DBRS Morningstar Confirms Kruger Products L.P.’s Issuer Rating at BB and Senior Unsecured Notes Rating at B (high); Removes Ratings from Under Review with Developing Implications

DBRS Limited (DBRS Morningstar) confirmed Kruger Products L.P.’s (KPLP or the Company) Issuer Rating at BB and its Senior Unsecured Notes rating at B (high). The Recovery Rating on the Senior Unsecured Notes remains RR6. Both trends are Stable. This rating action removes the ratings from Under Review with Developing Implications, where they were placed on March 1, 2021, following KPLP’s announcement of a planned $240 million fully debt-funded investment to expand its Sherbrooke, Québec, plant (the Sherbrooke Expansion Project) through the construction of a bathroom tissue converting line (the BT line), a facial tissue converting line (the FT line), and a light dry crepe tissue machine (the LDC machine).

The rating confirmations acknowledge the potential benefit of the Sherbrooke Expansion Project over the medium term, as the additional capacity generated by the project will facilitate the expansion of the Company’s product offering and grow its market share. The rating confirmations also incorporate KPLP’s strong operating performance in 2020 in the context of the Coronavirus Disease (COVID-19) pandemic. That said, DBRS Morningstar expects that operating results and credit metrics will moderate as the economy reopens, demand normalizes, and debt levels increase, and, as such, has confirmed the ratings with Stable trends.

Over the medium term, DBRS Morningstar believes that the Sherbrooke Expansion Project will enable the Company to expand its product offering across its bathroom tissue, paper towel, and facial tissue categories in both the Consumer and Away-From-Home (AFH) segments. Furthermore, it will allow KPLP to increase its premium tissue capacity, which is expected to help the Company strengthen its leading market position in Canada and continue to expand in the U.S. premium private-label market.

In terms of financing for the Sherbrooke Expansion Project, Kruger Products SB Inc., a newly formed wholly owned unrestricted subsidiary of KPLP that will operate the LDC machine and the FT line, will raise $193 million of debt by way of a $75 million convertible debenture and a $43 million subordinated loan from Investissement Québec (IQ), as well as a $75 million senior bank facility. Kruger Products Sherbrooke Inc. will raise the remaining $47 million, by way of a subordinated loan from IQ, to finance the construction of the BT line.

DBRS Morningstar’s confirmations of KPLP’s Issuer Rating and Senior Unsecured Notes rating on May 29, 2020, were based on the expectation that the Company’s credit risk profile would remain within the BB category over the medium term despite the near-term stress on the AFH segment because of the coronavirus pandemic.

As expected, in 2020, the Company’s topline and earnings were pressured by a contraction in demand from the AFH segment, an increase in freight and warehousing costs, higher compensation-related expenses, and a larger investment in advertising and marketing. However, this was more than offset by volume growth in the Consumer segment, lower input costs, and benefits from cost-saving and productivity-improving initiatives (the Operational Excellence Program). Consequently, the Company achieved solid year-over-year EBITDA growth in 2020. In terms of financial profile, operating cash flows increased in tandem with earnings. Capital expenditure (capex) increased in 2020 and related primarily to the Sherbrooke tissue plant (the TAD Sherbrooke Project). Furthermore, KPLP’s cash dividend increased because of a reduction in Kruger Inc.’s (Kruger) Dividend Reinvestment Plan (DRIP) participation to 50% from 100%. Consequently, KPLP’s free cash flow (FCF) after dividends and before changes in working capital was negative in 2020. The Company applied cash inflows from changes in working capital, proceeds from Kruger’s DRIP participation, and increased borrowings, to finance the remaining investment in the TAD Sherbrooke Project, finance mandatory debt repayments, and make IFRS 16 lease payments. Consequently, debt-to-EBITDA strengthened as EBITDA increased by a greater proportion than the increase in debt. That said, DBRS Morningstar notes that the Company’s financial metrics were in the context of the coronavirus pandemic and expects them to moderate as the economy reopens, demand normalizes, and debt levels increase, and, as such, has confirmed the ratings with Stable trends.

DBRS Morningstar expects that AFH volumes will continue to trend in line with population mobility and that they should recover by the second half of 2021 as the dissemination of coronavirus vaccines gains momentum. The topline should also continue to benefit from strong Consumer segment volumes as pandemic-related behavioural shifts, including enhanced cleaning and sanitization measures, remain. That said, DBRS Morningstar believes that demand from the Consumer segment will be curtailed as consumers are expected to first reduce their existing tissue inventories. DBRS Morningstar forecasts EBITDA margins to contract in 2021 on the back of rising pulp prices and input and operating cost inflation, which will more than offset the effect of potential selling-price increases and benefits from the Operational Excellence Program. Consequently, DBRS Morningstar anticipates that EBITDA will decline in 2021, but that it should remain higher than prepandemic levels. In the medium term, DBRS Morningstar expects KPLP’s earnings profile to benefit from a strengthening business risk assessment as the TAD Sherbrooke and Sherbrooke Expansion Projects ramp up.

The anticipated reversion in operating income and corresponding cash flows will moderate KPLP’s near-term financial profile. DBRS Morningstar forecasts FCF after dividends and before changes in working capital to remain negative in 2021, as operating cash flows decrease in tandem with earnings, capex trends upward because of the Sherbrooke Expansion Project, and the cash dividend outlay remains relatively flat on prior-year levels. DBRS Morningstar anticipates that the forecast FCF shortfall, working capital outlays, and mandatory debt and IFRS 16 repayments will be funded by proceeds from Kruger’s DRIP participation (which DBRS Morningstar anticipates will remain at 50% in 2021) and higher borrowings. Consequently, DBRS Morningstar forecasts credit metrics to temporarily heighten, with the potential for a longer-term improvement from growth in operating income and mandatory debt repayment. Should leverage remain high for the BB rating category as a result of weaker-than-expected operating performance and/or more aggressive financial management, the ratings will be pressured. Although unlikely, a positive rating action could be influenced by a material reduction in leverage below 3.0 times on a normalized and sustainable basis, based primarily on the growth in operating income.

KPLP’s current ratings continue to be supported by its strong brands and leading market position in the Canadian tissue products market, stable demand, and significant barriers to entry. The current ratings also continue to reflect the intense competition, input cost volatility, and product/market concentration.

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/373262.

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

The principal methodologies are Rating Companies in the Consumer Products Industry (July 30, 2020; https://www.dbrsmorningstar.com/research/364690), DBRS Morningstar Criteria: Guarantees and Other Forms of Support (January 14, 2021; https://www.dbrsmorningstar.com/research/372344), and DBRS Morningstar Criteria: Recovery Ratings for Non-Investment-Grade Corporate Issuers (August 24, 2020; https://www.dbrsmorningstar.com/research/366063), which can be found on dbrsmorningstar.com under Methodologies & Criteria. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021; https://www.dbrsmorningstar.com/research/373262).

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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@dbrsmorningstar.com.

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.

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

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at info@dbrsmorningstar.com.

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