DBRS Downgrades Kruger Products L.P. Notes to B (high) from BB (low), Confirms Issuer Rating at BB, Trends Stable

DBRS Limited (DBRS) downgraded Kruger Products L.P.’s (KPLP or the Company) Senior Unsecured Notes (the Notes) to B (high) based on a Recovery Rating of RR6 from BB (low) and a Recovery Rating of RR5 and confirmed the Company’s Issuer Rating at BB. All trends are Stable. The downgrade of the Notes reflects the structural subordination to KPLP’s new senior secured credit facility, which caused a downgrade to the Recovery Rating to RR6 from RR5 and in turn led to a one-notch downgrade on the Notes. These rating actions remove the Company’s ratings from Under Review with Negative Implications where they were placed on August 22, 2018, when Kruger announced its plan to invest $575 million in a tissue plant in Sherbrooke, Québec, that features a through-air-dry (TAD) machine (the TAD2 Project). At the time, the structure, terms and conditions of the financing package had not been finalized. As such, this was the focus of DBRS’s review.

The confirmation of the Issuer Rating reflects the business benefits of the TAD2 Project, including future improvements to the business risk profile once the project fully ramps up, as it will allow KPLP to increase and rebalance its premium tissue capacity across North America and increase its offering of tissue products, which is expected to help KPLP maintain its strong market position in Canada and continue to expand in the U.S. premium private label market.

On November 19, 2018, Kruger announced that the TAD2 Project would be financed by the following:
(1) Credit facilities of USD 198 million and $123.5 million (together, the Project Facility) issued by certain unrestricted subsidiaries of KPLP;
(2) A convertible debenture of $105 million issued by Kruger Products Sherbrooke Inc. (KPSI; the entity that will construct and operate the TAD2 Project);
(3) A senior secured credit facility of USD 48.8 million (the Nordea 2 Facility) issued by KPLP; and
(4) An accounts receivable securitization facility of $50 million (the Factoring Facility) issued by KPLP.

KPLP will use funds from the Nordea 2 Facility and the Factoring Facility as well as cash on hand to fund a $125 million equity investment in KPSI; half will have been funded at the close of the financing package, and the remainder will be funded over the next two years. The Project Facility is non-recourse to KPLP.

The confirmation of the Issuer Rating is based on there being no material change initially to the Business Risk Assessment factors of KPLP with a potential benefit over the medium term. Construction of the TAD2 Project is expected to begin in early 2019, and the plant is anticipated to begin production in early 2021. At maturity, the TAD2 Project will produce approximately 70,000 metric tonnes per annum of bathroom tissue and paper towels to increase KPLP’s offering of tissue products under the Cashmere, SpongeTowels and Purex brands. Along with the existing TAD location in the United States, the TAD2 Project will allow the Company to increase and rebalance its premium tissue capacity across North America, which is expected to help Kruger maintain its strong market position in Canada and continue to expand in the U.S. premium private label market. Following ramp-up and after leverage thresholds are met at K.T.G. (USA) Inc. (KTG)/KPSI, the TAD 2 Project will generate equity income, and dividends could flow up to KPLP.

In the course of its analysis of establishing an Issuer Rating on KPLP, DBRS excludes subsidiaries that are unrestricted and non-recourse to KPLP in its financial metric analysis (using the deconsolidated financial statements of KPLP). Previously, the major excluded entity was limited to KTG, which held TAD1, but now also includes KPSI, which holds the TAD2 Project. For more information, please see the Organizational Structure section of the related presale report dated April 16, 2018.

Despite an increase in debt from the funding package for the TAD2 Project, DBRS expects KPLP’s financial profile to remain acceptable for the current rating. On a pro forma basis for the transaction, leverage increases to approximately 4.3 times (x) from 3.7x at the last 12 months (LTM) ended Q2 2018. DBRS expects KPLP’s cash flow from operations to track operating income and increase toward $85 million over the near to medium term. Capex outlay is expected to be between the $30 million to $35 million range, with approximately $25 million allocated to routine asset maintenance and the remainder to expansionary initiatives. DBRS expects KPLP’s per-share dividend to remain stable but expects cash dividend outlay to decrease, as Kruger Inc. announced its DRIP participation will rise to 75% from 50%, previously. As a result of the above, DBRS does not expect KPLP to generate a meaningful level of free cash flow. DBRS expects KPLP will use any free cash flow primarily for mandatory debt repayments, such as the Nordea 1 facility, which is set to mature in December 2019. As such, KPLP’s credit metrics are expected improve back toward a range acceptable for the rating and toward 3.5x over the next two years, supported by modest EBITDA growth. Should KPLP be challenged to return to and maintain credit metrics in a range considered acceptable for the current BB rating (i.e., lease-adjusted debt-to-EBITDAR below 4.0x) as a result of weaker operating performance and/or more-aggressive-than-expected financial management, a negative rating action could result.

That said, the TAD2 Project does have an impact on the overall credit risk profile of KPLP based on the magnitude of debt being added to the consolidated entity, KPLP’s interest in the success of the TAD2 Project, and the potential benefit to KPLP’s Business Risk Assessment once the TAD2 Project is operational, on earnings and cash flows. With an additional $470 million of debt being added to the consolidated entity and no immediate EBITDA benefits, there is execution risk. Additionally, there is an incentive for KPLP to fund any project cost overruns. DBRS will monitor this throughout the construction period and project ramp-up.

The one-notch downgrade of the Notes reflects the Notes’ structural subordination in relation to the new Nordea 2 Facility at KPLP. The new Nordea 2 Facility will rank ahead of the Notes, which lowers the recovery prospects for the Notes, causing a downgrade to the Recovery Rating to RR6 from RR5, which in turn causes a one-notch downgrade to the Notes.

As a part of the financing announced on November 19, 2018, KTG issued a term loan of USD 147 million (the KTG Facility) and used funds from the KTG Facility to refinance its Caisse credit facility, with a fair value of about $190 million at September 30, 2018, which was part of the financing of TAD1. DBRS notes that this refinance transaction does not affect KPLP’s financial metrics or recovery, as both the KTG Facility and the Caisse credit facility are non-recourse to KPLP.

KPLP’s ratings are supported by its strong brands and market positions in the Canadian tissue products market, efficient production facilities and effective operations; stable tissue products demand; and the significant barriers to entering the tissue products market. The ratings also reflect the Company’s exposure to volatile commodity prices while operating in a highly competitive industry, single-product/single-market exposure and the strong bargaining power of major retailers.

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

The principal methodologies are Rating Companies in the Consumer Products Industry and DBRS Criteria: Recovery Ratings for Non-Investment Grade Corporate Issuers, which can be found on dbrs.com under Methodologies.

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 under Related Documents or by contacting us at info@dbrs.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

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