DBRS Upgrades Ratings of Domtar Corporation to BBB (low)

DBRS has today upgraded the Issuer Rating and Senior Unsecured Notes rating of Domtar Corporation (Domtar or the Company) to BBB (low) from BB (high) and changed the trends to Stable from Positive. The upgrade is a reflection of the improving industry conditions, which will support Domtar’s ability to maintain strong credit metrics for the current rating as well as stabilize its EBITDA level despite having weakened in the past two years. The upgrade also recognizes the Company’s progress in stabilizing its business risk by growing the personal care business to lessen its dependence on the declining paper business. DBRS expects the current ratings to be stable in the medium term in the absence of unexpected actions by the Company to materially weaken the current financial profile such as a material debt-financed acquisition. DBRS has also discontinued the recovery rating previously assigned to the Company’s Senior Unsecured Notes.

The paper industry in North America has been beset by the ongoing structural decline in the consumption of uncoated freesheet (UFS) paper, Domtar’s dominant business, with the advent of the digital age. Supply management by industry participants has moderated the pace of pricing decline but maintaining profitability at a reasonable level is challenging. Domtar’s operating performance has been deteriorating in line with the industry. Nevertheless, internal cash generation has been strong even through the recessionary years. Tight control over capital expenditures to well below depreciation was a key contributor to strong free cash flow generation during this period. Furthermore, Domtar has actively paid down debt with the free cash flow. The sharp reduction in debt levels between 2008 and 2010 has significantly strengthened Domtar’s financial profile despite weakening profitability.

The supply/demand imbalance has pressured pricing and lowered profits through 2012 and the first nine months of 2013. Additionally, the Company has also been active in acquisitions to grow its personal care business, and its decision to return a majority of free cash flow to shareholders has further added to cash usage since 2010. Nevertheless, the Company has continued to generate free cash flow before investments although not enough to fund all the increase in cash usage. Notwithstanding the recent modest increase in debt levels, the Company’s balance sheet leverage remains moderate and all debt coverage ratios, albeit weakened slightly, still stay strong for the current rating.

Conditions in the paper industry which have been under pressure due to the structural decline in consumption have received a welcome boost. International Paper, the second largest UFS producer in North America behind Domtar, announced the closure of one its large mills in September 2013. This combined with earlier closure announcements by Boise Inc. and Georgia-Pacific is expected to reduce industry capacity by more than 10% by early 2014. These actions will materially improve the supply/demand situation in North America and are expected to materially raise the operating rate of the industry (from about 90% recently to the high 90% range). Therefore, the impact of shrinking demand due to a structural decline in paper use in North America has been muted in the medium term as a result of significant production capacity closures in the next few months. Domtar and other industry producers have already announced price increases effective for late October and more increases are expected in the coming months. DBRS expects that near term price increases should boost Domtar’s profitability and the resultant cash flow and strengthen its financial profile. Additionally, the improved supply/demand conditions will provide a supportive operating environment and lessen the head winds to maintain strong credit metrics for the current rating in the medium term.

DBRS has recognized that the Company has a conservative financial leverage and has maintained debt coverage metrics compatible with an investment grade rating. Furthermore, DBRS has indicated that continuing prudent management at growing the personal care business and the sustainability of strong credit metrics may lead to an upgrade (see press release dated November 28, 2012, for details). The improved industry condition has lessened the uncertainty regarding Domtar’s ability to maintain a strong financial profile in light of the declining demand for UFS. Domtar will benefit from these plant closures and the resultant improved supply/demand conditions and operating environment in the medium term. Moreover, the improved environment in the paper industry has lessened the pressure on Domtar and allowed it more time to grow its personal care business. DBRS notes that the latest positive industry development is a key consideration supporting upgrading Domtar’s ratings and as a result, DBRS expects Domtar’s credit rating to be stable in the investment grade range for the medium term. However, Domtar remains acquisitive and has stated that it intends to grow its personal care business via acquisitions. Although the Company’s financial profile has some cushion to absorb moderate debt increases, a significant debt-financed acquisition that causes the adjusted debt-to-EBITDA ratio to be in excess of the 3.0 range would put the current rating at risk.

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 methodology is Rating Companies in the Forest Products Industry, which can be found on our website under Methodologies.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

This is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer and did not include participation by the issuer or any related third party.