News Column

Fitch Rates Arendal's Proposed Issuance at 'B(exp)RR4'

May 14, 2014

MONTERREY, Mexico--(BUSINESS WIRE)-- Fitch Ratings has affirmed Arendal, S. de R.L. de C.V.'s (Arendal) local and foreign currency Issuer Default Ratings (IDRs) at 'B' and assigned a 'B(exp)/RR4' rating to its proposed issuance of up to USD100 million under a medium-term note program. The expected maturity of the first tranche is up to two years.

The Rating Outlook is Stable.

The proceeds from the issuance are expected to be used for general corporate purposes. The company expects to issue USD75 million-USD100 million in its first issuance under the program, with subsequent financing of future projects to continue to be a combination of individual project cash flows pledged to specific debt instruments and subsequent issuances under the program. Fitch estimates that unsecured debt could represent 40%-55% of total debt.

Fitch has assigned an 'RR4' Recovery Rating to the proposed issuance reflecting average recovery prospects given default. 'RR4' rated securities have characteristics consistent with securities historically recovering 31%-50% of current principal and related interest.

Arendal's ratings are supported by the company's track record and technical experience in the Mexican heavy construction industry as a recognized player in the construction of fluid transportation systems and plants, its participation in both public and private sector projects across Mexico, and its positive operating performance despite a challenging economic environment. Conversely, the ratings are limited by the characteristics of the industry, which is highly linked to economic cycles, project concentration of revenues and cash flow, as well as the current process of institutionalization and adoption of corporate governance practices.

KEY RATING DRIVERS:

Relevant Business Position

The company has a significant business position in the construction of pipelines when measured in kilometers built during the last few years. Arendal engages primarily in project contracts that include full or partial engineering, procurement and construction of pipelines and plants. Also, the company has the capacity to execute projects across all of the Mexican territory and to efficiently manage its technical and workforce resources. Arendal's competitive advantage among industry peers includes a historical project completion rate of 98% before or on settled dates. Fitch considers that these elements can contribute to Arendal maintaining its business position in the long term.

Revenue Diversification Potential

Fitch considers that the company's strategy to increase revenue diversification could contribute to a reduction of business risks and cash flow volatility over the long term. In Fitch's opinion, Arendal's recent experience in the construction of the Federal Prison will allow it to gradually participate in larger infrastructure projects as well as in the construction of energy projects and plants. Additionally, Arendal is expanding its presence in the oil and gas services industry, which presents attractive growth prospects. The company is likely to continue to enter into joint ventures (JVs) or consortiums to serve different projects that are expected to come on line in the near term, which in turn will strengthen its business profile.

Project Concentration Risk

Arendal has gained increasingly larger projects over the years which have helped the company grow rapidly, but this growth has come with large-project concentration risks. A single large project can at times represent 40% of revenues or more. Additionally, the company's revenue mix is significantly oriented toward the public sector, with the Federal Government (Secretaria de Seguridad Publica) being its main customer during the last three years. During 2013, Arendal generated 53% of its revenues from contracts with Pemex. With the available backlog, concentration in the public sector and revenues from Pemex as the ultimate client will likely continue to represent a large portion of the company's revenue source.

Fast-Growing Resilient Operations

In the last five years, the company has continued to grow organically. As of Dec. 31, 2013, the company has more than tripled its yearly revenues to MXN3,306 million from the MXN952 million pre-crisis levels in 2007. Compounded annual growth rate (CAGR) of revenues and operating income for the last five years ended Dec. 31, 2013 was 33% and 28%, respectively. These factors, in Fitch's opinion, reflect management's ability to adjust its operating and business strategies depending on economic environment, and they also reflect management's ability to bid for, secure and execute larger size contracts.

