DBRS Confirms Cascades Inc. at BB (high), Changes Trend to Negative

DBRS has confirmed the Issuer Rating of Cascades Inc. (Cascades or the Company) at BB (high) and has changed the trends to Negative from Stable. The rating action reflects that the Company’s operating results have improved since mid-2011, but not as much as expected. In addition, the rise in debt levels during the same period has mostly offset the benefits of stronger operating results, with the resultant credit metrics remaining below the current rating range. A higher leverage has weakened the balance sheet, eroded Cascades’ capacity to absorb negative development and increased its financial risk. Furthermore, the uncertainty of the United States’ economy caused by potential fiscal problems has increased the risk that Cascades’ profit recovery will remain muted. With capital spending expected to remain elevated, there is higher risk of adding on more debt. A lack of progress in strengthening the financial profile may lead to a one-notch downgrade to the rating. Pursuant to “DBRS Criteria: Rating Leveraged Finance,” DBRS has confirmed the recovery rating of the Senior Unsecured Debt at RR4 and the corresponding instrument rating at BB (high). However, the trends are changed to Negative from Stable.

Despite weak operating results in the last few years, DBRS has maintained the rating in light of the following considerations: (1) the Company’s stable and above-average business profile (a favourable market position, a diversified product portfolio and an efficient operation); (2) a steady deleveraging of the balance sheet since 2008, helping to keep debt coverage ratios manageable, albeit aggressive, for the current rating; (3) an expectation of a recovery in profitability and credit metrics, along with the advent of improving market conditions; and (4) Cascades’ modest near-term debt maturity and the resultant financial flexibility. However, the steady rise in leverage since mid-2011 has impaired the support to maintain the current rating. Moreover, the weaker-than-expected improvement in operating results coupled with the higher debt level has kept credit metrics below the current rating range.

Cascades’ operating performance in 2011 was disappointing, and all business segments reported lower year-over-year results. A significant increase in recycled fibre costs and a stronger Canadian dollar, eroding the Canadian operations’ competitiveness, were the key negatives.

During 2011, spending on acquisitions and modernizing facilities to execute the Company’s strategic shift to focus on packaging and tissue paper business segments has led to a much higher level of cash usage. Weakened cash flow from operations (from lower earnings) and proceeds from asset disposals (notably, the divestiture of Dopaco) were not sufficient to meet the increased funding needs. The steady increase in debt level since Q2 2011 has put renewed pressure on the Company’s already aggressive credit metrics. Ongoing funding toward modernizing the manufacturing facilities and upgrading the information system is expected to keep capital expenditures at an elevated level in the term. Unless internal cash generation can keep pace with the high investment spending, the debt level will continue to increase. These investments, although positive for the Company in the long run, further increase the Company’s financial risk. The Company has committed to a leverage target of debt to EBITDA at about 3x (5.3x at June 30, 2012, based on DBRS estimates), but Cascades has indicated that the target is more likely to be achieved through rising EBITDA than debt reduction.

DBRS expects the Company to report year-over-year improvement in profitability, supported by announced price increases (containerboard), a continuing decline in raw material costs, benefits from efficiency initiatives and extra earnings from recent acquisitions. However, it is uncertain that internal cash generation would match the expected increase in spending. Any further meaningful increase in debt level could negate the benefits of stronger operating results and stall the recovery of credit metrics to a level t compatible with the current rating. DBRS notes that a lack of improvement in the Company’s financial risk profile and associated debt coverage ratios is likely to lead to a downgrade of the current rating.

DBRS has updated its default scenario for Cascades in order to analyze the potential recovery for the Company’s Senior Unsecured 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, and EBITDA quickly declines and turns negative over the forecast period. DBRS assumes that the Company would be reorganized as a going concern in the event of default, and has derived a recovery rating of RR4 for the Senior Unsecured Debt. The RR4 rating corresponds to recovery prospects between 30% and 50% for senior unsecured debtholders.

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

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