DBRS Downgrades TimberWest Forest Corp.

DBRS has today downgraded the Senior Unsecured Debentures of TimberWest Forest Corp. (TWF or the Company) to BBB from BBB (high). The ratings remain Under Review with Negative Implications, where they were placed on October 30, 2008, due to the refinancing risk facing the Company over the near term; the direct result of the ongoing global credit crisis. DBRS is concerned about TWF’s ability to successfully refinance debt maturities in the next 12 months. The downgrade reflects increased business risk and a weakened credit profile which is no longer compatible with a BBB (high) rating.

TWF’s financial performance has deteriorated at a faster than expected rate in 2008 with operating losses reported in Q3 2008 and the nine months ended September 30, 2008. The rapid deterioration in U.S. residential housing market conditions is largely responsible for the sharp drop in demand for logs and in pricing, which are the key drivers of the Company’s earnings and cash flows. More than half of the Company’s sales revenues are generated from North American saw log and pulp log markets, and the continuing deterioration in construction activity and increasingly oversupplied global pulp markets does not bode well for medium-term earnings and cash flow generation. The North American building products sector is close to the bottom of the cycle but a meaningful improvement is unlikely to occur until 2010 or 2011, much later than originally expected. In the interim, ongoing weakness in the U.S. housing market and sawmill curtailments in western Canada and the U.S. Pacific Northwest are expected to keep saw log demand and prices at unusually low levels for the next 12 to 24 months. In addition, reduced global economic activity has lowered demand for paper and packaging products and the associated raw material, market pulp. Rapidly rising pulp inventories have negatively impacted pulp prices, a condition that is expected to be maintained into 2009 with an associated negative impact on the demand and pricing for pulp logs. As a result, TWF’s log production and associated log sales are forecasted to remain weak through 2009 and possibly 2010 and 2011, and the Company’s earnings and cash flows will remain under pressure in that time period.

With weak earnings and cash flows forecasted for at least the next two years, the Company is unlikely to generate sufficient distributable cash in those years to cover its distribution obligations. To address the cash flow concerns, TWF will seek unitholder approval on December 19, 2008 for a modification to the Series A Subordinate Note component of the Company’s stapled units which will move to a variable rate of 2% to 12% in lieu of the current 12% fixed rate. TWF also intends to defer the January 2009 distribution and subsequent distributions until market conditions improve. The Company is also negotiating changes to the covenants associated with its existing term loans as well as extending the maturity of its Tranche B term loan facility, which currently matures in September 2009. TWF is currently in compliance with its covenants but expects to be non-compliant when it files its fiscal 2008 financials. DBRS expects these negotiations will be successfully concluded before the end of 2008. However, failure to resolve either the credit facility or compliance issues could lead to negative rating actions.

Despite the pessimistic near-term outlook, and assuming the finance issues are timely resolved, TWF is well positioned to weather a period of weak market conditions. The balance sheet is modestly leveraged (debt imbedded in the stapled units is considered to be equity). The Company could take on additional debt to cover the expected free cash flow deficit and leverage would still be acceptable for the rating. TWF also has cash and unused credit facilities of $72 million at September 30, 2008, which is more than sufficient to fund near term cash requirements. Annual capex is expected to be less than $5 million a factor that will positively impact free cash flow. In addition, the Company has the option of deferring cash distributions or paying the distributions in the form of equity which provides additional financial flexibility.

While the collapse of the U.S. housing market has brought timber and lumber prices to trough levels in the past nine months, the longer term outlook is optimistic. Significant reductions in global log availability should lead to increased sawlog prices in future years. The implementation of Russian log export taxes that commenced in 2007 and are expected to increase substantially in late 2009, will significantly reduce Russian log exports to Japan and other Asian countries in 2010 and subsequent years. In addition, ongoing log supply restrictions in Ontario and Quebec as well as anticipated harvest curtailments as a result of the mountain pine beetle epidemic in the interior of B.C. will also tighten log demand/supply ratios. Demand could outstrip supply as the peak of the next building products cycle is approached producing record high prices for sawlogs. TWF has the potential to significantly increase earnings and cash flows in the next housing market upturn.

TWF owns 796,000 acres of forest lands that have an estimated market value of USD1.2 billion. A portion of the forest lands on Vancouver Island have been classified as higher and better use (HBU) properties with a market value in excess of $300 million. TWF’s recognized HBU lands are expected to benefit from the regions’ high desirability, limited land availability and changing demographics in future years, augmenting cash flows. The Company has reclassified its HBU land portfolio into “core” and “non-core” lands. Core lands (80,000 acres) require further development, including planning and zoning changes to maximize market value and are unlikely to translate into increased sales until 2010. Non-core lands (54,000 acres) have reached maximum value and will be sold “as is” in the near term. Timberlands and HBU properties are easily saleable, and the Company’s asset value to debt coverage ratio of 6x provides a high level of liquidity and a financial risk that is substantially less than forest products industry averages.

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

The applicable methodology is Rating the Forest Products Industry which can be found on our website under Methodologies.

This is a Corporate rating.