May 25, 2012 / 5:54 PM / 8 years ago

TEXT-S&P cuts Synagro Technologies ratings

Overview	
     -- The headroom under Synagro Technologies Inc.'s financial covenants has 	
become limited and the company's revolving credit facility matures in less 	
than one year.	
     -- The company's profitability has weakened as the alternative fuel 	
mixture credit (AFMC) has expired.	
     -- We are lowering our corporate credit rating on Synagro to 'CCC+' from 	
'B-' and are lowering our issue-level ratings by one notch.	
     -- The negative outlook reflects our estimate that covenant cushions may 	
tighten further and that liquidity may become constrained as the absence of 	
AFMC proceeds could overshadow any improvement in operating performance.	
	
Rating Action	
On May 25, 2012, Standard & Poor's Ratings Services lowered its ratings on 	
Houston, Texas-based Synagro Technologies Inc. (Synagro) by one notch to 	
'CCC+' from 'B-'. The outlook is negative. 	
	
Synagro's senior secured credit facilities consist of a $100 million ($89 	
million after considering unavailable commitments) first-lien revolving credit 	
facility due 2013, a $249 million first-lien term loan due 2014, and a $100 	
million second-lien term loan due Oct. 2, 2014. We are lowering the 	
issue-level ratings on the first-lien facilities to 'CCC+' (the same as the 	
corporate credit rating) from 'B-'. The recovery rating on this debt is '4', 	
indicating our expectation for average (30% to 50%) recovery in the event of a 	
payment default. We are lowering the issue-level rating on the second-lien 	
term loan to 'CCC-' (two notches below the corporate credit rating) from 	
'CCC'. The recovery rating on this debt is '6', indicating our expectation for 	
negligible (0% to 10%) recovery in the event of a payment default.	
	
At March 31, 2012, Synagro had approximately $533 million of total adjusted 	
debt outstanding.	
	
Rationale	
The downgrade on Synagro reflects the company's "highly leveraged" financial 	
risk profile and "weak" liquidity, as the headroom under the total leverage 	
covenant has become very thin and availability under the revolving facility 	
has become limited. We estimate that as of March 31, 2012, Synagro's 	
trailing-12-month EBITDA would only need to decline by less than 5% to breach 	
the total leverage covenant. Although we expect the company and its lenders to 	
develop a plan to address the situation, the resolution of this issue is 	
uncertain at this time. The company's revolving credit facility is due on 	
April 2, 2013, and it is possible that the company could encounter 	
difficulties refinancing its credit facilities. Covenant headroom has 	
deteriorated quickly, following the expiration of the AFMC that had benefitted 	
the company's reported EBITDA by more than $20 million in each of the past two 	
years. Moreover, the total leverage covenant stepped down by 0.5x in 	
first-quarter 2012, further constraining headroom.	
	
Standard & Poor's ratings on Houston-based Synagro Technologies Inc. reflect 	
the company's "highly leveraged" financial risk profile, which is marked by 	
weak liquidity, high debt, and weak cash flow protection measures, with funds 	
from operations (FFO) to total adjusted debt of 9%. Although the essential 	
nature of its services and the high percentage of sales under long-term 	
contracts provide stability to the top line, Synagro derives more than 90% of 	
its revenues from municipalities, which still face budgetary pressures. Given 	
this backdrop, Synagro's volumes and pricing could continue to be weak. 	
Moreover, the company's adjusted debt balance of $533 million as of March 31, 	
2012, has remained static during the past year and it is uncertain whether the 	
company's profitability can improve quickly enough to offset the drop-off of 	
AFMC proceeds. The AFMC was a federal incentive designed to promote the use of 	
biofuels, which Synagro used at its incineration facilities. The amount of the 	
tax credit was significant, improving Synagro's EBITDA and liquidity by a 	
little more than $5.5 million on average during each quarter in 2011. Our 	
credit statistics do not include proceeds from AFMC, and we do not anticipate 	
such proceeds to be available in the future.	
	
