TEXT-S&P cuts Waste Connections rating to 'BBB-'
Overview -- U.S.-based Waste Connections Inc. plans to issue a term loan and incur revolving facility borrowings to fund its proposed acquisition of R360 Environmental Solutions Inc. -- We are removing our corporate credit rating on Waste Connections from CreditWatch and are lowering it by one notch to 'BBB-'. -- The stable outlook reflects our view that the company will achieve and maintain credit measures that are appropriate for the rating during the next two years. Rating Action On Oct. 19, 2012, Standard & Poor's Ratings Services lowered its corporate credit rating on Woodlands, Texas-based Waste Connections Inc. by one notch to 'BBB-' from 'BBB'. The outlook is stable. We are removing the rating from CreditWatch, where we placed it with negative implications on Sept. 17, 2012, following the company's announcement of its plans to acquire non-hazardous oilfield waste services provider R360 Environmental Solutions Inc. for $1.3 billion. The purchase price represents an EBITDA multiple of roughly 6.5x, in our view. We expect the acquisition to close in the fourth quarter of 2012, subject to certain closing conditions, including the receipt of regulatory approvals. Rationale The one-notch downgrade reflects our view that the additional debt incurrence needed to finance the $1.3 billion acquisition will hurt Waste Connections' financial risk profile to some extent, though we still view it as an "intermediate" risk. We believe the company intends to issue a sizable unrated term loan and to borrow a substantial amount on its unrated revolving facility. At the outset, we estimate that the company's pro forma funds from operations to debt ratio and its free operating cash flow to debt ratio will be 21% and 12%, respectively. In comparison, these figures were 36% and 22%, respectively, as of June 30, 2012, having benefitted from the issuance of $370 million of equity and associated debt reduction earlier this year. We believe that the company will stay committed to maintaining investment-grade financial policies and will use its free cash flow primarily to reduce debt over time, but we also believe that it is likely to remain acquisitive. Therefore, we think the company is unlikely to return credit measures to levels appropriate for the former rating within a two-year time horizon. Waste Connections' acquisition of Houston-based R360 is a larger-than expected transaction, a major departure from its core business, and a bold move into the field of oil and gas production-related waste services. We believe this will have a mixed effect on our view of the company's "satisfactory" business risk profile. Revenues from these services are less stable and predictable than those from Waste Connections' core essential services of solid waste collection and disposal, as market volatility in oil prices tend to govern the demand for services. With the addition of R360, we believe that the proportion of the company's sales from oilfield waste services will rise to over 15% from 2%, and that EBITDA from such services will exceed 25% of total EBITDA. On the other hand, R360's profit margins are very good at present, and are supported by a difficult-to-replicate network of permitted disposal sites, transfer stations, and saltwater injection wells. R360's operating site and geographic diversity is solid, as it operates 26 facilities in many active oil-rich shale basins including the Williston, Permian, and Eagle Ford. The use of unconventional hydraulic fracturing to extract natural gas, natural gas liquids, and oil from shale deposits has increased rapidly in recent years, but as of late the supply-demand imbalances and low natural gas prices have resulted in declining rig counts and lower activity in certain dry-gas concentrated areas. Consequently, many oilfield services companies and environmental companies have re-mobilized assets to more oil-rich areas, creating greater competition. R360's assets are positioned in areas with more exposure to oil and natural gas liquids, which are currently performing well. However, if oil prices were to drop to a low level, then oil exploration and production could slow, potentially causing lower demand for oilfield waste logistics and disposal services, which could result in revenue declines and some margin compression. Waste Connections provides collection services (64% of revenues through the first six months of 2012), disposal and transfer services (29%), and recycling, intermodal, and other services (7%) in mostly secondary (non-urban) markets. The company serves more than two million residential, commercial, and industrial customers in 30 U.S. states, primarily in the western and southeastern regions. The company's demonstrated operating strength reflects its unique business strategy, including a focus on secondary markets and significant operations under exclusive franchise contracts. The relatively high proportion of exclusive arrangements is an advantage for the company, as higher customer retention affords Waste Connections greater ability to maintain solid pricing and reduces volume erosion during recessionary periods. The essential nature of Waste Connections' services, its leading presence in a number of growth markets, and the benefits expected from recently completed acquisitions enhance the company's earnings prospects. However, the solid waste management industry is mature and competitive, which results in some pressure to pursue acquisitions to promote growth and to contain costs. The company's still relatively limited exposure to more cyclical industrial markets somewhat mitigates these concerns. We characterize the company's financial risk profile as intermediate, as it has a demonstrated track record of maintaining prudent financial policies. We believe management will remain committed to sound financial policies, and will primarily use cash flow to reduce debt until debt leverage is lower. On a pro forma basis, we expect the company's funds from operations to debt ratio to improve to 25% by year-end 2013, which is at the low-end of the 25% to 30% range we expect at the current ratings. We also expect the company's free cash flow to debt ratio to improve to 14%, which is within the 10% to 15% we anticipated. We anticipate that steady operating performance and solid generation of free cash flow will benefit credit metrics as the company prioritizes debt repayments in lieu of large acquisitions or share repurchases. Our belief in the company's