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

DBRS has today confirmed the Issuer Rating of West Fraser Timber Co. Ltd. (West Fraser or the Company) at BB (high), with a Stable trend. The confirmation reflects the fact that the Company’s financial profile remains compatible with the current rating, despite renewed weakness in operating performance in 2011. Furthermore, the Company has been actively deleveraging its balance sheet. The stronger balance sheet increases the Company’s ability to handle a further decline in earnings in the near term and still maintain credit metrics within the current rating range. DBRS has also confirmed the recovery rating on West Fraser’s Secured Debentures at RR3, which corresponds to an instrument rating of BB (high). The trend is Stable.

Persistent weak market conditions have derailed the Company’s recovery, and operating results in the first nine months of 2011 were well below the comparable year-ago period. All business segments reported weaker results in 2011, and, unsurprisingly, lumber, the Company’s largest business, was among the worst performers. The U.S. housing market and residential construction activities have struggled near record-low levels since the financial crisis in 2008, and the timing of a sustainable turnaround is highly uncertain. Weak industry fundamentals have depressed the demand for and pricing of lumber. On top of this, higher log and fuel costs and a strong Canadian dollar have further affected the Company’s Canadian lumber operations. The timing of a sustainable turnaround is highly uncertain, and the near-term outlook is not encouraging. Headwinds facing the Company include (1) still very weak housing market fundamentals. The U.S. economy is facing the rising odds of a ‘double dip’ recession. A weak labour market and the large unsold house inventory further weigh on demand; (2) a potential slowdown in the demand for lumber from China due to tightening credit conditions; (3) high global pulp inventory levels pressuring pricing; and (4) a strong Canadian dollar. DBRS expects West Fraser’s operating performance to remain under stress in 2012; the Company is likely to show a moderate year-over-year decline in earnings.

Nevertheless, West Fraser has been actively paying down debt with free cash flow and de-risking its financial profile over the past few years. The ratio of gross debt-to-total capitalization has declined to below 18% at the end of September 2011. In addition, the Company has consistently demonstrated its ability to generate free cash flow (before working capital), despite weak operating performance. Although operating results were weaker in the first nine months of 2011, all debt coverage metrics remained strong for the current rating. Moreover, the low leverage increases the Company’s ability to maintain credit metrics acceptable to the current rating even with a further moderate decline in earnings.

DBRS believes that the worst is over for the current cycle in the residential construction industry. Although operating results at West Fraser are expected to weaken moderately in the near term, they should still be well above the lows seen before 2010. In addition, the Company has ample liquidity (cash and available credit facility totalling over $700 million at the end of September 2011) to weather the current weak market conditions. Hence, DBRS expects the Company’s financial profile to remain compatible with the current rating despite further deterioration in operating performance.

The current rating is also supported by the Company’s stable business profile. West Fraser is the largest lumber producer in North America, with strong exposure to the West Coast and southern United States. It is also one of the lowest-cost producers. The Company has a solid position in pulp, which provides a degree of business diversity, and has recently stepped up its investment program to modernize its operating assets. West Fraser is well positioned to benefit from the eventual upturn in the U.S. housing industry. The long-term outlook for the U.S. residential construction market remains positive, supported by macro trends such as household formation. The U.S. housing market will indeed recover – only the timing is uncertain.

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%.

Notes:
All figures are in Canadian dollars unless otherwise noted.

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