Growth Likely to Continue

Fitch expects Arendal to continue to grow rapidly in 2014 supported by a robust backlog and potentially from increased availability of energy-related infrastructure projects in Mexico. Fitch estimates Arendal's current backlog is over 1.7x 2013 sales. In addition, Arendal recently obtained a project for the construction of a gas plant in Veracruz, Mexico with a contract value of MXN2.2 billion. Furthermore, in April, 2014, Arendal entered a consortium formed with Odebrecht and Techint, into an early-works agreement for engineering, procurement & construction services for the Ramones II Norte project, a portion of a larger project aiming to increase the supply of natural gas in Mexico via the construction of a pipeline system extending from the U.S. border city of Camargo, Tamaulipas to El Alto, Guanajuato. Such agreement has potential to translate into future revenue for Arendal.

Short-term Debt Financing

Projects will require larger investments in working capital and to less extent capex and Fitch expects that most of these requirements will be funded with debt. Arendal's financing strategy has been primarily to raise new debt after securing a project, allowing the company to match debt payments with specific project revenues. Given that most projects have periods of completion that range between 18-24 months, financing tends to be short term, resulting in high levels of short-term debt. Liquidity and profitability depend on timely collection of accounts receivable and to a lesser extent on the availability of credit lines or alternative financing to support working capital needs.

Increasing Leverage

Fitch expects Arendal's leverage metrics to increase as a result of financing the start-up of incremental construction engagements and that future financing will continue to be a combination of individual project cash flow pledged to specific debt instruments and subsequent issuances under the program. Fitch also expects that the company's long-term leverage measured as total debt/EBITDA will be in the range of 4.5x to 5.0x. Total debt including leases as of Dec. 31, 2013 was MXN1,064 million, 66% of which was guaranteed by project cash flows. As of the LTM ended March 31, 2014, EBITDA/Interest Expense and total debt-to-EBITDA ratios were 2.0 and 4.5x, respectively, compared to year-end figures of 2.1x and 3.6x in 2013, 7.2x and 1.0x in 2012, and 5.6x and 1.9x in 2011.

Liquidity

Poor FCF generation and reliance on short-term debt financing can pressure the company's liquidity. Fitch expects high working capital needs resulting from rapid growth to lead to negative FCF in the medium term. However, sound cash flow generation after interest paid and before net working capital requirements will be considered a positive indicator of company performance. In its base case, Fitch considers that the company's cash balance will continue to be strong and recognizes that refinancing risk can be partially mitigated by the company's access to bank lending mainly as a result of the credit characteristics of the company's receivables. Company cash as of March 31, 2013 was MXN718 million.

Recovery Prospects

In Fitch's opinion, under a stress scenario recovery of debt instruments associated with pledged contracts would have access to the existing accounts receivable to cover outstanding debt; the remaining balances would form part of the mass of unsecured creditors with average prospects of recovery between 31%-50%.

RATING SENSITIVITY:

The ratings could be negatively pressured by a combination of the following factors, among others: Deterioration of Arendal's credit metrics as a result of higher than expected competition which pressures operating performance or, alternatively, delays in collectability of receivables that pressure cash flow. A rating downgrade could also be driven by limited access to financing sources affecting the company's liquidity position.

Factors which could lead to positive rating actions include lower project concentration, high level of repeat business or service type contracts in conjunction with strong credit metrics, liquidity, and full implementation of corporate governance practices.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (Aug. 5, 2013);

--'Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers' (Nov. 20, 2013).

Applicable Criteria and Related Research:

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=721836

Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=830185

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.



Fitch Ratings

Primary Analyst

Gilberto Gonzalez, CFA, +52-81-8399-9100

Associate Director

Fitch Mexico, S.A. de C.V.

Prol. Alfonso Reyes 2612

Monterrey, N.L., Mexico

or

Secondary Analyst

Alberto de los Santos, +52 81-8399-9100

Associate Director

or

Committee Chairperson

Sergio Rodriguez, CFA, +52 81-8399-9100

Senior Director

or

Media Relations

Elizabeth Fogerty, +1-212-908-0526 (New York)

elizabeth.fogerty@fitchratings.com

Source: Fitch Ratings


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