DBRS Downgrades Finning International Inc. to BBB (high), Changes Trend to Stable

DBRS Limited (DBRS) has today downgraded the Issuer Rating and the Senior Debentures and Medium-Term Notes rating of Finning International Inc. (Finning or the Company) to BBB (high) from A (low). As a result, DBRS has downgraded the Company’s Commercial Paper rating to R-2 (high) from R-1 (low). DBRS has also changes the Trends on all ratings to Stable from Negative. On November 16, 2015, DBRS changed the trend on Finning’s ratings to Negative from Stable, citing the Company’s weakening financial profile and the difficult operating environment caused by cyclical downturns in the key mining and energy sectors. In Q4 2015, results continued to fall below expectations and financial metrics continued to weaken. More importantly, as a result of further weakness in commodity market prospects, the outlook has deteriorated below DBRS’s projections as per the November 2015 review. At this stage, DBRS does not anticipate that operating earnings and cash flows will recover to 2014 levels for the next two years at least.

In 2015, adjusted cash flow-to-debt and debt-to-EBITDA weakened to 22.4% and 2.83 times (x) from 38.5% and 2.07x, respectively, in 2014. While a small portion of the decline is attributable to a modest increase in total adjusted debt, the majority of the impact stemmed from severe declines in operating earnings and cash flows. Adjusted EBITDA declined on a year-over-year basis by 18% to $600 million while adjusted cash flow from operations (before accounting for changes in working capital) registered a 37% decline to $377 million. Please note that both EBITDA and cash flow from operations have been adjusted for non-recurring restructuring costs, such as severance.

Results in earnings and cash flows have declined because of the very difficult operating environment that has resulted from cyclical downturns in Finning’s key mining and oil and gas operating sectors. The Company continues to aggressively reduce costs throughout the business segments, with measures such as workforce decreases and facility footprint reductions. These efforts have delivered substantial results. For example, the South American segment delivered a normalized EBIT margin of 9.3% in 2015, an impressive result under the circumstances; however, the additional step-down in commodity prices and activity required additional workforce reductions. Overall, Finning is managing as well as can be expected under very challenging operating conditions.

As DBRS pointed out in November 2015, Finning continues to have a very strong business risk profile. While the severe and prolonged cyclical downturn is materially weakening operating earnings and cash flows, most of the Company’s long-term structural strengths remain intact. Finning is the world’s largest distributor of Caterpillar Inc. (CAT; rated “A,” Stable, by DBRS) equipment. CAT’s distribution network, consisting almost entirely of independent operators, is an extremely important component of its business model; therefore, CAT has stated and demonstrated that supporting its dealers is a strategic priority. Finning’s geographic diversification, its superior proportion of revenues (over 50%) generated from the higher-margin and more resilient Product Support business as well as the counter-cyclical nature of working capital needs, which provides cash during slowdowns, remain important strengths.

However, the weakening that has occurred in the Company’s financial risk profile is substantial and has proven that the operating earnings and cash flow protection from volatility afforded to Finning from the diversity of its sector exposure is not as effective as previously assessed. The adjusted cash flow-to-debt and debt-to-EBITDA metrics noted above are far weaker than what DBRS’s “A”-rating range would normally require. While adjusted EBITDA-to-interest coverage at 7.05x remains just above the threshold between the “A” and BBB ranges, DBRS expects this metric to fall into the BBB range in the near term (please refer to the “Rating Companies in the Capital Goods Dealership Industry” methodology, available on the DBRS website). While the methodology anticipates and accommodates cyclical deviations from the rating ranges, DBRS does not expect these key metrics to recover to the “A” range until 2018 at the earliest, based on expectations of another very challenging operational year in 2016, followed by only very modest recovery in 2017 and 2018. Any further extension of the projected downturn or increase in the severity of the weakened outlook could easily push this timeline back even further.

Liquidity remains strong. Finning has $1.9 billion in unsecured credit facilities, including $1.0 billion of committed bank facilities. As at December 31, 2015, $877 million was available under the committed facilities and there was $475 million in cash on the balance sheet. The Company has a solid track record of generating free cash flow and DBRS anticipates that this will continue going forward; therefore, DBRS views Finning’s full commitment to its dividend going forward as manageable. The Company has not declared what it may do with projected excess cash (after dividends) in 2016. Finning’s decision to finance its operations with longer-term debt has left it with no opportunity to reduce its structural debt load until 2018, assuming that it does not prepay long-term debt, which would incur early redemption penalties. In June 2018, the Company’s $350 million 6.02% Medium-Term Notes mature. Should Finning choose to reduce debt by this amount, the financial profile as measured by DBRS’s key metrics would improve noticeably. If this action coincided with the market outlook described above, the financial profile could achieve a full recovery.

The Stable trend reflects that, despite the current stress on the financial profile and the uninspiring outlook, Finning’s strong business profile makes it unlikely that the Company’s performance would deteriorate to the point at which an additional downgrade would be considered. This view incorporates not only the structural strengths discussed above, but also the aggressive cost-reduction efforts which Finning has undertaken. That said, another unfavourable step-change in commodity prices and activity could change the trajectory of the expected financial metrics going forward, especially if delays of Product Support maintenance work by customers persist. Under such a scenario, if DBRS believes that key metrics such as adjusted cash flow-to-debt and adjusted debt-to-EBITDA appear to be on course to breach thresholds into the BB-rating category ranges (20% and 3.5x, respectively), a Negative trend would likely result. Alternatively, if the market outlook improves and the Company reduces or commits to reducing its structural debt load, a Positive trend may be considered; however, this is not anticipated in the near term.

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 Capital Goods Dealership Industry (June 2015) and the DBRS Criteria: Commercial Paper Liquidity Support for Non-Bank Issuers (April 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.