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Some Grim Omens for 2006

By Frank E. Benassi Economic signals such as consumer confidence, housing, and employment statistics have weakened significantly following the worst hurricane season on record, during which Katrina and Rita helped drive up already steep energy and commodity prices. Higher energy prices, coupled with rising interest rates and labor costs and alongside modest pricing power caused by strong global competition, imply that corporate profits could come under pressure in 2006.

"Higher energy costs are finally taking their toll on U.S. spending habits and are expected to keep spending levels down for nonessentials and limit travel and related purchases," says Thomas Kelly, managing director for Standard & Poor's Ratings Services. "Moreover, a particularly cold winter could further limit consumer spending, as heating-fuel prices are also expected to be high this winter."

At the same time, soaring energy costs are fueling higher operating costs throughout the manufacturing supply chain -- including raw materials, factory overhead, and transportation -- further affecting profit margins of consumer-products companies. For some sectors, such as consumer products, rising costs for raw materials and operations are expected to largely offset the moderately positive volume trends and any benefits gained from restructuring initiatives undertaken in the past several years.

"Looking ahead, 2006 is likely to be a somewhat more challenging year for corporate credit quality than 2005," says S&P Ratings Managing Director Nicholas Riccio. "Expectations are being tempered by higher interest rates, continued high energy costs, and already-high consumer-spending levels, given the low savings rate and high consumer household debt-service obligations," he continued.

Aerospace & Defense Faces Mixed Outlook

Commercial aerospace companies continue to benefit from modest strengthening in the operating environment, supported by generally healthy global economic activity, growing air traffic, and mostly improving airline financial results (outside the U.S.). Those factors have helped aftermarket suppliers of products and services, an important business for a number of rated companies. Moreover, stronger orders for new airplanes have led to an increase in planned deliveries for the remainder of 2005 and 2006.

Defense contractors face cutbacks in planned weapon outlays in the coming years. Some large weapons programs, such as the F16 and F22 fighter jets, as well as certain ship programs face likely cancellation, reductions, or extensions of production, which, over time, will affect big contractors such as Lockheed Martin (LMT) and Northrop Grumman (NOC).

Still, spending overall remains substantial and should support good continued earnings and cash flow. Spending on defense electronics, surveillance, intelligence, and many Army programs remains robust. In addition, some contractors have diversified into operations and maintenance services, whose overall budgeted amounts exceed those for development and procurement.

"The large defense contractors have strengthened their balance sheets over the past several years, so moderation or even leveling off of earnings and cash-flow growth shouldn't have a material negative impact on their financial profiles," says S&P credit analyst Roman Szuper. "However, ratings could be affected if those firms seek to support their share prices through material increases in share buybacks or large, debt-financed acquisitions."

Building Materials Sector on Mostly Firm Ground

For the housing markets, S&P expects the credit quality of U.S.-based building materials companies to remain stable to slightly negative in 2006. New residential construction and home improvements are expected to decline from the strong levels of the past few years, primarily because of increased interest rates, declining consumer confidence, and higher input costs. Infrastructure spending will remain robust from the increased spending authorized under the recently signed federal highway bill, and commercial construction should experience modest growth, but credit quality won't be affected.

Despite the significant amount of damage to the U.S. Gulf Coast, credit quality in the building-materials sector isn't expected to benefit from hurricane-related rebuilding efforts. "Short-term benefits from a surge in demand and higher selling prices are likely to be offset by higher raw material, energy, and transportation costs," says S&P credit analyst Lisa Wright.

Favorable Outlook for Capital-Goods Sector

"While capital-goods companies continue to face the challenge of raw material and component price increases, most firms have enough product pricing power to offset most, if not all, of these increases," says S&P credit analyst Daniel DiSenso.

Economic growth could slow meaningfully in 2006 if energy prices remain very high, causing consumer spending to decline, and if margins and profits are affected by corporations' inability to pass along higher energy costs to customers. Under this scenario, the industrial-sector recovery could be truncated, which in turn would cause demand for capital equipment to decline. However, S&P Ratings doesn't expect this to happen.

