DBRS Assigns Recovery Ratings and Upgrades Domtar Secured Debt

DBRS has today confirmed the Issuer Rating and unsecured debt ratings for Domtar Corporation and its subsidiary companies (collectively, Domtar or the Company). The trends remain Stable. Concurrently, DBRS has upgraded Domtar’s secured debt rating to BBB from BBB (low). Pursuant to DBRS’s Leveraged Finance Rating Methodology, a recovery rating of RR1 (90% to 100% recovery) has been assigned to the Company’s Senior Secured Credit Facility and a recovery rating of RR5 (10% to 30% recovery) has been assigned to its Senior Unsecured Notes and Unsecured Notes and Debentures, which correspond to the ratings of BBB and BB (low), respectively.

The recovery ratings are based on determining the value of the Company as a going concern versus a liquidation value in which its assets are sold to the highest bidder. DBRS’s secured rating was originally based on a liquidation approach in early 2007, when Domtar Inc. combined with Weyerhaeuser Company’s Fine Paper business. Domtar’s success in merging the two low-cost operations and achieving acquisition synergies has improved margins in the subsequent two years. In addition, the recent closure of one million tons of high-cost capacity has not only helped to stabilize paper prices but has also further reduced overall unit costs of production. The net effect has been to increase the Company’s future capability to generate higher returns. As a result, Domtar’s value as a going concern is now higher than DBRS’s initial liquidation assessment in early 2007.

The retention of a Stable trend reflects expectations that pulp and paper markets will trough in H1 2009, with a modest recovery commencing in H2 2009. Although the Company’s financial profile and coverage ratios are forecast to weaken in 2009, they are expected to remain acceptable for the rating. The Company’s favourable cost structure provides important protection against earnings and cash flow downside in 2009. A low Canadian dollar and reduced energy, chemical and transportation costs will further reduce operating expenses this year, providing additional support to profit margins in the near term. Although financial performance is expected to be weaker than reported in 2008, cash flow from operations and free cash flow is forecast to remain positive. Capex is expected to remain less than depreciation in 2009, a strategy that will benefit cash flow. Liquidity is not expected to be an issue over the near to medium term, given cash and unused A/R securitization and credit facilities of $757 million, as well as a lack of large debt maturities until 2011. In addition, the U.S. alternative fuels tax credit program could provide the Company with additional cash of up to $390 million in 2009. The Company is committed to stemming cash outflows by curtailing production when operating costs fall below breakeven levels, a strategy that will conserve cash until market conditions rebound. Furthermore, Domtar, as a low-cost producer, should generate favourable profitability once the paper market turns around.

As prescribed under its methodology for leveraged finance, DBRS has simulated a default scenario for Domtar in order to analyze the potential recovery for the Company’s debt in the event of default. In order to analyze potential recovery for various debt classes in the event of default, DBRS must first simulate a default scenario, regardless of how hypothetical it might appear, and the relatively unlikely default probability that this rating implies. The default scenario stresses the operating results to the point at which default would be considered likely to occur, in order to enable DBRS to project potential levels of recovery that would be available to various debt classes in such event. In the case of commodity-based companies, that scenario includes severe economic conditions, usually a deep, protracted recession or depression in which product demand and prices plummet. EBITDA quickly declines and usually turns negative, and companies with large debt maturities and/or insufficient short-term liquidity can quickly reach the point of default.

In the case of Domtar, earnings and cash flows would rapidly deteriorate from 2008 levels, and the Company would exhaust its credit facilities in 2011. For the purposes of this analysis, DBRS assumes that the ongoing deterioration of corporate finances, and general pessimism about future economic conditions would require the Company to restructure. The Company’s capability of generating large returns at cycle peaks, and the potential for substantial earnings gains in the next paper cycle, suggests creditors would gain the greatest recovery by reorganizing the Company’s pulp and paper assets as a going concern. The most likely prospect is that a private equity investor would purchase Domtar’s pulp and paper assets with a view to taking the Company public during the next North American economic recovery.

DBRS considers that a ten-year EBITDA trend, omitting outlier years, represents a realistic assessment of the Company’s prospects through the next business cycle. A conservative EBITDA multiple of 5.0 times has been used to value Domtar’s operations at the time of restructuring. The relatively low multiple reflects expectations of pessimistic outlooks by forest products industry participants and the financial community at the time of reorganization. At the distressed valuation level, DBRS believes the secured debt holders would recover 100% of the principal and has therefore assigned a recovery rating of RR1. Conversely, the unsecured debt holders would only recover about 25% of the principal and DBRS has assigned a recovery rating of RR5.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodologies are Rating the Forest Products Industry and Rating Leveraged Finance, which can be found on our website under Methodologies.

This is a Corporate rating.