Fitch Revises Wijaya Karya's Outlook to Negative, SCP to 'b'; Affirms at 'BB'/'AA-(idn)'

(Fitch Ratings - Singapore - 25 Jun 2020)--Fitch Ratings has revised the Outlook on the ratings of Indonesian state-owned construction company PT Wijaya Karya (Persero) Tbk (WIKA) to Negative from Stable. The Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) are affirmed at 'BB'. At the same time, Fitch Ratings Indonesia has revised the Outlook on WIKA's National Long-Term Rating to Negative from Stable and affirmed the rating at 'AA-(idn)'. A full list of rating actions is at the end of this rating commentary.

Fitch has also revised WIKA's Standalone Credit Profiles (SCP) to 'b' and 'bbb+(idn)' from 'b+' and 'a-(idn)', respectively. The revision of the SCPs reflects our expectations of a sustained weakening in its financial profile after the coronavirus pandemic. We forecast its net leverage (measured by debt net of seasonally adjusted cash/ EBITDA) to be around 4.5x in the next four years, considerably higher than the average of around 1.5x in the past five years.

Fitch expects the pandemic to significantly impact WIKA's performance in 2020, although we expect the company's financial profile to improve by 2021, driven by a recovery in economic activities. However, WIKA's medium-term investment pipeline and capex for large projects to support the government's infrastructure drive will result in leverage remaining above the pre-pandemic level for an extended period. The SCPs also continue to reflect its small operating scale relative to peers, and its robust order book.

The pace of recovery is highly dependent upon the governments' efforts to control the outbreak domestically. In the event of a strong rebound in business and commercial activities in 2H20, WIKA would be well-positioned to restore its operating performance. The Negative Outlook on the ratings captures the risk that the recovery may be delayed or the downturn may be deeper than expected, which could result in a larger-than-expected decline in WIKA's operating earnings.

The affirmation of the IDRs reflects our view that WIKA warrants up to three notches of rating uplift from its SCP for government support given its strategic importance to Indonesia's infrastructure development programme. WIKA's support score under our Government-Related Entities Rating Criteria is 15, which with the six-notch distance between WIKA's SCP and the sovereign rating (BBB/Stable), could lead to either a two or three-notch uplift being included in WIKA's IDRs.

We have chosen a three-notch uplift because of WIKA is one of the largest state-owned construction companies, with a strong record of executing large strategic infrastructure projects. State-owned companies lead the infrastructure programme, which not only requires participants to overcome regulatory and bureaucratic hurdles, but also requires investments in projects that have long payback periods on behalf of the government. In addition, these projects are largely turnkey contracts where payments are received only upon completion, which puts pressure on 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 state-owned companies, such as WIKA.

'AA' National Ratings denote expectations of a very low level of default risk relative to other issuers or obligations in the same country or monetary union. The default risk inherent differs only slightly from that of the country's highest rated issuers or obligations

KEY RATING DRIVERS

Deterioration in Financial Profile: We expect WIKA's leverage to rise to 5.2x (2019: 3.6x) in 2021 and remain around 4.5x in the medium term. We believe the company's role in the government's infrastructure programme will expand its investment pipeline and raise its capex needs in the next few years. Work on new contracts that halted in 1H20 will gradually resume and WIKA will rush to complete backlog, so we expect project completions to pick up in 2021. We expect WIKA to continue to rely on debt to bridge the free cash flow deficit associated with its government contracts.

In the past two years, WIKA had IDR4.3 trillion in capex and investments annually (11%-14% of revenue), much higher than the 4%-5% in 2014-2017. Our rating case assumes WIKA's capex and investments will remain high over the next few years at 11%-12% of revenue as the company executes its order book and participates in the government's infrastructure programme.

Temporary Order Book Decline: Fitch expects significant short-term disruptions to WIKA's business due to the coronavirus pandemic and the resultant slowdown in new contract tenders and construction activities. New project tenders are likely to dip as the pandemic takes a toll on business activities in Indonesia, while construction activities also slow due to social distancing measures. We estimate WIKA's new contract wins to decline by close to 60% to IDR17 trillion and revenue to fall by around 50% in 2020.

Risks to Forecast; Negative Outlook: Our rating case assumes that business activities in Indonesia will gradually improve from late 2020, and major project tenders will resume in 2021. This could boost WIKA's new contracts growth in the next few years. However, a prolonged pandemic may weaken the recovery in new order wins and lengthen WIKA's working-capital cycle as payments are delayed, which will weaken its financial profile. The Negative Outlook reflects these risks to our forecasts in the medium term.

'Strong' Government 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 the company's investment decisions, strategy and operations. The government holds a golden share that gives it veto power over important decisions regarding the appointment and dismissal of board members, distribution of profit and M&A, among others.

'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. While it is not an essential service, such as food or utilities, we believe the implications are not 'Weak' as the company lends its balance sheet to government-related infrastructure projects, where WIKA funds the working capital in arrears so that key infrastructure projects can be completed promptly. Therefore, WIKA is of key importance to the government's infrastructure growth drive.

'Weak' Financial Implications of Default: Fitch believes that a default by WIKA will have only a minimal impact on the ability of the sovereign and other government-related entities (GREs) to raise financing. WIKA has only limited exposure to capital markets, mainly via the international issuance of local-currency "Komodo" senior unsecured notes of IDR5.4 trillion due in 2021.

