Fitch Ratings has affirmed the ratings of Doman Building Materials Group Ltd. (DBM; Doman), including the company's Long-term Issuer Default Rating (IDR) at 'B' and unsecured notes at 'B/RR4'.

The Rating Outlook is Stable.

Doman's IDR and Stable Outlook reflect its modest leverage levels, which provides a cushion as the housing market slows down and lumber prices decline from record levels. Fitch forecasts debt to EBITDA to increase next year, situating between 4.5x-5.0x in 2023 and 2024.

The IDR also reflects Doman's relatively commoditized product offering and the thin EBITDA and FCF margins inherent to the two-step building products distribution sector. The cyclicality of the residential housing market and the company's susceptibility to swings in lumber prices are also factored into the rating. DBM is one of the top North American pressure treated lumber manufacturers and distributors and maintains a sufficient liquidity position.

Key Rating Drivers

Modest Leverage Provides Cushion: Fitch expects Doman's debt to EBITDA (excluding capitalized leases as debt and including lease amortization and interest as an operating expense) to be about 3.7x at year-end FY2022 and settle between 4.5x-5.0x in 2023 and 2024. Fitch's assumption for mid- to high-single digit volume declines and lumber prices around USD475 to USD500 per thousand board feet leads to higher debt to EBITDA next year, although still below Fitch's negative rating sensitivity of debt to EBITDA above 5.5x for the 'B' IDR. Fitch's forecast also assumes modest FCF is applied toward debt reduction during 2H22 and in 2023.

Low EBITDA and FCF Margins: DBM's profitability metrics are low relative to more highly-rated peers and large distributor peers but are commensurate with 'B' category building products issuers. Fitch-adjusted EBITDA margins (including capitalized lease costs as operating expenses) are forecast to be between 5%-6% during the rating horizon, below the 7%-8% levels in 2020 and 2021 when the company reported higher volumes and elevated lumber prices. Fitch expects the company will generate flat to modestly positive FCF margins during the next few years, compared to more volatile FCF generation before the Hixson acquisition when the company was smaller and applied most of its FCF towards dividends.

Susceptibility to Lumber Volatility: Doman's revenues are highly concentrated towards the sale of lumber. The company estimates about 65% of sales are from pressure treated lumber. The remaining 35% of sales are from the company's building products distribution sales, which also includes some sale of lumber. The company's high lumber exposure weighs negatively on the rating due to the commoditized nature of the product offering and volatility of pricing, particularly in recent years. U.S. lumber prices have declined by about two-thirds from their recent March 2022 high, which will contribute to lower revenue and EBITDA levels in 2023.

Competitive Position: DBM's position is weaker than more highly rated building products manufacturers in Fitch's coverage due to its position as a two-step distributor in the building products supply chain, its relatively low brand equity and mostly commoditized product offerings. However, company's scale and position as the number two pressure treated wood manufacturer in North America position it well within the two-step distribution subsector. Fitch believes this scale and manufacturing capacity provide modest competitive advantages relative to distributors with only local presences and niche product offerings

Capital Allocation and Dividends: Fitch expects management to apply modest amounts of FCF after dividends towards debt reduction during the rating horizon, which is consistent with management's strategy of maintaining a flexible balance sheet and relatively conservative credit metrics. The company has also demonstrated willingness in the past to protect credit metrics via equity issuances and dividend reductions opportunistically and during periods of uncertainty. Fitch expects common dividends to be CAD48-50 million annually during the next few years.

Cyclical End-Market Exposure: Fitch expects housing activity will fall mid- to high-single digits in 2023 while repair and remodel spending is forecast to decline slightly. The majority of DBM's sales are directed to the Canadian and U.S. residential real estate markets. Management estimates that about half of the company's distribution sales are exposed to residential new housing and the other half exposed to repair and remodel demand, which is less cyclical. The company's wood pressure sales have modest exposure to agricultural and industrial end-markets. DBM's pressure treated wood sales are highly exposed to decking and fencing demand, which Fitch believes experienced a pull forward in demand during the pandemic.

Derivation Summary

Fitch expects DBM to maintain credit metrics that are modestly stronger than its closest Fitch-rated peer, LBM Acquisition, LLC (LBM; B/Stable). LBM is less exposed to the volatile lumber market than DBM, has greater scale and typically maintains slightly higher EBITDA and FCF margins. LBM's highly aggressive capital allocation strategy weighs negatively on its credit profile when compared to DBM. Park River Holdings, Inc. (Park River; B/Negative) has a stronger margin profile and less commoditized product offering than DBM but maintains higher leverage levels than DBM.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer --Revenues grow 17%-18% in 2022 and declines 25%-30% in 2023;

EBITDA margin of 5%-5.5% in 2022 and 5.5%-6% in 2023;

FCF margin of 3%-3.5% in 2022 and 1.0%-2.0% in 2023;

Debt/EBITDA of 3.5x-4.0x at year-end 2022 and 4.5x-5.0x at year-end 2023.

