-- We have reduced our EBITDA and profitability estimates for U.S. oilfield services company FTS International Services because significant capacity additions and high costs combined with moderating demand continue to pressure margins in the fracture stimulation services industry.
-- As a result, we are lowering our corporate credit rating on FTS to ‘B-'.We are also lowering our rating on FTS’ term loan to ‘CCC+’ and lowering our rating on the company’s senior unsecured debt to ‘B+'.
-- Our negative outlook reflects FTS’ potential for violation of covenants under the company’s term loan, and the possibility that debt-to-EBITDA could exceed levels that are appropriate for the revised rating.
On Nov. 26, 2012, Standard & Poor’s Ratings Services lowered its corporate credit rating on Ft. Worth, Texas-based FTS International Services LLC (formerly known as Frac Tech Services LLC) to ‘B-’ from ‘B’. The outlook is negative.
We also lowered our issue rating on the company’s senior unsecured debt to ‘B+’ (two notches higher than the corporate credit rating) from ‘BB-'. The recovery rating remains ‘1’, indicating our expectation of very high (90% to 100%) recovery for bondholders in the event of a payment default. We also lowered our issue rating on the structurally subordinated term loan held at the company’s parent, FTS International Inc. (FTI), to ‘CCC+’ (one notch below the corporate credit rating) from ‘B’. We revised our recovery rating on the term loan to ‘5’, indicating our expectation of modest (10% to 30%) recovery for creditors in the event of a payment default, from ‘4’.
Significant capacity additions and high costs combined with moderating U.S. demand due to low natural gas prices have continued to depress margins in the fracture stimulation industry. As a pure-play fracturing services provider, FTS’ gross margins have dropped to below 20% in the third quarter of 2012 from over 50% in the first half of 2011, with corresponding EBITDA margins falling to 9% from about 40%, respectively. Although we had anticipated a slight recovery in the fourth quarter of 2012, accelerating into 2013, we have pushed out our recovery expectations to mid-to-late 2013. Consequently, we have reduced our EBITDA estimates for the fourth quarter of 2012 and 2013. As a result, we expect credit protection measures at the end of 2013 to weaken beyond levels appropriate for the ‘B’ rating, and thus we are lowering the corporate credit rating on FTS to ‘B-'.
The ratings on FTS reflect our view of the company’s “vulnerable” business risk profile, “highly leveraged” financial risk profile, and “less-than-adequate” liquidity. The company is one of the top five fracturing service providers in North America. Fracturing (or fracking) services are primarily pressure-pumping services provided to exploration and production (E&P) companies in the oil and gas industry as part of well completion, and are subject to a high degree of demand and price volatility. FTS is particularly vulnerable to demand volatility given that it is completely reliant on this single product line within the oilfield services industry. FTS is vertically integrated in fracking services and we believe this vertical integration provides a competitive advantage by assuring timely equipment deliveries, reducing maintenance downtime and avoiding the proppant delivery bottlenecks that have plagued others in the industry. However, in a market downturn the company’s margins are exposed to excess manufacturing, processing, and transportation capacity, as the experience of the last few quarters attests.
Industry-wide demand for fracking services has increased significantly over the past few years, as E&P companies shifted to drilling more horizontal wells, drilling longer laterals, and completing more fracking stages per well. However, significant additions to capacity during the past year and persistent low natural gas prices have led to 20% to 40% year-over-year declines in pricing (depending on the region). At the same time, tight supplies of guar, a key fracking fluid ingredient, increased costs during the first nine months of 2012. Thus, EBITDA margins for FTS dropped to about 9% in the third quarter ended Sept. 30, 2012, from 40% in the first half of 2011. Although in recent months guar costs have dropped to more normal levels, the company was still working through its higher-cost inventory in the third quarter. Looking forward, E&P companies are drastically cutting capital budgets to live within cash flows (particularly for the remainder of 2012). Consequently, we expect EBITDA margins to deteriorate further in the fourth quarter, but rebound to about 10% in 2013.
We characterize the company’s financial risk profile as highly leveraged because of potential term loan covenant violations over the next few quarters - although the company currently has the ability to resolve any non-compliance by drawing down on a negotiated $175 million “cure basket” or exercising its equity cure right; its willingness to significantly increase debt in last year’s buyout transaction (May 2011); its private-equity ownership; its aggressive fracking capacity growth in the first nine months of 2011; and the high degree of cash flow volatility in the oilfield services business.
Although FTS had initially planned to pursue an IPO of the company and to pay down debt in late 2011, the offering has continued to be postponed because of industry conditions, and we do not expect an IPO to occur before late 2013. As a result, the company is carrying an above-average debt load, particularly in view of the volatility of cash flows.
