Morningstar DBRS Confirms British Columbia Ferry Services Inc.’s Issuer Rating and Senior Secured Bonds at A (high), Stable Trends

DBRS Limited (Morningstar DBRS) confirmed British Columbia Ferry Services Inc.’s (BC Ferries or the Company) Issuer Rating and Senior Secured Bonds credit rating at A (high) with Stable trends. The Company is an independent regulated ferry transportation provider that, through a network of 25 routes, serves Vancouver Island, the Gulf Islands, the Haida Gwaii, and the mainland with a fleet of 35 vessels. It also administers ferry service delivery on eight other routes serviced by independent contractors.

KEY CREDIT RATING CONSIDERATIONS
The confirmations are backed by the essentially full traffic recovery from the negative impact of the coronavirus pandemic, healthy financial metrics during Performance Term (PT) 5 (F2021–24), a consistent and reasonable price cap determination by the Commissioner for PT6, as well as the proven support of the Province of British Columbia (the Province; rated AA (high) with a Stable trend by Morningstar DBRS).

Vehicle and passenger volumes in F2023 were at 105% and 97% of pre-pandemic levels, respectively. With little help from the Safe Restart Funding, which had been essentially depleted during F2021 and F2022, total revenues in F2023 reached a record high at $1,098.6 million, a 10% year-over-year growth, partially driven by an annual tariff increase of 2.3%. Because of the cost escalation across labour, maintenance, and fuel, total operating expenses (excluding depreciation and amortization) also materially increased by 18% to $849.5 million in F2023, partially offsetting the higher revenue and leading to a total EBITDA of $249.2 million, approximately 10% lower than the F2020 level. This, combined with essentially unchanged interest payments and scheduled loan repayments to KfW IPEX-Bank GmbH, led to a debt service coverage ratio (DSCR) of 3.1 times (x) in F2023, compared with 3.4x in F2022. Morningstar DBRS considers F2023 to mark the first year that BC Ferries restored self-sustainability since the pandemic.

Vehicle and passenger volumes continued to recover in H1 F2024 (the six-month period ended September 30, 2023), reaching 105% and 100%, respectively, of H1 F2020 levels. During H1 F2024, total revenues and operation and maintenance expenses also went up by 11.3% and 9.4%, respectively, leading to a 15.1% increase in EBITDA compared with the same period in the prior year. As of September 30, 2023, BC Ferries reported a trailing 12-month DSCR at 3.44x.

CREDIT RATING DRIVERS
From a credit point of view, Morningstar DBRS believes BC Ferries' revenue risk has become largely normalized and that headwinds will be mainly from the cost perspective. While the Company’s ability to control costs may be limited by the aging fleet, an overall inflationary environment, and higher interest rates, Morningstar DBRS acknowledges the Company’s prudent management style, successful track record of capital project delivery, and proven ability to fine tune its capital programs for efficiencies where feasible.

In addition, the prompt and meaningful government supports during and after the pandemic reinforced Morningstar DBRS’ view of the essentiality of the services BC Ferries provides. While Morningstar DBRS considers a credit rating upgrade to be unlikely given the current financial targets, the credit ratings can now withstand temporary negative financial impacts to a larger extent, compared with Morningstar DBRS' view at the onset of the pandemic. However, prolonged material and negative erosion of the Company’s financial performance relative to Morningstar DBRS' expectation could still have a negative credit rating impact.

FINANCIAL OUTLOOK
On October 3, 2023, the British Columbia Ferry Commission announced its final decision on the price cap for PT6 (F2025–28), allowing a maximum 3.2% annual tariff increase. This is markedly lower than the 9.2% price cap from the preliminary decision released on March 31, 2023. Such reduction is mainly attributable to additional one-time funding of $500 million offered by the Province, which was intended to keep annual tariff increases at inflation.

As an asset-intensive company, BC Ferries has cyclical needs to heavily invest in its asset base. Morningstar DBRS has witnessed multiple rounds of major capital programs be successfully executed by the Company in the past, although the upcoming capital outlays during PT6 will represent a significant surge compared with historical levels. The spike is partly caused by the pandemic, whereby the Company cautiously deferred more than $800 million in planned capital spending during PT5. With a strategy to standardize its fleet and reduce carbon emission, the Company currently plans to incur up to $2.5 billion in capital expenditures during PT6, with a focus on vessel replacements and terminal upgrades. About two-thirds of such spending is expected to be funded through additional debts, which will double the Company's total long-term debt by the end of P6 and press financial metrics, to a degree.

As per the Commissioner's final price cap determination report (September 30, 2023), the target DSCR of 2.50x is expected to be achieved through PT6, except for F2025. Morningstar DBRS notes that the coverage ratios during PT6 will be affected by the revenue recognition profile of the Province’s $500 million contribution. Assuming no traffic volume growth during PT6 and that operating expenditures will grow faster than inflation until any meaningful cost savings can be realized from vessel replacements (in the second half of PT6), Morningstar DBRS forecasts that the DSCR will gradually improve after F2025 and the average coverage ratio during PT6 will remain above 2.5x, supportive of the credit ratings.

CREDIT RATING RATIONALE
The credit ratings are supported by strengths that include (1) the industry’s substantial barriers to entry, (2) the essentiality of services the Company provides, (3) the Company’s right to resell vessels to the Province under specific circumstances, and (4) the presence of the Commissioner, which reduces risk of political interference and protects the operator’s financial integrity. The challenges include (1) significant capital programs during PT6 driving up leverage amid economic uncertainties, (2) BC Ferries’ limited operating flexibility because of fare caps and minimum service requirements, (3) heavy labour unionization and a shortage of professional seafarers, and (4) the highly regulated sector.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://dbrs.morningstar.com/research/427030 (January 23, 2024).

RATING DRIVER AND FINANCIAL RISK ASSESSMENT (FRA)
(A) Weighting of Rating Driver Factors
In the analysis of BC Ferries, the Rating Driver factors were considered in the order of importance contemplated in the methodology.

(B) Weighting of FRA Factors
In the analysis of BC Ferries, the following FRA factor listed in the methodology was considered more important: EBITDA to mandatory debt service payments.

(C) Weighting of the Rating Driver and the FRA
In the analysis of BC Ferries, the FRA carries greater weight than the Rating Driver.

Notes:
All figures are in Canadian dollars unless otherwise noted.

Morningstar DBRS applied the following principal methodology:
-- Global Methodology for Rating Public-Private Partnerships, Part Two—Rating Volume-Based PPPs (October 11, 2023), https://dbrs.morningstar.com/research/421701

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

A description of how Morningstar DBRS analyzes corporate finance transactions and how the methodologies are collectively applied can be found at: https://dbrs.morningstar.com/research/397223.

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 info-DBRS@morningstar.com.

The credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

Morningstar DBRS had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS trends and credit ratings are under regular surveillance.

Information regarding Morningstar DBRS credit ratings, including definitions, policies, and methodologies, is available on dbrs.morningstar.com or contact us at info-DBRS@morningstar.com.

DBRS Limited
DBRS Tower, 181 University Avenue, Suite 700
Toronto, ON M5H 3M7 Canada
Tel. +1 416 593-5577