DBRS Downgrades Sherritt International Ratings, Trend Negative

DBRS has today downgraded the Issuer Rating and Senior Unsecured Debt rating of Sherritt International Corporation (Sherritt or the Company) to BB (low) from BB (high), both with a Negative trend, following the Company’s announcement that it has completed the sale of its Coal unit. The ratings have also been removed from Under Review with Negative Implications, where they were placed on December 24, 2013. In addition, the recovery rating for Sherritt’s Senior Unsecured Debt under a hypothetical default scenario remains at RR4.

Sherritt’s financial metrics have been weak in the recent environment of relatively soft nickel and cobalt prices and high debt accumulated in part to fund its share of the Ambatovy project. Following the disposal of the Company’s Coal unit, DBRS expects (1) increased volatility of Sherritt’s earnings and cash flow; (2) an overall reduction in its size and scope; (3) a narrower business profile; (4) higher average political risk; and (5) continuing poor current financial metrics, albeit with improved liquidity. These expectations have resulted in the current two-notch downgrade of Sherritt’s ratings. The Negative trend of the ratings reflects the risks inherent in the incomplete nature of the Ambatovy project, the ongoing need of funds to bring the project to completion, which may be less than fully successful, and the potential added strain to the Company’s already weak financial metrics.

Successful ramp-up of the Ambatovy project to near design expectations and the reversal of Ambatovy’s status from cash consumer to cash contributor can be expected to lead to a restoration of Stable trends to Sherritt’s ratings. In addition, Sherritt faces the expiry of important oil production sharing contracts in Cuba in 2017 and 2018. Failure to successfully ramp up Ambatovy or to successfully extend the life of the Company’s Cuban oil operations may lead to further ratings downgrades.

The RR4 recovery rating for Sherritt’s Senior Unsecured Debt corresponds to an estimated 30% to 60% recovery of principal amounts of its Senior Unsecured Debentures, based on the results of examining a hypothetical default scenario for the Company. The RR4 rating, in turn, results in no change (notching) to the rating of Sherritt’s Senior Unsecured Debt.

Sherritt completed the sale of its Coal unit on April 28, 2014, for total consideration of $946 million, including $793 million in cash received on closing. The sale remains subject to post-closing adjustments, expected to be finalized in Q2 2014, and which DBRS does not expect to be material. The Company indicates that a significant portion of the cash proceeds will be used for debt reduction and that any proceeds that are not used for debt reduction will be used for internal investment projects, including the funding of the Ambatovy ramp-up.

Sherritt’s bond indentures restrict the use of proceeds from the sale of the Coal unit to specified debt repayments and to acquire assets over a 360-day period following the close of the transaction. DBRS expects that by far the majority of the proceeds will be used for qualifying debt repayment, funding of the Ambatovy ramp-up and other existing corporate projects as opposed to acquisition of any new lines of business.

Of Sherritt’s $2.5 billion in debt at March 31, 2014, the Company had approximately $365 million drawn under revolving credit facilities and about $604 million in cash and short-term investments. The Company has indicated that immediately prior to closing of the Coal unit sale it repaid $300 million of debt drawn under the revolving credit facility of the Coal unit and it subsequently terminated that facility. On a pro forma basis, this would indicate that a modest portion of Sherritt’s revolving-credit-facility debt remained outstanding and that it had cash resources of about $1.1 billion before any further debt repayments or transaction costs had been paid. The remainder of the Company’s debt at the end of Q1 2014 consisted of $1.2 billion of outstanding bonds and $1.0 billion of loans from its partners in the Ambatovy project used to provide a portion of Sherritt’s historic contributions to Ambatovy development.

DBRS expects the sale of Sherritt’s Coal unit will lead to reduced debt and enhanced short-term liquidity, but will remove a significant Canadian-based, medium-to-long-term, relatively stable source of earnings and cash flow from its business profile (as well as a much less significant but more volatile export coal business). With the Coal unit sale, Sherritt has become focused on its Oil and Gas, Metals (nickel/cobalt-oriented) and the much smaller Power businesses, which generally face significant social and political risks, high earnings volatility and, in the case of its Oil and Gas business, a limited life expectancy under current contract terms. In addition, Sherritt’s Metal business includes the development of its 40%-owned Ambatovy project, which, although in its ramp-up phase, has material project completion uncertainties in terms of meeting original design expectations as well as the prospect of being a long-lived operation in the high political/social risk environment of Madagascar. In addition, following the Coal unit sale, most of the remaining operations, other than Oil and Gas, are jointly owned with others sharing operating decisions, thereby reducing the Company’s relative operational control.

Sherritt’s Oil and Gas unit has been and continues to be an important earnings and cash flow generator for the Company. It is largely based on Cuban operations that are characterized by a readily available market, competitive production costs and low exploration risks, but with a short reserve life given that its key Cuban operations are subject to contract expirations in 2017 and 2018. Sherritt indicates it is pursuing the extension of existing Cuban oil production sharing contracts and the addition of four new exploration blocks, but if received, there is no certainty that Cuban production levels can be maintained at existing rates.

The Company’s current Metal’s business is a low-cost nickel producer based on mining and processing operations in Cuba and refining operations in Canada. The operations have a long and successful production history as well as a reserve base that can support ongoing production for many years.

In addition, the Company’s Metals unit is in the process of ramping up its 40%-owned nickel-cobalt project in Madagascar (Ambatovy), which also has the potential of being a long-lived, low-cost asset, but which, as of yet, has achieved neither planned production rates nor met unit cost expectations at full production. 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 to cover its share of ramp-up costs as well as its share of senior project loan repayment installments, which have already begun.

Low nickel and cobalt prices, despite recent improvements, 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 project. 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 Oil and Gas and Metals businesses are subject to volatile commodity prices (nickel, cobalt, oil and natural gas) and high political risk (Cuba/Madagascar).

The Company’s Power operations are small and are also largely Cuba-dependent, but act much like a regulated utility with low cost and earnings risks.

The added liquidity afforded Sherritt by the sale of its Coal unit will be welcomed, given that at March 31, 2014, its operating cash flow (excluding the Coal unit) had been significantly diminished because of relatively low realized nickel and cobalt prices and the need to fund cash flow deficits and loan payments at Ambatovy as it ramps up. The Company’s operating units have historically been self-funding in the normal course of operations (ex-expansion activity), and Ambatovy can be expected to be the same if it meets its design objectives. Until Ambatovy becomes self-financing, a major uncertainty as to Sherritt’s cash will remain; hence, DBRS has retained the Company’s ratings on a Negative trend. Accordingly, the reversal of Ambatovy’s status from cash consumer to cash contributor can be expected to lead to a restoration of Stable trends to the Company’s ratings.

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), Rating Companies in the Oil and Gas Industry (July 2013) and DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers (March 2014), which can be found on our website under Methodologies.