DBRS Confirms Royal Utilities Income Fund at STA-2 (low)

DBRS has today confirmed the stability rating of Utilities Income Fund (RUIF or the Fund) at STA-2 (low). The confirmation reflects that the Fund’s operating results are in line with expectations as a result of RUIF’s superior operating characteristics and its position as largest thermal coal producer in Canada. RUIF is the 100% owner of Prairie Mines and Royalty Ltd. (the Company), which operates eight mines: six are owned and two are operated under contract. (DBRS notes that the contract mines recently had their agreements extended through the end of 2009.) As such, the significant majority of the Fund’s revenue comes from supplying thermal coal to utility customers (all rated solid investment grades) in Alberta and Saskatchewan. The supply contracts are mostly long term and feature either a direct pass-through of operating costs or include inflation-indexed pricing for the majority of operating costs. In addition, the Company has a substantial royalty income stream, which adds to earnings and cash flow stability.

All of the Fund’s mines are surface mines, which are generally more cost efficient with higher coal recovery (there are less operational risks with open pit mining than underground mining). The mines have large reserves and long mine lives with low maintenance capital needs. The mines are mine-mouth mines (i.e., the mines are located next to the power plants) and are the exclusive coal suppliers to power plants. The proximity to the power plants eliminates most of the transportation costs, giving the Fund a major cost advantage (and minimizing the risk that the utility customers would seek an alternate supply of coal and not renew existing contracts).

In addition, the Fund’s financial profile is superior in light of the much reduced debt levels given the debt restructuring in connection with the IPO of the Fund. For the twelve-month period ended March 31, 2007, per cent gross debt was 23.2% and cash flow-to-total debt was 0.50 times. This relatively conservative capital structure provides RUIF with financial flexibility, which facilitates organic and acquisition-driven growth. DBRS notes that two growth opportunities presently under evaluation by the Fund include increased production at the Boundary Dam mine (to supply a new clean coal unit proposed by Saskatchewan Power Corporation) as well as mining services to the proposed Dodds-Roundhill coal gasification project.

DBRS expects the Company’s debt-to-capital ratio to remain moderate, supported by strong cash flow relative to debt. This somewhat offsets the relatively high payout ratio, targeted at 97% of distributable cash.

Notwithstanding the Canadian government’s announcement last year regarding proposed revised income trust tax legislation, DBRS expects the Fund to continue with is existing business and financing strategies until such time that more information becomes available. Support is provided by the Fund’s co-owners, each with a 41.2% stake: Sherritt International Corporation (Sherritt) and Ontario Teachers’ Pension Plan Board (Teachers).

DBRS notes that the major challenge to RUIF is its lack of diversification, as it concentrates on just one commodity, thermal coal, and only operates in Alberta and Saskatchewan, exposing the Fund to the economic cycles of two regions with similar industrial characteristics. Furthermore, the Fund is also exposed to time lags between the changes in coal prices to reflect changes in input costs on the inflation-based escalator contracts. Nevertheless, DBRS is of the view that these challenges are not significant, with the Fund easily managing to maintain distributions over the medium term

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