Despite generating positive operating cashflow, Emeco’s cash position continues to weaken. Full year earnings have been downgraded to take account of a weak Canadian oil sands market. It is becoming increasing likely that the company is heading towards a default scenario in the absence of a recovery in earnings. We look at the Atlas Iron experience as a guide to how debtholders fare in a mining-related default scenario
Emeco recently provided a quarterly operational update for 2Q16 (announcement here
). Revenues were down 12.7% on the prior corresponding quarter to $54.4m. The Canadian oil sands business has been hit particularly hard by the sustained lower oil price with producers delaying works to reduce operating costs, and the company provided FY16 EBITDA guidance to $53m-$57m. S&P has also downgraded Emeco’s credit rating from B- to CCC+, highlighting a very high probability of default (over 40% according to historical S&P default studies). The news continues to reflect the highly challenging conditions faced by mining services companies in a low commodity price environment.
Based on recent performance, the company’s cash position has fallen by about $10m over the past year as reflected in the table below. The start of FY16 has been disappointing with revenue down by about $10m per quarter on prior quarterly periods. Assuming this cash burn rate continues the company has about another 2.5 years of cash available (to mid-2018). Realistically, if the cash position continued to fall at this rate we would expect the negotiations between bondholders and the company would start sooner in anticipation of default.
Source: Emeco. Bond coupons are paid semi-annually.
At such time, bondholders would face the following options:
- Negotiate a debt structuring with the company (while technically a default, would be structured to ensure the ongoing survival of the business). This could involve, for example, a principal ‘haircut’ on the bond and a refinancing, or a ‘debt-for-equity’ swap
- Alternatively, if a restructuring cannot be agreed, the company could be placed into receivership and bondholders enforce their security over the company’s assets, predominantly made up of mining equipment. Given the slowdown in exploration activity in the mining sector it would be expected that the mining equipment assets would sell at a significant discount (at least 50%) of written-down value in an orderly liquidation scenario
In terms of other sources of liquidity, Emeco has a $75m asset backed loan which it can draw up to 50% of without any covenants. However, the asset backed loan ranks ‘super-senior’ to Emeco’s senior secured bonds and as such drawing on the loan would weaken the position of senior secured lenders in a recovery scenario. Given Emeco’s heavily depressed share price and market capitalisation (currently $23m) it is difficult to see the company successfully raising capital in the current environment.
If Emeco’s performance deteriorates further from current guidance, then the pathway to a technical default could come sooner than the maturity date and the scenarios above may play out earlier than expected.
Atlas Iron Debt Restructure
On the 23 December 2015, Atlas Iron, an ASX listed iron ore producer, announced that it had signed a debt restructuring agreement with more than 75% of its senior secured lenders (link to announcement herehere).
Under the terms of the debt restructure, the senior secured lenders will exchange their existing debt for cash, a new senior secured loan with an extended maturity date and be issued shares and options to the value of 70% of the company’s total shares and options on issue post restructure. The position of existing senior secured lenders pre and post restructure is summarised in the table below:
Source: FIIG Securities, Hartley’s equity research
The proposed restructure is subject to shareholder approval and lender approval (unanimous or through a creditor scheme of arrangement) and is expected to be finalised by the end of this quarter.
Ultimately the Atlas Iron lenders were prepared to take a view that the prospect of generating a return via an equity stake (and therefore being highly leveraged to a recovery in iron ore prices) was a better scenario than trying to force a winding up of the company and receive a heavily discounted value for the business in the current weak commodities environment. However, the restructure also means that the income return that existing senior secured lenders would receive under a restructure scenario is significantly reduced. Atlas lenders take a haircut on the debt owed, giving the company a better chance of survival and in the event iron ore prices recover and the company does pull though, the upside should be reflected in an improving equity price, increased value in the equity options and possible dividends.
Implications for Emeco bondholders
While Emeco is not a mining business, its operations and earnings have nonetheless been heavily impacted by the downturn in the commodities sector. The value of the business, and the associated value of its mining equipment, has been heavily impaired by the low commodity price environment.
If Emeco’s earnings and cash position weaken further, holders of senior secured Emeco bonds may face a similar scenario to Atlas Iron bondholders, where a debt restructure via a debt-for-equity swap is seen to be the most economic scenario for all parties. In such a situation, Emeco bondholders would ultimate become the majority shareholders of the company, sacrificing the income component of their return with the prospect of an improved return on capital in the future if conditions in the mining sector improve.
The Emeco bonds currently trade around the $50 level, highlighting the market’s valuation of less than full recovery on principal. In holding onto the bonds, current bondholders need to be alert to the possibility of an Atlas Iron-like scenario recognising that the pathway to a default is usually not clear-cut and could involve a number of varying outcomes.
Please contact your FIIG representative for further information and current pricing levels on the Emeco bond. Available to wholesale investors only.