Domtar (ticker UFS) is an un-loved, mis-understood and under-valued long opportunity that is largely ignored by most investors given negative sentiment around uncoated freesheet (i.e. office copy paper) which is uniformly recognized for its secularly declining end-market with the shift to digital. As a result of this secular “taint”, the market has failed to recognize an early inning transformation story as Domtar is shifting more capital and attention towards Personal Care products (i.e. adult incontinence and baby diaper products growing at ~4%+ on volume and couple % on price). Domtar trades at a ~20%+ FCF yield and less than 4x EBITDA and 5x EBITDA – capex and has a strong balance sheet with less than 1x of net debt / EBITDA on my YE 2014E estimates. Earlier this evening, International Paper nominated a 2nd price increase for uncoated freesheet which will materially benefit Domtar (>$4.50 / share of improved FCF) which will make Domtar trade at an even more impressive Domtar presents a compelling risk-reward proposition with a total return potential of >40% over the next 3 – 6 months on a standalone basis and >65% as we get more clarity around Domtar management allocating capital toward Personal Care acquisitions.
Why the opportunity: Earlier in 2013, Domtar suffered from operational hic-cups driven by temporary dynamics (i.e. re-positioning of capacity and plant outages). In addition, the uncoated freesheet market suffered from over-capacity resulting in downward price declines. As a result, Domtar’s stock price languished in the $70 - $80 / share range from January – early September 2013.
Fast forward to September 2013: Uncoated freesheet has been thecontroversy around the stock given structural demand declines require proactive supply discipline by the industry. In September 2013, supply announcements led by International Paper totaled ~10% of capacity. With utilization rates in the high 80% range, removing 10% of industry capacity is a significant move as 2014E – 2015E utilization rates will be likely remain above >95% (a level NOT since since 1994!). Domtar’s business will be a large beneficiary (given its ~35% PF market share). An initial price increase of $60 / ton is in final stages of being implemented. Earlier this evening, International Paper nominated a 2nd price increase of $50 - $70 / ton (4.50 – 5.00 / share of FCF for Domtar if successfully implemented).
Given improved trends in the uncoated freesheet segment, investors will likely re-focus their attention on Domtar’s growing businesses (~40%+ of profit). Moreover, improved trends will provide Domtar management “breathing room” to execute on the transformation of the business.
Why Domtar is exciting now: (a) uncoated freesheet profits more stable than the market anticipates given industry structure (2nd price increase nominated this evening); (b) Personal Care earnings power is largely ignored by investors BUT harder to ignore; (c) valuation is too cheap (market applying punitive multiple to all businesses ignoring >40% of business that is growing):
Uncoated freesheet profits more stable than the market anticipates given industry structure (2nd price increase nominated this evening): International Paper and Domtar control >55% of NA supply. Recent industry closures (~10% NA capacity) have tightened the uncoated freesheet market and will likely lead to $100 - $120 / ton of price improvements during 2014. >95% utilization rates will keep the market balanced in 2014 – 2015 resulting in significant FCF generation for Domtar and providing them with breathing room to focus on Personal Care acquisition opportunities
Personal Care earnings power is largely ignored by investors BUT harder to ignore: Personal Care will represent >20% of profitability in 2014E and management has stated a long-term goal of getting >30 – 50% of profits from this segment. Given the underlying FCF generation of uncoated freesheet, additional accretive acquisitions are likely in the n-term.
Valuation is too cheap (market applying punitive multiple to all businesses ignoring >40% of business that is growing): Domtar trades at less than 4x EBITDA and 5x EBITDA – capex. Applying conservative multiples to Domtar’s non-uncoated freesheet segments after factoring in 2-years of FCF generation, creating the uncoated freesheet segment at less than 3x EBITDA – capex
What’s Domtar worth: Applying relatively conservative multiples to Domtar’s businesses and factoring in 2-years of FCF generation gets to a ~$135 / share FV (implies less than 6.5x EBITDA – capex on 2015E figures). In the scenario where management acquires more Personal Care assets (with sub-5% financing), my upside valuation is ~$155 – 160 / share.
Downside protection: Given improved visibility on the uncoated freesheet portion of business (2nd price increase nominated earlier this evening by International Paper), Domtar will likely generate >$20 / share of FCF per annum in 2014E and 2015E (i.e. in 2-years time, Domtar will be trading at less than 4x EBITDA –capex). In addition, its worth highlighting that Domtar management has a solid track record of capital allocation: repurchasing ~25% of shares outstanding over the past 4-years, paying a ~2.3% dividend (will go up over time), and increasing exposure to Personal Care at attractive acquisition multiples (5 acquisitions over the past 3-years and now represents >$200MM of EBITDA)
I do not hold a position of employment, directorship, or consultancy with the issuer. I and/or others I advise hold a material investment in the issuer's securities.
I do not hold a position of employment, directorship, or consultancy with the issuer. Neither I nor others I advise hold a material investment in the issuer's securities.
1. International Paper announced 2nd px increase for uncoated freesheet earlier this evening (Domtar and others likely to follow suite)
2. FCF generation in 2014E will surprise to the upside
3. Personal Care acquisitions more likely in the n-term (5 over the past few years and mgmt focused on additional acqs n-term)
4. Capital allocation (shares buybacks, dividend and acquisitions) will aid the story