DBRS Confirms GFL Environmental Inc. at B (high), Trends Stable

DBRS has today confirmed the Issuer Rating and Senior Unsecured Notes rating of GFL Environmental Inc. (GFL or the Company) at B (high), with Stable trends. The recovery rating for the Senior Unsecured Notes is RR4. The rating actions reflect that GFL’s business risk profile has remained relatively stable and its operating performance has been mostly in line with expectations. Operating EBITDA (as defined by DBRS) and margins have improved due to contributions from new contracts, acquisitions and benefits from cost savings initiatives. However, the increase in borrowings to fund the much higher capital expenditures, working capital and acquisitions has boosted leverage and weakened all debt coverage ratios. Nevertheless, the financial risk profile, albeit weakened, remains within the current rating range. Acquisition will remain a key component of GFL’s growth strategy going forward. DBRS expects internal cash generation to strengthen in line with improved earnings but not likely to be sufficient to fund acquisitions and growth. Hence, GFL will likely continue to borrow to fund the deficit in free cash flow. Nevertheless, GFL has a good track record in integrating newly acquired companies and has demonstrated its ability to generate integration synergies and implement cost savings initiatives. DBRS expects contributions from acquisitions and organic growth should strengthen earnings and internal cash generation and maintain all debt coverage ratios at near current levels. However, GFL’s financial profile is weak and the cushion to absorb further deterioration is reduced. The current rating assumes that the gross debt operating EBITDA ratio (as defined by DBRS) will not significantly increase above 5 times (x) on an ongoing basis with allowance for short term working capital and acquisition events that may take the ratio temporarily into the 5.0x to 5.5x range.

GFL has continued to be active in acquisitions, a key component of its growth strategy. The Company made five modest acquisitions in 2013 totalling $11.5 million as well as about $7.7 million on intangible assets. Despite its acquisition activity, the Company’s business mix has not changed much with solid waste, its largest business, still accounting for 50% of the overall revenue. The Company has maintained its focus on the most populated areas of Ontario built on its existing network and has increased its presence in solid waste in Calgary, Alberta, and strengthened its position in used motor oil collection, maintaining its leadership position in Alberta and Manitoba. GFL has a good track record in acquisitions and managing integration risks and has consistently demonstrated its ability to generate integration synergies from completed acquisitions. The Company’s competitive cost position is a key factor for winning major contracts in the last couple of years. GFL remains well positioned in the growing and relatively stable waste handling industry. The industry is expected to maintain a moderate long term growth trend supported by a growing population base and the normal expansion of industrial activities. The Company’s relatively stable business risk profile continues to provide key support to the current rating.

However, the Company still lacks scale and resources compared with the industry leaders. The Company’s aggressive acquisition strategy presents a major risk to the current rating and the use of debt to fund growth further adds to the risk. Even though the Company has good cash flow generation capability, internal cash generation has remained well short of the level needed to fund the high capital expenditures and acquisitions. The Company’s debt level has been on a steady rising trend and the balance sheet is aggressive.

Operating results in 2013 showed a year over year improvement but performance was mixed among the three businesses. Solid waste reported much stronger earnings while liquid waste was flat. Internal cash generation continued to be strong, but was not sufficient to fund acquisitions and a large increase in capital expenditures (on equipment to fulfill new contracts). Gross debt and associated interest expense rose markedly. Despite stronger earnings, all key debt coverage metrics weakened. Gross debt (including capitalized leases but excluding the $32.2 million to prefund an acquisition in January 2014) / operating EBITDA increased modestly to about 4.4x in 2013 from 4.1x in 2012 and cash flow from operations dropped to 0.17 from 0.20 in the same period. GFL has made two more debt financed acquisitions in early 2014 for about $38 million. On a pro forma basis, gross debt / Operating EBITDA would increase to over 5.0x and cash flow to total debt would decline to 0.15. (The exclusion of contributions from the acquired companies in the calculation has overstated the deterioration of the coverage ratios.) DBRS notes that all debt coverage ratios, although weakened, still remain within the current rating range but the cushion to absorb further debt financed acquisition has been reduced considerably. Furthermore, the recent pace of acquisition has increased the risk of contributions from newly acquired companies to fail to keep pace with the rising debt levels and associated higher interest expense. Further deterioration in GFL’s financial profile may no longer be compatible with the current rating.

In summary, the Company’s stable business profile provides a key support to the current rating. GFL’s financial profile, albeit weakened, remains within the current rating range but the cushion to absorb further weakness is much reduced. DBRS expects earnings and internal cash flow to strengthen in 2014 and would maintain all debt coverage ratios to remain near current levels and within the current rating range. However, the rating could be at risk if the gross debt / operating EBITDA ratio is above 5.0x.

Pursuant to the rating methodology for recovery ratings for non-investment grade corporate issuers, DBRS has created a default scenario for GFL 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 the Company has failed to renew a few key contracts in 2015 and 2016 and would exhaust its liquidity, trip the financial covenants and default in late 2016. DBRS has determined GFL’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. Based on the default scenario above, the Senior Unsecured Notes would have recovery estimated between 30% and 60%, which aligns with a recovery rating of RR4. Therefore, the instrument rating on the Senior Unsecured Notes is B (high), identical to the Issuer Rating.

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 methodology is Rating Companies in the Services Industry, which can be found on our website under Methodologies.

The full report providing additional analytical detail is available by clicking on the link under Related Research at the right of the screen or by contacting us at info@dbrs.com.