Synagro, which has trailing-12-month revenues of $312 million, manages the 	
organic, nonhazardous biosolids that water and wastewater treatment facilities 	
generate (materials that meet government regulations for beneficial reuse are 	
referred to as biosolids). Its size and scope of operations are limited to 	
wastewater residuals management, though the company is a leading national 	
provider in its market. Until it expands its business model or introduces new 	
services, Synagro's somewhat high customer concentration (its top 10 customers 	
account for a little less than 40% of revenues) will remain a weakness, and 	
competitive industry conditions, including the presence of larger industry 	
participants (such as water companies and municipalities), will constrain 	
profit potential. In addition, Synagro's operations are subject to Part 503 	
regulations under the federal Clean Water Act, and any changes to 	
environmental laws concerning wastewater residuals treatment could lead to 	
additional costs for the company.	
	
Synagro's business prospects are still subject to some uncertainty. The 	
company continues to cope with 2010's sizable contract loss, and its municipal 	
customers continue to face budget pressures. Though the company's 	
year-over-year revenue growth in first quarter was a healthy 11%, much of this 	
growth is acquisition-driven, attributable to Synagro's June 2011 purchase of 	
Drilling Solutions LLC (not rated), a provider of solids control and waste 	
management services to the oil and gas industry. Although high oil prices and 	
active energy exploration may provide opportunities for this segment, Drilling 	
Solutions still comprises a small part of Synagro's operations (we expect it 	
will account for less than 10% of revenue in 2012). In addition, the company 	
is exposed to energy costs via including diesel fuel expenses on its 	
transportation operations, though it mitigates rising prices with pass-through 	
agreements and hedges on natural gas, diesel, and electricity costs. Inclement 	
weather can also hurt operating performance, since rain and snow limit the 	
company's ability to provide land application services, whereby organic waste 	
is applied to soils. The company's adjusted trailing-12-month EBITDA margins 	
are above average, at 17% as of March 31, 2012, and the quarterly figure has 	
improved on a year-over-year basis to almost 16% from 13% for the March 2011 	
quarter. Given the state of municipal budgets, we expect top line growth to 	
remain a key challenge, although the company should be able to maintain 	
operating margins of 15%-20%.	
	
Synagro's balance sheet is highly leveraged, with total adjusted debt 	
(including $100 million of nonrecourse revenue bonds and $17 million of 	
capitalized operating leases) of approximately $533 million as of March 31, 	
2012. The company's high debt leverage stems from The Carlyle Group's (not 	
rated) acquisition of Synagro in 2007. As of March 31, 2012, total adjusted 	
debt to EBITDA excluding AFMC proceeds was 10.3x (excluding $100 million of 	
nonrecourse project revenue bonds, adjusted debt to EBITDA was 8.4x). Growth 	
prospects and cash flow generation are limited relative to its significant 	
debt levels and, absent any AFMC proceeds, we expect credit measures to remain 	
weak with FFO to debt at less than 10% for the next year.	
	
Liquidity	
We believe Synagro's liquidity is weak, as the EBITDA headroom under the total 	
leverage financial covenant of the revolving credit facility is less than 5%, 	
with the facility due in less than one year on April 2, 2013. Absent an 	
amendment or refinancing of the capital structure to provide adequate headroom 	
under the financial covenants, Synagro's liquidity could become further 	
constrained and the company may not be able to incur any additional borrowings 	
under its credit facility. Our assessment of Synagro's liquidity incorporates 	
the following expectations and assumptions:	
	
     -- If Synagro does not refinance the revolving facility, then the debt 	
borrowed under the revolving facility would become a use of liquidity and the 	
company may be unable to satisfy all uses with available sources of cash. 	
However, if the revolving credit facility is refinanced, then the company's 	
sources of liquidity should be sufficient to cover uses by more than 1.2x, as 	
capital expenditures and scheduled debt amortization are manageable.  	
     -- In the event of a covenant violation, we believe Synagro's private 	
equity sponsor The Carlyle Group could likely provide relief through an equity 	
contribution. The credit agreement restricts the company's ability to cure 	
potential covenant violations through an equity contribution to three of any 	
four consecutive quarters and limits the amount of the contribution up to the 	
amount necessary to render compliance.	
	
