DBRS Confirms Armtec Ratings, Trend Now Negative

DBRS has today confirmed the Issuer Rating of Armtec Holdings Limited (Armtec or the Company) at B (high) but has changed the trend to Negative. The confirmation recognizes that the Company has significantly reduced its financial risk by securing committed financing (the Brookfield Facility) from Brookfield Management Inc. (BAM; rated A (low) by DBRS). This has removed the uncertainty regarding refinancing in the next 24 to 30 months, allowing the Company to focus on turning its operations around. The Negative trend reflects the fact that Armtec’s financial profile is weak and it faces significant headwinds to stage a recovery. DBRS has also confirmed the recovery rating on Armtec’s Senior Unsecured Debt at RR5 and the associated instrument rating at B; the trend is also Negative. With these rating actions, the ratings have been removed from Under Review with Negative Implications, where they were placed on July 26, 2011.

The Company announced on August 19, 2011, that it had completed the Brookfield Facility – a $125 million secured loan facility with a term of two years (extendable to 30 months at Armtec’s option) and has paid off the secured bank credit facility in full. DBRS deems securing the Brookfield Facility a net positive development, as this facility has a longer term and less-restrictive financial covenants (albeit higher interest costs) than the bank facility. This is favourable because (1) it removes a significant risk that the Company may breach the bank facility covenants and suffer the resultant dire consequences; (2) the Company will have more operating flexibility due to less financial constraints; and (3) senior management has been relieved of a huge distraction in not having to negotiate constantly with the banks and can now focus on turning the operations around. On the day the Brookfield Facility was completed, the Company borrowed the full $125 million and paid off the senior bank facility in full, with remaining proceeds of $28 million available for general corporate purposes and transaction costs. The Company’s working capital needs normally peak in the third quarter. DBRS believes that the remaining cash on hand, although modest, should provide the Company a sufficient cushion to meet its funding needs. Furthermore, working capital will decline in the fourth quarter according to its seasonal pattern and generate cash to bolster cash reserves.

Armtec’s performance suffered a sharp deterioration in the first half of 2011 due to a combination of operating inefficiencies, bad (low-margin bidding) contracts, customer project delays, unforeseen higher costs related to project complexity and unfavourable market conditions. In addition, DBRS believes that senior management has been distracted by the ongoing major organizational changes. A key focus of management in 2010 was on reorganizing its operations into regional operating units. Further complicating matters, the Company was also implementing a new company-wide Enterprise Resource Planning (ERP) system trying to merge its existing disparate systems. The disruptions and complications of implementing these major changes to the organization concurrently have contributed to the inefficiencies and poor operating results.

The Company faces significant challenges to turn its operations around. The near-term outlook is not encouraging. The general economy appears to have stalled, extending the slowdown of work in the Construction and Infrastructure (CIA) business. Margins are also expected to be affected by the low bidding margin Engineered Solutions (ES) business at least through the end of 2011. In addition, the Company needs to overcome operating inefficiencies in the organization and ensure the conversion into a single ERP system to run smoothly. The transition into a single system in the first half of 2011 proved to be difficult and has impaired management visibility into the business and its ability to forecast. The key priority for the balance of 2011 is to ensure that the conversion is successful, allowing management to have timely information to manage the business effectively. In addition, the Company appointed a chief operating officer in March 2011 to drive operational improvement. Armtec’s liquidity position, although deemed adequate, is modest; the Company has to be diligent in managing its highly seasonal working capital needs.

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 expenditures requirements, which in combination with the suspension of dividends should help improve its liquidity.

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. DBRS will monitor the Company’s progress in overcoming the headwinds mentioned above. Special attention will be on the progress in improving ES margins in 2012 after the run-off of the low bidding margin projects. In addition, DBRS will evaluate the Company’s progress in driving operational improvements and the deployment of the ERP system. DBRS expects operating performance in the last half of 2011 to be at least comparable to the year-ago period. Failure to stabilize operating results in the last half of 2011 and to show steady improvement, especially gross margins in ES projects, in 2012, and to demonstrate progress in the two key management initiatives (operational improvement and ERP deployment) would likely lead to at least a one-notch downgrade.

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 4.0 times (x) multiple of normalized EBITDA for Armtec. Based on the default scenario, the Unsecured Notes have recovery estimated between 10% and 30%, hence the assigned recovery rating of RR5. The instrument rating of the senior unsecured debt is thus B.

Note:
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.