Domtar (UFS) Wants to Talk about Incontinence, Market Doesn’t Care

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 3rd, 2015

Domtar (UFS) Wants to Talk about Incontinence, Market Doesn’t Care

  • The market is apparently very skeptical about Domtar’s transition towards a more Personal Care oriented company, and we cannot reconcile forward EBITDA estimates without any dramatically negative assumptions for the core Paper business.
  • Domtar’s Personal Care segment manufactures absorbency products (baby diapers, adult incontinence, feminine hygiene) currently sold mostly at the institutional level (hospitals), but with a large and growing retail opportunity the adult incontinence market is ~$9 billion, growing at 3-5% a year, and demographic trends are very supportive of sustained long term growth.
  • This is not a topic many people are keen to discuss, but there’s nothing uncomfortable about a 14% FCF yield, far and away the highest among its peers. Cash earned is being funneled into growth opportunities in Personal Care and delivered back to shareholders (30% CAGR in dividends per share since 2010, 3.5% yield, $1B repurchase program), and flows should remain robust for some time. The paper business (68% of 2014 EBITDA) remains in decline but will not disappear tomorrow (Domtar has secured some longer term volumes, 15% of shipments are specialty grades growing in line with GDP) and the pulp segment (14% of EBITDA) is expected to grow around 1-2% annually (likely a touch higher now that fluff is a larger part of the mix).
  • The growth is there but nobody caresimplied growth analysis shows UFS has implicit growth on par with companies that are valued at EBITDA multiples several multiple points higher. If estimates are understated as we believe, this multiple would be even lower.
  • Those skeptical that a paper maker can successfully market consumer products could refer to Swedish paper and packaging giant SCA which has long had positions in both markets, and where, not coincidentally, Domtar CEO John D. Williams spent eight years of his career.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

Domtar (UFS) has been on our radar for some time, the result of its depressed valuation and strong cash flows ($9.77 operating cash flow per share in 2014, dividend yield of 3.5%). Domtar’s main business is represented in its ticker symbol, Uncoated Free Sheet, the standard 8 ½” x 11” paper this report would be printed on, and the market here is in perpetual decline. To offset this, the company has been expanding into the Personal Care space where its pulp and fiber expertise can be utilized in diapers and feminine hygiene products. After a blowout Q4 and optimism that 2015 will be a significant step forward in the company’s transformation, the stock has caught some momentum (up 12.5% vs. the S&P in February) but continues to have the lowest multiple in our Paper & Packaging index. We explore Domtar’s consensus estimates in more detail to see where the market’s skepticism is focused and whether it is justified. Further specific areas of segment analysis include: paper pricing and the impact of imports, the outlook for pulp, and ramp up concerns in Personal Care.

What Estimates Are Implying

Management believes its current Personal Care platform can get to $200-250 million of EBITDA by 2017. The broader, longer term goal for the segment is $300-500 million, but it has been acknowledged on many occasions that M&A will be needed to reach this goal and we do not assume any growth from acquisitions in our analysis, as estimates clearly do not. The high end of Domtar’s organic targeted range implies 27% annual growth in Personal Care over 2014 levels – not implausible given the 54% seen from ’13 to ’14. Projecting out to 2017 from 2014 levels, if we assume a base case where we:

  • Assign a more conservative 15% growth to Personal Care (which would leave EBITDA $13 million shy of the target range’s low end)…
  • Assume Pulp will grow at the midpoint of the target range (1.5%)…
  • And mark down paper at a percentage point below the low end of that business’ secular 3-4% decline (so -5%, which seems aggressive given Paper EBITDA grew $30 million in 2014)…

…we would still come in about $50 million above the current consensus estimate ($772 on our base case vs. $724 consensus).

Exhibit 2

Source: Capital IQ, SSR Analysis

So estimates are implying:

  • The current Personal Care platform cannot achieve even $200 million of EBITDA and any intended acquisitions will be insufficient to move the needle
  • The decline in Paper is going to be significantly worse than UFS is anticipating, worse than what has been seen over the past few years

We ran a few additional scenarios to determine what you would have to assume to arrive at current consensus EBITDA estimates.

  • Paper declines by 6% a year, Pulp is flat and Personal Care grows by only 9%, putting EBITDA in that segment about $100 million below management’s goal:

Exhibit 3

Source: Capital IQ, SSR Analysis

  • The market believes in the Personal Care story, EBITDA flat lines in the Pulp segment and declines by 13% annually in the Paper business:

Exhibit 4


Source: Capital IQ, SSR Analysis

Note again, however, that Paper is a declining business yes, but EBITDA in this segment grew by $30 million in 2014. This is not a business that is going to disappear tomorrow, or by the end of 2015, or even by 2020, and as the company curtails capacity to align with demand, the costliest tons are inherently removed from the system, improving profitability. Pulp is on track to fall behind Personal Care as the company’s second largest segment in 2015, but the company’s focus on fluff pulp (~40% of pulp capacity following the Ashdown conversion) is a prudent one, as this market is expected to grow in line with GDP. On the Personal Care side, the market apparently believes this will be a spectacular failure despite steady progress and execution (admittedly slower than management would have liked). All in all, we think current forward estimates are understated for Domtar. There also does not appear to be any consideration of growth by acquisition, which management has long made clear will be needed to meet the broader goal of $300-$500 million of EBITDA in Personal Care.

