DBRS Morningstar Assigns Ratings to Kruger Products Inc.

DBRS Limited (DBRS Morningstar) assigned an Issuer Rating of BB with a Negative trend to Kruger Products Inc. (Kruger Products or the Company) and concurrently assigned a rating of B (high) with a Negative trend to the Company’s Senior Unsecured Notes, with a Recovery Rating of RR6.

On January 1, 2023, Kruger Products, through a corporate reorganization, purchased and assumed from its parent company, Kruger Products L.P. (KPLP), all of its properties, operations, assets, and liabilities. KPLP was subsequently dissolved. Consequently, DBRS Morningstar assigned KPLP’s Issuer Rating and Senior Unsecured Notes rating to Kruger Products, and discontinued KPLP’s ratings. (Refer to the press release titled “DBRS Morningstar Discontinues Ratings on Kruger Products L.P.” published on March 28, 2023).

The ratings on Kruger Products continue to be supported by the Company’s strong brands and leading market position in the tissue products industry, stable demand, and significant barriers to entry and also reflect the intense competition, volatile input costs, and product/market concentration. The Negative trends reflects DBRS Morningstar’s concerns that, against the backdrop of a challenging operating environment, Kruger Products could be challenged to grow EBITDA enough to support a sufficient level of deleveraging over the near to medium term, given the Company’s aggressive debt funded capital expenditure (capex) program.

On September 2, 2022, DBRS Morningstar changed the trends on KPLP’s Issuer Rating and Senior Unsecured Notes rating to Negative from Stable and confirmed the Issuer Rating at BB and the Senior Unsecured Notes rating at B (high). The Negative trends reflected the significant deterioration in KPLP’s financial performance in H1 2022 (six months ended June 30, 2022), attributable to soaring inflation on input and operating costs. DBRS Morningstar also commented that a near-term recovery might be difficult to achieve as KPLP could be challenged to continue to pass through price increases to protect its gross profit margins without negatively affecting volumes. At that time, DBRS Morningstar stated that, should a meaningful recovery in EBITDA from a combination of margin and/or volume growth not occur in the next two quarters, the ratings could be downgraded, regardless of any capital conserving measures undertaken by KPLP to improve credit metrics through debt reduction. Conversely, if price increases, input and operating cost relief, and cost-saving and efficiency-improving initiatives were to lead to restored EBITDA growth and consequently a recovery in key credit metrics over the following four quarters, the ratings outlook could stabilize.

Since DBRS Morningstar’s last rating action, KPLP reported results for the H2 2022 (six months ended December 31, 2022). Revenue grew to $885 million in H2 2022, up 11% on H1 2022 levels of approximately $800 million, driven by price increases in the Consumer and Away-From-Home segments. Contrary to DBRS Morningstar’s previous expectations, volumes grew from H1 2022 levels, particularly in the Consumer segment, notwithstanding these price increases. As such, revenue for the full-year 2022 increased to approximately $1.7 billion, from below $1.5 billion in 2021. EBITDA recovered to $75 million in H2 2022, compared with $41 million in H1 2022, attributable to price increases, lower freight costs, improving operating leverage, and cost-saving and efficiency-improving initiatives, which more than offset pulp and commodity price pressures and higher labour and manufacturing costs, as well as labour shortages and operational inefficiencies at KPLP’s Memphis manufacturing facility. Consequently, EBITDA for the full-year 2022 declined to $116 million, compared with $153 million in 2021. The decline in EBITDA, coupled with an increase in debt in relation to KPLP’s expansionary capex initiatives—the TAD Sherbrooke and Sherbrooke Expansion projects—resulted in debt-to-EBITDA deteriorating to 10.8 times (x) in 2022 from 7.3x in 2021.

