesian government-owned construction company PT Wijaya Karya (Persero) Tbk's (WIKA) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDR) to 'BB-', from 'BB'. At the same time, Fitch Ratings Indonesia has downgraded WIKA's National Long-Term Rating to 'A(idn)', from 'AA-(idn)'. All ratings have been placed on Rating Watch Negative (RWN).

The downgrade follows Fitch's revision of WIKA's Standalone Credit Profile (SCP) to 'b-'and 'bbb-(idn)', from 'b' and 'bbb+(idn)', respectively. This reflects 2Q20 performance that was significantly weaker than we expected, with WIKA's leverage (measured by net debt/EBITDA) increasing to above 5x; the level above which Fitch would consider negative rating action. We forecast leverage to remain high for the next few years.

The RWN signals a potential re-assessment of Fitch's view of government linkages. WIKA's financial profile has deteriorated and we think its credit metrics will remain under pressure over the medium-term given the economic slowdown caused by the coronavirus pandemic, as reflected in its revised SCP. WIKA, along with a number of other government-owned construction companies, last received tangible government support in 2016. The government's pandemic-related support amounts to around IDR695 trillion, or 4.4% of GDP, and includes direct cash transfers, provision of foods, guarantees and tax incentives. However, support to WIKA has not been forthcoming, despite its weakening financial profile. Accordingly, Fitch is reviewing government support to determine whether it has weakened.

The company's IDR benefits from a three-notch uplift from its SCP for government support in light of its strategic importance to Indonesia's infrastructure programme. WIKA's support score under our Government-Related Entities Rating Criteria is 15, which, with the seven-notch distance between WIKA's SCP and the sovereign rating (BBB/Stable), could lead to a two or three notch uplift being included in WIKA's IDR. We have chosen a three-notch uplift given WIKA's position as one of Indonesia's largest government-owned construction companies, with a strong record of executing strategic infrastructure projects. Government-owned construction companies, which lead the country's infrastructure programme, must overcome regulatory and bureaucratic hurdles and investment in projects that have long payback periods on behalf of the government. The projects are largely turnkey contracts where payments are received only upon completion, pressuring companies' financial performance. Therefore, private-sector and foreign companies tend to shy away from government projects, increasing the government's reliance on, and importance of, large government-owned companies, such as WIKA.

In accordance with Fitch's policies, the issuer appealed and provided additional information to Fitch that resulted in a rating action that is different than the original rating committee outcome.

'A' National Ratings denote expectations of a low level of default risk relative to other issuers or obligations in the same country or monetary union.

KEY RATING DRIVERS

Potential Reassessment of Support Expectations: Fitch assesses WIKA's support record and expectations as 'Strong', based on its strategic role, but the RWN highlights a potential reassessment upon evidence of weaker government support in light of WIKA's deteriorating credit metrics. The government last provided tangible support in the form of a IDR4 trillion equity injection in 2016 to promote WIKA's order-book growth and the execution of large strategic projects. WIKA's credit metrics have deteriorated over 2020 on account of the pandemic, however, support has not been forthcoming. This raises questions about the ability and willingness of the government to provide consistent support.

Operational Disruption: We estimate that WIKA's new contract wins in 2020 will drop by around to 60% to IDR17 trillion and that revenue will plunge by around 45% due to significant short-term business disruption caused by the coronavirus pandemic and the resultant slowdown in tenders and construction activity. New project tenders are likely to dip as the pandemic takes a toll on business activity, while construction is also set to slow due to social-distancing measures.

Investment Pipeline Raises Leverage: We expect leverage will rise to around 14.0x in 2020 (2019: 3.6x) due to the pandemic, then improve to 6.2x in 2021. Leverage is likely to stay at 5.0x-5.5x in the medium-term as WIKA's role in the government's infrastructure programme expands its investment pipeline and raises capex in the next few years. Work on new contracts that were halted in 1H20 will gradually resume and WIKA will rush to complete its backlog, increasing project completions in 2021. We think WIKA will continue to rely on debt to bridge the FCF deficit associated with its government contracts.

