DBRS Downgrades Armtec to B (high), Remains Under Review with Negative Implications

DBRS has today downgraded the Issuer Rating of Armtec Holdings Limited (Armtec or the Company) to B (high) from BB (low). The rating action reflects the fact that the Company’s financial profile is no longer compatible with the BB (low) rating because of deteriorating operating performance and increased debt levels. Furthermore, DBRS believes a recovery is unlikely in the near term due to a weak market outlook and operational challenges. DBRS has also downgraded the recovery rating of the Senior Unsecured Debt to RR5 from RR3 and, as a consequence, has downgraded the Senior Unsecured Debt rating to B from BB. The ratings remain Under Review with Negative Implications in view of the ongoing due diligence work by Brookfield Asset Management Inc. (BAM, rated A (low) by DBRS) regarding the committed credit facility. Securing an agreement on the credit facility is critical to safeguarding adequate liquidity for Armtec’s operating needs.

The Company’s operating performance has been below expectations. DBRS had expected EBITDA to soften in 2010 as a result of slowing revenue and tighter margins in the Engineered Solutions (ES) business. However, reported operating profit was much lower than anticipated because of additional margin pressure from higher production costs caused by project delays, work complexity and low utilization rates. DBRS had also expected operating performance to stabilize in 2011, but actual results in Q1 2011 were below expectations as a result of lower earnings in the Construction and Infrastructure (CIA) business. Poor operating results have also led to a large deficit in free cash flow and a corresponding increase in debt. The combination of higher debt levels, weaker earnings and low operating cash flow generation has led to a sharp deterioration in Armtec’s debt coverage ratios. The debt-to-EBITDA ratio (as calculated by DBRS) rose to nearly 6.0 times (x) in 2010 and about 6.5x (under International Financial Reporting Standards (IFRS)) for the 12 months ending March 31, 2011, from about 3.0x in 2009 and 2008. Also, the cash flow-to-total debt ratio declined to approximately 0.10x in 2010 from 0.27x in 2009. In April 2011, the Company raised about $55 million from an equity issue and used the proceeds to pay down the term credit facility. However, the key credit metrics (on a pro forma basis) only improved marginally and are still not compatible with the BB (low) rating range. More worryingly, the Company also expects continuing pressure on its operating results for the rest of 2011, with lower volume in the CIA business and no improvements in the ES business until the end of the year.

Furthermore, DBRS believes that, in addition to challenging market conditions, Armtec also faces some operational challenges. The Company has grown rapidly through acquisition the last few years and merged its divisions into a regionally based organization in 2010. DBRS believes that distractions and disruptions from the reorganization are likely to have contributed to the inefficiencies that affected recent results. The appointment of a chief operating officer in March 2011 to drive operational improvement should help address the situation. The Company has also completed amalgamating eight disparate accounting systems into a single SAP Enterprise Resource Planning (ERP) system. Adopting a new, complex ERP system at the same time as introducing major organizational changes would add to the challenge of a smooth transition. Near term, the Company has to manage the deteriorating business environment, drive operational improvement from the “new” organizational setup and deploy the new ERP system effectively. It is uncertain that the Company is able to overcome such significant headwinds, both internally and externally. Consequently, DBRS has concluded a one-notch downgrade is warranted at this time.

Another consequence of the poor operating performance is that Armtec is seriously at risk of breaching the covenants of its existing senior secured bank facility. The Company has been successful in securing agreements from its banking syndicate to waive compliance with the financial covenants and to access the bank facility to ensure adequate liquidity for operating needs in the short term. On July 3, 2011, the Company announced that it has entered into a committed financing agreement with a BAM company to provide a $125 million credit facility for a two-year term, extendible to 30 months at Armtec’s option. The first tranche ($90 million) will become available upon finalization of appropriate documentation and the second tranche ($35 million) will become available upon the satisfaction of certain additional due diligence conditions. The new facility will allow Armtec to repay in full the lenders under its existing senior secured bank facility. DBRS views this as a positive development that will remove the uncertainty regarding the Company’s medium-term funding source. Currently, due diligence is ongoing and is expected to be completed in the third or fourth quarter of 2011. This is the major reason the ratings remain Under Review with Negative Implications.

Going forward, the Company expects results in the ES business to remain under pressure until existing lower-margin projects run off near the end of 2011. Additionally, the CIA business is not expected to rebound in 2011 as activities in the residential, commercial and industrial construction markets remain subdued. Nevertheless, DBRS believes that the Company’s business profile remains sound despite the disappointing operating results. Armtec is the only national provider of infrastructure-related products in Canada, with leading market positions in its core markets. The Company has a well-balanced portfolio of work between the lower-margin but stable CIA business and the normally higher-margin but volatile ES business. Armtec has low capital expenditure requirements and the suspension of dividends should help improve its liquidity. DBRS expects the Company to be able to weather the current difficulties, albeit with a weakened financial profile.

Pursuant to our rating methodology for leveraged finance, DBRS has created a default scenario for Armtec 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 2012. DBRS has determined Armtec’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 $148 million, using a 4.0x multiple of normalized EBITDA for Armtec. Based on the default scenario, the Senior Unsecured Debt has recovery estimated between 10% and 30%; therefore, the assigned recovery rating is RR5. The instrument rating of the Senior Unsecured Debt is B.

DBRS will remove the Company from Under Review with Negative Implications once the Company has secured a committed credit facility from BAM. Additionally, DBRS will assess the progress of the Company in addressing the challenges to its full recovery at that time to ascertain the appropriateness of the current Issuer Rating as well as the recovery rating. However, a failure to secure the committed facility from BAM would have negative rating consequences unless the Company has an acceptable alternative in place to ensure adequate liquidity to fund its operating needs.

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

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