DBRS Confirms Finning at A (low) and R-1 (low), Stable Trends

DBRS has today confirmed the A (low) Senior Debentures and Medium-Term Notes rating and the R-1 (low) Commercial Paper rating of Finning International Inc. (Finning or the Company), following the announcement that the Company plans to acquire the distribution rights of Bucyrus International (Bucyrus) from Caterpillar Inc. (CAT, rated “A” by DBRS) for total consideration of US$465 million to be funded with debt. The trend on both ratings is Stable. The confirmation reflects Finning’s stronger business profile, although DBRS does recognize that the Company’s projected financial profile is weak for the A (low) rating. We expect Finning to improve its financial ratios in the coming quarters toward an adjusted debt-to-EBITDA level of around 2.5 times and adjusted cash flow-to-debt of approximately 28% by the end of 2012. DBRS would consider taking negative rating action if the Company fails to show such improvement. In addition, DBRS expects the Company to further improve its financial ratios to levels compatible with the A (low) level by 2013.

DBRS expects that the purchase will strengthen the Company’s already superior business profile. The acquisition is similar to Finning’s current business operations, minimizing integration risk. Finning will now be able to provide a significantly larger product offering (for mining), which is expected to improve its competitive advantage over other capital equipment dealers in the same regions. As the installed base of this equipment grows, the potential for product support business, which provides earnings stability and is a higher-margin business compared with equipment sales, could also be strengthened. The current rating also reflects support from CAT, the world’s leading producer of heavy construction equipment. CAT has been known to provide financial assistance to its dealers in difficult times.

Neutralizing the positive impact on the business profile is the fact that Finning’s projected financial profile would materially weaken as a result of the acquisition, since the Company has stated that it will finance the acquisition entirely by debt. DBRS estimates that the full-year 2011 financial profile (including the additional debt and the financial results of Bucyrus and Finning) would weaken, with adjusted debt-to-capital at 58%, adjusted debt-to-EBITDA at 2.9 times and adjusted cash flow-to-debt at 25%. We consider these levels indicative of a financial profile that is weak for an A (low) rating.

However, as stated above, DBRS expects that the Company’s debt coverage ratios will improve in 2012, given the positive outlook for the mining, construction and power systems markets, the high backlog levels in Finning’s global order book, the accretive nature of the acquisition, and resolution of the Company’s enterprise resource planning issues.

Going forward, the Company’s 2012 forecasted growth in earnings is supported by a positive outlook for the mining, construction and power systems markets in Canada and South America, accretive earnings related to the Bucyrus purchase, as well as a $1.8 billion backlog of orders as at September 30, 2011. Despite the recent volatility in the price of copper, commodity prices remain attractive, which continues to drive investment in mining, thereby supporting ongoing demand for capital equipment. Finning’s South American segment continues to be bolstered by mining investments, as well as by construction and power system activity driven by private-sector and government spending on infrastructure and energy projects. The outlook for the Canadian segment remains solid, with support from oil sands activities, heavy construction and power systems. While the U.K. division’s EBIT margin performance in 2011 has improved significantly over 2010 (to 6% from 2%), our outlook remains tempered by slowing GDP forecasts and the eurozone crisis.

DBRS understands that the Company remains committed to achieving overall corporate targets of a 9% to 10% range for its EBIT margin in 2013 and reducing Selling, General and Administrative (SG&A) costs as a percentage of revenue to 20% by 2013. We also expect the Company to remain focused on efficiency efforts, such as reducing SG&A costs and shifting revenue mix to more product support. Product support revenues are expected to represent approximately 44% of total revenues in 2012 and 2013. These revenues are higher margin, represent an annuity-like stream of earnings, and can help reduce the impact of cyclical industry downturns on operating results.

DBRS projects that Finning would be free cash flow negative in 2011, given higher working capital requirements to support strong levels of demand for equipment and higher capex spending (related to product support infrastructure). In 2012, DBRS expects the Company’s free cash flow levels to be negligible as most operating cash flow would be channeled to support continued high levels of capex and working capital requirements. As a result, total debt should remain in line with expected 2011 year-end levels and expected improvement in debt coverage metrics would most likely be driven by higher operating earnings and cash flow. By the end of 2012, DBRS expects that Finning’s adjusted debt-to-EBITDA will be around 2.5 times and adjusted cash flow-to-debt at approximately 28%. We expect that Finning will generate positive free cash flow in 2013, which could be applied toward debt repayment and to improving these metrics in 2013 to levels more firmly within the A (low) range.

While leverage (adjusted debt-to-capital) is still expected to be high for the rating at the end of 2012 and 2013, DBRS will be able to tolerate these levels given the countercyclical nature of Finning’s free cash flow generation. In the event of a downturn in the economy causing weak demand, the Company is able to free up cash resources from its lower working capital requirements, which could be used to reduce debt levels. During the recent recession in 2009, Finning was able to reduce its debt level by more than $300 million and improve its financial profile. DBRS would fully expect that the Company would reduce debt in a similar manner in the event of another economic downturn.

With no upcoming maturities in 2012, and sufficient availability on a newly expanded credit facility, the Company’s liquidity remains solid.

In view of the improvement in its already strong business profile, and despite a weaker projected financial profile, which is expected to improve to levels commensurate with the current rating, DBRS has confirmed Finning’s ratings at A (low) and R-1 (low). If the financial profile does not improve as expected, this could result in a negative rating action.

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

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