Risk to Estimates: Our rating-case assumes that business activity will start to improve from late 2020 and that major project tenders will resume in 2021, boosting WIKA's new-contract growth. However, a prolonged pandemic may prompt the government to reallocate resources away from infrastructure projects to combat the virus and cause the private sector to shy away from expansionary activity. This would reduce the number of contracts up for tender and affect WIKA's financial profile for a longer period.

Another risk to our medium-term forecasts is the uncertain timing and trajectory of sector recovery from the unprecedented severity of the economic downturn, especially amid the possibility of a second wave of infections and a return to lockdown measures.

'Strong' Ownership and Control: Fitch assesses WIKA's status, ownership and control as 'Strong'. The Indonesian government owns 65% of WIKA, mainly via the Ministry of State Owned Enterprises, and has strong influence over its investment decisions, strategy and operation. The government also holds a golden share that gives it veto power over the appointment and dismissal of board members, distribution of profit and M&A.

'Moderate' Socio-Political Implications of Default: We assess the socio-political impact of WIKA's default as 'Moderate', because infrastructure development is a cornerstone of the government's economic growth and urbanisation agenda. Infrastructure development is not an essential service, such as food or utilities, but we do not think the implications are 'Weak' as WIKA lends its balance sheet to government-related infrastructure projects; under this practice, WIKA funds working capital in arrears so key projects can be completed promptly, making WIKA vital for the government's infrastructure growth drive.

'Weak' Financial Implications of Default: Fitch believes a default by WIKA would have a minimal impact on the ability of the sovereign and other government-related entities to raise financing. WIKA has limited capital market exposure, mainly via its Komodo senior unsecured notes. Nevertheless, Fitch may reassess this factor should there be evidence that WIKA's default may have a moderate impact on other GREs' fundraising activities.

DERIVATION SUMMARY

Our assessment of government support for WIKA can be compared with that for PT Hutama Karya (Persero) (HK, BBB-/AA+(idn)/Stable, SCP: b-, bb+(idn)), PT Indonesia Asahan Aluminium (Persero) (Inalum, BBB-/Stable, SCP: b-), China Railway Group Limited (CRG; A-/Stable, SCP: bb-) and Shanghai Construction Group Co., Ltd. (SCGC; BBB+/Stable, SCP: bbb-).

HK and Inalum are rated using a top-down approach at one notch below the sovereign rating, given their aggregate government-related entity support score of 35.

We assess HK's status, ownership and control as well as its support record and expectations as 'Very Strong', due to the government high influence over its operation. HK also receives more frequent government support for its Trans Sumatera toll road than WIKA. We think HK's default would significantly affect the availability and cost of domestic and foreign financing options for the government, especially in light of the proportion of HK's government-guaranteed debt.

We believe Inalum differs from WIKA in that Inalum's default would have 'Very Strong' implications for the cost and availability of financing for the government and government-related entities, since we believe investors view Inalum as a proxy financing vehicle for the government.

We rate SCGC using a bottom-up approach with a two-notch uplift from its SCP, given its aggregate government-related entity score of 15; the same as WIKA's score. However, we provide up to three notches of uplift to WIKA above its SCP because we believe it is strategically more important to the government. A default by SCGC would disrupt construction projects in Shanghai, but social consequences would be limited due to the city's high urbanisation rate. WIKA's default would have a higher impact on Indonesia's national infrastructure development plan.

WIKA's National Long-Term Rating can be compared with that of PT Pupuk Indonesia (Persero) (PTPI; AAA(idn)/Stable) and PT Waskita Karya (Persero) Tbk (WSKT, B(idn)/RWN, SCP: ccc-(idn)). PTPI's rating is equalised with the Indonesian government on strong operational and strategic linkages, driven by the company's strategic role as the government's sole agent in producing and distributing subsidised fertiliser to eligible farmers through a public-service obligation scheme. Similarly to WIKA, WSKT's rating benefits from a four-notch uplift on the national scale, reflecting moderate-to-strong government linkages in light of the government's significant oversight over WSKT's operation and the company's strategic importance to Indonesia's infrastructure development.

WIKA's SCP is comparable with that of global construction companies, such as China's CRG, as well as US-based Infrastructure and Energy Alternatives, Inc. (IEA; B-/Stable) and Tutor Perini Corporation (TUT, B+/Stable).

