DBRS Confirms Fording Canadian Coal Trust at BBB (low)

DBRS has today confirmed the BBB (low) rating of Fording Canadian Coal Trust (the Trust or Fording) with a Stable trend. With this rating action the Trust is removed from Under Review with Negative Implications status where it was placed on April 18, 2007, due to negative cash flows. However, the Trust now benefits from much-improved market fundamentals, which will result in significantly stronger cash flows. As such, DBRS is comfortable confirming the rating.

Despite low profitability in 2007, high leverage and an upcoming high capex spending program, the Trust’s business profile and financial profile are commensurate with the assigned rating. In addition to expected significant increases in earnings due to the substantial surge in metallurgical coal prices, the BBB (low) rating is further supported by the favourable debt coverage metrics and adequate liquidity to cover cash flow shortfalls (which may occur in the near term), along with the Trust’s strong market cap, which can be used to raise funds to support capex funding requirements.

The Trust’s overall business profile, through its 60% ownership of Elk Valley Coal Partnership (Elk Valley), the second largest export metallurgical coal producer in the world, continues to underpin its investment-grade rating.

The main risk to the Trust is the volatility of its earnings over the business cycle. The Trust is a single-commodity company and is significantly influenced by the steel industry, in addition to being highly sensitive to the Canadian dollar. Earnings in 2007 compared with the same period in 2006 were negatively impacted by lower realized average prices, flat volumes and higher input costs. Over the past few years, the Trust has been benefiting from record metallurgical coal prices – prices have doubled since the beginning of 2004 – producing record profitability and distributions to unitholders.

Average realized coal sales prices started to decrease in 2006 and have further retreated by 20% during 2007 (average realized price during 2007 was US$97/tonne) due to a perceived strengthening of supply and the significant strengthening of the Canadian dollar relative to the U.S. dollar.

Due to supply side shock (i.e., widespread flooding in Australia), metallurgical coal prices have rebounded considerably in late 2007 and early 2008 (spot prices in April 2008 have escalated above US$300/tonne). However, since the Trust’s production is mostly contracted, the Trust has been unable to realize the impact of the recent surge in spot prices. Earnings are expected to weaken in the first half of 2008 and distributions to unitholders are expected to be lower than 2007 levels, since 1) most sales up to Q2 2008 will be reflective of 2007 prices (US$97/tonne due to carryover tonnage); 2) input costs are expected to increase (10% to 15%) in 2008; and 3) volumes will be relatively flat. In addition, the Trust’s share of capex spending is expected to more than double in 2008 (from $49 million to $120 million). DBRS does expect this to be offset by a significant turnaround in profitability and cash flow for distributions in the second half of 2008 and in 2009 as contracts are re-negotiated at the start of the 2008 coal year (April 1) and take effect in Q3 2008 and throughout 2009. The average prices should reflect the surge in coal prices (at levels higher than 2005/2006) and as such, the Trust will generate sufficient cash flow to cover high capex requirements. Despite the uncertainty about continued high prices post-2009, DBRS expects the Trust to continue to generate free cash flow to cover still-significant capex requirements.

At present the Trust’s leverage is at approximately 55% (adjusted for capitalized operating leases and securitization), which is aggressive for the current rating. During 2007 – as was the case in 2006 – lower internal cash generation associated with lower earnings led to a deficit in net free cash flow, which was partially funded by debt. Part of the shortfall is related to timing differences between distribution declarations made in the last quarter of one year and the payment made in the following year (related to that declaration). Exacerbating the shortfall was the declining earnings related to the lower coal prices. Any shortfalls that may be experienced in the first half of 2008 (due to anticipated weak results as described above) can be mitigated by the Trust’s strong available liquidity position (approximately $400 million). With the expected surge in profitability in the near to medium term, DBRS does not expect debt levels to increase.

Further supporting the assigned rating are the Trust’s favourable financial metrics and strong market cap. The Trust’s cash flow-to-debt is at 1.0 times, EBITDA interest coverage is over 11.0 times and total debt-to-EBITDA is 1.1 times (as at December 31, 2007). DBRS does expect that the coverage metrics will continue to strengthen as profitability increases. As well, the Trust has a market cap of approximately $7.7 billion (as at March 31, 2008), which allows for easy access to capital markets to raise funds (through issuance of units) to support debt service and capex requirements.

Note:
All figures are in Canadian dollars unless otherwise noted.