DBRS Downgrades Sherritt International Ratings, Trend Changed To Stable From Negative

DBRS Limited (DBRS) has today downgraded the Issuer Rating and Senior Unsecured Debt ratings of Sherritt International Corporation (Sherritt or the Company) to B from BB (low), and has changed the trends to Stable from Negative. Low nickel and oil prices and the disposition of Sherritt’s Coal unit in 2014 have contributed to a significant decrease in operating cash flow since 2010 at a time when the Ambatovy mine remains in need of cash injection to fully meet design targets if the Company wishes to maintain its 40% interest in the project, resulting in a strain on Sherritt’s liquidity. The recovery rating for Sherritt’s Senior Unsecured Debt under a hypothetical default scenario remains at RR4.

Sherritt’s business profile weakened in 2014 with the sale of its Coal unit. Although the Ambatovy mine project has the potential to restore or exceed some of that lost earnings power, the mine has not yet been able to achieve near-design capacity output on a consistent basis. In a period of low nickel prices and with Ambatovy’s ongoing need to make senior project debt repayments, the mine continues to absorb Sherritt cash resources to support Ambatovy’s operating, capital expenditure and financing needs. Even when Ambatovy design parameters are achieved on a sustained basis, the mine’s cash flow will be more volatile than the Coal unit’s and it operates in a jurisdiction with significant political risk. The strength of Sherritt’s Oil and Gas unit has also diminished despite the extension of certain production-sharing contracts (PSCs) and the addition of new development areas. Production accruing to Sherritt from these will only be from new discoveries once original PSCs end in 2017 and 2018, making it hard to replicate existing output without significant drilling successes.

The sharp decline in nickel, cobalt and oil prices since 2010–2012, combined with the sale of Sherritt’s Coal unit in April 2014, have driven the Company’s EBITDA to only $110 million (annualized) in the first half of 2015 (H1 2015) from $632 million in 2011. The achievement of commercial production of the Ambatovy mine in January 2014 has added about $200 million per year in equity losses (partly offset by just under $10 million equity income from the Moa joint venture), driving net income before non-recurring items negative.

Sherritt’s financial profile underwent a significant change in 2014 with the sale of its Coal unit, the reduction and extension of its long-term debt obligations and the drive to achieve Ambatovy financial completion all in the face of sharply lower commodity prices. Although the Company has modest debt maturities before 2018, Ambatovy remains a net cash user; net free cash flow is in deficit and liquidity is currently adequate, but constrained and depleting.

Sherritt’s traditional financial metrics have been very weak for its ratings in part because the bulk of operating earnings (and now losses) from its Metals unit are booked as equity earnings, not impacting EBITDA and other financial measures. With the recent sharp drop in oil prices, operating earnings from the Oil and Gas unit have been sharply eroded as well. Although Sherritt was able to significantly reduce its non-Ambatovy-related debt in 2014 with proceeds from the sale of the Coal unit and was able to extend its Senior Unsecured Debt note maturities to later in the year, net free cash flow was $73 million in deficit in H1 2015, resulting in a reduction of cash balances, the Company’s main source of short-term liquidity, by $78 million. With low net cash generation from its Oil and Gas, Power and Moa joint venture expected, modest existing short-term credit capacity and the need to fund Ambatovy, Sherritt’s cash balances are expected to diminish unless circumstances change.

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 Debt, 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.

DBRS expects Sherritt’s losses before non-recurring items will continue in H2 2015 and throughout 2016 as the Company faces the challenges of low nickel, cobalt and oil prices. The Company will also face challenges replacing lost oil production from expiring leases 2017 and 2018. Over the longer term, commodity prices are expected to improve, and, if Ambatovy operates close to design expectations, Sherritt will become a solid player in the nickel and cobalt world. Lower earnings in H2 2015 and into 2016 are expected to reduce near-term operating cash flow. Combined with an ongoing need to fund Ambatovy deficits (including senior debt principal payments) and Ambatovy’s debt reserve account (about $60 million in Q3 2015), plus with elevated Oil and Gas drilling, Sherritt’s credit metrics are expected to be challenged and its current cash/available credit resources reduced.

Bringing Ambatovy to cash self-sufficiency is expected to stabilize cash use and/or external funding needs, but stronger nickel, cobalt and oil prices will be required to begin the restoration of credit strength. Sherritt’s liquidity is constrained and mainly provided by $398 million of cash and investments on hand at June 30, 2015, as well as by about $69 million in unutilized credit capacity subject to annual renewal.

Oil, nickel and cobalt prices are not expected by DBRS to materially fall further over the next 18 months, nor are they expected to rebound sharply either. A fully ramped-up Ambatovy mine with improved product pricing can be expected to be a solid net cash generator (most of which will initially be dedicated to debt repayment) for many years to come. In the interim, Sherritt will have mange its cash resources carefully in order to maintain its existing 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 (October 2015), Rating Companies in the Oil and Gas Industry (September 2015) and DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers (February 2015), which can be found on our website under Methodologies.

For more information on this credit or on this industry, visit www.dbrs.com or contact us at info@dbrs.com.