Finland-Based Metsa Board 'BB+/B' Ratings Affirmed Despite Operational Issues; Outlook Remains Positive

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1 Research Update: Finland-Based Metsa Board 'BB+/B' Ratings Affirmed Despite Operational Issues; Outlook Primary Credit Analyst: Terence O Smiyan, London (44) ; terence.smiyan@spglobal.com Secondary Contact: Gustav Liedgren, Stockholm (46) ; gustav.liedgren@spglobal.com Table Of Contents Overview Rating Action Rationale Outlook Ratings Score Snapshot Recovery Analysis Related Criteria Ratings List FEBRUARY 23,

2 Research Update: Finland-Based Metsa Board 'BB+/B' Ratings Affirmed Despite Operational Issues; Outlook Overview Paperboard producer Metsa Board Corp. underperformed our forecast for 2016, as a result of complications related to the ramp-up of a new machine at its Husum mill. We believe the group's operational issues are behind them, however, and forecast strong cash generation and improving margins on the back of recently completed investments. We are therefore affirming our 'BB+/B' ratings on Metsa Board. The positive outlook indicates that we could raise our rating on Metsa Board to 'BBB-' if its operating performance improves in 2017, and we believe that the correspondingly stronger credit metrics were sustainable and in line with its financial policy, with similar expectations for Metsa Board's parent company, Metsa Group. Rating Action On Feb. 23, 2017, S&P Global Ratings affirmed its 'BB+/B' long- and short-term corporate credit rating on Finland-based paperboard producer Metsa Board Corp. The outlook remains positive. We also affirmed our issue rating on Metsa Board's senior unsecured debt at 'BB+'. The recovery rating is unchanged at '3', indicating our expectation of 65% recovery in the event of a payment default. Rationale The affirmation follows Metsa Board's weaker-than-expected performance in 2016, which was materially affected by a problematic ramp-up of the group's new folding boxboard line at its Husum mill in Sweden. The ensuing shortfall in earnings resulted in funds from operations (FFO) to debt falling to about 36% in 2016, compared with our expectations for a higher rating of over 45%. Despite the setbacks last year, we have maintained the positive outlook, since we still forecast improvements in credit metrics in 2017 that we believe can be sustained going forward. We believe that the group has left its operational issues behind them, and that the new machine should now be producing higher quality folding boxboard at an increased capacity and improved price point, resulting in a rebound in profitability for this year. FEBRUARY 23,

3 In addition, the group has now fully exited the weak-performing paper segment and has completed the bulk of its expansionary capital expenditure (capex), which should further boost cash flow generation going forward, leading us to believe that the likely improvement in credit metrics will be sustainable. Furthermore, we anticipate that the credit quality of Metsa Board's parent, Metsa Group, could also improve in the coming year. We expect Metsa Group's earnings will improve in line with those of Metsa Board, which accounts for about 40% of group sales (or a 25% direct contribution when considering eliminations from other group companies), while the group's sizeable Aanekoski pulp mill project (in which Metsa Board has a 25% share) is on track and expected to contribute to both Metsa Board's and the group's earnings later in the year. Metsa Group's credit metrics were somewhat stronger than Metsa Board's at year-end 2016, with adjusted FFO to debt at around 44%, and we expect this figure will climb to over 50% in 2018 following the completion of the bulk of the group's planned expansionary capex. We see further potential improvements, in absence of any significant mergers and acquisitions (M&A) activity, or large one-off dividend distributions. As a result, we think that both the Metsa Board and Metsa Group will be able to maintain strong credit metrics in the coming three years, with FFO to debt of above 50% and debt to EBITDA well below 1.5x, which we view as consistent with the modest financial risk profile. Our business risk assessment still takes into account Metsa Board's relatively small size and narrow product and geographic scope, compared with larger forest and paper groups, such as Mondi Group, Stora Enso, and UPM-Kymmene. Although growth prospects for paperboard appear favorable, we think that this focus makes Metsa Board particularly exposed to adverse market developments, such as overcapacity and potential changes in customer preferences. We think that Metsa Board's satisfactory profitability in its paperboard operations, the positive demand trends for paperboard, its strong market share in Europe, and its strong backward integration into key raw materials are supporting factors for the business risk. We also assess management and governance favorably on account of management's successful implementation of strategy over the past few years to increase profitability. In our base case for Metsa Board, we assume: Eurozone GDP growth of 1.4% in 2017 and 1.3% in 2018 and U.S. GDP growth of 2.4% and 2.3% for the same years, respectively, supporting demand growth for paperboard. Metsa Board's sales will increase by mid-single digits in 2017 as operational hindrances at the Husum mill subside and incremental volumes of folding boxboard are sold at higher average prices than in Stable pricing environment for paperboard in 2017, given the robust demand-supply balance. We expect some price pressure in folding boxboard market from 2018, give that the market is likely to be oversupplied as new capacity comes online. EBITDA margins widening to about 15%, driven by the ramp-up of the Husum mill, a complete exit from the loss-making wallpaper business, and the positive impact of extrusion coating on the pricing of board products. FEBRUARY 23,