"A more likely scenario is that the capital-goods industry will benefit from large hurricane clean-up and rebuilding activities, which could cost as much as $200 billion," says DiSenso, "and the economy will continue growing at a moderate pace." Accordingly, the near-term outlook for most capital-goods companies remains favorable, and most are expected to experience solid growth for the rest of 2005 and for 2006.

For the engineering and construction (E&C) subsector, credit quality will most likely be mixed, as it's dependent on backlog growth, risk-management techniques, operating performance, financial polices, and individual companies' liquidity profiles. Nonetheless, growth prospects for 2006 look solid across many E&C end markets.

Chemical Sector Challenged by Higher Raw Material Prices

Most North American chemical companies continue to benefit from a favorable supply/demand balance and strong pricing, but the key challenge for this industry in 2006 will be the cost of raw materials. After Hurricanes Katrina and Rita, natural gas reached a historic high of $15 per million Btu and remains near $11.50 per million Btu, testing the abilities of both specialty and commodity chemical players to preserve margins.

Recent operating results suggest that if economic conditions remain supportive of pricing power, commodity chemical companies should be able to weather the current raw material crunch.

"The picture remains upbeat enough to support at least a stable view on credit quality across the sector, as economic conditions are expected to remain fairly good through 2006," says S&P credit analyst Kyle Loughlin, "and the commodity side of the industry continues to benefit from the lack of any meaningful capacity additions in North America. In addition, against the backdrop of favorable economic conditions in the U.S., companies have reduced debt, bolstered liquidity, and strengthened measures of credit quality to levels appropriate for the ratings."

The implications are less certain for many specialty chemical producers. Extraordinary upward price movements for key building block chemicals used in product formulations are likely to compress margins somewhat, as higher-cost inventory flows through income statements coming into the seasonally soft fourth quarter.

Higher Energy Prices May Hurt Consumer Products

The consumer-products sector will be challenged to maintain sales growth and earnings momentum in light of mounting external issues affecting operating costs and consumer confidence. Hurricanes Katrina and Rita helped drive up already steep energy and commodity prices, and now U.S. consumers are being forced to reassess their usual spending habits and reconsider big-ticket purchasing decisions -- due largely in part to surging gas prices, higher home heating bills, and rising interest rates.

At the same time, soaring energy costs are fueling higher operating costs throughout the manufacturing supply chain, including raw materials, factory overhead, and transportation, further affecting profit margins.

"Higher raw material and operating costs will largely offset moderately positive volume trends and any benefits of restructuring initiatives undertaken in the past several years," says S&P credit analyst Kenneth Drucker. "Intense competition among consumer-products companies and the shifting of the balance of power toward the retailer will continue to limit upside potential for issuers in 2006," he continued.

Substantial Restructuring for Forest-Products Companies

Although most U.S.-based forest-products companies have stable outlooks, the prospects for credit quality are beginning to diverge between paper and paperboard producers and wood-products manufacturers. With generally mediocre paper and packaging earnings, companies in this sector should continue to focus on operating improvements in 2006, as well as disciplined capital spending, very limited capacity additions, and moderate shareholder initiatives.

The sector is expected to experience substantial restructuring of 2006 initiatives, including sales of noncore businesses, mill closures, machine conversions, cost cutting, energy-conservation measures, productivity improvements, and timberland divestitures. As a result, M&A activity will increase in this sector in the next 12 months.

Companies with wood-products operations should continue to fare much better than those with just pulp or paper production, resulting in healthier credit measures for most such producers.

"Although we expect housing starts to decline nationally next year, there should be a lift in demand from rebuilding following the recent hurricanes," says S&P credit analyst Pamela Rice. "However, any short-term benefit derived from higher prices and a spike in demand in the Gulf Coast states is likely to be offset by higher fuel, energy, transportation, and chemical price increases."

