DBRS Downgrades West Fraser to BB (high), Negative Trend

DBRS has today assigned an Issuer Rating to West Fraser Timber Co. Ltd. (West Fraser or the Company) of BB (high) with a Negative trend, meaning that our opinion on the default risk of West Fraser has declined from BBB (low) to BB (high). The Negative trend reflects the fact that the Company’s ratings remain at risk due to significant headwinds to the Company’s efforts to stabilize earnings and cash burn. DBRS has also assigned a recovery rating of RR3 to the Unsecured Debentures of West Fraser, which reflects prospects for a good recovery (estimated 50%-70%) in the event of default. As a result, DBRS has downgraded West Fraser’s Unsecured Debentures from BBB (low) to BB (high), the same as the Company’s new Issuer Rating.

The lower Issuer (i.e., default) Rating reflects the Company’s weak financial risk profile which is not likely to improve in the near term due to continuing weak residential housing market conditions. DBRS has long regarded West Fraser as having an investment grade business risk profile, and being capable of maintaining its investment grade status through most economic downturns. However, the current downturn in the housing sector started in 2007 has been unusually severe, leading to a sharp deterioration of the Company’s credit metrics which are well below the range for an investment grade company. Although signs of recovery are appearing across the economy generally, the turnaround in the residential construction sector, which is critical to the Company, has lagged. Moreover, a nascent upturn in housing starts in the United States appears to have stalled. DBRS now expects a meaningful recovery in the housing sector to occur around 2011, much later than our original forecast. DBRS no longer perceives West Fraser as being able to restore its credit metrics, in terms of earnings and free cash flow margins and debt coverage ratios, until the upturn in the housing sector takes hold. The severe deterioration in credit metrics and a prolonged downturn in the housing sector have increased the default risk of the Company and, hence, have led to the rating downgrade.

However, the Company’s ratings remain at risk due to continuing deterioration of its credit metrics despite actions taken to conserve cash such as reducing capital expenditures to maintenance levels and dividend payments. Additionally, the Company still faces significant headwinds in its turnaround. (1) The Company is very susceptible to the strength of the Canadian dollar; the near-term outlook remains strong with a target of parity or higher against the U.S. dollar. (2) The recovery in the housing sector could be delayed due to: (a) a persistent high unemployment rate in the United States damaging the confidence of potential house buyers; and (b) tight credit conditions for builders and homebuyers, a major contributor to the current poor construction market, may persist. As highlighted by the Negative trend on the ratings, unless the Company can overcome weak market conditions in 2010 and stabilize its credit metrics, there may be further negative rating action.

Despite the weakening financial profile, West Fraser’s liquidity is not a concern in the near term. The Company has available credit to more than pay off its maturing debts and fund its operating needs. However, the Company is exposed to a potential risk of losing access to the credit facility if its debt-to-capitalization ratio exceeds 37.5%. With the Company’s debt-to-capitalization at about 25% at the end of September 2009, the Company has lots of head room at present. However, an increase in borrowing to cover cash flow deficits coupled with erosion to the equity base due to losses and other negative adjustments could put the availability of the credit facility at risk.

The Company’s current rating continues to be supported by its above average business risk profile among its forest product company peers. West Fraser is a low cost producer and it has a strong market position as the largest lumber and plywood producer in North America, with diversity in geography and products. The Company is able to supply about two-thirds of it log requirements internally from the timber-cutting rights on public lands in British Columbia and Alberta, moderating its exposure to risks associated with log price fluctuations and supply shortages. Additionally, the Company maintains a conservative financial policy with a moderately leveraged balance sheet.

In order to assign a recovery rating, DBRS has simulated a default scenario for West Fraser to determine the potential recovery of the Company’s debt in the event of default. In order to do this, DBRS first simulates a default scenario, regardless of how hypothetical it might appear and despite the relatively unlikely default probability that the Company’s BB (high) rating implies. The default scenario stresses the operating results to the point at which default would likely occur in order to enable DBRS to project potential levels of recovery that would be available to various debt classes in such an event. In the case of commodity-based companies, that scenario could include protracted recession or depression in which product demand and prices plummet, EBITDA declines sharply, and companies with large debt maturities and/or insufficient short-term liquidity can no longer service their debt.

In West Fraser’s case, given its strong capital and liquidity position, we can not foresee it defaulting absent a long protracted downturn that causes bankers and other secured creditors to conclude at some point that they must force a restructuring while the remaining value still covered their debt, rather than waiting until the Company deteriorated to the point of insolvency. Such a scenario – admittedly hypothetical – would most likely occur at a point when a major debt issuance was due for renewal or refinancing, the earliest being 2012. In formulating such a scenario, DBRS assumes a ten-year EBITDA trend (omitting outlier years and adjusting for lower future housing starts on a seasonally adjusted annual rate) to arrive at a realistic assessment of the Company’s going-forward value. A conservative EBITDA multiple of 4.0 times has also been used, to reflect 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 about 50% to 70% of principal and has therefore assigned a recovery rating of RR3. For further information, please refer to DBRS’s Leveraged Finance Methodology.

Notes:
All figures are in Canadian 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.