DBRS Confirms Noranda Operating Trust at BB (high), Stable Trend

DBRS Limited (DBRS) has today confirmed the Senior Secured Notes rating of Noranda Operating Trust (the Trust) at BB (high) with a Stable trend. The Trust is a well-established processor of zinc concentrates and refiner of zinc metal and is strategically located to serve North American zinc markets. However, the Trust is currently dependent upon a zinc concentrate Supply and Processing Agreement (SPA) with Glencore Canada Corporation (Glencore) that ends its initial term in May 2017.

Currently, the Trust’s credit metrics remain strong for its rating, and they are expected to remain so with steady, near-capacity operation of the CEZinc facility through the remainder of 2016. The Notes mature on December 28, 2016, and have been amortizing at $7.5 million semi-annually, with $22.5 million outstanding as of March 31, 2016. The Trust was scheduled to make a $7.5 million payment on June 28, 2016, leaving $15.0 million due on December 28, 2016. DBRS expects that these payments should be funded from cash flow as the Trust continues to manage its liquidity, with a reduction in its monthly distribution announced in May 2016. Zinc prices have also been strengthening, which should modestly increase the value of the zinc metal that accrues to the Trust’s account for recoveries above 96%. As a backstop, the Trust had $107.7 million in available liquidity as at March 31, 2016, under its asset-based revolving credit facility (the ABL facility) that could be drawn down to repay the remaining Notes.

Under the SPA, Glencore is obligated to supply the Trust with up to 550,000 tonnes of zinc concentrates annually to produce up to approximately 270,000 tonnes of zinc metal per year. In return, Glencore pays the Trust an escalating processing fee per payable pound of zinc metal produced. The Trust has to pay for 96% of the contained zinc in the concentrate, but is otherwise protected from any subsequent movements in the zinc price through a derivatives hedging program that largely covers the period from when the concentrate is priced, approximately two months after delivery, to when the resulting zinc metal is sold. The Trust is, however, exposed to swings in working capital requirements that are linked to zinc prices and relies on the ABL facility to manage this risk. Zinc production levels were relatively steady from 2011 to 2014, but increased by 4% in 2015 compared to the previous year following the completion of the cell-house re-line project in 2014. As a result, the net income before non-recurring items in 2015 improved to $48.9 million, compared to $35.4 million in 2014.

The Trust continued to generate positive gross free cash flow of $47.0 million in 2015, which was used to partially fund a $60.5 million increase in non-cash working capital that also required a net $13.1 million increase in debt. In Q1 2016, this trend was reversed as the Trust monetized approximately 5,000 tonnes of zinc metal inventory, resulting in a $65.0 million decrease in non-cash working capital that was used to repay debt. As a result, the Trust’s gross debt of $28.3 million at the end of Q1 2016 was much less than the available liquidity of the ABL facility of $107.7 million, compared to $61.3 million at the end of 2015. In addition, the Trust faces a material increase in its legislated remediation security obligations to $23.5 million by January 2017, requiring an additional $5.9 million in security (letters of credit) at that time, which would reduce the available liquidity of the ABL facility.

Since April 2014, an Independent Committee established by the Trust has been in discussions with Glencore regarding the expiry of the SPA. While these discussions have yet to result in an agreement to extend the SPA, Glencore has committed to supplying zinc concentrates to the CEZinc operations for all of calendar 2017. As a result, from May 3, 2017, onward, the Trust will secure its concentrate requirements under market terms, as opposed to the current processing fee. At the same time, the payable component of the zinc concentrate will decline to approximately 85% from the 96% level under the SPA. As a result, the Trust will benefit from the 11% differential in produced metal as a partial offset to the loss of $0.41 per lb. zinc processing fee. DBRS estimates that it would require materially higher zinc prices above USD 1.00 per lb. to completely offset the loss of the processing fee after next May and allow the Trust to fulfill its capital requirements, as well as reset distributions at $0.04167 per month per Priority Unit.

The Trust has invested, and continues to invest, significant capital in maintaining and enhancing the CEZinc operations; however, the economic viability of CEZinc under market terms for its zinc concentrate inputs remains uncertain. The available supply of zinc concentrates from Canadian sources has been reduced over the last few years with the closure of the Brunswick and Perseverance mines, and CEZinc has become more dependent on offshore concentrates. These different concentrates increase the technical processing challenges, such as higher silica or iron, and could lead to reduced production and increased capital spending to resolve processing bottlenecks. If concentrates are unavailable, or processing terms uneconomic post-May 2017, CEZinc may be forced to close and incur significant remediation costs.

DBRS expects the Trust’s 2016 earnings before non-recurring items to be lower than in 2015, mainly due to lower zinc premiums, sulphuric acid netbacks and copper price realizations, partially offset by a weaker outlook for the Canadian dollar. DBRS also expects zinc production to decline by a modest 1.0% compared to 2015, but expects zinc sales to increase by 4.7% as inventories were worked down in Q1 2016, with an approximate 5,000-tonne reduction in zinc metal inventories. DBRS also expects the Trust’s operating cash flow to decrease in 2016 compared to 2015, but that its credit metrics will continue to improve as term debt and interest costs are reduced and capital expenditures are modestly lower than in 2015. That being said, DBRS expects that the Trust should generate significantly lower profitability post-May 2017, subject to the outcome of negotiations with Glencore to renew the SPA. Beyond 2016, DBRS expects the Trust’s only debt to be for working capital purposes. However, operating cash flow is expected to be materially lower based on market terms for concentrates and Bloomberg consensus analyst’s estimates (as of July 5, 2016) for zinc prices that are currently below USD 1.00 per lb. zinc until 2020.

The Trust has continued to restrict distributions to its unitholders in order to provide funds to maintain the operational capability of CEZinc and to build resources to accommodate any transition/remediation/closure costs that may be incurred post-May 2017. DBRS views this as a prudent action, given that the viability of the CEZinc facility post-May 2017 remains in doubt.

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.

The applicable methodologies are Rating Companies in the Mining Industry (October 2015) and Rating Companies in the Industrial Products Industry (April 2016), which can be found on our website under Methodologies.