DBRS Assigns New Rating to Newalta Corporation

DBRS has today assigned an Issuer Rating of BB (low) to Newalta Corporation (Newalta or the Company). Pursuant to DBRS’s Leveraged Finance rating methodology, a recovery rating of RR2 has been assigned to the Company’s proposed Unsecured Notes and an associated instrument rating of BB. The trends are Stable. The Issuer Rating reflects the Company’s strong market position as a leader in the Canadian industrial waste management industry with scale, diversity (both by geography and industries served) and technical capabilities. The rating also reflects the Company’s moderately aggressive financial risk profile. The balance sheet leverage is near the 40% range and earnings are fairly volatile due to high exposure to commodity prices (crude oil and lead) and the general economy. Additionally, Newalta’s operations are exposed to changing environmental standards which add to uncertainties. The Company has a strong position in the waste management industry in Canada.

Newalta is the largest provider of industrial waste management and environmental services in the country and a leader in the recovery and recycling of valuable products from waste streams. The Company has an extensive integrated network of facilities and the necessary regulatory permits across Canada to serve both regional and national clients. Newalta also enjoys an incumbent advantage because new entrants have to go through a demanding and time consuming regulatory review process to secure a permit to participate in the industry. The increasing complexity of the environmental standards and regulations as well as an onerous permit process has effectively set high barriers to entry. The Company has strong technical expertise in recycling and recovering resource waste and has frequently acted as an advisor to government agencies in designing and improving new regulatory programs. This provides the Company with an advantage to adjust and respond to new environmental regulations. With increasing awareness in protecting the environment and tightening regulations in waste handling, the Company is well positioned to benefit from the growing trend for waste management services.

Moreover, the rising demand on resources to keep pace with stricter regulations has led large companies to increase outsourcing their waste-handling function, another positive development for Newalta. Despite its strong position in the industry, the Company is modest in size and still needs to expand its geographical coverage, especially in eastern Canada, to solidify its leadership position in the Canadian market. Furthermore, the Company’s growth is constrained by the size of the Canadian market. To date, a major contributor to growth is through acquisitions. Even though the Company has a good track record on acquisitions, buying a new company exposes Newalta to integration risks as well as potential ”hidden” liabilities, especially in this industry with evolving regulations. Newalta is strongly influenced by the state of the Canadian economy and highly volatile commodity prices, especially crude oil and lead. The Company’s service volume is directly linked to industrial and oil drilling activities. The Company’s profitability is very sensitive to service volume because low activities would lead to smaller quantities of recovered materials for sale and low utilization of equipment would also depress margins. With its operations mostly in Canada, the Company is also exposed to the relative value of the Canadian dollar because a meaningful portion of it revenue is based on the US dollar (commodities and US sales).

The Company’s revenue and earnings had been on a rising trend until 2009, with acquisitions being a major contributor. However, the Company’s exposure to the economy, commodity prices and the Canadian dollar was amply highlighted during the recession in 2009, and the subsequent recovery in 2010. The Company suffered a sharp decline in operating performance during the downturn but reported good results for the first nine months of 2010 as the economy rebounded. DBRS expects the Company’s operating performance to continue to track industrial activities and ongoing benefits from cost reduction initiatives implemented during the downturn should give a slight boost to margins.

Prior to 2009, the Company had constantly incurred a deficit in free cash flow due to its spending on growth initiatives, high capital expenditures and acquisitions despite respectable cash generation from operations. The Company’s high dividend policy to maintain its income fund status further added to the cash outflow. The Company has financed the deficits with both debt and equity and its financial leverage remains moderately aggressive for a company in a cyclical industry. Nevertheless, Newalta has also demonstrated its financial discipline and flexibility in controlling cash usage during the downturn. The Company sharply reduced capital expenditures to near maintenance levels, curtailed acquisitions and used the surplus cash for debt reduction. The Company’s conversion to a corporation has also increased its flexibility in adjusting dividend payouts, another positive to cash preservation. Going forward, DBRS expects the Company to continue to generate strong cash flow from operations and to be able to fund most of its operating needs internally. DBRS also expects the Company’s financial profile to remain little changed. The Company has been on an aggressive growth path, mostly through acquisitions, since 2005, but the Company has indicated that acquisitions are likely to be modest in the near term. However, any material increase in debt to fund acquisitions could weaken the balance sheet and pressure the current rating. The Company has set a leverage target of total debt-to-EBITDA of between 1.5x and 2.0x. Meaningful progress in achieving this leverage target or returning the Company’s profitability and coverage metrics to the pre-2009 levels could lead to positive rating actions.

Pursuant to our rating methodology for leveraged finance, DBRS has created a default scenario for Newalta in order to analyze when and under what circumstances a default could hypothetically occur and the potential recovery of the Company’s debt in the event of such default. The scenario assumes that the economy fails to recover and falls into a recession again in 2011.
DBRS has determined Newalta’s estimated value at default using an EBITDA multiple valuation approach, consistent with a view that default would likely result in the restructuring and/or recapitalization of the assets with value as a going concern versus the sale of its individual assets. EBITDA multiples utilized are applied to cyclically normalized EBITDA at default as opposed to the actual low EBITDA values expected at the time of default, reflecting the forward-looking nature of the valuation. The valuation considers the issuer and the specific debt instruments, allocating value proceeds accordingly. DBRS has forecast the economic value of the components of the enterprise at approximately $288 million using a 4.0 times (x) multiple of normalized EBITDA for Newalta. Based on the default scenario, the Unsecured Notes have recovery estimated between 70% and 90%, hence the assigned recovery rating of RR2. The instrument rating of the Unsecured Notes is BB. Limiting the notching of the instrument rating of the Unsecured Notes to only one notch instead of the customary two notches for a RR2 is to reflect structural subordination to the Secured Bank Credit Facility.

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

The applicable methodology is Rating the Industrial Products Industry, which can be found on our website under Methodologies.