DBRS Confirms Newalta Corporation and Changes Trend to Stable

DBRS Limited (DBRS) has today confirmed the Issuer Rating of Newalta Corporation (Newalta or the Company) at CCC (high). The Company’s Recovery Rating remains unchanged at RR6 (poor) based on an anticipated unsecured debt recovery of less than 10% in a hypothetical default scenario. This results in a two-notch adjustment to arrive at an Unsecured Notes rating of CCC (low). However, DBRS is changing the trend on both ratings to Stable as a result of recent operating results being consistent with expectations.

When DBRS downgraded Newalta’s ratings on November 11, 2016, the rationale for the action included worse-than-expected operating performance and key credit metrics that were weak. The disappointing operating performance resulted from, in part, non-recurring events such as the fires in Fort McMurray in Q2 2016 and road restrictions caused by heavy rainfall in Q3 2016. DBRS noted Newalta’s substantial cost-cutting efforts, minimized capital spending and suspended dividends, and that despite continued weak operating conditions, if the Company could deliver operating results that were consistent with Q3 2016 EBITDA (excluding the impact of the road restrictions) into subsequent quarters, DBRS would consider changing the trend to Stable.

In Q4 2016 and Q1 2017, Newalta delivered EBITDA of $11.3 million and $8.6 million, respectively, using DBRS’s calculation. These were ahead of the normalized Q3 2016 result and represented substantial year-over-year (YOY) improvements. The better YOY performances were driven by a mix of cost rationalization benefits and, importantly, increased drilling activity in Q1 2017. This performance was consistent with DBRS’s expectations. Furthermore, DBRS views this level of EBITDA generation as roughly the expected run-rate for the coming quarters, even accounting for seasonal fluctuations such as the regular Q2 spring breakup impact on the Oilfield Services division. Such a view implies that key coverage metrics (adjusted for operating leases) may return to the B range by year-end 2017, implying a strong recovery of key coverage metrics from the particularly weak base in 2016. In the last 12 months (LTM) to Q1 2017, adjusted debt-to-EBITDA improved to 10.0 times, and DBRS expects this material improvement to continue. For example, the LTM Q2 2017 period will exclude the Q2 2016 results, when EBITDA dropped to $1.3 million primarily because of the impact of the Fort McMurray fires.

Note that while DBRS is projecting further rapid improvement in coverage metrics in the coming quarters, followed by generally steady, albeit modest improvement going forward, DBRS anticipates that adjusted total debt-to-capital, already at a record high of 61% in Q1 2017, is likely to increase as a result of (1) debt additions to cover free cash flow deficits and (2) a declining equity base from projected net losses, exacerbated by a change in taxation accounting introduced in 2016. As a result of the large magnitude of the Company’s recent net losses and tax loss carryforwards, which created deferred tax assets on a scale well above deferred tax liabilities and not likely to be required to offset potential positive net income that may occur beyond the near term, Newalta is no longer recognizing net deferred income tax assets. The non-cash implication of this change is that net losses are not mitigated by tax recoveries, meaning that the full impact of net losses is felt on the equity base. As a result, while DBRS continues to monitor adjusted debt-to-capital as a key credit metric, DBRS is placing even less weight in this measure.

Newalta’s $150 million total secured credit facility is due to mature on July 12, 2019, and is generally extended on an annual basis. As of March 31, 2017, Newalta was in compliance with all active debt covenants. During Q1 2017, the terms of the facility were amended and extended. The total debt-to-EBITDA covenant waiver was extended to Q2 2019, certain modest adjustments to the senior debt-to-EBITDA and interest coverage covenants were agreed upon with the lenders, and dividends may not be declared until at least June 30, 2019. As at March 31, 2017, $75.3 million was available and undrawn on the facility, and the Company held no cash on the balance sheet. Assuming capital spending remains constrained in 2017 as it was in 2016, and considering the restrictions on dividends noted above, DBRS anticipates a modest free cash flow deficit in 2017. Overall, DBRS believes Newalta’s current available liquidity is sufficient for near-term needs. Newalta’s next long-term debt maturity is in November 2019 when its $125 million Series 2 Senior Unsecured Debentures are due. In November 2017, these bonds will enter a par call period, and the Company is “proactively assessing market conditions and options for optimum refinancing.”

