DBRS Assigns Ratings to Federated Co-operatives Limited

DBRS Limited (DBRS) has today assigned an Issuer Rating of BBB (high) to Federated Co-operatives Limited (FCL or the Company) and a provisional rating of BBB (high) to FCL’s proposed issuance of approximately $300 million of Senior Unsecured Notes (the Notes). The trends are Stable. The ratings are based on the strong brand and market position of the Co-operative Retailing System (CRS) which comprises FCL and its 212 retail co-operative (co-op) member-owners as well as the nature of the co-op structure, the high barriers to entry for its refinery business and its low financial leverage. The ratings also reflect key challenges that constrain FCL’s ratings from improving beyond the current rating category, including single-asset risk related to the refinery; the intense competitive environment in which the CRS operates in fuel, food, home improvement retail and crop inputs; disadvantages of the co-op structure; and FCL’s geographic concentration in the Prairies.

FCL’s earnings profile has remained relatively stable in recent years, incorporating the inherent variance in refiners’ margins and capacity utilization (particularly after the expansion to refinery capacity in 2012) as well as the stable nature of its Food, Home and Building Supplies and Crop Supplies segments. Revenues increased in each of the past five years, rising to $10.8 billion in F2014 from $7.1 billion in F2010. The increase in revenue has been driven primarily by high fuel prices and growth in fuel volumes from nearly 4.4 billion litres in 2010 to 5.7 billion litres in 2014. Revenues have also started to benefit recently from CRS-driven acquisitions of 14 food retail stores from Sobeys Inc. in 2014 and 17 crop-input retail locations from Viterra Inc. in November 2013. Earnings before interest, taxes, depreciation and amortization (EBITDA) margins have declined in each of the past four years to approximately 8.8% in F2014 from a higher-than-normal historical level of 13.5% in F2011. Changes in EBITDA margins have been primarily attributable to the Company’s refinery operations, including changes to refinery utilization levels, refiners’ margins and rising selling, general and administrative costs. EBITDA margins in FCL’s Food, Home and Building Supplies as well as its Crop Supplies wholesale segments have remained very stable as FCL has successfully passed on rising costs to the retail co-ops in the form of price increases while remaining competitive. As such, FCL’s EBITDA has remained relatively stable in the past four years, declining modestly in 2014 to approximately $957 million, primarily because of the lower-than-expected utilization levels at the refinery, versus approximately $1.1 billion per year from 2011 through 2013.

FCL’s financial profile is considered strong for the current rating category based on the Company’s low financial leverage and solid cash-flow generating capacity. Cash flow from operations has continued to track operating income in recent years, while capex levels declined toward normal levels ($375 million in F2014) after completion of the Company’s refinery expansion project in F2012. Maintenance capex is generally in the $300 million range. FCL makes significant distributions consisting of an equity and cash component, the level of which is generally based on operating performance. The patronage allocation (equity component of distribution) has typically ranged between 60% and 70% of net income in any given year. Cash distributions associated with the patronage allocation (share redemptions) is typically approximately 80% of the total patronage allocation. Free cash flow (before changes in working capital) has improved in recent years to approximately $187 million in F2014, primarily as a result of the decline in capex spending. Despite notable free cash flow deficits while FCL was investing in expanding its refinery capacity, FCL has maintained a highly conservative balance sheet. At YE2014, FCL had approximately $517 million of total balance-sheet debt, comprising $50 million drawn on its revolving credit facility and $467 million of member funds. As a result of the longer-term nature of the member funds, DBRS includes such in calculations of long-term debt, despite the fact that they are payable on demand. FCL does use its revolving credit facility to fund working capital seasonally as required, which can result in draws nearing the $500 million limit on the revolver. As a result, credit metrics have remained relatively stable at a level considered strong for the current rating (i.e., lease-adjusted long-term debt-to-EBITDAR of 0.58x and lease-adjusted cash flow from operations-to-long-term debt of 203% in F2014 versus 0.56x and 195%, respectively, in F2013 and 0.52x and 197%, respectively, in F2012).

DBRS believes that FCL’s earnings profile will remain relatively stable over the medium term, reflecting the largely staple nature of FCL’s product offerings, the integrated nature of the CRS network and the inherent variance in refiners’ margins and capacity utilization. Revenues are expected to decline in F2015 toward the $9.5 billion level, largely because of a decline in fuel prices, while FCL’s refiners’ margins should decline only modestly on a cents-per-litre basis. Over the longer term, DBRS expects that revenues will continue to be affected by fuel prices and FCL’s refiners’ margins, which will be partially offset by organically increasing volumes and modest growth in other wholesale segments. DBRS expects EBITDA margins to improve moderately in the near term to over 10% as utilization levels at Co-op Refinery Complex are expected to recover after unplanned downtime in F2014 as a result of the December 2013 incident. As such, DBRS forecasts that EBITDA will remain in the $1 billion range over the medium term.

FCL is expected to issue approximately $300 million of Senior Unsecured Notes. Proceeds from the Notes are expected to be used to repay amounts drawn on the revolving credit facility and for general corporate purposes. As such, FCL’s long-term balance-sheet debt will increase by approximately $300 million versus YE2014. Pro forma the proposed Notes issuance, FCL’s credit metrics will remain more than adequate for the current rating (i.e., lease-adjusted long-term debt-to-EBITDAR of approximately 0.85x, lease-adjusted cash flow from operations-to-long-term debt of approximately 128% and lease-adjusted EBITDA coverage of approximately 37.5x). Cash flow from operations is expected to continue to track operating income in the near to medium term while capex is expected to be in the $450 million to $550 million per year range, reflecting planned maintenance capex as well as investments in organic growth. FCL’s patronage allocation policy is expected to remain consistent with recent practice, thus free cash flow should be in the $100 million to $200 million per year range over the medium term. DBRS expects that FCL will use any free cash flow along with possible incremental debt to invest in growth (organic or through acquisition) and/or any large refinery repair projects as well as possibly increasing cash returns to its member-owners. That said, DBRS expects FCL’s credit metrics to remain within the range considered acceptable for the current rating (i.e., lease adjusted long-term debt-to-EBITDAR below 1.25x). Should FCL use its revolving credit facility for a reason other than funding its working capital inventories, DBRS will consider such to be long-term debt for the purpose of the above calculation. Further, should FCL’s credit metrics weaken beyond the range considered acceptable for the current rating as a result of more aggressive-than-expected financial management and/or weaker-than-expected operating performance (beyond the normal variance in refiners’ margins and capacity utilization), the ratings could be pressured.

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 DBRS Criteria: Guarantees and Other Forms of Explicit Support (February 2015), Rating Companies in the Merchandising Industry (January 2015) and Rating Companies in the Oil and Gas Industry (October 2014), 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.