cash-generating capability and our view of management's commitment to using a major portion of cash flow to pay down debt is a critical underpinning to the ratings. Liquidity The company's liquidity is "adequate," characterized by strong and historically consistent internally generated free cash flows, which are partially offset by a sizable amount borrowed under its revolving credit facility to fund the R360 acquisition. The company's sources of cash should be sufficient to cover its needs for the foreseeable future, even if EBITDA declines sharply. We base our liquidity assessment on the following factors and assumptions: -- The company has good relationships with its banks, in our assessment, and has a good standing in the credit markets. -- We expect the company's liquidity sources (including cash, funds from operations, and credit facility availability) over the next 12 to 18 months to exceed its uses by more than 1.2x. -- Even if EBITDA declines by 15%, we believe net sources would be sufficient to cover cash requirements. Compliance with the credit facility's total debt to EBITDA financial covenant could also survive a 15% drop, in our view. -- In our analysis, we assume liquidity over the next 12 months of about $800 million, mainly consisting of availability under the credit facility and funds from operations. We estimate that the company will use approximately $550 million to $600 million during the same period mainly for capital spending, debt repayment, and dividends. As of June 30, 2012, Waste Connections had about $136 million in cash and $785 million available under its $1.2 billion unsecured revolving credit facility maturing in July 2016. Pro forma for the acquisition, we believe that these figures will be roughly $15 million and $275 million. Revolving facility borrowings of over $900 million are substantial, though we do expect the company to use free cash flow to reduce this amount during the next two years. We anticipate the amortization on the proposed term loan and other debt maturities to be manageable for the next several years and believe the company will continue to have appropriate access to sources of capital. In addition to the revolving facility borrowings and proposed term loan, its debt includes the following privately placed debt: $175 million of 6.22% senior notes due October 2015, $100 million of 3.3% senior notes due April 2016, $50 million of 4% senior notes due April 2018, $175 million of 5.25% senior notes due November 2019, and $100 million of 4.64% senior notes due April 2021. Financial covenants include a maximum debt to EBITDA ratio (no more than 3.5x under the credit facility and no more than 3.75x under the senior notes) and a minimum EBIT to interest coverage ratio (no less than 2.75x). The company was well in compliance with the financial covenants as of June 30, with respective headroom levels of more than 45% and 60%, but headroom levels will likely be tighter at the end of the December quarter immediately following the acquisition because of the additional debt. We anticipate that the terms of the financial covenants will allow for a pro forma acquisition-related adjustment to EBITDA, but headroom under the debt to EBITDA covenant could still slip to less than 15% at the end of the December quarter before improving in subsequent periods as debt is repaid. Waste Connections benefits from good free cash generation. Adjusted free operating cash flow to total adjusted debt as of June 30, 2012, was roughly 22%, which exceeds the median for the 'BBB' rating category. This figure has averaged 16% per year for the past five years. Working capital is usually a modest source of cash, and capital expenditures average 10% of sales. Pro forma for the acquisition, we expect Waste Connections' capital spending to be about $200 million in 2013. We expect the company to use free cash generation mainly for debt reduction and tuck-in acquisitions. The company has suspended share repurchases in advance of the R360 acquisition, and we believe management will not resume large repurchase activity until debt leverage has been reduced. Outlook The outlook is stable. Despite the substantial addition to debt to fund the R360 acquisition and the potential for somewhat increased earnings volatility, Waste Connections' leading positions in most of its markets and its strong free cash generation support credit quality. Although we expect muted growth in the core solid waste collection and disposal business stemming from weak volumes, along with headwinds from fuel costs and recycled commodities prices, stable pricing in its legacy business and effective cost management should keep profitability solid. We expect management to maintain prudent financial and strategic policies, and to improve its credit measures. We could raise the ratings during the next two years if the economy rebounds more rapidly and solid waste collection and disposal sales improve; if activity in oilfield waste services remains solid, and if the company adheres to prudent financial policies. Profitability has continued to improve over the years, and could be boosted by the company's enhanced position in oilfield waste disposal. If the company uses its free cash flow to reduce outstanding borrowings such that its FFO to debt ratio improves to (and then consistently exceeds) 30%, then we may consider an upgrade. Though less likely, we could consider a negative rating action during the next couple of years if Waste Connections undertakes more or larger-than-expected acquisitions before repairing its balance sheet or if cash flow generation declines to a level we deem inappropriate for the current ratings. The latter could occur if market conditions prompt weaker-than-expected volumes, pricing pressures, or contract cancellations, or if liquidity deteriorates. We estimate that it could take a roughly 10% decline in the company's pro forma revenue to $1.8 billion combined with a marked compression in adjusted EBITDA margins to 27% in order to yield an FFO-to-debt ratio of approximately 20%, which could prompt a review of the ratings. Related Criteria And Research -- Waste Connections Inc. 'BBB' Rating Placed On CreditWatch Negative On Acquisition Of R360 Environmental Solutions Inc., Sept. 17, 2012 -- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Corporate Ratings Criteria 2008, published April 15, 2008 Ratings List Downgraded; Off CreditWatch; Outlook Stable To From Waste Connections Inc. Corporate Credit Rating BBB-/Stable/-- BBB/Watch Neg/--