As of March 31, 2012, Synagro reported $17 million of cash on its balance 	
sheet. Synagro also had $10 million in restricted cash, allocated toward the 	
construction and debt service for a biosolids processing facility in 	
Philadelphia. The company also had $17 million available under its $89 million 	
revolving credit facility, net of $18 million of letters of credit and $54 	
million of drawn borrowings. The drawn amount under the revolving facility 	
increased significantly in 2011 following the company's June 2011 purchase of 	
Drilling Solutions LLC. Peak seasonal working capital needs typically occur in 	
the spring and summer months, and we believe liquidity has dropped a bit from 	
March 31, 2012, though this should improve again toward the latter part of the 	
year.	
	
Synagro's debt amortization requirements are manageable. The company's 	
first-lien term loan matures April 2, 2014, and amortizes at $725,000 per 	
quarter. The company's second-lien term loan matures Oct. 2, 2014, and is not 	
subject to amortization.  	
	
We assume that Synagro's free cash flow will deteriorate in 2012 to very 	
modest levels, as the company is unlikely to benefit from the receipt of AFMC 	
proceeds (which approached $23 million in 2011). We estimate capital 	
expenditures of roughly $35 million in 2012. Maintenance capital spending is 	
modest (about 2% to 3% of revenues), although we expect the company to spend 	
more on growth-related investments in 2012, which could result in higher 	
capital expenditures than typically incurred in recent years.	
	
Recovery analysis	
For the complete recovery analysis, see Standard & Poor's recovery report on 	
Synagro, to be published on RatingsDirect following this report. 	
	
Outlook	
The negative outlook reflects the likelihood that Synagro's liquidity could 	
continue to remain constrained or its financial risk profile could deteriorate 	
further. Given our estimate of less than 5% of EBITDA headroom under the total 	
leverage covenant as of March 31, the lack of AFMC proceeds this year could 	
result in the company breaching its covenants as soon as the second quarter if 	
operating results are weak, if it doesn't amend the levels, or if its sponsor 	
doesn't provide an equity contribution. In addition, there is still some 	
uncertainty regarding how Synagro intends to deal with the near-term maturity 	
of its revolving facility. If credit markets deteriorate, then the company 	
could encounter some difficulty in attracting sufficient lender commitments to 	
refinance the debt. We will continue to have discussions with management as 	
they develop their financial plans.	
	
Although unlikely in the near-term, we could raise our ratings if the company 	
quickly and sufficiently refinances its credit facilities, with a healthy 	
extension of the maturity dates and the allowance of sufficient financial 	
covenant headroom to improve liquidity. We believe this would entail a 	
financial covenant cushion of at least 15%. We could also raise ratings if the 	
company's profitability improves rapidly, either because of new contract wins 	
or a renewal of the AFMC, though we view these possibilities as remote.	
	
	
Related Criteria And Research	
     -- Methodology And Assumptions: Liquidity Descriptors For Global 	
Corporate Issuers, Sept. 28, 2011	
     -- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, 	
May 27, 2009	
	
Ratings List	
Downgraded; Outlook Action	
                                        To                 From	
Synagro Technologies Inc.	
 Corporate Credit Rating                CCC+/Negative/--   B-/Stable/--	
	
Downgraded	
                                        To                 From	
Synagro Technologies Inc.	
 Senior Secured revolving credit fac    CCC+               B-	
   Recovery Rating                      4                  4	
 Senior Secured term loan B bank ln     CCC+               B-	
   Recovery Rating                      4                  4	
 Senior Secured 2nd lien term loan      CCC-               CCC	
   Recovery Rating                      6                  6
0 : 0
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