DBRS Downgrades GreenField Ethanol to B (high)

DBRS has today downgraded the Issuer Rating of GreenField Ethanol Inc. (GreenField or the Company) to B (high) from BB (low). The trend is Stable. At the same time, DBRS has withdrawn the provisional instrument rating of the planned Senior Secured Second Lien Guaranteed Notes as they were not issued. The rating downgrade reflects a number of operating challenges facing GreenField, which include (1) the adverse impact of declining and expiring government incentives on GreenField’s earnings, (2) expected weakening of financial metrics in 2013 as a result of reduced earnings and cash flows, and (3) risks associated with the execution of numerous investment projects that are designed to expand the Company’s sources of revenue or to reduce costs. DBRS now assumes that the government incentives will not be renewed in their current form after they expire, although we expect that the legislation in Canada requiring a minimum ethanol content of 5% in gasoline will remain.

The rating recognizes the Company’s higher-than-average business risk as the ethanol industry has been dependent on government incentive programs designed to reduce the environmental impact of fuel gasoline. Without these programs, the fuel ethanol business in North America would be barely profitable. The incentive programs run by federal and provincial governments in Canada are awarded to ethanol production facilities at inception, with the incentive amounts gradually decreasing over time until they expire. The federal program will expire in March 2015 (for all facilities, with the exception of the Johnstown, Ontario, plant, expiring March 2016), while the provincial programs will expire in December 2012 for the Johnstown, plant; December 2016 for other Ontario-based plants; and March 2017 for the Varennes, Québec, plant.

Various circumstances in the past two years have reduced the likelihood that, when they expire, these incentives will be renewed with similar terms. The increased fiscal deficits at both the federal and provincial levels due to the economic slowdown since 2009 have placed government spending, particularly spending used to support uneconomical industries, under increasing scrutiny. Reduced corn production since the second quarter of 2012 and the resulting increases in corn prices have renewed concerns that corn-based ethanol production contributes to shortages and higher prices for food and animal feeds. In view of these developments, DBRS now believes that government incentives are not likely to be renewed in their current form and, even if they are renewed, the benefits to the ethanol producers could be materially reduced. As government incentives contributed to about two-thirds of the Company’s EBITDA for the first eight months of 2012, DBRS believes that non-renewal or a substantial reduction in incentives would have a material impact on GreenField’s earnings and the cash flow available for further debt reduction.

GreenField is the largest ethanol producer in Canada and operates four production facilities in Ontario and Québec, where there is a large supply deficit in ethanol and where the proximity of the facilities to corn farms and gasoline-producing facilities gives the Company a logistical advantage, especially considering that the cost of transportation of fuel ethanol is material. In addition to government incentives, GreenField sells a substantial portion (about 90%) of ethanol production through take-or-pay contracts with three major gasoline producers, which helps ensure revenue stability. Corn and, to a lesser extent, energy (natural gas and electricity) are the two main cost components, accounting for approximately 80% and 10% of production costs, respectively. Revenue from these contracted sales is indexed to either ethanol or gasoline prices, roughly evenly split by volume. While ethanol prices are generally highly correlated with corn prices, this is not the case with gasoline prices. The Company has a team of employees dedicated to hedging to manage market risks.

The Company also produces industrial and beverage alcohol through additional distillation processes, which are used in various consumer personal and health-care products, as well as diluents and solvents in chemical products. The processes also produce other co-products such as dried distillers grains with soluble (DDGS), wet distiller grains (WDG), both used as animal feeds and carbon dioxide. These products, sold either in bulk or as packaged products, together contribute to approximately 40% of revenue and 15% of EBITDA. GreenField is a leader in the small Canadian market for industrial alcohol, with about 80% market share, while it supplies 5% of the much-larger U.S. market. Both markets are mature and expected to grow only slowly. As industrial alcohol can also be produced using sugar cane, GreenField has little control over product prices, especially in the U.S. market, and rising corn prices relative to sugar cane could result in margin compression for the Company.

In the likely event that the government incentive program related to the Johnstown production facility is not renewed after December 2012, DBRS expects that GreenField’s EBITDA will be reduced by about $26 million in 2013, from our estimate of $89 million in 2012. Should the remaining programs not be renewed upon their respective expiry dates, government incentives would be completely eliminated by 2017. GreenField has responded by undertaking a number of investment initiatives aiming at creating sustainable long-term cash flow by (1) improving operating efficiency to reduce production costs, and (2) creating new revenue sources through developing higher-valued co-products or new products.

DBRS recognizes GreenField’s commitment toward its long-term target of lowering debt-to-EBITDA to within 2.5x and its dedicated effort in deleveraging via use of its free cash flow, reducing its debt level to $299 million at July 1, 2012, from $413 million at December 31, 2008, and paying no dividend during the period. The effort has resulted in steady improvement in financial metrics, with adjusted debt-to-EBITDA declining to 3.2x for the last-12-month (LTM) period ended July 1, 2012, from 5.1x in 2009, and adjusted cash flow-to-debt improving to 21% from 16%. As most of these investments are targeted for completion in the second half of 2013 or first half of 2014, their benefits will only begin to affect GreenField from 2014 onward. Therefore, despite continuing debt repayment, DBRS expects the Company’s financial metrics in 2013 to weaken significantly to levels considered more appropriate for the revised rating level due to lower cash flow and EBITDA resulting from the reduction in government incentives. DBRS estimates that adjusted cash flow-to-debt could weaken toward the 11% to 14% range, while adjusted debt-to-EBITDA could approach 4.5x in 2013. GreenField could also face refinancing risks in 2013 (when the weakened financial metrics could cause breaches of its debt financial covenants) and in 2014 (when about two-thirds of its debt will mature). The Company’s ability to overcome these challenges will depend materially on lenders’ confidence that the Company can withstand the headwinds it faces and successfully execute on its investments.

If executed according to plan, the incremental EBITDA from these investment initiatives could offset a large proportion of the impact from the loss of the Johnstown-related incentives and reduction in other incentives in 2014 and 2015. Provided that GreenField continues to reduce debt with the free cash flow derived from these new investments, the Company could resume its improving trend in financial metrics after 2014. However, given that a number of the investment projects involve new technologies or require entry into new markets for new co-products, smooth execution of all these projects is by no means certain, despite the Company’s track record of technical knowhow and project execution. Difficulty in execution or disruptions that these new projects could bring to the core ethanol and alcohol production operations could delay improvement in financial metrics.

The Stable trend on the revised rating has already factored in the aforementioned challenges and the expected weakening of financial metrics in 2013. Nevertheless, DBRS believes that the rating could come under further pressure if liquidity concerns increase due to loss of confidence among lenders ahead of the 2014 maturities or if there are indications that significant execution problems relating to the new investments could further erode cash flows or increase debt levels. DBRS believes that, in the longer term, the following events could alleviate pressure on GreenField’s rating: (1) the Company becomes successful in refinancing the maturing debt in 2014 with long-term financing; (2) a favourable resolution arises that could compensate for the Company’s eventual loss of government incentives in the ethanol business; (3) the Company achieves the expected cash flow generation from completion and operation of its new investments; and (4) the Company becomes able to resume the earlier improvement trends in its debt coverage metrics.

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.