DBRS Comments on Domtar’s Acquisition of Indas

On November 19, 2013, Domtar Corporation (Domtar or the Company) has announced the signing of a definitive agreement to acquire privately-held Laboratorios Indas, SAU (Indas), a leading branded incontinence products manufacturer and marketer in Spain. The enterprise value of the acquisition is expected to be €400 million, and the transaction is expected to close the end of 2013. DBRS notes that the acquisition is not unexpected and is consistent with Domtar’s strategy of growing its personal care business.

DBRS views this acquisition to be neutral to Domtar’s credit rating. DBRS notes that while the acquisition would slightly weaken the Company’s financial risk profile, this factor is partly offset by a modestly stronger business risk profile. Under the worst-case scenario, assuming the acquisition to be fully financed by debt, DBRS estimates the adjusted debt-to-EBITDA ratio, on a pro forma basis, will initially rise to 2.4 times (x), which remains acceptable for the current rating range of BBB (low). (On November 20, 2013, Domtar announced an offering of senior notes due 2044 in an aggregate principal amount of $250 million. The Company intends to use the net proceeds from the offering to pay a portion of the purchase price of its proposed acquisition of Indas. As a result, Domtar may use less debt to finance this acquisition than our worst-case scenario.) Moreover, the addition of Indas would accelerate the growth of Domtar’s personal care products business, lessening its dependence on the uncoated freesheet (UFS) business, which is still in structural decline, resulting in a modestly positive impact on Domtar’s business risk profile.

The transition of Domtar’s credit rating from BB (high) to BBB (low) has taken a few years. Active debt reduction from free cash flow between 2008 and 2010 significantly strengthened Domtar’s credit metrics. However, DBRS continued to maintain Domtar’s rating at BB (high), reflecting the Company’s risky business profile, significant dependence on the shrinking UFS business and the uncertainty of Domtar’s ability to sustain its strong credit metrics.

In 2012, the rate of decline in the North American UFS market appeared to have stabilized (at an annual rate of decline at 2% to 3% per year, according to RISI (essential information for the forest products industry)). Additionally, ongoing supply management by key producers was effective in moderating the impact of the structural decline in demand for UFS. DBRS placed Domtar on a Positive trend, in recognition of its ability to sustain strong credit metrics since 2010, with the expectation that Domtar would stabilize its operating performance and maintain strong credit metrics in 2013 (see DBRS press release dated November 28, 2012).While Domtar’s operating performance was well below expectations in the first nine months of 2013, due to unfavourable North America UFS supply/demand conditions, Domtar’s credit metrics remained solid, despite worse than expected operating results.

In September 2013, International Paper, the second-largest UFS producer in North America behind Domtar, announced the closure of one of its large mills. This event, combined with 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 paper use demand in North America is expected to be muted in the medium term. Domtar and other industry producers have announced price increases effective late October, and more increases are expected in the coming months.

DBRS expects these positive developments to boost Domtar’s profitability in 2014 and beyond, but not meaningfully affect results in Q4 2013. Consequently, DBRS upgraded Domtar’s rating to BBB (low) with a Stable trend, from BB (high) (see DBRS press release dated November 8, 2013). This upgrade reflected: (1) significant positive developments in the North America UFS industry (about 10% reduction of North America capacity by early 2014), which will effectively mute the impact of shrinking demand due to the structural decline of North America UFS for the medium term; (2) stronger profitability going forward for Domtar, and therefore a material lessening of the uncertainty regarding Domtar’s ability to maintain solid credit metrics in the medium term; and (3) Domtar’s progress in strengthening its business profile, with steady growth in the personal care products segment, to reduce its dependency on the declining North America UFS business.

DBRS notes that the addition of Indas will further strengthen Domtar’s business profile and lessen its dependency on the declining North America UFS business. On a pro forma basis, DBRS expects the personal care products segment will contribute about $160 million of annual EBITDA, which represents about 20% of the total EBITDA, in terms of the last twelve months (LTM) September 2013 results.

Assuming the acquisition is fully financed by debt, the increase in debt will weaken Domtar’s credit metrics. On a pro forma basis, adjusted debt-to-EBITDA will initially rise to 2.4x from 1.9x as at the end of September 2013. Although weaker, all debt coverage ratios will remain acceptable for the current rating. In the medium term, DBRS expects Domtar’s credit metrics to strengthen, supported by higher earnings in both the UFS and personal care businesses.

Domtar will acquire all the outstanding capital stock for €285 million, and the business is expected to have approximately €140 million of debt, net of cash, at closing. The net debt is expected to be reduced by the collection of approximately €25 million of past due accounts receivable before year-end 2013 or early 2014, resulting in an enterprise value of €400 million. The majority of the Indas debt will be repaid by Domtar in connection with the closing of the transaction. DBRS views the acquisition as being fully priced at about 8.7x enterprise value/EBITDA.

Going forward, DBRS expects Domtar to remain acquisitive and maintains its goal of expanding its personal care products segment to $300 million of EBITDA by 2017. The acquisition of Indas has elevated the adjusted debt-to-capital ratio to 41%, near the top of the current rating range. As stated in the DBRS press release at the time of the rating upgrade, any debt-financed acquisition that causes the adjusted debt-to-EBITDA ratio to exceed the 3.0x range would put the current rating at risk.

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

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