Morningstar DBRS Confirms British Columbia Ferry Services Inc.'s Credit Ratings at A (high), Changes Trends to Negative

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) and changed the trends to Negative from Stable. 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 37 vessels. It also administers ferry service delivery on eight other routes serviced by independent contractors.

KEY CREDIT RATING CONSIDERATIONS
The trend changes mainly reflect the materially higher operating expenses as well as capital expenditures and additional debts to be incurred during Performance Term (PT) 6 that are higher than Morningstar DBRS' previous expectations. The deteriorating EBITDA margin and higher debt service payments during PT6 are expected to result in lower-than-expected debt service coverage ratios (DSCRs). Based on the Company's inputs, Morningstar DBRS currently forecasts that the DSCR will drop to around 1.6 times (x) in F2026 and remain pressed during the rest of PT6, which is weak for the credit ratings. However, the average DSCR during PT6 is forecast to be above 1.7x and the Company is actively seeking opportunities to improve operational efficiencies, chasing affordable alternative sources of funding, and expecting further discussions with the Province of British Columbia (the Province; rated AA (high) with a Stable trend by Morningstar DBRS) on an appropriate funding model of the ferry system. Despite the elevated financial pressure faced by the Company, Morningstar DBRS confirmed the credit ratings on the back of robust revenue generation, stable traffic volume outlook, and the deemed implicit support from the Province if the Company became financially distressed.

Vehicle and passenger volumes in F2024 reached record highs, at 111% and 103% of pre-pandemic levels, respectively. Total revenues continued to rise in F2024, reaching $1,184.0 million, a 7.8% year-over-year growth, partially driven by an annual tariff increase of 3%. Because of the cost escalation across labour, maintenance, and fuel, total operating expenses (excluding depreciation and amortization) increased by 11% to $945.6 million in F2024, notably higher than Morningstar DBRS' expectation of approximately $900 million. Higher operating expenses offset the strong revenue growth and resulted in a decline in EBITDA to $238.4 million in F2024 from $249.2 million in F2023. This, combined with essentially unchanged interest payments and scheduled loan repayments to KfW IPEX-Bank GmbH (KfW), led to a DSCR of approximately 3.0x in F2024.

Vehicle and passenger volumes continued to grow in H1 F2025 (the six-month period ended September 30, 2024), achieving 3% and 1% year-over-year growth, respectively. During H1 F2025, total revenues went up by 2.4%, mainly because of higher vehicle traffic volume and rates, net retail sales, and provincial contribution (the Fare Affordability Funding), partially offset by lower fuel surcharges, ferry transportation fees, and other incomes. Operation and maintenance expenses (including cost of retail goods and excluding depreciation) increased by14.3%, which is higher than Morningstar DBRS' expectation and was mainly driven by higher wage rates, fuel prices, and maintenance expenses, as well as an increased number of sailings with resulting higher labour costs and fuel consumption, and higher administration expenses. The Company reported total EBITDA of approximately $199.2 million during H1 F2025, 18.5% lower than the $244.2 million EBITDA during H1 F2024. This translated into lower trailing 12-month DSCR as of September 30, 2024, at 2.32x, compared with 3.44x for the same period in the prior year.

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 successful track record of capital project delivery and proven ability to fine tune its capital programs and optimize operations 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.

CREDIT RATING DRIVERS
Morningstar DBRS may change the trends back to Stable if the Company proves that the DSCR will be reliably sustained above 1.7x. Conversely, Morningstar DBRS may downgrade the credit ratings if the Company's actual performance were to suggest that the DSCR will not improve to above 1.7x on a sustainable basis, or if there is any evidence weakening Morningstar DBRS' view of the implicit support from the Province.

FINANCIAL OUTLOOK
As per the British Columbia Ferry Commission's final determination (October 3, 2023), Morningstar DBRS expects the Company to implement a maximum 3.2% annual tariff increase during PT6 (F2025-28). Assuming around 1% annual traffic volume growth, roughly proportional growths in Fare Affordability Funding and retail revenues, as well as stable ferry transportation fees and Federal-Provincial subsidy, total revenues are forecast to grow at a healthy annual average of 5.7% during PT6.

The high escalation pressure of operating expenses faced by the Company during F2024 is expected to continue into F2025 and F2026. According to the Company, such pressure mainly stems from the following areas: persistent cost escalation and emergent condition-based scope within maintenance activities; additional workforce capacity to deliver higher service levels based on growing customer demand; and investment in initiatives to reduce crew-shortage related service risk, mitigate turnover and overall improvements to recruitment in a competitive labour market. Morningstar DBRS understands these are reflecting not only elevated CPIs but also changes in service plans, such as different labour, fuel costs, and capital project operating cost adjustments, to meet higher demand with an aging fleet. The Company expects total operating expenses to increase at an annual average of approximately 9% during F2025-F2026 before any meaningful cost savings can be realized from vessel replacements (in the second half of PT6). Morningstar DBRS currently forecasts the Company's annual EBITDA will decline to around $170 million in F2025 and F2026 and rebound to around $250 million in F2027 and F2028.

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 $2.6 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 bring the Company's total long-term debt to around $3.5 billion by the end of PT6. The current forecasts of incremental debt and capital expenditures to be incurred during PT6 are somewhat higher than but generally in line with our expectations.

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 persistent cost escalation pressure and 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 Factors in Credit Ratings (August 13, 2024), https://dbrs.morningstar.com/research/437781.

RATING DRIVER AND FINANCIAL RISK ASSESSMENT (FRA)

(A) Weighting of Rating Driver Factors
In the analysis of the Company, the Rating Driver factors listed in the volume-based section of the methodology are considered in the order of importance.

(B) Weighting of FRA Factors
In the analysis of the Company, the following FRA factor listed in the volume-based section of 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 the Company, 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 (August 13, 2024), https://dbrs.morningstar.com/research/437820

Morningstar DBRS credit ratings may use one or more sections of the Morningstar DBRS Global Corporate Criteria (April 15, 2024; https://dbrs.morningstar.com/research/431186), which covers, for example, topics such as holding companies and parent/subsidiary relationships, guarantees, recovery, and common adjustments to financial ratios.

The following methodology has also been applied:

Morningstar DBRS Global Corporate Criteria (April 15, 2024)
https://dbrs.morningstar.com/research/431186

-- Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (August 13, 2024), https://dbrs.morningstar.com/research/437781

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/431153.

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 https://dbrs.morningstar.com or contact us at info-DBRS@morningstar.com.

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