DBRS Downgrades Noranda Operating Trust Ratings to BB (high), Stable Trend

DBRS has today downgraded the Issuer Rating of Noranda Operating Trust (the Trust) from BBB Under Review with Developing Implications to BB (high) with a Stable trend following the Trust’s recent announcements regarding its refinancing efforts (see DBRS news release, “DBRS Maintains Noranda UR-Dev on Revolving Credit Facility Announcement”, June 10, 2011). Although the Trust’s zinc concentrate processing operations have been running at close to capacity levels and generating solid earnings and cash flows since October 2009, it continues to face delays in renewing its long-term financing structure. These delays arise in the light of competing interests of the unitholders of its parent, the Noranda Income Fund (the Fund), that seek restoration of the Fund’s distributions and the need to reduce long-term debt levels in advance of the potential expiry (or significant change in terms) in May 2017 of the Trust’s concentrate supply and processing agreement (Supply and Processing Agreement) with Xstrata Canada Limited (Xstrata Canada) that is the foundation of the Trust’s earnings and cash flow, adding to the financial uncertainty related to the Trust.

The Trust is currently being financed under the auspices of an interim $220 million bridge credit facility maturing on December 2, 2011 following the full repayment of its Senior Secured Notes and senior secured revolving credit facilities, which matured in December 2010. The Trust has indicated that it has executed a commitment letter for and is pursuing a five-year, asset-based secured revolving credit facility for up to $150 million that requires the Trust to concurrently arrange term debt financing having proceeds of at least $90 million (the March 31, 2011 indebtedness of the Trust totaled $157 million).

DBRS expects the Trust to be successful in arranging new long-term financing essentially in the form anticipated but DBRS remains vigilant in terms of the implications any financing arranged will have to the pre- and post- May 2017 end of the initial term of the Supply and Processing Agreement.

A reduction in concentrate processing for about seven months in 2009 led to a suspension of distributions by the Trust and its parent, the Fund, in July 2009. The suspension of distributions has continued during a protracted period in which the Trust’s long-term debt (which matured and was repaid in December 2010) and its short-term borrowing agreements were refinanced with various short-term arrangements. The suspension of distributions and normal operations allowed a $34 million reduction of the Trust’s $191 million in total debt at the end of June 2009 to $157 million by March 31, 2011. Consequently, the Trust’s financial metrics, which had weakened in 2009, returned to historical levels in 2010 and have added strength in early 2011. Debt as a percentage of total capitalization (45% at March 31, 2011) dropped to under 50% in 2010 for the first time since 2005; cash flow-to-total debt was 39% and EBITDA gross interest coverage was 12.8 times in Q1 2011.

The Trust’s refinancing efforts have been complicated by a number of factors including the expiry date of the initial term of the Supply and Processing Agreement on May 2, 2017. Under the Supply and Processing Agreement, the Trust has been able to process zinc concentrates supplied by Xstrata Canada and generate earnings and cash flow to fund all of its operating and capital expenditure needs, plus provide sufficient cash to support the Fund’s distribution of $51 million per year to its unitholders in each of the five years prior to and including 2008. Going forward, the Trust will face an added income tax burden due to changes in the Canadian taxation of income trusts. Over the longer term, DBRS believes that the cost of processing zinc concentrates under the Supply and Processing Agreement is high compared with current market rates for toll zinc refining and should these difficult market conditions prevail that it is unlikely that the Supply and Processing Agreement will be extended beyond May 2017 under current terms, leading to the expectation of a significant drop in earnings and cash flow for the Trust after that date. In addition, the bulk of zinc concentrate supplied by Xstrata Canada is from its Canadian operations and beyond 2017, the availability of concentrates from those operations is expected to be greatly reduced.

DBRS believes that the value of the Trust’s zinc refining facilities to Xstrata Canada, in terms of bringing its Canadian zinc production to markets in North America and around the world, would likely result in Xstrata Canada providing financial assistance in the event that the Trust had difficulties in meeting its financial obligations in the short term. Nonetheless, once the initial term of the Supply and Processing Agreement expires, its terms are likely to be renegotiated or it may not be extended. In either case, the Trust’s ability to generate earnings and cash flow would be significantly reduced and potentially eliminated as would its ability to support the servicing of long-term debt not related to working capital needs.

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

The applicable methodology is Rating Companies in the Mining Industry, which can be found on our website under Methodologies.