Looking ahead to 2023, DBRS Morningstar projects Kruger Products’ revenue to grow to approximately $1.85 billion, as the Company should realize the full benefit of pricing actions that were implemented in 2022, coupled with the impact of further potential price increases during the year. The topline should also benefit from volume growth in 2023, as both the facial tissue line at the Company’s Memphis manufacturing facility and the TAD Sherbrooke project ramp up. DBRS Morningstar believes revenue should grow toward $2.0 billion by 2025, driven by further volume growth as these expansionary capex initiatives reach full production capacity and the Sherbrooke Expansion project ramps up. These increased volumes of higher-margin tissue products, coupled with the benefit from further potential price increases and cost saving-initiatives, should contribute to EBITDA margin recovery and growth in the near to medium term. Kruger Products’ efficiency-improving initiatives, including the shut-down of certain older and inefficient production assets at its Memphis manufacturing facility in early 2023, should also improve operating leverage and benefit EBITDA margins. That said, DBRS Morningstar believes that EBITDA margin recovery and growth could be moderated by a change in product mix as consumers shift from branded to private-label products in response to higher prices, coupled with persistent inflationary cost pressures. As such, DBRS Morningstar believes EBITDA should grow toward $200 million in 2023 and rise above $230 million by 2025.

DBRS Morningstar believes that operating cash flows should continue to trend in line with earnings, growing to approximately $115 million in 2023 from above $50 million in 2022, and toward $150 million by 2025. However, in 2023, DBRS Morningstar forecasts free cash flow (FCF) after dividends and before changes in working capital to remain in a net deficit position, as capex, including the Sherbrooke Expansion project, increases to between $200 million and $230 million from $115 million in 2022, and the gross dividend outlay remains relatively flat on the 2022 level of approximately $50 million. Kruger Products is expected to complete the Sherbrooke Expansion project by the end of 2024; consequently, capex is expected to decrease to around $50 million in 2025. The lower capex, coupled with higher operating cash flows and a modest increase in the cash dividend outlay, should result in meaningful levels of FCF over the medium term. In the near term, DBRS Morningstar expects the forecast FCF shortfall, principle lease payments, and mandatory debt repayments will be funded by available cash on hand, higher borrowings, and proceeds from Kruger Inc.’s dividend reinvestment plan participation (DRIP), which DBRS Morningstar anticipates will remain at 100% in 2023. That said, over the medium term the projected FCF surplus, together with proceeds from Kruger Inc.’s DRIP participation, should finance principle lease payments and mandatory debt repayments. As such, DBRS Morningstar forecasts operating cash flow as a percentage of debt to increase to above 8.0% in 2023 from approximately 4.0% in 2022, debt-to-EBITDA to improve to below 7.5x in 2023 from 10.8x in 2022, and EBITDA interest coverage to increase to 2.5x in 2023 from below 2.0x in 2022. By 2025, DBRS Morningstar projects operating cash flow as a percentage of debt to increase above 10.0%, debt-to-EBITDA to improve below 6.0x, and EBITDA interest coverage to grow toward 3.0x.

That said, should DRBS Morningstar become increasingly concerned that the Company will be challenged to deliver results in line with DBRS Morningstar’s expectations (i.e., debt-to-EBITDA remaining above 7.5x at the end of 2023, 6.5x at the end of 2024, and 6.0x at the end of 2025) because of weaker-than-expected operating performance and/or more-aggressive-than-expected financial management (i.e., further debt-financed capex), a negative rating action will result. Conversely, if the Company delivers an operating performance in line with or better than DBRS Morningstar’s expectations such that DBRS Morningstar gains sufficient confidence that the Company will further deleverage to a level appropriate for the BB rating (i.e., debt-to-EBITDA below 6.0x), the ratings outlook could stabilize.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

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

The principal methodologies applicable to the rating are Global Methodology for Rating Companies in the Consumer Products Industry ( https://www.dbrsmorningstar.com/research/402329/global-methodology-for-rating-companies-in-the-consumer-products-industry, September 2, 2022), and DBRS Morningstar Global Criteria: Recovery Ratings for Non-Investment-Grade Corporate Issuers (https://www.dbrsmorningstar.com/research/402218/dbrs-morningstar-global-criteria-recovery-ratings-for-non-investment-grade-corporate-issuers, September 1, 2022).

The rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

A description of how DBRS Morningstar analyzes corporate finance transactions and how the methodologies are collectively applied can be found at: https://www.dbrsmorningstar.com/research/397223/interplay-of-global-corporate-finance-rating-methodologies-when-analyzing-corporate-finance-transactions.

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 [email protected].

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

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.

Information regarding DBRS Morningstar ratings, including definitions, policies, and methodologies, is available on www.dbrsmorningstar.com or contact us at [email protected].

DBRS Limited
DBRS Tower, 181 University Avenue, Suite 700
Toronto, ON M5H 3M7 Canada
Tel. +1 416 593-5577