DBRS Changes Trend on Newalta to Positive; Downgrades RR, Unsecured Debt on Refinancing Assumption

DBRS has today changed the trend on the BB (low) Issuer Rating of Newalta Corporation (Newalta or the Company) to Positive from Stable. The trend change reflects the fact that the Company has performed above expectations, with operating performance almost returned to pre-recession levels. In addition, the Company has made progress in strengthening its business profile by growing and increasing profitability of its on-site business. Further strengthening of its business profile, especially gains in the more stable long-term on-site contracts and returning its operating performance to historical levels before the recession in the next six to 12 months, could lead to a one-notch upgrade. However, DBRS would reinstate the Stable trend if the Company’s performance reverted back to the weak 2009 levels.

Notwithstanding an improving business profile and performance, DBRS has downgraded the recovery rating of the Unsecured Notes to RR4 from RR2 to reflect our expectation of lower recovery, solely due to an anticipated increase in the amount of unsecured debt. In the recovery analysis, DBRS assumes that Newalta will refinance the maturing convertible debentures (which now rank junior to unsecured debt) with the same amount of unsecured debt. This leads to a sharply lower recovery for the Unsecured Notes at the time of default because the amount of outstanding unsecured debt will almost double. With a revised recovery rating of RR4, Newalta’s Unsecured Notes will have the same rating as the Issuer Rating, according to our leveraged finance methodology, instead of one notch higher, as previously. Consequently, the Unsecured Notes rating has been downgraded to BB (low) from BB.

Prior to 2009, the Company had been growing rapidly through acquisitions to expand its services offered and geographical markets. Amid the integration of recent acquisitions, the recession hit. The severe recession in 2009 exposed the vulnerability of Newalta’s business to economic conditions and commodity prices, especially oil and lead. The Company was able to adjust to the downturn and remained profitable, albeit barely. More importantly, the Company has been able to integrate its new acquisitions without much disruption and position itself for the upturn. With the Company’s strategic focus shifted to organic growth and improving returns from its existing assets, the risk to the Company’s business profile is lessened.

The Company’s operating results have been on a steady uptrend since bottoming in 2009. With the economy on the mend, Newalta’s operating performance has made good progress, and operating margin for the first half of 2011, at more than 20%, was well on its way to the historical average level. Going forward, the Company still faces some headwinds to a full recovery. Growth momentum in the general economy appears to have stalled recently. Heightened concerns about fiscal problems in some member states in the European Union and the United States could lead to a double-dip recession. A slowing economy not only lowers the demand for the Company’s services, it also depresses oil and lead prices, delivering a double whammy to Newalta’s operating profits. The strength of the Canadian dollar is another challenge that the Company needs to overcome. Nevertheless, the Company expects its earnings momentum to continue in the second half of 2011, unless oil prices fall significantly from current levels.

The sharp downturn has also highlighted the Company’s financial flexibility. Large depreciation and modest maintenance capital needs allow Newalta to stabilize cash flow generation. In addition, the Company has demonstrated its willingness to take actions to bolster its financial position, lowering dividends and raising cash from equity issues. These measures allowed the Company to bolster its free cash flow for debt reduction and moderate the deterioration of its financial profile. The Company has continued to use free cash flow for debt reduction through the recovery in 2010. Going forward, the Company expects to boost capital expenditures to support organic growth. In 2011, Newalta plans to increase capital spending substantially to $100 million from about $68 million in 2010. With earnings and, therefore, cash flow from operations set to increase, the Company should be able to fund its operating needs internally. The balance sheet is expected to remain stable in the medium term. The Company has set a leverage target of total debt-to-EBITDA of between 1.5 times (x) and 2.0x. In the event that the economy slows down sharply, the Company has the flexibility to curtail cash usage as it did in 2009 and stabilize its financial position. Although acquisitions are not a top strategic priority for Newalta, DBRS believes the Company could still participate in more. Nevertheless, DBRS notes that the Company has demonstrated financial discipline and will be judicious in any debt finance acquisitions.

The Positive trend reflects that the rating will likely be upgraded a notch in the next six to 12 months if the Company maintains its improving momentum, continues to strengthen its profitability to near historical average levels and makes meaningful progress in achieving its leverage target. Furthermore, the Company also needs to complete the refinancing of its maturing convertible debentures appropriately without weakening its capital structure and financial stability.

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. DBRS has determined Newalta’s estimated value at default using an EBITDA multiple valuation approach at approximately $288 million, using a 4.0 x multiple of normalized EBITDA. In addition, DBRS assumes that the Company would refinance its convertible debt (maturing in November 2012) prior to maturity with same amount of unsecured debt ranked pari passu with the rated Unsecured Notes. As a result, at the time of default, the Company would have almost double the amount of unsecured debt outstanding. Based on the default scenario, the Unsecured Notes would have recovery estimated between 30% and 50%, which aligns with a recovery rating of RR4. Therefore, the instrument rating of the Unsecured Notes is BB (low), the same as the Issuer Rating. The reason for the lower recovery of the unsecured notes compared to the recovery analysis done in the report dated November 10, 2010, is solely the amount of unsecured debt outstanding at the time of default.

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

The applicable methodologies are Rating Companies in the Industrial Products Industry and DBRS Rating Methodology for Leveraged Finance, which can be found on our website under Methodologies.