4 Annual capex of approximately 70 million in 2017 and 2018, which represents a significant reduction compared to previous years, indicating the completion of expansionary investments. Dividend payments of about 68 million in 2017 as announced, increasing thereafter in line with profits and dividend policy. No M&A transactions or share buybacks, although we consider new growth projects as likely from Based on these assumptions, we arrive at the following credit measures for the company: FFO to debt of above 50% in 2017 and Debt to EBITDA of about 1.5x. Free operating cash flow to debt of 40%-45% in Given Metsa Board's close integration into the Metsa Group, we consider that Metsa Board cannot be rated higher than our assessment of the creditworthiness of its parent, Metsa Group, which we currently assess at 'bb+'. We assess Metsa Board to be a highly strategic subsidiary for the Metsa Group, the parent company of which is Metsaliitto Cooperative. This is because: The group is unlikely to sell Metsa Board in the near term, in our view, given that it provides forward integration in the forest and paper products value chain; The group's senior management has a track record and long-term commitment of support for the company; Metsa Board accounts for about 40% of group sales; and Its reputation, brand, name, and treasury management is closely tied to that of Metsa Group. We assess Metsa Group's credit profile as 'bb+'. This is supported by moderate consolidated leverage, favorable growth prospects among its paperboard and pulp segments, and strong product diversification. However, we think that these strengths are offset by exposure to cyclical and volatile pulp and sawn timber segments, tissue operations with below-average profitability, and the fact that there are large minority shareholders across the Metsa Group structure, which somewhat distorts consolidated financials. It is further constrained by project and execution risks relating to subsidiary Metsa Fibre's 1.2 billion pulp mill project in Aanekoski, expected to come online in the second half of We could revise upward our assessment of the group credit profile (GCP) if we think it is likely that the Aanekoski mill will come online on budget and on time and that consolidated leverage will not deteriorate from current levels. Liquidity We assess Metsa Board's liquidity as strong, supported by large cash balances, full access under its revolving credit facility (RCF), as well as our expectation of strong operational cash flow generation and manageable debt maturities in We think that the company's liquidity sources can comfortably cover its liquidity uses by above 1.5x over the coming 24 months. We also view positively the company's access to multiple funding sources, its FEBRUARY 23,

5 well-established and solid relationship with banks and its satisfactory standing in the credit markets. For the 12 months from Dec. 31, 2016, we estimate that principal liquidity sources include: About million in cash and cash equivalents as of Dec. 31, This takes into account 5.1 million of cash held on Metsa Board's balance sheet and about million of cash deposited with Metsa Group's internal bank, Metsa Group Treasury, under a cash-pooling system among entities within Metsa Group. We understand that Metsa Board has access to these funds at short notice, if needed, to cover temporary liquidity needs. An unused 100 million RCF expiring in March We also understand that Metsa Board has access to a credit line of 150 million from Metsa Treasury, although we do not factor this into our calculations as this depends on cash deposits from other group companies and thus would be an uncertain source of liquidity under a stress scenario. Access to loans from pension funds of about 102 million. Expected FFO of about 220 million- 230 million in We assume that principal liquidity uses for the same period include: Debt amortization of about 219 million. Capex of about 65 million- 70 million. Working capital outflows of up to 35 million- 40 million. Dividends of about 68 million in 2017 and a little over 70 million in Outlook The positive outlook indicates that there is at least a one-in-three likelihood that we could raise the rating on Metsa Board by one notch in the coming 12 months. Upside scenario We could upgrade Metsa Board if we were to see a recovery in Metsa Board's credit metrics following weaker-than-expected performance in 2016 and believe the improved earnings profile were sustainable. We would expect the company to maintain a ratio of FFO to debt of sustainably above 45% for a higher rating. For an upgrade, Metsa Board would also need to maintain a financial policy commensurate with an investment-grade rating and limited event risk relating to acquisitions and extraordinary dividends. An upgrade of Metsa Board would also be contingent on us revising upward our assessment of Metsa Group's GCP to 'bbb-'. This could result from the large pulp project within Metsa Fibre coming in on time and on budget and our view that there would be only a low risk of leverage increasing from current levels, for example through extraordinary dividend payments, or major new investments. We would view a ratio of FFO to debt of at least 50% as FEBRUARY 23,

