DBRS Confirms the Ratings of Newalta Corporation

DBRS has today confirmed the Issuer Rating of Newalta Corporation (Newalta or the Company) at BB with a Stable trend. Using the methodology DBRS Criteria: DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers, DBRS has also confirmed the recovery rating and rating of the Unsecured Notes at RR4 and BB respectively, with a Stable trend.

The rating confirmation reflects Newalta’s continued progress in executing its business strategy toward improving business stability through increasing its proportion of contracted revenue from on-site waste processing and management works primarily in its Heavy Oil segment and continued leadership and management focus in adhering to its target financial metrics, which are strong for the rating. For the last 12 months (LTM) period ended June 30, 2013, these contracts contributed to 11% of total revenue and the Company targets to increase the proportion steadily to 15% by 2014. In addition, the contracted works help the Company cement a stronger and ongoing working relationship with contracted customers and help entrench the Company’s market position against its competitors. These contracts also reduce the Company’s overall exposure to commodity prices since they tend to base their fees on service solutions provided. A higher mix of the more stable on-site contract works coupled with the improved operating efficiency and equipment utilization has strengthened Newalta’s business profile.

The Company’s business risk profile and rating remain constrained, however, by a number of business challenges, which includes demand and revenue being sensitive to crude oil prices and drilling activities in the oil and gas sector, possible changes in environmental regulations, limited geographic presence beyond the North American markets and exposure to commodity prices in the Industrial division. In addition, the timing and amount of its growth capital expenditure, in particular those related to its on-site contracts, could be influenced by the Company’s ability to win contracts and the timing of their executions. As demonstrated since 2012, growth capex has exceeded the Company’s plan as a result of winning a new on-site contract and the initial phase of the execution of previously won contracts, resulting in periods of free cash flow deficits.

Newalta’s financial metrics have moderately weakened in LTM June 30, 2013, with adjusted debt-to-EBITDA of 3.0 times(x) (from 2.4x in 2011) and adjusted cash flow-to-debt of 27% (from 36%). The deterioration was the combined result of an increase in debt to fund the higher growth capital expenditure associated with the newly awarded contracts and weaker-than-expected operating performance in the fourth quarter of 2012 due to lower drilling activities and crude oil prices. Market conditions have stabilized since the first half of 2013. DBRS believes that these financial metrics are still consistent with Newalta’s rating, taking into consideration expected cash flow improvement of the revenue-accretive investments. Newalta has provided guidance at the release of the second quarter 2013 financial results that it is on target to lower its total debt-to-adjusted EBITDA (as defined in financial covenants for its credit facility, not a DBRS definition) from 2.8x in LTM June 30, 2013, to 2.5x by the end of the year and targets to maintain the ratio within 2.0x to 2.5x in the longer term. DBRS also notes that the Company has raised equity capital from time to time to finance its growth, the most recent one being a $77 million equity issue concluded in October 2012, and total equity issued in the five-year period between 2008 and 2012 amounted to $122 million or about one-quarter of its total capital expenditures.

Newalta remains one of the established leaders in the niche market of providing waste processing and management services to the oil and gas sector in Western Canada and increasingly in the United States. Demand for such services has increased and is likely to continue so as a result of increasingly stringent environmental regulations relating to the production and drilling activities in the sector. Compared to its industry peers, the Company’s competitive advantage lies mainly in its capability to provide on-site services (which has been instrumental in its recent acquisitions of mature fine tailings treatment and slop-oil processing contracts) to its wider Canadian and U.S. network of full and satellite facilities and its better financial flexibility (operating with lower leverage). DBRS understands that the recent corporate reorganization effective January 1, 2013, should help the Company improve its customer focus and better allocation of capital resources to higher-margin and faster-growing businesses.

Overall, DBRS considers the Company’s near-term outlook as stable, although market conditions remain mixed among the business segments. Low natural gas prices, though moderately improved recently, will continue to constrain material increases in drilling activities, which in turn may limit improvement in the Company’s equipment utilization rate, while commodity (base oil, crude oil and lead) prices remain under pressure. On the other hand, Newalta’s future revenues should be supported by its recently acquired contracts in the higher-margin Heavy Oil and Oilfield segments, improved operating efficiency in the lead battery recycling Ville de Sainte-Catherine facility in Quebec and moderate increase in business in the U.S. markets.

The Stable trend reflects DBRS’ expectation that Newalta will continue its efforts to improve its business risk profile by increasing its contracted revenue and reducing its exposure to commodity price swings over time. DBRS also expects the Company to finance its growth capex by a balanced mix of operating cash flow, debt and equity so that its financial metrics will improve and not weaken further from the current levels. DBRS believes that Newalta’s rating could be pressured if its business becomes materially affected by a severe and sustained drop in demand for waste processing services due to lower oil and gas drilling and production activities, if changes in environmental regulations or operational errors result in a material increase in operating costs or if the Company financial metrics materially weaken from the LTM June 2013 levels for a sustained period. Conversely, sustained improvement of their competitive position and in revenue and earnings stability through an increased proportion of contracted revenues while maintaining its financial metrics similar to their full-year 2012 levels could be positive to the rating.

Pursuant to our rating criteria on recovery ratings for non-investment grade corporate issuers, 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 $360 million, using a 4.0x multiple of normalized EBITDA. Based on the default scenario, the Unsecured Notes would have recovery estimated between 30% and 60%, which aligns with a recovery rating of RR4. Therefore, the instrument rating of the Unsecured Notes is BB, the same as the Issuer Rating.

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

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

The applicable methodologies are DBRS Criteria: DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers, DBRS Criteria: Financial Ratios and Accounting Treatments – Non-Financial Companies and Rating Companies in the Service Industry which are available on our website under Methodologies.

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.