DBRS Confirms Domtar Corporation at BB (high), Trend Positive

DBRS has confirmed the Issuer Rating and Senior Unsecured Notes of Domtar Corporation (Domtar or the Company) at BB (high), with a trend change to Positive from Stable. The Positive trend reflects that Domtar’s credit metrics have remained above its rating range, having weathered the downturn in 2012, and the steady strengthening of Domtar’s business profile. Moreover, its credit metrics are expected to be sustainable and remain solid going forward, based on the expectation of comparable results in 2013.

DBRS has downgraded the recovery rating of the Company’s Senior Unsecured Notes to RR2 from RR1, but this has no impact on the senior unsecured rating, as the prior strength of RR1 did not warrant an investment-grade rating per our criteria. The Company increased its debt level during 2012; as a result, the recovery of unsecured debt decreased from slightly over 100% to between 70% and 100%, corresponding to a recovery rating of RR2.

Domtar’s operating results in the first nine months of 2012 were weaker from last year, due to lower results in both of its major businesses, pulp and paper. Lower pulp results were due to weaker pulp price, as it declined from the high levels reflecting the current downturn in the global pulp market. The demand for paper has been in structural decline for a decade, though since 2002 this decline has been slow (the exception being between 2007 and 2009, when the rate was higher due to the financial crisis). As a highly consolidated industry, supply management by producers has been successful in supporting prices in the past; such wasn’t the case for 2012, however, as continued weakness in North America communication paper demand more than offset the reduction in industry supply. As a result of the lower prices, paper results were lower. Nonetheless, despite weaker results, Domtar’s credit metrics remained above its rating range.

Looking forward to 2013, the global pulp market is expected to be stable due to stabilized demand from China, pulp prices and world pulp inventory level. Pulp results are therefore expected to remain stable. Paper results are expected to be comparable, as the industry continues to balance supply with the decline in the domestic communication paper demand. Moreover, 270 thousand tons of communication paper capacity, representing about 8% of last 12 months’ (LTM) September 2012 paper production volume, will be fully converted to specialty paper in 2013, thereby reducing supply.

In 2012, Domtar has added more stability to its paper business, having entered into a 15-year UFS supply agreement valued at $3 billion with Appleton Papers, a coated paper producer. Domtar has also been strengthening its business profile by expanding its personal care business into adult incontinence products, a less volatile business with a growing trend. This business is still relatively small (8% of nine months 2012 EBITDA), but is expected to continue to grow both organically and through acquisitions. Until the personal care business reaches critical mass, Domtar’s business profile remains risky, relying highly on its paper business (LTM production volume of 2.5 million ST), demand for which is in structural decline, and a highly volatile pulp business (LTM production volume of 1.2 million ST).

Domtar’s balance sheet is strong, though it has been distributing excess cash through shareholder-friendly actions. As of September 30, 2012, Domtar has spent $659 million since the inception of the $1 billion share repurchase program. Additionally, Domtar intends to expand its personal care businesses through acquisitions, saying it intends to add another $200 million to $400 million EBITDA to its personal care business by means of acquisitions, along with organic growth. Domtar has stated that the acquisitions are intended to be done at a careful pace. As of today, the run rate of personal care is about $75 million, and total acquisition costs were $581 million. Domtar was able to finance the acquisitions mostly from internal cash flow. Going forward, DBRS expects Domtar to continue to demonstrate financial discipline to balance its expansions and shareholder-friendly objectives and maintain the credit metrics at a solid level.

The risky business profile, coupled with the market challenges Domtar faced in 2011, were the main reasons DBRS did not take a positive rating action on the Issuer Rating in the past. Domtar had demonstrated sustainability of its credit metrics, having weathered the 2012 downturn, and they are expected to remain sustainable going forward. On top of that, Domtar’s business profile has been strengthening, resulting in Domtar’s rating being placed on a Positive trend. Moreover, the continuation of prudent management at growing the personal care business and the sustainability of credit metrics have the potential to lead to positive rating action in 2013. However, a large debt-financed acquisition that has a material impact on Domtar’s credit metrics could lead to negative rating actions.

DBRS has discontinued Domtar Inc.’s Unsecured Notes and Debentures rating, given the insignificant amount of debt outstanding.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodologies are Rating the Forest Products Industry (June 2011) and DBRS Criteria: Rating Leveraged Finance (June 2011), which can be found on our website under Methodologies.

This is an unsolicited credit rating. This credit rating did not include participation by the issuer or any related third party.