Because of a strong first quarter and sales of fracking equipment to third parties this year, we project revenues will increase by nearly 15% in 2012, but that they will decline by about 10% in 2013 as E&P spending remains subdued, particularly in the fracking-intensive North American gas shale plays. We project EBITDA margins will average about 11% in 2012 and remain flat in 2013, resulting in EBITDA estimates of about $235 million and $210 million, respectively. We expect margins to remain flat in 2013 as a likely drop in pricing is offset by the company’s cost-cutting efforts, as well as a drop in the price of guar.
After spending nearly $500 million in capital expenditures last year, FTS is planning to spend $170 million in 2012, and we estimate just $50 million to $60 million in 2013. Because of the increase in market fracking capacity, the company is no longer manufacturing fracking units for its own use, and orders from third parties are winding down. Based on these assumptions, we project FTS’ debt to EBITDA will increase to nearly 7.0x at year-end 2012 and approach 8.0x at year-end 2013, up from 2.3x at the end of 2011. Assuming the fracking market recovers and FTS is able to reduce operating costs, we expect debt-to-EBITDA to improve in 2014.
FTS’ parent company FTI recently raised $350 million through an offering of convertible preferred stock to its existing equity holders (led by Asian investment firms Temasek and RRJ Capital). Proceeds were used to pay down $200 million of the $1.375 billion term loan held at FTI and $150 million of the $550 million senior notes due 2018 held at FTS. FTI also obtained amendments on its term loan to, among other changes, loosen financial covenants, establish a $175 million basket from which FTI may draw to ‘cure’ any EBITDA shortfalls under the new covenants, increase FTS’ ability to enter into joint ventures, and allow a portion of the preferred stock offering proceeds to be used to fund the redemption of senior notes.
Liquidity We view FTS’ liquidity as less than adequate. Key aspects of our assessment of liquidity include the following:
-- As of June 30, 2012, FTS had $278 million of cash and $97 million available on its $100 million revolving credit facility maturing in 2016.
-- We assume capital expenditures of $170 million in 2012 and $55 million in 2013 will be funded by projected funds from operations (FFO) of $135 million and $110 million, respectively, and drawing down its revolver.
-- We include the $1.175 billion term loan, held at parent company FTI in our calculation of debt, and assume FTS pays the full interest due on this loan (about $100 million per year including amortization).
-- The term loan has two financial covenants starting on Dec. 31, 2012, which require the company to hit certain quarterly EBITDA targets (starting at $25 million increasing to $110 million on June 30, 2014), and to maintain an interest coverage ratio of greater than about 1.0x. A debt-to-EBITDA covenant of 5.0x will become effective on Sept. 30, 2014, stepping down to 4.0x over the subsequent four quarters.
-- Based on our updated assumptions, we no longer expect FTS to remain in compliance with the amended covenants on internally generated EBITDA alone. However, the company has established a $175 million “cure” basket, which can be drawn upon to meet EBITDA shortfalls per the covenant. Thus, we do not currently expect FTS to breach its covenants before the end of 2013.
-- If the U.S. fracking market does not recover as we currently anticipate, or if FTS is unable to reduce operating costs, we believe there is the potential for covenant breaches in 2014 once the cure basket is depleted. Recovery analysis For our complete recovery analysis, see Standard & Poor’s recovery report on FTI International Services to be published shortly after this release on RatingsDirect.
The negative outlook reflects FTS’ potential covenant violations, and the possibility that debt-to-EBITDA could exceed levels that are appropriate for the rating. Last year’s aggressive buyout financing left the company with an above-average debt load relative to the extreme volatility of EBITDA and cash flows in the fracking industry. We could downgrade the company if we no longer expect fracking industry fundamentals to recover in mid to late 2013 or if the company is unable to reduce costs, which could well result in deteriorating liquidity and covenant breaches.
We could revise the outlook to stable if U.S. fracking market conditions were to improve above our current expectations and we believed these conditions would be sustainable. We could also revise the outlook to stable if the company is successful in meaningfully reducing its debt, potentially from an IPO or an equity infusion by a strategic investor.
Related Criteria And Research
-- Key Credit Factors: Global Criteria For Rating Oilfield Services And Equipment Companies, July 30, 2012
-- Standard & Poor’s Raises Its U.S. Natural Gas Price Assumptions; Oil Price Assumptions Are Unchanged, July 24, 2012
-- Methodology And Assumptions: Standard & Poor’s Revises Key Ratios Used In Global Corporate Ratings Analysis, Dec. 28, 2011
-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
Downgraded; Outlook Negative
FTS International Services LLC
Corporate Credit Rating B-/Negative/-- B/Negative/--
Senior Unsecured B+ BB-
Recovery Rating 1 1
Downgraded; Recovery Rating Revised
FTS International Inc.
Senior Secured CCC+ B
Recovery Rating 5 4