DBRS Confirms Domtar at BB (high)

DBRS has today confirmed the Issuer Rating and Senior Unsecured Notes of Domtar Corporation (Domtar or the Company) at BB (high) and the Unsecured Notes and Debentures by Domtar Inc. at BB (high). The trends on the ratings are Stable. DBRS recognizes that Domtar’s financial profile is well above the current rating range. The lack of a positive action on the Issuer Rating at this time is due to Domtar’s risky business profile, with its dominant paper business in structural decline and the other meaningful business, pulp, highly volatile. In addition, Domtar faces the near-term challenges of worsening global economic conditions and ongoing labour contract negotiations. There is also a concern that Domtar may weaken its financial profile with shareholder-friendly initiatives and its pursuit of acquisitions to diversify into other businesses. However, DBRS would consider positive rating action if the Company weathers the expected downturn in the industry while maintaining the financial profile above the current rating range.

DBRS has upgraded the recovery rating of the Company’s Senior Unsecured Notes and Domtar Inc.’s Unsecured Notes and Debentures to RR1 from RR2. The Company replaced its secured credit facility with an unsecured credit facility in June 2011. As a result, all of the debts are ranked pari passu. Based on our default recovery analysis, all holders unsecured notes and debentures would recover all of their principal. However, DBRS deems the recovery of slightly more than 100% not robust enough to warrant an investment-grade rating per our criteria; therefore, the instrument ratings are not notched up and remain at BB (high).

The Company has performed as expected in 2011, with results in the two major businesses comparable with the level a year before. All key credit metrics stayed strong and well above the current rating range. Near term, DBRS believes that the Company faces operating headwinds. The demand for paper has been in structural decline, albeit at a modest pace. Supply management by producers has been successful in supporting prices. However, global economic conditions are expected to weaken as a result of the expanding sovereign crisis in the euro zone and slowing growth in emerging markets. DBRS notes that the added burden of a slowing economy would accelerate the decline in demand, pressuring the supply/demand imbalance despite production curtailment by producers. Paper prices, which have been trending down, are expected to continue to decline in the near term. Additionally, China’s strong demand for pulp appears to have peaked. Global pulp inventory is rising and prices are starting to trend down as well. Near term, DBRS expects Domtar’s operating performance to weaken in line with industry conditions.

The Company is currently engaged in a number of contract negotiations. Although there is no indication of potential labour actions, ongoing discussions are still a distraction for senior management. Moreover, a lack of progress on the contract negotiations still poses a risk of potential disruptions.

The Company has done a good job deleveraging its balance sheet the last few years and the balance sheet is above average. However, Domtar intends to distribute excess cash through higher dividends and stock repurchases. Domtar has launched a $600 million share repurchase program and has spent $415 million in the first nine months of 2011. Additionally, Domtar intends to expand into other businesses through acquisitions; for example, it spent about $288 million to acquire Attends Healthcare Products Inc. (Attends), an adult incontinence products producer. The Company was able to finance these expenditures mostly from internal cash flow. Going forward, Domtar has to demonstrate financial discipline to balance its expansion and shareholder friendly objectives and its commitment to a strong balance sheet.

The Company’s business profile remains risky, relying too much on the paper business (66% of sales in the last 12 months ending September 30, 2011 (LTM), and 77% of LTM EBITDA), demand for which is in structural decline, and a highly volatile pulp business (20% LTM sales and 23% LTM EBITDA) despite the recent acquisition. The risky business profile, coupled with the near-term challenges facing the Company, is the main reason for not taking any positive rating action on the Issuer Rating at this time. However, DBRS would consider positive rating action if the Company weathers the expected downturn in the industry while maintaining its financial profile above the current rating range. Making meaningful progress in contract negotiations and demonstrating financial discipline in keeping a strong balance sheet would lend further support.

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.

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.