407 International Inc. (407 or the Company) has observed significant traffic declines because of the physical distancing and self-isolation measures taken by the Province of Ontario (Ontario or the Province; rated AA (low) with a Stable trend by DBRS Morningstar) to fight the Coronavirus Disease (COVID-19).
The Company has sufficient liquidity, including the proceeds from the previous bond issuance and the drawn amount under the credit facilities, to provide coverage for its financial obligations in 2020. While DBRS Morningstar expects the ratings to be maintained under its base-case forecast and to continue to be protected by the rating affirmation test, a material change to DBRS Morningstar's base-case assumptions and/or a significant equity distribution could have a negative rating impact. DBRS Morningstar also notes that the next payment to the subordinated bonds would be restricted under its stress-case scenario.
Traffic volumes during the first two months of 2020 were up approximately 1.1%, compared with the same period in 2019. The Company applied a rate increase on February 1, 2020, including a new seasonal tolling regime. However, after the World Health Organization declared coronavirus a pandemic on March 11 and a series of containment measures by governments took effect, 407 saw significant traffic volume drop in March, with the monthly volume down 39% compared with last year. An even more severe impact has been observed in April as stringent lock-down measures were imposed during the second half of March and many companies had to arrange remote work for their employees. Total volume in April is expected to decrease by more than 75% compared with last year's, with heavy vehicles and business traffic being less affected by coronavirus.
Even though the pandemic curve seems to be flattening in Toronto, the risk of governments further extending the self-isolation order is still present. DBRS Morningstar assumes that there will be some success in containment within Q2 2020, with limited recovery during Q2 2020, followed by a gradual relaxation of restrictions and economic recovery in Q3 2020, leading to a notable rise in traffic volume in Q3 2020. Based on these assumptions and the Company's input, DBRS Morningstar forecasts that 407's 2020 traffic volume, as measured in vehicle kilometres travelled (VKT), would be 33% below the 2019 level, translating to approximately 28% lower revenue. The operation performance of 407 during the previous recession (2008-09) was generally in line with the Ontario economy, with traffic volume recovered within one year post-recession. Moreover, the Company was able to grow its EBITDA during the previous recession by charging higher tolls. Based on the historical performance, DBRS Morningstar considers a full recovery in 2021 to be plausible; however, the shadow of coronavirus may linger, depending on to what extent the 'working from home' culture has been cultivated and to what extent the jobs lost will be refilled after the lockdown is lifted. As such, DBRS Morningstar assumes that a full recovery to the pre-crisis revenue level will not occur until 2022 on a conservative basis, with 2021 revenue 6% lower than that of 2019, followed by a typical year-over-year (YOY) revenue growth of 8% during both 2022 and 2023, (the DBRS Morningstar Base Case).
Under the DBRS Morningstar Base-Case scenario, the senior debt service coverage ratio (DSCR) including shadow amortization and the senior and junior interest coverage ratio (ICR) in 2020 are expected to fall below 1.7 times (x) and 2.0x, respectively, which represent the thresholds considered by DBRS Morningstar to be suitable for the current rating levels. However, DBRS Morningstar expects these metrics to increase over the thresholds in 2021, depending on the amount of future issuances, which will be subject to the rating affirmation that no adverse rating effect would result from such additional indebtedness. DBRS Morningstar understands that the intention of the Company was to increase its leverage by $700 million per year, although the Company also indicated that it will revisit this target once the current situation stabilizes, taking into consideration the future revenue projections.
If 407's annual revenue drops by 33% in 2020 (i.e., a 5% risk buffer on top of the base-case assumption of 28%) compared with 2019 (the DBRS Morningstar Stress Case), DBRS Morningstar estimated that on a 12-month forward-looking basis, the senior DSCR including 30-year shadow amortization (as per the Master Trust Indenture) would drop below 1.35x, triggering a restriction to make any payments to the Subordinated Bonds. Nonetheless, DBRS Morningstar notes that the subordinated debt by definition does not require payments to be made as long as senior bonds or junior bonds are still outstanding and a failure to pay the subordinated debt will not result in a default or acceleration of the senior or junior bonds.
The Concession Agreement requires the Company to make congestion payments (the Schedule 22 Payments) to the Province of Ontario if traffic falls below certain thresholds and if the toll for a segment becomes greater than the relevant toll threshold, which is effectively limited to grow at the CPI. A Schedule 22 Payment of approximately $1.8 million was incurred during 2019 and is expected to be paid in 2020. Because of the coronavirus, the Company could incur a significant Schedule 22 payment this year, which has been incorporated in the DBRS Morningstar analysis above, based on the Company's inputs. DBRS Morningstar expects the Schedule 22 Payment to revert to the ordinary levels after 2020.
The DBRS Morningstar Base Case could be revised as the coronavirus pandemic continues to develop rapidly. DBRS Morningstar will monitor 407 closely and will revisit its analysis if the underpinning assumptions for the DBRS Morningstar Base Case are no longer valid. The ratings could also be negatively affected if, prior to any meaningful traffic volume recovery, the Company decides to incur significant amount of equity distribution that would materially jeopardize its liquidity.
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