6 commensurate with a GCP of 'bbb-', assuming our current assessment of the business risk profile remains unchanged. Downside scenario We could revise the outlook to stable if Metsa Board's operational performance does not rebound, for example due to significantly decreasing prices for paperboard or further operational issues linked to the ramp-up of its new capacity. We could also revise the outlook to stable if we no longer believed that Metsa Group's improving credit metrics could be maintained, or if we felt that Metsa Board's financial policy became less stringent, although we regard such a scenario as unlikely. Ratings Score Snapshot Corporate Credit Rating: BB+/Positive/B Business risk: Fair Country risk: Low Industry risk: Moderately high Competitive position: Fair Financial risk: Modest Cash flow/leverage: Modest Anchor: bbb- Modifiers Diversification/Portfolio effect: Neutral (no impact) Capital structure: Neutral (no impact) Financial policy: Neutral (no impact) Liquidity: Strong (no impact) Management and governance: Satisfactory (no impact) Comparable ratings analysis: Negative (-1) Stand-alone credit profile: bb+ Group credit profile: bb+ Entity status within group: Highly strategic Recovery Analysis Key analytical factors The 'BB+' issue rating and '3' recovery rating on Metsa Board's senior unsecured debt are supported by our going concern valuation of the company, but are constrained by the unsecured nature of the debt and the substantial level of prior-ranking debt obligations. Even though numerical recovery prospects may exceed 70%, the recovery rating is capped at '3', to account for the fact that recoveries of FEBRUARY 23,

7 unsecured debt instruments are at greater risk of being altered by the incurrence of additional prior-ranking debt that the company may raise on the path to default. In addition to typical carve-outs for this type of unsecured debt instruments, the notes' documentation and facilities agreement allow the raising of secured loans from Finnish pension insurance companies of up to 250 million (which we include as prior-ranking debt). We note that the loan and RCF are subject to maintenance financial covenants. In our simulated default scenario, we assume a combination of weaker operating performance due to difficult market conditions affecting packaging (price pressure and volume delivery decrease) and higher financial leverage. We value Metsa Board as a going concern given the group's strong market positions. Simulated default assumptions Year of default: 2022 Jurisdiction: Finland Simplified waterfall Emergence EBITDA: 127 million (Minimum capex at 2% of sales, representing the recurring capex required to maintain the business. This represents around 40 million; Cyclicality adjustment of 10% is standard for the forest and paper products industry; No operational adjustments) Multiple: 5.5x, which is 0.5x higher than industry average, reflecting Metsa Board's higher growth prospects compared to the industry average, supported by its exposure to paperboard and strong backward integration into pulp and energy. Gross enterprise value at emergence: About 700 million Net enterprise value after administrative expenses (5%): 666 million Priority claims and senior secured debt claims: 234 million* Total value available for senior unsecured debt claims: 432 million Senior unsecured debt claims: 578 million* --Recovery expectation: 65% --Recovery rating: 3 *Includes six months of prepetition interest. Related Criteria Criteria - Corporates - General: Recovery Rating Criteria For Speculative-Grade Corporate Issuers, Dec. 07, 2016 Criteria - Corporates - Recovery: Methodology: Jurisdiction Ranking Assessments, Jan. 20, 2016 Criteria - Corporates - General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014 Criteria - Corporates - Industrials: Key Credit Factors For The Forest And Paper Products Industry, Feb. 12, 2014 Criteria - Corporates - General: Corporate Methodology, Nov. 19, FEBRUARY 23,

8 General Criteria: Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013 General Criteria: Methodology: Industry Risk, Nov. 19, 2013 General Criteria: Group Rating Methodology, Nov. 19, 2013 Criteria - Corporates - General: Corporate Methodology: Ratios And Adjustments, Nov. 19, 2013 General Criteria: Methodology For Linking Short-Term And Long-Term Ratings For Corporate, Insurance, And Sovereign Issuers, May 07, 2013 General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities And Insurers, Nov. 13, 2012 General Criteria: Use Of CreditWatch And Outlooks, Sept. 14, 2009 Ratings List Ratings Affirmed Metsa Board Corp. Corporate Credit Rating BB+/Positive/B Senior Unsecured BB+ Recovery Rating 3(65%) Additional Contact: Industrial Ratings Europe; Corporate_Admin_London@spglobal.com Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at for further information. Complete ratings information is available to subscribers of RatingsDirect at and at spcapitaliq.com. All ratings affected by this rating action can be found on the S&P Global Ratings' public website at Use the Ratings search box located in the left column. Alternatively, call one of the following S&P Global Ratings numbers: Client Support Europe (44) ; London Press Office (44) ; Paris (33) ; Frankfurt (49) ; Stockholm (46) ; or Moscow 7 (495) FEBRUARY 23,

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