DBRS Confirms Canfor Corporation at BB (high), Trend Now Positive

DBRS has today confirmed the Issuer Rating and Senior Notes rating of Canfor Corporation (Canfor or the Company) at BB (high), with a trend change to Positive from Stable. The Positive trend reflects the fact that Canfor’s credit metrics have continued to strengthen, driven by the sustained improvement of the U.S. housing industry. It also reflects the improvement in Canfor’s business profile: disposition of underperforming non-core joint ventures, better lumber cost competiveness and added diversification in Asia. Moreover, DBRS believes that there is a sustained improvement in the U.S. housing industry and, consequently, a favourable lumber market in North America, which bodes well for Canfor’s operating performance going forward. If Canfor’s credit metrics remain solid, in the investment-grade range, its credit ratings are likely to be upgraded by one notch within the next 12 months.

DBRS confirmed Canfor’s ratings in February 2013, noting the possibility of positive rating action if the Company could demonstrate earning stability. Since then, North American lumber market conditions have remained solid, reflected by higher average SPF (spruce, pine, fir) and SYP (southern yellow pine) prices in the year-to-date (YTD) June 2013 period. This is in line with the continued strength in the U.S. housing market over the same period, reflected in higher single-family housing starts. As a result, Canfor’s H1 2013 operating results were very strong, largely driven by higher lumber prices. Moreover, the National Association of Home Builders/Wells Fargo sentiment index continued to rise, and is currently at its highest level since 2006; the U.S. unemployment rate also continued to improve in a steady manner, and is currently at its lowest point in four-and-a-half years: 7.6% as of July 2013. Moreover, both SPF and SYP prices remained above the average levels seen in 2012, despite a sharp decline in prices in Q2 2013; this decline stopped at the end of Q2 2013 and both prices are rising again.

Based on the positive trend of U.S. single-family housing starts, the high level of the home builders sentiment index, and the improving U.S. labour market, DBRS expects the U.S. housing market to continue its recovery, reaching about one million units at end-2013 from 780,000 units in 2012. As a result, Canfor’s 2013 full-year lumber results are expected to be much stronger than last year.

In the medium to long term, the reduced availability of logs from the British Columbia interior due to the mountain pine beetle infestation is expected to limit the supply of Canadian logs, and therefore have a positive effect on overall North American lumber prices during the recovery of U.S. housing market as the lumber demand strengthens. On the other hand, it would also increase logging costs for Canfor’s Canadian operations since most of its sawmills are located in the British Columbia interior; with that being said, the ultimate impact on Canfor’s future lumber earnings are expected to be neutral to positive, with higher lumber prices offsetting higher logging costs. Moreover, the previously announced purchase agreement with Scotch & Gulf Lumber, LLC to add more capacity in the U.S. south will also benefit from the beetle infestation issue.

During the last downturn, Canfor exhibited an added degree of volatility in its earnings, which can be attributed mainly to: (1) a materially large lumber capacity before the market crash, which exacerbated the situation at the beginning of the downturn; and (2) as a non-core business, the Company’s oriented strandboard (OSB) joint venture had been underperforming compared with the industry leaders due to a lack of cost-competitiveness.

However, in May 2013, Canfor sold its interest in the underperforming OSB joint venture and over the past few years has also improved its lumber operation’s cost-competitiveness, with the closure of uneconomical capacities and continued efficiency improvements. In addition, the Asian market (mainly China) has grown into a sizeable business for Canfor in the past few years and now provides an added degree of diversification. Therefore, DBRS views Canfor’s business profile as stronger, which would likely translate into less earnings volatility in the next downturn. Moreover, North American lumber industry capacity had been adjusted to current market conditions throughout the years with capacity reductions; therefore, the impact from another unexpected downturn would not be as severe as in the 2007 to 2009 period.

Canfor has continued to maintain a conservative financial profile, with adjusted debt leverage (including operating leases as debt) below 26% since 2009, currently at 17% at the end of Q2 2013.

Canfor is currently in the midst of labour negotiations with United Steelworkers, which are proceeding favourably. DBRS expects an agreement to be reached soon and does not expect any labour-related manufacturing disruptions.

In conclusion, DBRS expects the U.S. housing market to sustain its recovery and views Canfor’s business profile as stronger. If the Company’s credit metrics remain solid in the investment-grade range, its credit ratings are likely to be upgraded by one notch within the next 12 months.

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 60% to 80% of the principal; therefore, the recovery rating remains at RR3.

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

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 to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodology/criteria are Rating Companies in the Forest Products Industry and DBRS Recovery Ratings for Non-Investment Grade Corporate Issuers, which can be found on our website under Methodologies.