KEY RECOVERY RATING ASSUMPTIONS

The recovery analysis assumes that Doman Building Materials Group Ltd. would be considered a going-concern rather than liquidated in a recovery scenario.

We have assumed a 10% administrative claim.

We have assumed an EV multiple of 5.5x

Going concern EBITDA of CAD105 million

Going Concern EBITDA Approach

Fitch's GC EBITDA estimate of CAD105 million estimates a post-restructuring sustainable EBITDA. This is about 40% below Fitch calculated LTM EBITDA and 34% below forecasted FY2022 levels.

The GC EBITDA is based on Fitch's assumption that distress would arise from a meaningful and continued decline in the residential housing market combined with lumber prices sustained at below average levels. Fitch estimates that revenues of about CAD2 billion (about 33% below June 30, 2022 LTM levels and forecasted 2022 levels) and EBITDA margins of about 5.3% would capture the lower revenue base of the company after emerging from the downturn in a lower lumber price environment than 2020-2022, plus a sustainable margin profile after right sizing, which leads to Fitch's CAD105 million GC EBITDA assumption.

Fitch assumed a 5.5x enterprise value (EV) multiple to calculate the GC EV in a recovery scenario. The company purchased Hixson Lumber Sales in June 2021 for 5.0x Fitch-calculated FY2020 EBITDA and 10.9x FY2019 EBITDA. The 5.5x GC EBITDA multiple is below the 6.0x multiple applied in the recovery analysis of LBM Acquisition, LLC, mainly due to Doman's relatively smaller scale, less diversified business and weaker profitability metrics when compared to LBM.

Priority claims over the unsecured debt include the ABL revolver and about CAD16.1 million of other secured debt. Fitch assumes the ABL has CAD350 million outstanding at the time of a potential recovery, which accounts for shrinkage in the available borrowing base during a period of deflating lumber prices and contracting volumes that causes a default. Remaining claims are recovered by the unsecured debtholders, resulting in a recovery corresponding to an 'RR4' for DBM's 2023 and 2026 unsecured notes.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Fitch's expectation that total debt to operating EBITDA will be sustained below 4.0x;

Fitch's expectation that the company will maintain FCF margins (after dividends) in the low- to mid-single digit percentages;

The company significantly lowers its proportion of sales from lumber or reduces exposure to the cyclical new home construction market in order to reduce earnings and credit metric volatility through lumber and housing cycles;

The company maintains a strong liquidity position with no material short-term debt obligations.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Fitch's expectation that total debt to operating EBITDA will be sustained above 5.5x;

Total available liquidity maintained below CAD50 million;

Fitch's expectation that FCF generation (after dividends) will be sustained at neutral or negative levels;

Significant and sustained contraction in lumber prices leading to Fitch's expectation for meaningfully higher leverage levels (above 5.5x total debt to operating EBITDA) or a potential covenant breach under the ABL credit agreement.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Adequate Liquidity: DBM has adequate liquidity with about CAD171 million of borrowing availability under its CAD500 million ABL revolver (CAD323.6 million of outstandings) as of June 30, 2022 and CAD3 million of cash. During the last nine months, the company has maintained about CAD100-200 million of excess availability on its ABL.

Fitch believes current liquidity is adequate to fund operations and fixed charges, but the company has limited cushion to avoid a challenging liquidity scenario, particularly during a stressed environment where the company generates negative FCF and capital markets access worsens. Fitch forecasts the company to generate slight to modestly positive FCF after dividends in its rating case and to pay down its ABL over time, leading to a moderately improving liquidity position during the next few years.

Debt Maturities: DBM's debt maturities are well-laddered, including CAD2.7 million of annual amortization under its non-revolving term loan, CAD60 million of unsecured notes maturing in 2023, and the remaining CAD12.1 million non-revolving term loan maturing in 2024. Fitch expects the company to refinance unsecured notes or draw on its ABL to meet this maturity. The ABL is currently set to mature in 2024.

Issuer Profile

Doman Building Materials Group Ltd. (DBM; Doman) is a manufacturer and distributor of lumber products and building materials in the U.S. and Canada.

Summary of Financial Adjustments

Fitch adds back merger and integration expense and stock-based compensation to operating EBITDA. Per Fitch's criteria, operating lease liabilities are not considered debt. Fitch deducts lease amortization and lease interest expense from operating EBITDA. This totals about CAD26 to CAD27 million annually. Fitch's calculation of total debt includes the 2023 and 2026 unsecured bonds, ABL borrowings outstanding, promissory notes outstanding, term loans and bank overdrafts.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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