DBRS Morningstar Upgrades Source Energy Services Canada LP and Source Energy Services Canada Holdings Ltd.

DBRS Limited (DBRS Morningstar) upgraded Source Energy Services Canada LP and Source Energy Services Canada Holdings Ltd.’s (together, the Co-Issuers) Issuer Rating to CCC with a Stable trend from Selective Default (SD). The upgrade follows completion of the recapitalization transaction (the Recap) by the Co-Issuers’ ultimate holding company, Source Energy Services Limited (Source or the Company). DBRS Morningstar has also assigned a Recovery Rating of RR4 and a rating of CCC with a Stable trend to the Co-Issuers’ new Senior Secured First Lien Notes (Senior Secured Notes). The rating actions and Stable trends reflect DBRS Morningstar’s opinion that the Recap has improved Source’s near-term liquidity position and provides the Company with the financial flexibility to wait for an expected improvement in the level of drilling activity in the Western Canadian Sedimentary Basin (WCSB) in 2022.

The Recap reduced the Company’s near-term cash outflow, increased the availability under its credit facility, and mitigated the refinancing risk associated with its long-term debt. As part of the Recap, Source has (1) exchanged its previously outstanding senior secured first lien notes with principal obligations of $157.7 million maturing in December 2021 for new Senior Secured Notes with principal obligations of $142.2 million maturing in March 2025 and new common shares (approximately 62.5% of common shares outstanding post Recap); (2) extended the maturity date of its $50.0 million borrowing base credit facility to September 2023; (3) availed an additional liquidity facility (Additional Credit Facility) of $20.0 million; (4) availed relief on the fixed-charge coverage ratio covenant until June 2022; and (5) renegotiated its annual ongoing lease payments, which is expected to reduce the amount by 45% compared with approximately $28.0 million in 2019. In addition, the Company retains the option to pay quarterly interest payments on the Senior Secured Notes in kind until February 2022 through the issuance of additional Senior Secured Notes.

DBRS Morningstar believes that Source’s integrated operations, storage, and logistics infrastructure provide the Company with a competitive advantage in the WCSB, which is reflected by its leading market share and demonstrated ability to win proppant supply contracts with some of the largest conventional oil and gas (O&G) producers in the WCSB. However, the rating is constrained by the Company’s financial risk profile, which remains weak because of lower earnings and a higher amount of debt in the capital structure. While the Recap has improved Source’s liquidity and maturity profile, overall debt (excluding capitalized leases) is expected to remain relatively unchanged post Recap because of the Additional Credit Facility and the expected increase in Senior Secured Notes as a result of the exercise of the payment in kind option.

Given the current focus to operate within cashflow, DBRS Morningstar expects O&G producers to maintain a cautious approach to capital spending in 2021 despite the recent improvement in commodity prices. Consequently, DBRS Morningstar expects activity levels in the WCSB and the Company’s earnings to remain relatively flat in 2021 before improving in 2022 as confidence in the commodity price recovery strengthens. While earnings are expected to improve in 2022, Source’s overall financial risk profile is expected to remain weak with lease-adjusted debt-to-cashflow ratio of over 6.0 times (x) in 2022. DBRS Morningstar notes that the cash outflow will increase in 2022 because of the resumption of cash-interest payments on the Senior Secured Notes and scheduled repayments under the Additional Credit Facility. While the Recap has provided the Company with relief over the next 12 months, Source remains dependent on a recovery in activity levels in the WCSB to fulfill its obligations in 2022 and beyond. If earnings and cash flow do not improve in line with DBRS Morningstar’s base-case assumptions, the Company’s ratings remain vulnerable to a negative rating action.

A rating upgrade would require a material improvement in the company’s key credit metrics, which would likely occur if activity levels in the WCSB rebound stronger than DBRS Morningstar’s expectation. DBRS Morningstar may consider a positive rating action if the Company maintains satisfactory liquidity and the lease-adjusted debt-to-cash flow ratio improves sustainably and trends towards 6.0x. Conversely, a material deterioration in liquidity or breach of financial covenants may lead to a negative rating action.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The principal methodologies are Rating Companies in the Oil and Gas and Oilfield Services Industries (August 17, 2020); DBRS Morningstar Criteria: Recovery Ratings for Non-Investment Grade Corporate Issuers (August 24, 2020); DBRS Morningstar Criteria: Rating Corporate Holding Companies and Parent/Subsidiary Rating Relationships (November 2, 2020); and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (January 14, 2021), which can be found on dbrsmorningstar.com under Methodologies & Criteria.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link under Related Documents or by contacting us at info@dbrsmorningstar.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at info@dbrsmorningstar.com.

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