DBRS Confirms Armtec’s Ratings and Changes Trends to Stable

DBRS has today confirmed the Issuer Rating of Armtec Holdings Limited (Armtec or the Company) at B and the instrument rating of the Senior Unsecured Debt at B (low) and has changed the trend for both ratings to Stable from Negative. The recovery rating on the Senior Unsecured Debt is unchanged at RR5. The trend change to Stable reflects that, with the completion of the refinancing of the original Brookfield Facility and the looser financial covenants of the new financing package, Armtec has improved its financial flexibility and materially reduced the risks of a near-term default and liquidity concerns as identified in the previous rating report. The Stable trend also indicates that any upside on Armtec’s ratings remains constrained by its very weak financial metrics associated with a highly leveraged capital structure and slow revenue growth prospects resulting from continued weak demand from the public sector.

The Company’s recent corporate reorganization and its Elevate 2015 plan represent well intended efforts to improve operating performance, customer focus, safety standards and financial metrics in the medium term. However, DBRS notes that these efforts could increase near-term personnel and other administrative costs and their successful execution will be critical to achieving the targeted performance improvements. Even assuming successful execution of these efforts, given uncertain market conditions, DBRS expects Armtec’s debt coverage metrics to remain consistent with its current rating levels in the next three years, with adjusted cash flow-to-debt likely to stay below 10% (3% in 2012) and adjusted debt-to-EBITDA to exceed 5.0 times (x) (7.2x in 2012).

Armtec is a manufacturer of infrastructure products and engineered solutions across Canada, with leading market positions in its core markets, providing a variety of products to a broad end market, including infrastructure, residential and commercial construction, agriculture and natural resources.

Armtec started 2012 facing numerous challenges, which included weak demand conditions (particularly from public sector drainage work), the need to complete a number of underperforming low-margin engineered solutions (ES) projects initiated in 2011 and uncertainty in complying with a key financial covenant in its financing package. The Company has managed to alleviate much of the near-term financial pressure during the year through (1) attainment of compliance of financial covenants when they became effective in June 2012; (2) successful implementation of its Turnaround Plan (TP), which modestly exceeded targeted cost savings of $20 million; and (3) refinancing and prepaying of the original Brookfield Facility (scheduled to mature in August 2013) with a new financial package in December 2013. DBRS also understands that the Company has increased its focus on operational performance and project quality and execution, which together with a more product-focused organization, could improve project bidding discipline and avoid underperforming projects.

DBRS believes that Armtec’s liquidity has materially improved following the refinancing completed in December 2012. The refinancing is particularly important because Armtec will have minimum scheduled debt repayments (mainly small financing leases) until December 2016, less restrictive financial covenants and a lower interest burden. Armtec now has more time and financial flexibility to turn its attention toward medium-term improvements. Despite the improvement, DBRS believes that the Company’s ability to access the debt capital markets remains very limited, given its already high leverage and weak financial metrics. Its ability to raise equity financing is likewise limited by the weak share price and an ongoing class action proceeding by investors seeking damages from the Company. The ratings currently do not factor in any potential adverse outcome of the lawsuits to Armtec because the timing and impact of the court decision cannot be reasonably foreseen at this point.

DBRS understands that, notwithstanding the challenges and limited revenue growth in 2012, Armtec’s operating performance was in line with the Company’s expectations and meaningfully improved from that in 2011. This reflected the combined benefits of cost savings from the TP, improved ES operating margin and better input cost and inventory management with the implementation of the enterprise resource planning (ERP) system. However, the Company’s profitability in 2012 was affected by the additional finance costs amounting to $41 million associated with the refinancing (including accreted interests, prepayment and exit fees for the original Brookfield Facility). DBRS reclassifies this non-cash finance cost as a non-recurring item and excludes it from interest expenses in its ratio computation.

Going forward, DBRS expects that Armtec will still face a challenging and uncertain demand outlook and will have to address the issues identified in its Elevate 2015 plan amid such business conditions. Demand for Armtec’s drainage products remains subdued by softness from the public sector and sensitivity to weather conditions. Although business conditions for the larger ES projects appear better, the market remains competitive and, as shown by the Company’s previous underperforming projects, discipline in bidding and execution are critical to the profitability of this business. In addition, Armtec’s profit margin remains sensitive to prices of key inputs such as cement, steel and plastics. The Company’s ability to manage its overhead costs as it reorganizes and increases its marketing and safety focus as part of the Elevate 2015 plan will also be important to the Company’s profitability and cash flow.

The Stable trend reflects the much improved headroom from complying with the revised financial covenants of the new financing package. The trend could be revised to Negative in the event of substantial erosion of this headroom resulting from material deterioration in EBITDA. As discussed, rating uplift is unlikely in the near term and would be considered only upon material improvement in financial metrics through deleveraging.

Pursuant to the DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers methodology, 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 business conditions unexpectedly worsen again in 2013, resulting in substantially lower revenue, coupled with material cost overrun and project execution problems. 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 recognizes that drawdown from the $60 million secured revolving credit facility is subject to borrowing base availability and assumes that, with depressed sales under the default scenario, the assets available to form the borrowing base could be meaningfully reduced. DBRS has forecast the economic value of the components of the enterprise at approximately $151 million using a 4.0x multiple of normalized EBITDA for Armtec. Based on the default scenario, the Senior Unsecured Debt has a recovery estimated between 10% and 30% and, therefore, a recovery rating of RR5. The instrument rating on the Senior Unsecured Debt is B (low) (one notch below Armtec’s Issuer Rating), in accordance with the recovery rating methodology.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

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