Description

Description:-

Domtar Corp. (UFS) seems cheap on an EV/EBITDA even though it is a dominant player with the highest market share in an oligopoly that is just forming and is probably going to change the long term dynamics of the uncoated fresheet market.

Domtar Corporation (UFS) begin trading on On March 7, 2007 and was formed as a result of a “Reverse Morris Trust” merger between Domtar Inc. and Weyerhaeuser’s fine paper business. The deal was structured so that Weyco’s shareholders first received “split off” shares in the new company – which then merged with Domtar Inc. to form Domtar Corp. After the deal, Weyco’s shareholders owned approximately 55% of the “new” Domtar, while the old Domtar Inc. shareholders owned the remaining 45%.

Before the transaction, Weyco’s business consisted of :- Timberland assets, Packaging business, Wood products, Papers  and Real Estate assets. To the extent that the shareholders receiving the split off shares did not want them (note jeeter961’s writeup of WY), there is a possibility that there is some non-economical selling pressure on this stock. Though it was not apparent in the first few months of trading- probably due to the “spin off” premium and the fact that UFS appeared in Baupost’s 13-F, the shares have subsequently sold off since then – and have pretty much tanked since the late August market turmoil and haven’t recovered since.

 
The Industry Backdrop :-

After the merger, UFS is the largest producer of Uncoated Freesheet Paper (ucfs) in North America with market share of 34%. The remaining players are – International Paper (26%), Boise Cascade (9%), Georgia Pacific (7%) and Glatfleter (4%). Uncoated Freesheet Paper (ie paper made from cooked wood fibres and chemicals) is used in a variety of applications in publishing (textbooks), writing and business applications such as photocopying and envelopes.

This is a commodity market. In a commodity market where price determines market share, it is important to be the low cost producer. The price setting mechanism at the margin is the cost of production of the highest cost producer. As lower cost firms bring newer low cost sources online, the higher cost producers drop out and are replaced by more efficient ones. As a result, over the long term, the price falls. The price of ucfs paper peaked at $1200/ton in 1980. Since then, it has steadily declined to around $800/ton today. On top of that, this is a cyclical business making it important for manufacturers to remain cost competitive to make profits over the cycle.

The paper industry is one of the most capital intensive industries in the US. As a comparison, per dollar of output, it takes twice as much investment in PP&E  to produce paper as it does cars. In addition, manufacturers have to deal with strict environmental and health safety issues. These costs create high barriers to entry making it unlikely that new players will emerge. The Neweset green field US paper production facilities were  built more than 10 years ago. In addition to the capital costs of actually setting up a mill, manufacturers have to deal with variables like energy, labor, transportation costs, and raw material like fibre and pulp. According to my research, since the 1970s, there has been an overall incentive to replace more expensive variable cost factors with more predictable capital stock leading to a trend towards larger machines (machines were on average 15,000 tpy in 1970 whereas UFS’s machines are on average 330,000 tpy).

Paper mills have declining marginal costs for some factors of production at high operating rates. It takes about the same amount of labor to run a machine at 95% versus 85%. Also, at higher operating rates labor and energy costs are spread over more tons of production leading to incentives to for manufacturers to run the mills at high operating rates.

In the past, most capital expansions were planned during boom periods. Since it takes considerable time to bring new capacity online, capacity additions were lumpy and were introduced just as the inevitable downturn began. This lead to severe industry downturns.

What is driving demand?

Historically, Uncoated Freesheet demand has expanded in line with GDP growth. But in recent years, this has not been the case. In 2005, UFS shipments fell 3.4% from the prior year, while real US GDP advanced at a 3.5% rate. In 2006, UFS shipments increased just 0.4%, while GDP growth reached 3.3%. Long term AF&PA (the American Forest and Paper Association) expects Uncoated Freesheet demand to decrease by 1-2% annually.

The biggest reason for this phenomenon is the increasing use of electronic communications (email, internet). The increase in postal rates also had an effect, with UFS used in envelopes declining by 4.7% in 2005 before rebounding by 1.8% in 2006. Uncoated Freesheet, though has many more uses than just envelopes – like textbooks, copy paper etc. so there is reason to believe that though overall use will decline in the future, it will not be as steep as newsprint.

The current situation :-

Manufacturers today seem to be more intent in reducing the cyclicality of the business and improving their financial returns. In recent years, they have taken steps to make sure that capacity is in line with demand. According to a survey published by AF&PA, US paper and paperboard capacity declined by 1.6% in 2006 to 97.7 million tons. This continues a favourable trend of declining capacity over the past five years. In 2001, capacity decreased for the first time in the history of the industry; from 2000 to 2006, production capability fell about 1% per year. This is very different from the past two decades when capacity rose at an annual rate of 2.2%. Reductions in capacity need not always imply reductions in output though. This is because, companies have been able to close inefficient plants and improve their overall operating rates. As well, they have taken ample advantage of production creep opportunities.