Good Demand Driving Freight-Transportation Credit

Freight-transportation companies (air freight, railroads, trucking, and shipping) should continue to benefit from solid demand, even as economic growth and the ability to recover most higher fuel costs through surcharges moderate. Favorable demand fundamentals for air-freight services, coupled with a continuing focus on efficiency improvements and yield initiatives, should lead to continued solid earnings and cash flow for both the small-package express carriers and heavyweight cargo companies next year.

Fundamentals in the rail sector remain encouraging, with solid demand presently in all end markets except automotive. High imports from Asia support demand for intermodal services (carrying cargo containers or truck trailers on flatcars), which have surpassed coal as the railroads' largest commodity.

M&A Activity Key to Health-Care Credit

Although 2005 is turning out to be a year of overall rating improvement (albeit slight) for the U.S. corporate health care sector, there are likely to be overarching influences on health-care company credit quality in 2006. As in many other fields, mergers and acquisitions and financial transactions may well be key drivers of rating changes. In fact, the preponderance of CreditWatch listings among health-care companies are related to these factors.

Looking toward 2006, two other factors are particularly relevant to health-care rating actions. These are, first, actual changes in financial capacity, and second, our degree of confidence that a given issuer will conduct itself in a manner consistent with a particular level of creditworthiness.

"Virtually all of the rating changes at the higher end of the rating scale have been accompanied by one or both of these factors," says S&P credit analyst Michael Kaplan. As important to the perception of credit strength, however, is the prospect that future changes in financial position will relate to the visibility of cash flows and managements' strategies for redeployment of capital.

Moderate Growth for the High-Tech Sector

S&P Ratings expects 2005 and 2006 to be years of moderate overall growth in technology spending, estimated in the mid-single digits. Growth will remain uneven, both among and within the various subsectors. The general trend of stabilizing to moderate growth in sales should support generally improving financial measures.

"A fairly balanced credit trend for the year is anticipated, as a focus on cost reductions over the preceding three years is helping to offset continuing pricing pressures across almost all sectors," says S&P credit analyst William Wetreich. "Similarly, increasing M&A activity, dividends, and share repurchases offset improving financial profiles, further supporting expectations for a balanced ratings trend."

Stable Outlook for Metals & Mining

A clear divergence in pricing has emerged among the different metals and mining subsegments, but the outlook for credit quality is decidedly stable. Although the near-term price outlook for copper, gold, and nickel remains quite strong, additional positive rating actions for these companies will be tempered by higher spending aimed at replenishing reserves, increasing production, enhancing efficiency, and rewarding shareholders. Despite a relatively high price for aluminum, credit quality of aluminum producers will be challenged by higher costs for power and alumina and, in some cases, the risk of capacity closures.

Unlike some segments that experienced better fortunes in 2005, steel conditions and prices waned significantly through the third quarter of 2005. "Conditions in the steel industry are expected to remain volatile due to rising global capacity levels, high input costs, and ebbs and flows in demand," says S&P credit analyst Paul Vastola. "However, many steel companies reduced debt and increased their cash balances and liquidity levels during the previous peak, which provides some additional cushion for these companies to weather difficult market conditions," he continued.

Negative Trends Continue for Retail

Negative rating trends are expected to continue in the retail sector for the remainder of 2005 and into 2006, despite a stable economy. Since the recent hurricanes, the first signs that rising energy costs may finally be affecting consumer spending have started to materialize. Efforts to enhance shareholder value, mergers and acquisitions, and execution issues are still driving rating activity, rather than consumer spending or economic conditions.

However, higher energy prices and consumer debt servicing obligations are increasing concerns -- although to date, these factors have restrained top-line growth only at certain retailers. Performance remains strongest among high-end retailers, while restaurant and discounters' customers appear to be pinched most by energy prices.

"Looking further ahead, 2006 will likely be a more challenging year for retailers than 2005, with expectations tempered by higher interest rates; continued high energy costs; and already high consumer spending levels, given the low savings rate and high consumer household debt service obligations," notes Wetreich. "Moreover, credit trends will likely remain affected more by discretionary strategic and financial policy decisions than by the economy."

Benassi is senior features editor for Standard & Poor's Ratings Services

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