The Stable trend and the implied financial profile recovery discussed above reflect DBRS’s view that, in lieu of further non-recurring shocks, operating performance in the near term would support at least the current rating. Unfavourable deviation from this expectation could result in a downgrade.

After the precipitous drop in the benchmark West Texas Intermediate (WTI) and Western Canadian Select oil prices in 2014 and 2015, prices improved modestly through 2016, and consensus expectations are for continued firming. Oil prices are the main driver of short-term and long-term activity among Newalta’s customers, with the most acute impact felt on exploration drilling and completions, and a more lagged impact on production. Therefore, given the early stage of recovery, in order to offer an opinion on what may result in an upgrade, a more in-depth look at the Company’s operating segments, and the expected sequencing of recovery through those segments is required.

Newalta operates two business lines: Oilfield and Heavy Oil.

The Oilfield division has averaged 57% of revenues since 2014, and the top line contribution from this division in the LTM Q1 2017 period was just above the historical average. With its expertise in centrifugation and chemical treatment, Newalta processes and recovers oil and water, and reduces solid wastes from customers’ drill site locations. The Oilfield – Facilities division in Western Canada and the Bakken field in North Dakota sources waste streams for processing from (1) customers’ production wells, which tend to be more stable; and (2) customers’ drilling and completion activities, which are more closely linked to changes in WTI oil pricing. The Oilfield – Drilling Services division has equipment that can be deployed as installable packages relatively quickly from various hubs strategically located in Western Canada and in the United States (e.g., Bakken, Eagleford, Marcellus).

A leading indicator of the business environment and Newalta’s performance is the extent to which the Oilfield – Drilling Services equipment is being utilized. The greater the proportion of the approximately 200 pieces of equipment standing idle in one of Newalta’s hubs, the lower the revenues, ceteris paribus. Between 2010 and 2014, drill site utilization in the United States and Canada ranged between 52% and 57%. However, in 2015, drill site equipment utilization dropped to 27% as drilling activity reacted to the weaker oil price environment, and then dropped again in 2016 to a very weak 16%, including only 8% in Canada. In Q1 2017, drill site equipment utilization rose to 37% overall, a major improvement compared with Q1 2016’s 14%, and every other quarter in 2016.

This is possibly an important result, because it may be the initial evidence of sustained drilling activity recovery. In terms of sequencing in a recovery scenario, drilling activity is expected to be the first part of the business to begin to gain traction. Subsequently, the Oilfield – Facilities business would be next, followed by the Heavy Oil business. Although some Heavy Oil project work improvement was observed in Q1 2017, the Company has stated that it would not expect a material improvement – a step change – in Heavy Oil until there is sustained WTI spot oil pricing of $60/barrel. Contracted revenues continue to deliver predictable cash flow through volume- and price-based agreements, with most of these sales generated through the Heavy Oil segment. Contracted sales accounted for 20% of total company revenues in the LTM Q1 2017 period, down from 22% in 2016 and 29% in 2015. Contracted revenues are affected by customers’ investment spending in steam-assisted gravity drainage and oil sands mining operations.

DBRS would consider a positive rating action if clear evidence shows that the recent progress has indeed been the harbinger of a recovery with traction. To this end, DBRS will be monitoring customers’ rig counts in the areas Newalta operates, especially those such as deeper depth horizontal drilling, which require invert (i.e., oil fluid-based techniques) as opposed to water-based drilling techniques that generate waste that can be more easily managed by the customers themselves. More importantly, DBRS will be monitoring to ensure that these potential increased invert rig counts translate into higher equipment utilization, sales and EBITDA for Newalta.

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 principal 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 dbrs.com under Methodologies.

The rated entity or its related entities did participate in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.