For Weyco, Fine papers was "just another" business segment and not core to its operations. For example, in the 1990s, when International Paper closed 5% of its capacity Weyco did nothing. The merger of Domtar Inc. and Weyco’s Fine paper business has basically achieved two things – a) Reduced the number of major players from Five to Four. And b) Since Papers now comprises over 84% of UFS’s sales, it can now act in its own self interest in matching supply and demand.

In fact, we now have an Oligopoly that seems to be acting rationally in this respect. Since the Domtar deal, all three of Domtar’s competitors have demonstrated this by removing capacity. According to various sources, International Paper escalated the conversion at Pensacola, to remove capacity faster than expected. Boise acted to reduce production at Wallula. Georgia-Pacific announced the closure of the #4 machine (this was an uncoated freesheet machine) at Wauna, Oregon. That means that the the total capacity removed in 2007 alone by these three players is 690,000 tons, or about 5% of starting capacity. And that’s before UFS did anything! In June, UFS announced the closure of three more mills (Gatineau, Woodland and Port Edwards) representing 284,000 tones of production capacity.

Capacity removal of course implies higher operating rates and lower per ton costs. Note that most of the capacity being removed is  inefficient capacity **. What is also interesting is that, most producers also seem to be intent on not increasing prices too much so as to not attract imports.

The threat of imports has always been there. But till date, monthly imports account for only 4% of production. A weak dollar and a strong Euro makes imports from Europe cost prohibitive. And imports from Asia are barely profitable. Another knock against imports as a threat is China and India – whose growth I expect will absorb most of the capacity in Asia.

 ** Mill efficiency is rated on a cost curve with the 1^st quartile mills being the most efficient and the 4^th quartile being the least. Though this implies cash costs at the mill gate, the total delivered cost (which includes transportation) is what is important. For example, the Woodland ME mill that Domtar cost was really a 2^nd quartile mill. But its location put it at a cost disadvantage.

So now, in uncoated freesheet, we have just four producers in an oligopoly, no real imports, and just a few coated and newsprint players who can opportunistically enter the grade (on the roll side). Basically, Weyerhaeuser's exit eliminated the major destabilizing force in this area.

Moreover, RISI an industry expert, predicts a strong pricing environment for uncoated freesheet in the future.

 
The Company :-

 
UFS operates in three segments –

    Papers (84% of sales):- This is their bread and butter uncoated freesheet operation. They own six highly efficient mills representing 2/3 of total capacity. This makes UFS, one of the low cost producers in North America. This segment can produce 5 million tons of fine paper capacity at 16 paper mills

    Paper merchants (11% of sales) – their paper distribution arm which consists of “of an extensive network of strategically located paper distribution facilities, comprising the purchasing, warehousing, sale and distribution of various products made by us and other manufacturers.” This is the second largest paper merchant organization owned by a paper manufacturer. Only 38% of their volume is in Domtar papers.

      Wood (5% of sales) :- From their filings this business “comprises the manufacturing, marketing and distribution of lumber and wood-based value-added products, and the management of forest resources. We operate five sawmills and one remanufacturing facility with a production capacity of approximately 550 million board feet of lumber. In addition, we own five sawmills that are currently not in operation but have an aggregate production capacity of approximately 760 million board feet of lumber.

Domtar has been divesting non-core assets. In December 29, 2006, Domtar sold its 50% equity interest in Norampac to Cascades Inc. (Norampac was Domtar’s packaging segment prior to this). And “On June 22, 2007, Domtar announced an agreement to sell substantially all of its Wood business to the newly created Conifex Inc. for approximately $268 million including an estimated $47 million of working capital. The operations being sold consist of substantially all of the Company’s Wood business, except for its sawmills in Saskatchewan and some forestlands.” This transaction is still awaiting regulatory approval and is slated to take place later this year.

 In addition, management has announced various measures to wring synergies out of the Domtar – Weyco merger. Typically I am skeptical of such announcements, but the following points give me confidence –

a)      Management has substantial incentives to deliver on these commitments. 60% of the CEO’s pay is based upon incentives tied to achieving synergy targets, and delivering shareholder value

b)      Out of a total of $200 million announced, they have already achieved $70 million ## (more on this below)

c)      Management seems intent to act rationally to maximize shareholder value by selling non-core assets.

d)      The companies being merged are commodity manufacturers and it makes sense that there can be synergies attained in SG&A, procurement, and transportation costs.

e)      Management is commited to using cash to delever the balance sheet going forward.

