UFS : Paper on the cheap

I usually write about a stock idea about 1-2 weeks after I have finished acquiring a full position. I do my write-up on the weekend after I am fully invested, and then publish it several days later. I find that a brief delay of 1-2 weeks typically does not matter. More often than not, the stock price has actually declined, allowing my readers to get in at lower cost basis than me. Unfortunately, in this case, I’ve gotten slightly behind in my writing, and UFS has popped by slightly more than 10% in the meantime and is now at a 2 year high. Readers who object on principle to buying stocks making new highs will probably want to give the following article a miss, although I feel that UFS is still moderately undervalued and has room to run.

Business

Domtar (UFS) is the largest producer of uncoated free sheet paper in North America, used for writing/printing paper and in various envelopes and stationery. The market for paper is in secular decline, and the industry has been consolidating slowly over the years as the marginal players sell out to the largest producers, which themselves have been cutting production capacity. Domtar has a market share of around 35%, with International Paper second at 25%, and Boise third at 10%. UFS was formed in 2006 by the merger of Domtar Inc, then Canada’s largest paper company and the third largest producer of free sheet paper, with the paper production assets of Weyerhaeuser. Weyerhaeuser was eager to offload its various production assets in order to convert to a timberland REIT, and the asset sale was generally regarded to be at a reasonable price. This has resulted in Domtar currently carrying a modest debt load of $825M, largely offset by cash holdings of $604M.

Domtar has a dominant position in the industry. It is a low cost producer, which is a crucial advantage in a commodity industry. It also owns Ariva, the largest paper distributor in North America with a network of warehouses serving both Domtar and other paper producers. The recession has accelerated the elimination of higher cost paper mills from the US market, and the paper industry has gained pricing power. In 2010, Domtar’s gross margin leapt to 25% from the 15-20% historically achieved, and revenue actually increased 7% despite a 4% decrease in units shipped. I estimate that free cash flow for Domtar in 2010 was around $900M, which means that at the current market cap of $4.2B, the stock is going for 4.7 times cash flow.

Management strategy

The challenge for management is how to handle cash flows in the face of a commodity business in secular decline. Domtar’s strategy appears to be to completely halt investment in the declining capital intensive business, and direct cash flows to shareholders. The company has announced an increase in dividend, and accelerated and increased its share repurchases. Capital expenditures are on a downward trend, with management is cutting capacity gradually, in line with expected secular decline, estimated by management to be 4% annually.

Investor valuation

Why are investors giving a business that has enormous cash flow, minimal debt, and a shareholder-friendly management such a low valuation? A major psychological obstacle is, of course, the secular declining trend. Clearly, even with decreasing capacity and increasing pricing power, price increases cannot continue indefinitely, and at some point, free cash flow must again decrease. That said, paper use has been in slow decline for a long time now, and would probably bottom out at some point. I ran a discounted cash flow analysis with a 5% decline in cash flow for 10 years followed by a bottoming out, with discount rates of 5-10%, and arrived at cash flow multiples of 7-9.

Before 2010, UFS had an average cash flow of around $400M. The stock chart reflects that fact, with a tendency for the stock to sell off at $80, a market cap of around $3.2B, around 8 times $400M cash flow. Right now, I believe that investors are just getting used to the idea that with price increases, UFS will earn a higher cash flow in the future. My target is for a cash flow of $800M and a multiple of 7, for a price target of around $135.

Threats to pricing power

The key to the above valuation is the obviously the durability of the pricing power. Investors have reason to be skeptical. Previous closure of plants by International Paper in 2001 was met with new capacity, so there is fear that irrational actors in the industry may again expand capacity in the face of high paper prices. However, things are likely to be different this time around. After the financial crisis, banks are now actually hesitant to loan money, and I consider domestic expansion of capacity as highly unlikely, given that setting up a new paper mill is enormously expensive.

Internationally, however, the picture is different. Paper use in Asian countries is increasing rapidly, which has prompted several US companies to purchase paper mills in those countries. Some investors fear that surplus capacity from overseas may be dumped in the US, especially if there is a second global recession. However, I view it this scenario as a low probability event. While paper is a commodity, transportation costs make it expensive to ship paper to US from Asia or Latin America. In addition, North America climate and terrain are especially suitable for the growth of trees, and the US and Canada are traditionally net exporters of wood and wood products to Asia. It is thus more likely that countries overseas will be a new market for US and Canadian based paper producers rather than a competing supplier, although transportation costs will make US-based suppliers less competitive in those markets compared to domestic suppliers.

In summary, I think that the new higher cash flow of UFS is here to stay, and that the stock market is slowly pricing in that fact. Paper sales is in secular decline, and is modestly impacted by the business cycle, but on the whole, paper is still indispensable for many uses, and will likely to around for many more decades. Given the new oligopolistic structure of the North American paper industry, UFS should be able to direct the cash flow from this profitable declining business to shareholders for years to come.

Disclosure : I have a long position in UFS