DBRS Confirms Canfor Ratings at BB (high), Trend Stable

DBRS has today confirmed the Issuer Rating and Senior Notes rating of Canfor Corporation (Canfor or the Company) at BB (high). The trends are Stable. The Issuer Rating is supported by the Company’s stable business profile and conservative balance sheet. Additionally, Canfor’s credit metrics remain compatible with the rating, despite recent weakness. With the U.S. housing market showing signs of a modest recovery, DBRS expects the Company’s lumber operations and overall financial results to show modest improvement and for the rating to remain stable in the near to medium term. However, a lack of improvement in Canfor’s operating performance and further deterioration in its credit metrics in the next six months may lead to negative rating actions.

Operating performance in 2011 was below expectations, with both business segments reporting a year-over-year decline in EBITDA. Negative market developments, especially in product pricing, and a stronger Canadian dollar were the primary contributing factors. The depressed U.S. housing market failed to show any meaningful improvement; as a result, residential construction activity remained anemic and continued to weigh on the lumber segment. Rising exports, mostly to China, helped boost shipments and revenue for the year. However, lower average product prices (notably on lower grades and wider dimensions), higher input costs (logs, fuel, etc.) and a stronger Canadian dollar all contributed to Canfor’s sharply lower earnings despite the higher shipment levels. The pulp and paper segment also reported a modest decline in operating results. The key factors behind the decline were higher manufacturing costs (downtime taken to upgrade the Northwood pulp mill) and a stronger Canadian dollar. Cash flow from operations also declined sharply, in line with earnings. Nevertheless, the Company continues to maintain a strong balance sheet, and all debt-related coverage ratios, although weakened, were still well within the rating range.

Near-term market conditions are expected to improve modestly for lumber but remain challenging for pulp and paper. Operating performance for 2012 at Canfor is expected to show a modest improvement over 2011 levels. Lumber shipments are expected to show a modest increase. DBRS expects higher U.S. housing starts and construction activities, supported by an improving unemployment rate, higher income levels, more optimistic consumer sentiment and low mortgage rates. In addition, shipment levels to China are on the mend after a drop in late 2011. However, lumber prices are not likely to recover due to a large potential supply and below-average capacity utilization. Average lumber prices in 2012 are expected to be below 2011 levels. Global softwood pulp demand is expected to remain soft in 2012, affected by slower growth in China and an ongoing structural decline in paper production.

Longer term, the fundamentals for lumber are favourable. Pent-up demand for housing caused by increasing household formation and record-high housing affordability are pointing to a return to much-higher residential construction activity levels. However, a still-large inventory of unsold homes and still-tight credit standards remain major headwinds to a full recovery in the United States. DBRS expects that a meaningful recovery in residential construction is not likely until the latter half of 2013.

The Company has continued to maintain a conservative financial profile, with adjusted debt leverage (including operating leases as debt) slightly above 20% at the end of 2011. Canfor is the midst of a $300 million, three-year strategic investment program at the lumber operations. Capital expenditure rose to $236.7 million from an average of around $90 million the previous five years. The lower cash flow from operations and higher investment spending led to a significant deficit in free cash flow. The shortfall in cash generation has consumed most of the Company’s cash on hand. Canfor is near the end of its spending program, with planned capital expenditures in 2012 around $140 million, slightly below depreciation. DBRS expects Canfor to be able to achieve breakeven in free cash flow from operations, with a modest improvement in operations. However, Canfor has agreed to acquire two saw mills and associated timber license assets from Tembec Inc. for about $60 million and the transaction is expected to close in the first quarter of 2012. Funding the acquisition would likely lead to a higher debt level, with adjusted gross debt leverage, on a proforma basis, rising to near 25% in 2012, a still-conservative level. Moreover, excluding the Canfor Pulp Limited Partnership (CPLP) debt, the Company only has a US$75 million debt maturing in April 1, 2013, after paying off the US$50 million in February 2, 2012. The Company has minimal refinancing risk. Furthermore, the Company has adequate liquidity to meet its funding needs with cash on hand and its available credit facility. (On February 20, 2012, Canfor exercised its right to exchange its 50.2% interest in CPLP for a 50.2% direct interest in Canfor Pulp Products Inc. (a publicly listed company) and the exchange is expected to be completed on or about March 2, 2012. DBRS believes that the exchange has no material effect on the Company.)

DBRS has simulated a default scenario for Canfor in order to analyze the potential recovery of the Company’s senior debt in the event of default. The scenario assumes a prolonged period of severe economic conditions, regardless of how hypothetical or unlikely the conditions may be, in which product demand and prices plummet. Based on the recovery analysis, DBRS believes that holders of the Senior Notes would recover approximately 50% to 70% of the principal and the recovery rating therefore remains at RR3.

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

This rating did not include issuer participation and is based solely on publicly available information.

The applicable methodologies are Rating the Forest Products Industry and DBRS Criteria: Rating Leveraged Finance, which can be found on our website under Methodologies.