DBRS Confirms Potlatch Corporation at BB (high)

DBRS has today confirmed the rating of Potlatch Corporation (Potlatch or the Company) at BB (high). The trend returns to Stable. DBRS has also removed Potlatch from Under Review with Developing Implications, where it was placed on July 21, 2008, following the Company’s announcement that its board of directors had unanimously approved the Company’s previously announced plan to pursue a tax-free spinoff of its pulp-based businesses into a publicly traded company called Clearwater Paper Corporation. The spinoff has been successfully completed and Potlatch is now a timber real estate investment trust (REIT), with 1.7 million acres of timberland in Arkansas, Idaho, Minnesota and Wisconsin. The Company has also retained its Wood Products business segment, which consists of four sawmills in Idaho, Arkansas, Minnesota and Michigan and one industrial-grade plywood mill and one particleboard mill in Idaho.

Potlatch has been focusing its business model by putting more emphasis on its timberland. To this end, the Company converted to a more tax-efficient REIT structure in 2006. This produced a one-off tax benefit, but it also has a long-term impact on liquidity in that the Company is required to distribute most of its earnings to maintain the tax-efficient structure. The spinoff brings the Company closer to a pure timberland business, with its relatively stable earnings and cash flows. However, the retention of building products and the loss of consumer products will likely increase earnings and cash flow volatility.

On a pro forma basis, the transformed Potlatch has experienced a slight deterioration in financial performance in the past 21 months, with both earnings and cash flow from operations in a downward trend. Debt-to-EBITDA has increased from 3.46 in 2007 to 4.1 in the 12 months ending September 30, 2008. Over the same period, interest and cash flow coverage ratios have declined from 5.41 to 5.25 and from 0.31 to 0.22, respectively. The deterioration in the U.S. residential housing market is largely responsible for the drop in demand and prices for logs and building materials in the past two years, which are the key drivers of the transformed Company’s earnings and cash flows. 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. In the interim, ongoing weakness in the U.S. housing market and sawmill curtailments are expected to keep saw-log and building products demand and prices at the low levels recorded in 2008. Real estate earnings are also expected to remain at low levels until the housing sector starts to recover.

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 affected pulp prices, a condition that is expected to be maintained into 2009 with an associated negative affect on the demand and pricing for pulp logs. As a result, Potlatch’s log production and associated log sales are forecast to remain at low levels through 2009 and possibly in 2010, and the Company’s earnings and cash flows will remain weak in that same time. Corporate earnings and free cash flows in 2009 are expected to remain positive, but at a slightly reduced level than 2008. Credit metrics are expected to remain compatible with the rating.

Despite a pessimistic near-term market outlook, Potlatch is well positioned to weather a period of weak market conditions. Potlatch had cash and available credit facilities of $138.5 million at September 30, 2008, and liquidity should not be a problem in the near term. The Company has additional financial flexibility in the form of timberland assets, which can be easily monetized. The estimated U.S. private timberland market value of more than $1.4 billion (about three times the value of the Company’s total debt) provides support to Potlatch’s long-term debt. As a REIT, the Company derives most of its income through investments in real estate, including the sale of standing timber. As a result of this strategy, the Company must grow through acquisition. A period of weak earnings and debt-financed acquisitions would negatively affect credit quality and therefore the rating.

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 North American saw-log prices in future years. The implementation of Russian log export taxes, which 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 Québec and anticipated harvest curtailments as a result of the mountain pine beetle epidemic in the interior of British Columbia will also tighten North American log demand-supply ratios. Demand could outstrip supply as the peak of the next building products cycle approaches, producing record high prices for saw logs. Potlatch has the potential to significantly increase earnings and cash flows in the next housing market upturn.

Note:
All figures are in U.S. 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.