Morningstar DBRS Assigns Long-Term Issuer Rating of BB (high) to Heavy Metal Equipment & Rentals and Provisional Credit Rating of (P) BB on Its Long-Term Senior Debt, Both With Stable Trends

DBRS Limited (Morningstar DBRS) assigned a Long-Term Issuer Rating of BB (high) with a Stable trend to Heavy Metal Equipment & Rentals (2122256 Alberta Ltd.; HME or the Company), reflecting an Intrinsic Assessment of BB (high) and a Support Assessment of SA3. Morningstar DBRS also assigned a provisional credit rating of (P) BB with a Stable trend to the Company's Long-Term Senior Debt. This one-notch differential reflects HME's substantial balance sheet encumbrance.

HME intends to issue senior unsecured notes (the Notes) of approximately $250 million, and the proceeds will be used to refinance existing indebtedness and for general corporate purposes. The Notes will be effectively subordinated to all secured indebtedness, including the asset-based revolving credit facility (the ABL Facility), to the extent of the value of the assets securing such indebtedness.

KEY CREDIT RATING CONSIDERATIONS
The credit ratings reflect HME's position as the largest provider of ultra-class heavy equipment rentals to Alberta's oil sands, a niche market with high barriers to entry. HME's earnings have been solid, with strong revenue growth driven by increased demand from its largest customers; however, the Company's significant concentration by business line, customer, and geography is a constraint on the credit ratings. HME has a sound risk profile, with concentration risk moderated by the strength of its customer base, while asset risk and operational risk have been well managed. Morningstar DBRS views the Company's funding and liquidity profile as weak, with heavy reliance on secured facilities. HME's tangible common equity ratio is good, and internal capital generation ability is solid, while cash flow leverage is around 3.0 times (x).

CREDIT RATING DRIVERS
Over the longer term, Morningstar DBRS would upgrade HME's credit ratings if the Company were able to lessen its dependence on oil sands-related revenues while maintaining similar risk-adjusted returns. The Long-Term Senior Debt credit rating would be equalized with the Long-Term Issuer Rating if asset encumbrance levels were reduced.

Morningstar DBRS would downgrade the Company's credit ratings if its earnings deteriorated significantly or if cash flow leverage increased materially. Over the longer term, the credit ratings would be downgraded should the North American economy materially transition away from the use of fossil fuels at a pace faster than expected, affecting demand for the Company's equipment.

CREDIT RATING RATIONALE
Franchise Building Block (BB) Assessment: Moderate
Founded (in its current form) in 2009, HME specializes in the rental of earth-moving equipment, including haul trucks, excavators, bulldozers, loaders, and graders, primarily to the Canadian mining industry. The Company's business is highly concentrated in the rental of ultra-class heavy equipment to companies operating in Alberta's oil sands. Within this niche market, HME enjoys a majority share that benefits from high barriers to entry given the long manufacturing lead times for heavy equipment and the technical expertise required to maintain the equipment. HME provides full support for its customers through the lifecycle of the equipment, including sourcing, maintenance, rebuilding, and disposal. The Company's management team has significant industry experience, although ownership by the executive team and the lack of an independent board of directors results in weaker corporate governance.

Earnings Building Block (BB) Assessment: Good/Moderate
HME's earnings have been solid, with strong revenue growth driven by increased demand from its largest customers. Revenues are concentrated by business line, customer, and geography. Net income for the fiscal year ended July 31, 2024 (F2024) was down 35% from a record-high F2023 because of lower gross profit margins and higher expenses, including amortization and interest. Expenses grew across nearly all categories in F2024, on par with revenue growth as the efficiency ratio remained stable at a strong 37%, as calculated by Morningstar DBRS. Meanwhile, EBITDA increased 22% year over year in F2024. In Morningstar DBRS' view, earnings are sufficient to cover credit or other losses, which have historically been low.

Risk Building Block (BB) Assessment: Moderate
HME maintains a sound risk profile. The Company's credit risk is heightened by customer concentration, but this risk is moderated by the investment-grade nature of HME's largest customers and its longstanding relationships with these customers. Modest credit risk is evidenced by low levels of charged-off receivables, which were just one basis point (bp) of income before provisions and taxes in F2024 and have averaged just 85 bps over the past five years. Asset risk is well managed as HME maintains strong relationships with the primary heavy equipment manufacturers/dealers in Canada and the Company is among the largest customers of each of these dealers. Additionally, the Company employs a conservative depreciation approach, resulting in a fleet fair-market value above net book value, and the equipment is independently appraised twice per year. Operational risk is moderated by management's extensive industry experience, various insurance policies, telematics fleet coverage, and safe work procedures.

Funding and Liquidity Building Block (BB) Assessment: Weak
Morningstar DBRS views HME's funding and liquidity profiles as weak. Although offered by a diverse group of providers, funding is narrow in scope with a high reliance on secured funding. Funding sources include the ABL Facility, equipment term loans and capital leases, and mortgages, supplemented by nominal amounts from shareholders and related parties. Liquidity is also highly reliant on these secured facilities, with some undrawn capacity available on the equipment lines from various financial institutions and equipment dealers while the ABL Facility is nearly fully drawn. Morningstar DBRS notes that the proceeds from the unsecured debt offering would be used to partially pay down these facilities, creating additional liquidity. The Company generates good net cash inflows from operating activities, and it does not hold a cash balance as all cash collections are used to pay down the ABL Facility.

Capitalization Building Block (BB) Assessment: Moderate/Weak
The tangible common equity ratio was solid at 18.4% in F2024, down from 21.6% in F2023 as asset growth outpaced retained earnings. Given the lack of substantial credit risk, the Company's cash flows provide an acceptable absorption capacity for unexpected charges and internal capital generation ability is solid. Cash flow leverage (i.e., debt/EBITDA) has been relatively steady over the past five years around HME's target of 3.0x. Leverage was 3.4x as of July 31, 2024, as calculated by Morningstar DBRS. The Company has limited flexibility to improve its capital position given its private ownership and lack of access to equity capital markets.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
Environmental (E) Factors
The following Environmental factor had a relevant effect on the credit analysis: Morningstar DBRS views the Climate and Weather Risks factor as relevant to the credit ratings, but it does not affect the assigned credit ratings or trends. Over the longer term, the Company's customers, particularly those operating in the oil sands, may be exposed to climate transition risks and HME may, in turn, be affected by any resulting reductions in oil production.

Governance (G) Factors
The following Governance factor had a relevant effect on the credit analysis: Morningstar DBRS views the Corporate/Transaction Governance factor as relevant to the credit ratings, but it does not affect the assigned credit ratings or trends. The Company is governed by a board of directors consisting of only two members: the president and chief executive officer, and the vice president of operations. The lack of independent directors, as well as the absence of formal audit or risk committees, indicates a weaker corporate governance structure and is considered within the Franchise Strength and Risk Profile grid grades.

There were no Social factors that had a relevant or significant 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) at https://dbrs.morningstar.com/research/437781.

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

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (November 19, 2024), https://dbrs.morningstar.com/research/443208. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (August 13, 2024) https://dbrs.morningstar.com/research/437781 in its consideration of ESG factors.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found on the issuer page at dbrs.morningstar.com.

A provisional credit rating is not a final credit rating with respect to the above-mentioned security and may change or be different than the final credit rating assigned or may be discontinued. The assignment of the final credit ratings on the above-mentioned security are subject to receipt by Morningstar DBRS of all data and/or information and final documentation that Morningstar DBRS deems necessary to finalize the credit ratings.

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.

For more information on this credit or on this industry, visit dbrs.morningstar.com.

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