DBRS Confirms Newalta Corporation at BB, Stable Trend

DBRS has confirmed the Issuer Rating of Newalta Corporation (Newalta or the Company) at BB with a Stable trend. DBRS has also confirmed the Recovery Rating and the rating of the Unsecured Notes at RR4 and BB, respectively, with a Stable trend. The rating action reflects that the Company has performed in line with expectations. Newalta’s business profile has strengthened modestly, supported by the growing multi-year on-site contracts with more predictable revenue, partly offset by the expanding oilfield business in the United States, which tends to be more volatile. Newalta’s debt coverage metrics, however, have weakened modestly because of increased borrowing related to upfront investments to support growth projects. Nevertheless, Newalta’s financial profile is still compatible with the current rating. DBRS expects the current trend to continue and the rating to remain stable; however, the Company has engaged an outside party to conduct a review of a full range of potential alternatives for the Industrial Division (Industrial), a comparatively lowered margin business. Since the future of Industrial is uncertain pending the completion of the review, the impact of any potential actions has not been factored into the confirmation action. DBRS expects the review to be completed in early 2015. DBRS will treat the strategic review as an event and assess the Company’s actions and the resultant impact on its credit profile when the results are announced.

Overall operating results improved in 2013 through H1 2014, although performance was mixed among the divisions. The New Markets Division (New Market) has been the strong performer supported by on-site contract wins and expansion in the United States, but results at Industrial have not been satisfactory. In response, the Company has implemented the Rationalization Plan, which entails closing plants, reducing overhead costs and redirecting some business lines. Near-term market conditions remain favourable and DBRS expects the Company to remain a steady performer with rising revenue and earnings.

There are a couple of developments that may impact the Company’s risk profile. The Company’s debt leverage has been rising because of high capital investment to support growth. The Company is making good progress in winning on-site contracts, especially in the mining and heavy oil sectors. These multi-year on-site projects provide a steady revenue stream and are highly profitable with low renewal risk; however, these projects require large upfront investment with returns spread over the life of the contracts. The Company is also making good progress in expanding into the United States and has to invest in satellite and on-site facilities to support growth. Capital expenditures have been at an elevated level for the last few years and are expected to remain high in the next few years. The Company’s recent actions of partially funding capital investment with debt have increased the Company’s financial risk. Newalta’s balance sheet leverage is still acceptable to the current rating, but is at the low end of the range. Despite recent success, the on-site revenue only accounts for 16% of consolidated revenue. Any unexpected deterioration in the other businesses could lead to a sharp decline in the Company’s earnings and a meaningful deficit in free cash. The higher debt level will exaggerate the impact of the declining operating results on the Company’s financial profile. Nevertheless, the Company has demonstrated its willingness to issue equity to deleverage the balance sheet in the past and DBRS expects the Company to remain judicious in managing its balance sheet leverage.

Secondly, the Company’s business model is in flux. Newalta has engaged an outside party to conduct a strategic review of Industrial aimed at optimizing the value from this division. The range of options include a potential sale, initial public offering or spinoff of the division in whole or in parts. Growing capital needs to fund expansion in the more profitable New Markets and Oilfield businesses have reduced the Company’s capacity to meet capital investment required to support growth at Industrial properly. The outcome and subsequent actions following the strategic review could have a material impact on Newalta’s business risk profile. Newalta has implemented the Rationalization Plan to boost operating results and benefits from the cost-saving initiatives have led to lower support costs and an increase in gross profit in H1 2014.

DBRS notes that the above confirmation has not incorporated the impact of the strategic review on Industrial because of the uncertainties regarding the potential actions. DBRS will treat the action on Industrial as an event and assess the impact of that action on the Company’s rating accordingly.

Pursuant to DBRS’s 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 a default. DBRS has determined Newalta’s estimated value at default at approximately $400 million using an EBITDA multiple valuation approach and a 4.0 times 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.

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 Services Industry and DBRS Criteria: DBRS Recovery Ratings for Non-Investment Grade Corporate Issues, which can be found on our website under Methodologies.

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