DBRS Limited (DBRS Morningstar) assigned a new Issuer Rating to Russel Metals Inc. (Russel or the Company) of BBB (low) with a Stable trend. Russel is one of the largest metals distribution companies in North America and also produces some value-added metal-based goods. The Metals Service Centre segment (66% of revenue; 78% of operating profit through the last 12 months (LTM) to September 2021) distributes metal products in a range of sizes, shapes, and specifications and also engages in higher margin value-added processing activities. The Energy Products segment (21% of revenue; 4% of operating profit through the LTM to September 2021) distributes metal products to energy sector participants in Western Canada and the United States and complements this logistical activity with certain maintenance and repair services. The Company recently contributed its more volatile and lower margin Canadian Oil Country Tubular Goods (OCTG) business into a joint venture and is now a preferred shareholder. Furthermore, Russel is near the completion of the liquidation of its U.S. OCTG business. The Steel Distribution segment (12% of revenue; 17% of operating profit in the LTM to September 2021) is a wholesale distributor of larger volume orders of steel and metals. This segment is a relatively lower-margin business but is a steady earnings contributor that offers ancillary benefits to the Company over the long term.
In light of the current atypically and unsustainably strong operating environment, it is important to note that the assignment of this long-term Issuer Rating is based on: (1) DBRS Morningstar’s view of Russel’s structural business risk strengths and challenges through the cycle and (2) DBRS Morningstar’s view of the Company’s projected financial risk profile in 2023 and 2024, which is expected to represent a more normalized operating environment.
The rating reflects the following core structural strengths: (1) Russel’s position as the largest steel and metals distributor in Canada, and its position as one of the leaders in its relevant U.S. markets in the U.S. South and Midwest regions. The Company’s market position and scale offer tangible benefits such as volume discounts on product purchases and preferential access to supplies of domestic and international steel and metals – an important business constraint for some competitors when inventories are tight and supply constraints occur. (2) Russel’s investment grade brand strength and reputation for customer service excellence. These structural business strengths form the foundation of the Company’s core service operations. DBRS Morningstar notes that Russel does not rely to any material degree on third-party contractors, performing most activity with in-house personnel and has an estimated repeat customer rate of at least 90%. (3) The Company is well diversified in several respects. Customer concentration is minimal. Russel’s Metal Service Centres service tens of thousands of customers annually with average per transaction invoices of approximately $2,000. The Company also benefits from a reasonably well diversified supplier base, both domestically and internationally, and supplies several types of product categories that are in demand in different, often unrelated sectors. (4) The Company’s operating efficiency is deemed robust, overall. Underlying product costs are passed along to customers and the Company’s focus going forward is to increase the proportion of relatively higher margin activity, including value-added processing. Returns on invested capital are supported by the “asset medium” nature of the business, with only $265 million of property, plant, and equipment (September 30, 2021) supporting $3.7 billion of revenue (LTM to September 30, 2021). Importantly, given the price and demand volatility characterizing the markets of the commodities Russel is distributing, the Company’s variable cost structure and countercyclical working capital business model were important considerations when DBRS Morningstar assigned the rating. With two thirds of the workforce engaged on an hourly basis and a history of cash sourced from working capital adjustments during market downturns, the Company benefits from two material mitigants to the underlying commodity market fluctuations, and it would not be appropriate to view Russel through the same lens as the producers of the underlying commodities. Finally, the Company’s operating efficiency is enhanced by a demonstrated commitment over many years to a strong liquidity position, including extended periods of time with no drawings on its credit facility ($450 million; currently undrawn) and material cash balances.
The assigned rating also incorporates the impact of certain structural challenges facing Russel. Notwithstanding the strong mitigants noted above, underlying commodity markets are inherently volatile and Russel is not fully protected from these gyrations. Decreasing volumes demanded directly affect revenue, but so do declining prices, as distribution services are linked to underlying commodity price benchmarks. Adjusting working capital can, and has, provided free cash flow relief when EBITDA and operating cash flows decline, but ultimately these actions can’t be sustained indefinitely. A particularly harsh and sustained decline in demand would ultimately directly affect both operating and free cash flows, but the essential nature of the steel and metals being distributed acts to reduce this risk. The underlying commodities are sometimes the target of trade actions. This represents an unpredictable source of volatility that can help or hurt Russel’s business. From DBRS Morningstar’s perspective, this dynamic is a credit negative, as it represents a source of unpredictability of operating results going forward. The assigned rating also incorporates the fact that the Company’s transactional business model does not operate under any long-term customer contracts. While this allows for significant operational flexibility, service providers across DBRS Morningstar’s ratings universe (which includes dozens of sectors) that can demonstrate that customers are locked in for longer periods of time under more restrictions (e.g. early termination penalties; pricing escalators, etc.) are generally viewed more favourably with respect to this factor. This perspective is certainly mitigated by the Company’s demonstrated ability to achieve repeat business, and DBRS Morningstar incorporated this, too, into the final rating determination.
DBRS Morningstar believes that Russel’s structural business risk profile can be described as being at the lower end of the investment grade spectrum. DBRS Morningstar does not anticipate any material changes in the business risk profile over the next 12 months.
DBRS Morningstar notes again that the Financial Risk Assessment (FRA) was based on projected metrics for 2023 and 2024, a timeframe that is expected to reflect a more normalized operating environment. Beyond 2024, DBRS Morningstar does not have a specific view regarding a potential FRA trend for the following 12 months but would anticipate that the historical fluctuations will persist over the long term. DBRS Morningstar also believes that the variable cost business model and the adjustability of working capital will continue to act as strong mitigants.
Overall, DBRS Morningstar believes that the Company’s low investment grade Business Risk Assessment, coupled with the strong FRA on a normalized basis, offers a healthy cushion to the current rating, and this includes an adjustment for exposure to the volatility of the underlying commodity markets. It would be challenging for the Company to achieve an upgrade while continuing to operate in a sector with such significant underlying volatility, despite the mitigants noted above. DBRS Morningstar may consider taking a negative rating action if the Company were to position itself financially in a more aggressive posture than expected over time. A major debt-financed acquisition far larger in scope
than DBRS Morningstar’s expectations of manageable acquisitions could lead to a negative rating action if a clear, credible, and short-term deleveraging plan were not in place.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.
All figures are in Canadian dollars unless otherwise noted.
The principal methodology is Rating Companies in the Services Industry (January 29, 2021; https://www.dbrsmorningstar.com/research/372947). The secondary methodology is Rating Companies in the Industrial Products Industry (January 29, 2021; https://www.dbrsmorningstar.com/research/372944). Based on an estimated, normalized, contribution to the Company’s annual EBITDA, the Services methodology accounts for a 75% weighting in the overall rating determination, while the Industrial Products methodology accounts for a 25% weighting. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021; https://www.dbrsmorningstar.com/research/373262), and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (May 31, 2021; https://www.dbrsmorningstar.com/research/379424). These documents can be found on dbrsmorningstar.com under Methodologies & Criteria.
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 under Related Documents or by contacting us at firstname.lastname@example.org.
The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.
Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.
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