DBRS Places Sherritt International Ratings Under Review with Negative Implications

DBRS has today placed the ratings of Sherritt International Corporation (Sherritt or the Company)
Under Review with Negative Implications following the Company’s announcement that it intends to divest its Coal business unit in a two-part transaction for total consideration of $946 million comprising approximately $793 million of anticipated cash proceeds and the assumption of capital leases valued at $153 million (subject to closing adjustments). Sherritt indicates the divestiture of its Coal unit is expected to enhance the liquidity of the Company and to give it flexibility to pursue opportunities to develop and grow its core businesses, as well as providing funds for debt repayment. The divestiture transaction is expected to close in the first quarter of 2014 and remains subject to customary closing conditions and consents, including applicable Competition Bureau, Investment Canada Act and court approvals. DBRS believes that the announced transaction, if completed as contemplated, will materially erode Sherritt’s business profile and significantly change the Company’s financial profile and liquidity. As a result, following an assessment of the business profile, prospects, go-forward strategy and financial profile of the remaining entity, a potential multi-notch downgrade of Sherritt’s ratings may result.

DBRS confirmed both Sherritt’s Issuer Rating and Senior Unsecured Debt rating at BB (high) and changed the trends to Negative from Stable on June 21, 2013 (see “DBRS Confirms Sherritt International at BB (high), Trend Changed to Negative,” June 21, 2013).

The two-part Coal unit disposition transaction consists of a sale of Sherritt's entire royalty portfolio and its interest in coal development assets for cash consideration of $481 million (subject to closing adjustments) to Altius Minerals Corporation and a sale of the Coal unit’s operating coal assets to Westmoreland Coal Company for $312 million in cash and the assumption of capital leases presently valued by the parties at $153 million (subject to closing adjustments). The transaction is to be carried out under a plan of arrangement, pursuant to the Business Corporations Act (Alberta).

The disposition of the Coal unit will materially increase the business risk of Sherritt by removing long-lived, low-risk operations, thereby emphasizing the earnings volatility and significant political risk of its remaining businesses. In addition, most of its remaining operations, other than Oil and Gas, will be owned jointly with others sharing operating decisions, thereby reducing relative operational control. Oil and Gas, the key earnings and cash flow generator for the Company, has a short reserve life and Cuban operations are subject to contract expiry in the next few years, although Sherritt indicates it continues to pursue the extension of existing Cuban leases and the addition of four new blocks. These and other changes may warrant a multi-notch downgrade of Sherritt’s ratings. In addition, the eventual use of proceeds may not lead to any significant improvement in Sherritt’s financial metrics, which are currently weak for its ratings, providing additional reasons for downgrade.

Sherritt currently consists of its Metals, Coal, Oil and Gas and Power business units, with its Coal unit providing about 31% of the Company’s reported average annual adjusted EBITDA before corporate and other costs ($190 million) over the five years through to 2012. The Coal unit is further subdivided into Prairie mine, Prairie royalty and Mountain mine operations, providing 44%, 31% and 25%, respectively, of average annual adjusted EBITDA of the Coal unit. The Prairie mine and Prairie royalty sub units can be characterized as stable, long-term earnings generators operating in a low-volatility market environment and in a low-risk political jurisdiction.

Sherritt’s Oil and Gas and Metals businesses are competitive operations but are subject to volatile commodity prices (nickel, cobalt, oil and natural gas) and currently are largely dependent on Cuban operations for nickel, cobalt and oil output. The Company’s Metals unit is in the process of ramping up its 40%-owned nickel-cobalt mine in Madagascar (Ambatovy), which has the potential of being a long-lived, low-cost asset but as yet has achieved neither planned production rates nor met unit cost expectations. Power operations, 8% of reported average annual adjusted EBITDA before corporate and other costs, are also largely Cuba-dependent, but act much like a regulated utility with low cost and earnings risks.

Sherritt’s go-forward business profile can be expected to be considerably weaker without the Coal unit if the disposition is completed as planned. Sherritt will be subject to higher commodity price volatility, higher political risks (Cuba and Madagascar), lower diversification and an overall reduction in its size and scope. In the near term, the successful ramp-up of Ambatovy to design targets will be an operational risk and potentially a significant user of Sherritt’s cash resources, including the need of the partners to cover ramp-up costs as well as senior project loan repayment installments, which have already begun. Sherritt is also paying for its share of the project’s $2.1 billion (100% basis) senior financing, for which repayment installments have already begun. If Ambatovy is successfully completed, the Metals unit will be characterized by long-lived and low-cost operations. Oil and Gas, although currently an important and solid cash generator, has a short-reserve life and its leases in Cuba are currently set to expire in 2017-2018.

At September 30, 2013, Sherritt’s total debt was $2.2 billion, comprising $1.2 billion of Sherritt Senior Unsecured Debt, $900 million in loans from it partners in and directly related to the Ambatovy project and approximately $150 million in its Coal unit, which is to be assumed by the purchaser. These amounts exclude Sherritt’s 40% share of the equity-accounted Ambatovy project. Gross debt leverage was 37%, with cash on hand of $371 million.

The use of the net proceeds from a Coal unit disposition will be important in determining the post-disposition financial profile of Sherritt. The Company has indicated that it is contemplating a range of options for the use of proceeds of the Coal disposition transaction, including retaining funds to enhance liquidity, investing in new businesses and debt reduction, although the specifics have not been provided. Sherritt’s Oil and Gas and Metals units have been largely self-funding over the last number of years, except for the substantial investment in the Ambatovy project. Low nickel and cobalt prices remain a key threat to Sherritt’s Cuba-related nickel operations, in terms of maintaining their cash self-sustaining status, as well as to the time required to bring Ambatovy to a cash self-sustaining operation. In addition, near-term recovery of cash invested in Ambatovy will be slow, with priority given to repayment of senior project lending and partner lending for surplus cash generated by the mine. It is also notable that Ambatovy has yet to meet requirements to convert its senior project loan into a non-recourse project loan. Sherritt’s next major note maturity is $275 million in October 2015. Accordingly, Sherritt, post-Coal unit disposition, will have approximately $2.1 billion in debt (about $900 million related to Ambatovy and excluding the senior Ambatovy project loan) and $371 million in cash and investments plus the net proceeds of the sale, bringing net non-Ambatovy debt close to zero. That said, it is uncertain how much of the proceeds and other cash available will be required for further Ambatovy funding, other investment projects and any shareholder payments.

DBRS expects to resolve the Under Review with Negative Implications status of Sherritt’s ratings once the details and certainty of the disposition transaction, business strategy, spending intentions and financial profile of Sherritt without its Coal unit become clearer.

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.

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

The applicable methodologies are Rating Companies in the Mining Industry (June 2011) and Rating Companies in the Oil and Gas Industry (July 2013), which can be found on our website under Methodologies.