DBRS Downgrades Norbord Ratings, Trend Now Stable

DBRS has today downgraded the Issuer Rating of Norbord Inc. (Norbord or the Company) from BB to BB (low) and has changed the trend to Stable from Negative. The Company’s Secured Debentures rating has been downgraded from BBB (low) to BB (high). The downgrades reflect the fact that the Company’s performance is below expectations. Norbord has reversed its loss-making trend but its financial profile is still not compatible with a BB rating and soft conditions in the construction industry are likely to lead to further weakness in the Company’s operating performance going forward. Furthermore, DBRS deems the reduction of Brookfield Asset Management Inc. (BAM) shareholdings in Norbord to 52% (from 75%) a slight negative. Implied support from BAM is a major consideration for the rating. The trend change to Stable from Negative indicates that DBRS expects further deterioration in the Company’s financial profile to be moderate and be within the BB (low) range.

The Company’s financial profile has been on a weakening trend in line with the decline in the construction sector over the last few years. Even though the Company’s financial profile has deteriorated, its solid business profile, ample liquidity to meet operating needs, and the implied support of its majority owner BAM have supported the rating at a level above that reflected by the Company’s financial metrics. DBRS has given strong consideration to the fact that the Company is one of the lowest-cost producers of oriented strand board (OSB) and is well positioned to benefit from the recovery of the industry and to restore its financial profile to be compatible with the BB rating as the industry recovers. Initially, DBRS had expected the residential construction sector to stage a meaningful recovery around late 2010. Yet even though construction activities appeared to have bottomed in mid-2009, the pace of recovery has been tepid. However, a number of one-off factors have led to a demand/supply imbalance during the first half of 2010.

(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. Additionally, dealers in the supply chain were running down their inventory. Inventory in the supply channels was extremely lean. (2) The weather in the southeastern United States was much wetter than normal, preventing loggers from accessing the trees. (3) Sentiment among builders was turning positive at the early part of 2010, supported by encouraging economic news and government incentives, and housing starts were showing sequential improvement. This demand/supply imbalance led to a sharp increase in OSB prices. Furthermore, Norbord was able to operate at much higher utilization rates, benefiting from the imbalance. The strong performance in the second quarter of 2010 allowed Norbord to strengthen its financial profile. Although Norbord has used free cash flow to reduce debt, leverage remained aggressive for a cyclical company. However, the short product conditions were corrected in the last half of Q2 2010. Demand petered out, with most restocking at supply channels complete and housing starting to plateau at an annualized rate of approximately 600,000 units – well below expectations. OSB prices retreated back to the 2009 price range of $160 to $190 by mid-July. Operating results at Norbord in Q3 2010, although still profitable, were much weaker than the previous quarter accordingly.

Going forward, DBRS believes that there are still significant headwinds facing the construction industry. (1) The boost from the homebuyer tax credit in the United States expired at the end of April 2010. The lack of stimulus and the negative impact of pulled forward sales could dampen demand for the rest of 2010 and into 2011. (2) The persistent high unemployment rate in the United States and its impact on the confidence of potential homebuyers could continue to dampen demand and further delay a meaningful recovery in the housing market despite favourable mortgage rates. (3) Credit availability remains tight and weighs on builders’ ability to start new projects. Consequently, DBRS believes that residential construction and the resultant demand for building products are not likely to show a meaningful improvement until late 2011, much later than our initial expectation of end-2010.

Norbord has done a good job at controlling cash usage and using excess cash for debt reduction. However, the balance sheet remains aggressive for a cyclical company, and the recent improvement in operating results and associated credit metrics is not likely to be sustainable in view of still-weak market conditions. DBRS believes that the Company’s financial profile should weaken further in the near term, albeit moderately. Nevertheless, DBRS believes that the worst is over for the construction industry for this cycle but the Company’s financial profile should not show meaningful improvement until construction activities rebound, now expected in late 2011 – much later than originally anticipated.

DBRS deems the sell-down of BAM’s shareholdings to 52% from 75% as a slightly negative factor. BAM had owned between 30% and 40% of Norbord shares since the Company went public in 1987, with BAM’s ownership increasing to 75% in late 2008 when it backstopped Norbord’s rights offering. This recent divestiture has lowered BAM’s investment in/exposure to Norbord to closer to pre-2008 levels. Nevertheless, as majority owner, potential support from BAM is still intact, in DBRS’s view. However, the implied support from BAM is a critical support to Norbord’s current rating and any further significant sell-down by BAM would have negative rating implications.

Pursuant to our rating methodology for leveraged finance, DBRS has created a default scenario for Norbord in order to analyze when and under what circumstances a default could hypothetically occur and the potential recovery of the Company’s debt in the event of such default. The scenario assumes that the U.S. economy fails to recover and falls into a recession again later in 2011. This would lead to continued deterioration in the demand for OSB. In addition, it is assumed that the Canadian dollar remains high relative to its U.S. counterpart in 2010 and 2011. Under this scenario, the Company would exhaust its liquidity in late 2012.

DBRS has determined Norbord’s estimated value at default using an EBITDA multiple valuation approach, consistent with a view that default would likely result in the restructuring and/or recapitalization of the assets with value as a going concern versus the sale of its individual assets. EBITDA multiples utilized are applied to cyclically normalized EBITDA at default as opposed to the actual low EBITDA values expected at the time of default, reflecting the forward-looking nature of the valuation. The valuation considers the issuer and the specific debt instruments, allocating value proceeds accordingly. DBRS has forecast the economic value of the components of the enterprise at approximately $493 million using a 4.0 times multiple of normalized EBITDA for Norbord. Based on the default scenario above, the Secured Debentures have recovery estimated between 70% and 90%, hence the assigned recovery rating of RR2.

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.