DBRS Confirms Tembec Inc. at CCC

Dominion Bond Rating Service (DBRS) has today confirmed the rating of Tembec Inc. (Tembec, or the Company) at CCC. DBRS downgraded the rating of Tembec on January 31, 2006.

The rating action reflected the sharper-than-expected decline in Tembec’s operating performance and liquidity position, and the risk that the Company would not have the liquidity required to fund its operations substantially beyond the next 12 months. However, the repayment of lumber duties in fiscal Q1 2007 will provide additional cash of US$242 million ($272 million) ensuring that Tembec’s liquidity will be sufficient to meet near-term requirements. The Company’s financial risk has been reduced to a level commensurate with the above rating.

Despite the much-needed cash infusion, the trend remains Negative, reflecting the high probability that (1) a deterioration in operating performance could occur in the next year, and (2) continued weak earnings and cash flows may jeopardize the refinancing of a large debt maturity in 2009.

Successful supply management strategies have enabled pulp and paper manufacturers to implement cost-push product price increases over the past year. However, industry supply discipline may be increasingly difficult to maintain since most of the high-cost production capacity has been closed. Failure to close a widening demand/ supply gap would result in price erosion and declining earnings. Continued weak pulp and paper markets and the possibility that industry production curtailments may not be sufficient to support cost-push price increases elevates the risk that Tembec’s operating performance and liquidity could quickly deteriorate. The declining U.S. residential construction industry, continuing lumber trade restrictions, and the potential of a U.S. economic slowdown exacerbates the situation.

The Company is highly exposed to weakness in the U.S. dollar relative to the Canadian dollar and the euro (every 1% change impacts EBITDA by $25 million), and additional strength in the Canadian dollar will have a significant impact on earnings. Equally important is the significant cost pressures facing Tembec (particularly fibre and chemicals), which are showing no signs of abating. The trend will remain Negative until the Company’s financial performance significantly improves and the 2009 debt maturity is successfully refinanced.

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