Bond Rating Same as IDR: We rate WIKA's senior unsecured bonds at the same level as its Long-Term IDR because they constitute its direct, unsecured, and unsubordinated obligations. Fitch regards a prior ranking and secured debt/EBITDA ratio of 2.0x-2.5x as the level at which unsecured creditors' interests are materially subordinated to interests of secured or prior-ranking creditors. WIKA's ratio was around 2.5x at 31 December 2019 and we forecast it to be above this level, but further bespoke recovery analysis suggests average recovery prospects for senior unsecured creditors. Therefore, we have rated the senior unsecured debt and notes at the same level as the IDR.

Moderate-Strong Parent-Subsidiary Linkage: Fitch assesses WIKA's linkage with its parent, the state, on the National Rating scale as moderate-to-strong, driven particularly by strong strategic linkages. This, combined with the sovereign's stronger credit profile than WIKA, results in the application of a four-notch rating uplift to WIKA's national SCP of 'bbb+(idn)' as defined in Fitch's Parent and Subsidiary Rating Linkage criteria. The state has significant oversight over WIKA's operations, and the company is strategically important to infrastructure growth Indonesia in the medium to long term.

DERIVATION SUMMARY

Our assessment of state support for WIKA can be compared with that for Indonesian peers such as PT Hutama Karya (Persero) (BBB-/AA+(idn)/Stable) and PT Indonesia Asahan Aluminium (Persero) (Inalum, BBB-/Stable), and Chinese construction companies, such as China Railway Group Limited (CRG; A-/Stable) and Shanghai Construction Group Co., Ltd. (SCG; BBB+/Stable).

Both Hutama and Inalum are rated using a top-down approach at one notch below the sovereign rating given their aggregate GRE support score of 35. The key difference between our assessment of Inalum and WIKA is that we believe Inalum's default would have 'Very Strong' implications on the cost and availability of financing to the Indonesian government and other GREs, because we believe investors view Inalum as a proxy financing vehicle for the state.

We assessed Hutama's 'Status, Ownership and Control' and 'Support Track Record and Expectations' factors to be 'Very Strong'— versus WIKA's 'Strong'— to reflect the government's greater role and influence in Hutama's operations, particularly in the development of the Trans Sumatera toll road. Hutama has also received more frequent support from the government for its Trans Sumatera toll road. Hutama's default would also have a significant impact on availability and cost of domestic or foreign financing options for the government, especially given the proportion of Hutama's government-guaranteed debt.

CRG is rated using a top-down approach and is two notches below China's sovereign rating (A+/Stable). Its aggregate GRE support score is 30 points. We assess the socio-political and financial implications of CRG's default as 'Strong', compared with 'Moderate' and 'Weak', respectively, for WIKA. We believe a default by CRG would significantly disrupt China's railway services and development plan, which is pivotal in the country's urbanisation and geopolitical goals. CRG is also an active domestic and international bond issuer and we believe that a default could reduce access to capital markets for the sovereign and other GREs.

SCG is rated using a bottom-up approach with two notches of uplift from its SCP of 'bbb-' given its aggregate GRE score of 15, the same as WIKA's. However, we provide up to three notches of rating uplift to WIKA above its SCP because we believe WIKA is strategically more important to the Indonesian government. A default by SCG 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 of 'AA-(idn)' can be compared with PT Pupuk Indonesia (Persero)'s (PTPI) 'AAA(idn)' and Hutama's 'AA+(idn)' rating. PTPI's rating is equalised that of its parent, the Indonesian state, due to their strong operational and strategic linkages. This is driven by PTPI's strategic role as the government's sole agent in producing and distributing subsidised fertilisers to eligible farmers through a public-service obligation scheme. WIKA is not as politically and socially important as PTPI.

WIKA's SCP of 'b' is comparable with that of Hutama (SCP: b-) and global construction companies such as Grupo Aldesa S.A. (BB-/Stable, SCP: b+) and Tutor Perini Corporation (B+/Negative). WIKA has a larger operating scale and wider profit margin than Aldesa, but these are offset by our expectations that Aldesa's financial profile will be considerably stronger, with leverage (net debt/ EBITDA) of below 2x in the future and a more robust FCF. As a result, Aldesa has a one notch stronger SCP.

Both WIKA and Tutor Perini have strong positions in their respective niche markets and comparable operating EBITDA scales. WIKA has higher profit margins than Tutor Perini, but we believe Tutor Perini's exposure to the more mature engineering and construction market in the US and its ability to better manage its cash flows will lead to stronger FCF and lower leverage over the next three years, leading to a one-notch gap in the assessments of their credit profiles.

Hutama and WIKA have similar order book and operating EBITDA scale with comparable profit margin. However, Hutama's EBITDA interest coverage and FCF are likely to be considerably weaker in the medium term due to its high capex commitment. Given these differences, we have also revised WIKA's negative leverage sensitivity to 5x from 4.5x previously.

WIKA's national-scale SCP of 'bbb+(idn)' is stronger than that of PT Waskita Karya (Persero) Tbk (BBB+(idn)/Negative, SCP: bb(dn)) and Hutama. As part of its remit, Waskita takes on a higher mix of turnkey engineering contracts on behalf of the state and it is one of the biggest investors in toll roads with long payback periods, leading to a significantly weaker financial profile than WIKA. Similarly, WIKA's SCP is several notches above that of Hutama due to the latter's significantly weaker financial profile. (ends)