 
Valuation :-

 

Share price = $8.22
Shares outstanding = 515.2 + 5.2 (options @ wap $7.68) = 520.4 million
Market Cap = $4.28 billion
Net Debt = $2.78 billion (including Other liabilities which includes pension liabilities).
NOLs = $1.1 billion (($603 million in Canada and $544 million in the U.S) which I value at $300million

EV = $6.76 billion.  

Assuming the Woods business sale goes through, management expects annualized EBITDA to be $872 million – they did $416 million in 1H 2007. Since their business is not very season, we can annualize this and subtract EBITDA drag from Woods (-$40 million). I am not adjusting for any forex benefits as this evens out over time.

Public market comparables trade at 9.8x EBITDA and have 4.2x Net Debt/EBITDA. UFS has a Net Debt/EBITDA of 3.34x not including any EBITDA gains from any transactions.

 So if we use a short table to see the range of values for which UFS may trade at –

 

		Implied EV @9.8x	Net Debt	Implied Market Cap	Implied stock price
EBITDA	$832	$8.15 billion	$2.48	$5.67 billion	$10.89
EBITDA after Woods sale	$872	$8.5 billion	$2.25 *	$6.25	$12
EBITDA with only $100 million runrate synergies	$932	$9.1 billion	$2.48	$6.62 billion	$12.7

* Minus $233 net from Woods sale

 
Management has guided to a capex of $300 million and is about 60% of annual D&A.

Another way to look at this is to value the mills –

 

Paper Production Facility	Location	Paper	Principal Paper Type	Annual Paper
		Machines		Capacity
				(millions of tons)	Quartile	$Cost/ton
Uncoated freesheet mills
Ashdown	Arkansas	4	Copy and offset	0.9	1	1200	1080
Windsor	Quebec	2	Copy and offset	0.6	2	800	480
Hawesville	Kentucky	2	Copy and offset	0.6	1	1200	720
Plymouth	North Carolina	2	Copy and offset	0.5	1	1200	600
Kingsport	Tennessee	1	Copy and offset	0.4	1	1200	480
Marlboro	South Carolina	1	Copy and offset	0.4	1	1200	480
Johnsonburg	Pennsylvania	2	Copy and offset	0.4	2	800	320
Dryden	Ontario	2	Copy and offset	0.3	2	800	240
Prince Albert(1)	Saskatchewan	1	Copy and offset	0.29	4	300	87
Port-Edwards	Wisconsin	4	Value added	0.2	3	400	80
Nekoosa	Wisconsin	3	Value added	0.2	2	800	160
Rothschild	Wisconsin	1	Opaque	0.1	3	300	30
Woodland	Maine	1	Opaque	0.1	2	800	80
Gatineau	Quebec	1	Coated lightweight	0.1	3	400	40
Port Huron	Michigan	4	Technical and specialty	0.1	4	300	30
Espanola	Ontario	2	Technical and specialty	0.1	2	800	80
Total Uncoated freesheet mills		33		5
Coated groundwood
Columbus	Mississippi	1	Coated groundwood	0.2	1	1200	240
							5227
Total Coated groundwood		1		0.2
Pulp Mills at $400/ton							772
		34		5.2			5999

 

I am valuing 1^st quartile mills at $1200/ton, 2^nd at $800/ton, 3^rd at $400/ton, 4^th at $300 ton and pulp mills at $400/ton – my own assumptions from news reports + some multiples from bcc VIC writeup by nha855.

EV = $6 billion + $233 million (Woods sale) + $300 million (NOLs) + $16x8 (Paper Merchants @8x EBITDA) = $6.67 billion which is around the current EV. So downside is low at the current price.

## The 4^th quartile mills have around $850-$1000 cash costs/ton. And with freesheet trading around $800, were losing (using midpoint of $900)  were losing $100 a ton which amounts to $40 million savings they got by closing mills at Gatineau, Port Edwards and Woodland.

Note that UFS’s “Canadian pension funds have approximately CDN $420 million (of which approximately $308 million is held by Domtar Inc.’s Canadian pension funds) invested in multiple ABCP conduits that are subject to the interim arrangement of the “Montreal Proposal”. These investments are primarily rated Under Review - Developing at R-1 (high) or AAA by DBRS.” As we know, the ABCP market is pretty tight right now. Assuming even a 50% haircut to this value, it reduces my EV estimate by only $210 million (and even lesser since these are future pension contributions and need to be discounted as such).

So tell me what I am doing wrong here, but at the current price, Domtar seems like a compelling buy.

 

Risks:-

1)      A sever downturn in the Economy may cause a big drawdown in the price of uncoated freesheet. In the end, this is a commodity market so I would be careful in holding this beyond 2 years.

2)      Imports as well as execution risk in management’s strategy. Also, a big part of my thesis is based upon the fact that other players act rationally.

 

 

Catalyst

1) Rational players in an Oligopoly keep supply tight
2) Transactions outlined by Management to increase shareholder value