CRG has a larger operating scale and stronger financial profile than WIKA. This, combined with CRG's greater geographical and product diversification, results in the company's SCP being multiple notches higher than that of WIKA.

IEA has a considerably stronger financial profile than WIKA. We forecast IEA's leverage, as measured by net debt/EBITDA, to be below 1x in the next four years. IEA also has more robust FCF generation. However, we believe this is offset by WIKA's larger operating scale, wider profit margin and IEA's higher project execution risk, given the fixed-price nature of its contracts that reduce its operational flexibility should there be cost overruns. We believe these factors warrant IEA's rating being at the same level as WIKA's SCP.

Both WIKA and TUT have strong positions in their respective niche markets and comparable operating EBITDA scale in the medium term. WIKA has a higher profit margin, but we believe TUT's exposure to the more mature engineering and construction market in the US and ability to better manage its cash flow will lead to stronger FCF generation. This, along with our expectation of TUT's much stronger financial profile over the next three years, results in a two-notch gap in the assessment of the companies' credit profiles.

WIKA's national-scale SCP is stronger than that of WSKT, as WSKT takes on a higher mix of turnkey engineering contracts on behalf of the government and is one of Indonesia's largest toll-road investors, with long payback periods. This leads to significantly higher leverage and weaker interest coverage than at WIKA. The multiple notch difference also reflects WSKT's poor liquidity profile. WIKA's national-scale SCP is also stronger than that of HK. Fitch believes WIKA's smaller operating scale is offset by its stronger financial profile, less capital-intensive operation and greater project diversification.

KEY ASSUMPTIONS

Fitch's Key Assumptions Within Our Rating Case for the Issuer

- New contracts wins of around IDR17 trillion in 2020 and IDR35 trillion in 2021 (2019: IDR41 trillion)

- EBITDA margin, including share of profit from joint operations, of around 7%-8% in 2020 and 11% in 2021 (2019: 15%)

- Aggregate capex and investments of around IDR2.3 trillion in 2020

RATING SENSITIVITIES

 

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Fitch may resolve the RWN upon further information with respect to WIKA's government linkages. Fitch may take negative rating action if it deems that overall linkages are weaker than expected.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Fitch may take a positive rating action if it deems that overall linkages between WIKA and the government are stronger than expected.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

LIQUIDITY AND DEBT STRUCTURE

Manageable Refinancing Risks: We believe WIKA's near-term liquidity is supported by the company's manageable refinancing risk on account of its strong working relationships with government-owned and private banks. WIKA has a high amount of debt maturing in the next six months, including its IDR5.4 trillion Komodo bond due in January 2021. WIKA plans to refinance the Komodo bond through domestic bonds and some bridging loans, primarily from government-owned banks.

WIKA had cash of around IDR7.1 trillion at end-June 2020 and uncommitted undrawn revolving cash lines of around IDR5.4 trillion, which should partially cover short-term debt and current maturities of IDR20.7 trillion in the next 12 months. These comprise the IDR5.4 trillion Komodo bond, IDR750 billion in medium-term notes maturing in October-November 2020, IDR205 billion in medium-term notes maturing in February 2021 and IDR14.3 trillion of short-term working capital lines and supply chain financing facilities.

We expect WIKA's short-term working capital lines to be rolled over by banks in the normal course of business given its satisfactory credit profile and strong relationships with government-owned banks. We believe the company's debt maturity profile will be extended should its refinancing be successful, providing greater flexibility to manage cash flow and shore up liquidity. A roll-over of working-capital debt would also free-up cash to fund forecast capex and investments of around IDR2 trillion-3 trillion in 2020, if required. Nevertheless, liquidity remains a key factor and failure to address upcoming maturities may lead to negative rating action.

SUMMARY OF FINANCIAL ADJUSTMENTS

-Share of profit from joint operations is included in EBITDA, as these form part of WIKA's core operations

-Supply chain financing due to be paid in more than 90 days is considered as debt, as this effectively extends the usual trade payable cycle

-We deduct IDR4 trillion from year-end cash, being the difference between year-end cash and average cash balance between the first and third quarters. This is to iron out seasonal working capital variances that affect leverage.