DBRS Confirms West Fraser at BB (high), Changes Trend to Stable

DBRS has today confirmed the Issuer Rating and the Secured Debentures rating of West Fraser Timber Co. Ltd. (West Fraser or the Company) at BB (high), and has changed the trends from Negative to Stable. The confirmation recognizes the solid improvement – well above our expectations – in the Company’s financial profile. In addition, DBRS believes that the Company has reversed its loss-making performance and its financial profile should remain compatible with the current rating even though operating results may weaken in the near term due to the still-depressed housing market.

Prior to 2010, operating performance at West Fraser had deteriorated sharply, in line with the prolonged downturn in the construction market, and the Company had reported losses in three consecutive years. During the first nine months of 2010, higher prices led to a significant increase in earnings in both the lumber and pulp and paper businesses. Lumber prices were helped by a combination of factors which led to a demand/supply imbalance. (1) During the latter part of 2009, in anticipation of weak construction activities, most producers in North America curtailed production, limiting supply to match the weak demand conditions. Dealers in the supply chain were also running down their inventory to reduce carrying costs and conserve cash. Inventory in the supply channels was extremely lean. (2) The weather in the southeast United States was much wetter than normal, preventing loggers from accessing the trees. (3) Sentiment among builders was turning positive, supported by encouraging economic news and government incentives, and housing starts were showing sequential improvement. Hence, a modest increase in lumber demand from restocking and a slight increase in housing starts coinciding with record-low lumber inventory levels throughout the supply chain led to a sharp run-up in lumber prices in the middle of Q1 2010. However, the surge in lumber prices was not sustainable and lumber prices started to retreat in the second half of Q2 2010. Nevertheless, disciplined response from producers and increasing demand from China have supported prices in Western Canada, where the decline was less severe than in the United States. In addition, operating results at the lumber operations were buoyed by much higher capacity utilization and benefited from cost-reduction initiatives implemented during the downturn. The Company’s pulp and paper business segment has also reported higher earnings due to favourable global demand and pricing. Furthermore, the Company’s discipline in controlling cash usage and using the resultant free cash to pay down debt led to the significant improvement in its financial profile.

Going forward, DBRS believes that there are still significant headwinds facing the construction industry. New home sales have been weaker than expected and housing inventory has remained at high levels despite modest new construction, low mortgage rates and a temporary boost from government grants for home buyers (expired on April 30, 2010). More worryingly, with housing prices remaining weak and high unemployment rates, more homeowners are facing financial difficulties (negative equity in houses, increasing delinquencies, etc.) and, ultimately, more foreclosures. It is not unreasonable to assume that more houses will be on the market in the near future, adding to the situation of oversupply and placing more downward pressure on new home construction. Further delay in the recovery of new home construction would prolong the weak demand for lumber. Lately, softening demand from China has weighed on pulp prices, adding further downward pressure on the Company’s operating results. Hence, DBRS expects West Fraser’s results to be weaker until meaningful demand materializes in late 2011. Notwithstanding the risk of weakness in the housing market and the resultant impact on the Company’s operating results in the near term, DBRS expects the Company to have no problems funding its operations internally. Nevertheless, DBRS believes that the worst is over for the current cycle in the construction industry. Even though West Fraser’s operating results may weaken in the near term, the Company’s financial profile would still be compatible with the current rating. DBRS does not expect any downside risk to the current rating in the near term. However, if the Company could demonstrate that its recovery is sustainable and maintain the strength of its financial profile, that may lead to positive rating actions.

DBRS has simulated a default scenario for West Fraser in order to analyze the potential recovery for the Company’s secured debt in the event of default. The scenario assumes a prolonged period of severe economic conditions regardless of how hypothetical or unlikely the conditions may be, in which product demand and prices plummet. EBITDA quickly declines and turns negative over the forecasted period. DBRS assumes that the Company would be reorganized as a going concern in the event of default, and has thus derived a recovery rating of RR3 for the secured debt, which corresponds to recovery prospects of between 50% and 70%.

Note:
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.