DBRS Confirms Sherritt International Ratings BB (low), Negative Trend

DBRS has today confirmed the Issuer Rating and Senior Unsecured Debt rating of Sherritt International Corporation (Sherritt or the Company) at BB (low), both with a Negative trend. The recovery rating for Sherritt’s Senior Unsecured Debt under a hypothetical default scenario remains at RR4.

DBRS downgraded Sherritt’s ratings and instituted a Negative trend in May 2014 following the completion of the sale of its Coal unit. Although the sale of the Coal unit increased the short-term liquidity of the Company, it removed an important stable, low-risk portion of its business. Going forward, Sherritt faces the challenges of bringing its important Ambatovy nickel mine to a desired stable level of near-capacity production in a period of volatile metal prices. In addition, constraints on the deployment of the proceeds from its Coal unit sale will impact the Company’s future capital structure. The Company has released its June 30, 2014, report and although performance by Sherritt’s historic operations were generally improved, overall results were weighed down by losses from Ambatovy and slower-than-expected progress in its ramp-up. In addition, it remains too early to ascertain how the funds received from the Coal unit sale will be deployed or the results of any related financing initiatives. Accordingly, Sherritt ratings remain on a Negative trend.

The RR4 recovery rating for Sherritt’s Senior Unsecured Debt corresponds to an estimated 30% to 60% recovery of principal amounts of its Senior Unsecured Debentures, based on the results of examining a hypothetical default scenario for the Company. The RR4 rating, in turn, results in no change (notching) to the rating of Sherritt’s Senior Unsecured Debt.

The sale of Sherritt’s Coal unit in early 2014 and a change in accounting for the Moa JV in its Metals unit significantly reduced the Company’s scale (without Coal) and its EBITDA and operating income without Coal and with Moa JV reported as an equity investment. Going forward, Sherritt’s interest in the important Ambatovy operation will be equity accounted leaving two major units reported below the operating income line with only the Oil and Gas and the small Power unit consolidated whereas the bulk of its debt has remained at the corporate level. With commercial production at Ambatovy achieved in early 2014, equity earnings will increase in significance adding to scale and volatility and with losses initially as Ambatovy ramps up.

The Company’s Oil and Gas unit has been a strong contributor of earnings and cash flow but earnings from its Cuba-related nickel business has declined significantly since 2010 due to lower nickel prices and rising costs. As a result, (and despite relatively steady contribution from its Coal unit), the Company’s credit metrics deteriorated and net debt increased by $880 million from the end of 2010 to the end of Q1 2014 during the period of peak construction activity at Ambatovy. Sherritt’s credit metrics are weak but have been largely stable since 2012.

The sale of the Coal unit in Q2 2014 contributed to a $725 million reduction in net debt during the quarter as a portion of Coal related debt was repaid and cash and investment balances increased greatly improving liquidity. Nonetheless, the covenants of the Company’s Senior Unsecured Debt constrain the use of the $804 million received from the Coal sale over the 360 days following closing to reinvestment in new businesses or debt reduction (excluding Coal unit debt repaid prior to close or vended with the business). Sherritt has indicated that it will use the bulk of these funds to reduce debt and to invest in its current business, including completing Ambatovy, but that it wishes to pursue a refinancing of its debt in order to preserve sufficient liquidity. The ultimate disposition of the funds remains unclear currently.

DBRS expects Sherritt`s adjusted earnings after tax to remain close to breakeven in 2014 with stable output and prices from Oil and Gas and Power operations, but with large equity losses to continue with Ambatovy remaining in ramp-up mode and Moa-related interests generating near-zero earnings at current metal prices. Added costs (losses) could arise from the expected restructuring of the Company’s capital structure. Over the longer term, Oil and Gas’s influence is expected to decline as production contracts end in 2017 and 2018 (subject to exploration success from 2014 onward on the production-sharing contracts extended to 2028), leaving equity earnings highly dependent on nickel and cobalt prices and the success of the Ambatovy ramp-up in 2014 and 2015.

In addition, DBRS expects that the Company’s corporate and other operations will be largely cash neutral in 2014, leading to the view that Sherritt’s debt will be reduced by year end using a portion of the Coal unit proceeds but that its financial metrics will remain weak for its rating. In the near term, negotiations with existing debt holders and the ability to bring Ambatovy to a cash-neutral status will determine the balance between debt reduction and liquidity needs. The expected longer-term trends of the Company’s indebtedness and financial metrics are for improvement, but will be closely tied to the successful ramp-up of Ambatovy and future nickel and cobalt prices.

Successful refinancing of Sherritt’s Senior Unsecured notes and completion of the Ambatovy project (including Ambatovy’s senior debt becoming non-recourse) along with preservation of sufficient liquidity can be expected to return the trend to Stable, otherwise further rating downgrades may be in order.

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

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 to the right under Related Research or by contacting us at info@dbrs.com.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

The applicable methodologies are Rating Companies in the Mining Industry (June 2011) and DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers (March 2014), which can be found on our website under Methodologies.