DBRS Upgrades Domtar’s Issuer Rating to BB (high), with a Stable Trend

DBRS has today upgraded the Issuer Rating of Domtar Corporation (Domtar or the Company) to BB (high) from BB and its Senior Unsecured Notes rating to BB (high) from BB (low). DBRS has also upgraded the rating of Domtar Inc. to BB (high) from BB (low). The trends on the ratings are Stable. The upgrade of Domtar’s Issuer Rating reflects the Company’s progress in de-leveraging its balance sheet and strengthening its financial profile. In addition, the Company has strengthened its business risk profile by rightsizing its manufacturing footprint and improving its cost competitiveness. In the next 12 to 18 months, DBRS expects the Company’s operating results to stabilize near current levels amid a slow recovery in the general economy. Unless the Company generates operating results well above our expectations and significantly strengthens its financial profile from current levels, the ratings will remain unchanged in the near term. Pursuant to the “DBRS Rating Methodology for Leveraged Finance,” a recovery rating of RR1 (90% to 100% recovery) has been assigned to the Company’s Senior Secured Credit Facility, which results in the BBB (low) instrument rating, and recovery ratings of RR2 (70% to 90% recovery) have been assigned to the Company’s Senior Unsecured Notes and to Domtar Inc.’s Unsecured Notes and Debentures, which result in BB (high) instrument ratings.

The Company took a number of actions to strengthen its business profile in 2009: (1) Domtar rationalized capacity aggressively, shutting down mills to reduce production capacity in both paper and pulp to match market demand; (2) the Company implemented initiatives to reduce costs and increase productivity; (3) the Company is repositioning its assets to improve returns by converting mills to make more profitable products (e.g., fluff pulp); and (4) the Company sharpened its focus on financial discipline and strengthened its balance sheet through debt reduction. The benefits from Domtar’s actions to improve its cost structure and operating efficiencies helped moderate the impact of the adverse economic and market conditions and limit the decline in profitability in 2009.

Additionally, the improved operating leverage allowed the Company to benefit from much higher margins when product prices improved in 2010. The Company has reported strong operating results, particularly in the first nine months of 2010, well above expectations. However, with the uncertainties in the global pulp markets, it will be a challenge for Domtar to maintain its strong performance in Q4 2010. Nevertheless, DBRS believes that the low point of the current cycle has passed, although the pace of recovery in the economy remains slow and operating performance at Domtar is expected to remain stable in the near term.

To improve its operating leverage, the Company has also done a good job strengthening its financial position. Strong cash flow from operations, tight control over capital expenditures and initiatives to reduce working capital contributed to a large increase in free cash flow in 2009 and the first nine months of 2010, which the Company used to pay down debt. The balance sheet is moderately leveraged and manageable for a company in a volatile industry.

Domtar has made good progress in rightsizing its production footprint and increasing its cost competitiveness. The recent sale of its less profitable Wood segment, completed on June 30, 2010, is another positive freeing up of the Company’s resources (both management and financial) for the two remaining segments: Papers and Paper Merchants. However, the Company continues to face structural decline in the demand for paper and uncertain conditions in the global pulp market. New mills in Latin America have recently added to the global supply of pulp and increased the volatility of pulp prices. Although the Company is better positioned to handle the structural decline in the demand for paper, ongoing focus to align production and demand remains critical to avoid the costly “lack-of-orders” downtime. DBRS expects the Company’s financial profile to remain stable, and the ratings are not likely to change in the near term.

Pursuant to its rating methodology for leveraged finance, DBRS has created a default scenario for Domtar 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 in 2011. This would accelerate the decline in demand for paper. In addition, the scenario assumes a double-dip recession the United States causes a sharp slowdown in the global economy and the demand for pulp. Moreover, it is assumed that the Canadian dollar remains high relative to the U.S. dollar in 2011. Under this scenario, the Company would exhaust its liquidity in late 2012. DBRS has determined Domtar’s estimated value at default using an EBITDA multiple valuation approach, which is consistent with the view that default would likely result in the restructuring and/or recapitalization of the Company as a going-concern operation rather than the sale of its individual assets. EBITDA multiples used were 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 $350 million, using a 4.0 times (x) multiple of normalized EBITDA for Domtar. Based on this default scenario, DBRS believes the secured debtholders would recover 100% of the principal and has therefore assigned a recovery rating of RR1. Conversely, the unsecured debtholders would only recover about 77% of the principal, resulting in a recovery rating of RR2.

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

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

This rating did not include issuer participation and is based solely on publicly available information.