Paper Pricing – Imports Having an Impact

Domtar has curtailed paper capacity to stay aligned with demand, and operating rates have been consistently in the mid to upper 90% range. Pricing has been the recent issue, impacted by imports. The North American paper industry saw a 5% surge in imports in 2014, following IP’s closure of the Courtland mill which effectively removed 10% of North American capacity overnight. The unit was running at capacity up to the closing date, which left purchasers scrambling to secure volumes. Import growth had not affected prices for much of the year – pricing contributed positively to Domtar’s paper sales until a sequential decline of $20 per ton in Q4 and a further $20 reduction in the first month of 2015. Prices have since stabilized and are anticipated to trend sideways. Long term, the logistics of the supply chain (good luck if your shipments are coming from Indonesia via LA/Long Beach) and basic cost economics (import producers have a transportation disadvantage and no real energy edge – see current electricity costs in Brazil) should keep imports subdued.

Exhibit 5

Source: Capital IQ, SSR Analysis

It has been noted that a chunk of the imports into the North American market have been coming from Brazil. Domtar has subtly suggested that IP may be using its Brazilian operations to make up for the Courtland closure, selling to the same North American customers but shipping the product in from South America (which would likely mean the imports are here to stay). IP has contradicted this theory, claiming that the company does not sell any paper in the US that is not domestically manufactured.

Pulp Pricing – Near Term Volatility, Shift Towards Fluff A Positive

The company recently announced one of its paper mills at the Ashdown, Arkansas facility will be converted to produce fluff pulp exclusively. The fluff market has been a focus for UFS in its pulp segment, and with the Ashdown conversion now represents about 40% of pulp capacity. This portion of the pulp industry is expected to grow roughly in line with GDP (trade publication forecasts see a 3.7% CAGR through 2018), and more importantly supplies the company with a key input into its absorbency products in the Personal Care space. In the near term the company anticipates pulp pricing will be volatile, partly as a result of US dollar strength (much of this business is global). The pulp business has historically been the most volatile component of Domtar’s portfolio, but the recent margin improvement has coincided with the declining percentage of hardwood shipments. Hardwood has seen significant growth over the past 20 years, notably so in comparison to softwood where growth is limited by the scarcity of supportive geographies (US Southeast and Northwest, Canada, certain parts of Scandinavia and Russia).

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

Personal Care Ramp-Up Concerns

Domtar’s expansion into Personal Care has been a growth by acquisition story thus far. The company has made five purchases over the past five years and has been working to meld them together into a coherent business. Much of this work is already done and the effects on the top line are evident – 2014 was the first year since 2010 that total sales grew.

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

Increasing sales in the Personal Care space should begin to more positively impact margins and cash flows as Domtar moves from outsourced to in-house production, and the first half of 2015 will be telling as to whether the company is ramping up in line with expectations:

In December we began transitioning from outsourced supply to Domtar-manufactured finished products. We expect the full cost-saving benefits of this transition to be realized over the next few months as inventory becomes fully depleted. Exiting the quarter, we have reached the inflection point where cost savings are now fully offsetting the ramp-up costs.” – John D. Williams, CEO, Q4 2014 earnings call

The Historical Precedent

Domtar’s Personal Care push may seem like more of a desperate gambit than a sound strategic initiative, but there is considerable historical precedent for a paper maker to move into consumer goods.

Kimberly Clark’s first business, dating back to 1872, was a paper mill. In 1920, after seeing the success of their absorbency products in the US military in World War I (nurses used their cotton pads during menstruation) the company brought the first disposable feminine napkin to market. Granted the competitive landscape is significantly fiercer than it was 100 years ago, but it still is not a stretch for a pulp and paper manufacturer to foray into personal care applications.

More significantly, Domtar’s move into personal care should not have come as a surprise, considering CEO John D. Williams spent eight years of his career at Swedish paper & packaging giant SCA, which has long had a presence in both the paper/pulp and personal care markets.

Valuation and Return on Capital

The current Domtar has a relatively short public history, dating to its 2007 merger with Weyerhaeuser’s paper business. Using the average return on capital over this span, Domtar does not look like an expensive stock on our model.

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

The recent move higher in the stock has come as forward twelve month EPS estimates have come down, and as a result the stock no longer looks cheap on a relative P/E basis, though it is possible the move higher has come in anticipation of positive revisions. On an EV/EBITDA basis, Exhibit 1 showed the stock has the lowest multiple of any name in our Paper & Packaging group, but with the strength seen in February, UFS is now slightly above its multi-year average here. Over the past five years, the price/book ratio has been fairly accurate at identifying the valuation floor, seemingly around 0.8 (this would imply $35 as a support level). On this metric the stock is also off its lows but not at a critically high level relative to history.

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

Exhibit 15

Source: Capital IQ, SSR Analysis

Capital Allocation – Strong Cash Flows, Growing Dividends, More M&A to Come

Domtar still generates large amounts of cash in its core paper business, and Personal Care is expected to begin contributing positively to cash flow in 2015.

Exhibit 16

Source: Capital IQ, SSR Analysis

Dividends have been a focus for the company, and have grown at nearly 30% annually over the past five years. The yield at current prices is 3.6% and compares favorably to others in the space. The exhibit below does not reflect the recent increase approved by the company, which raises the payout to $1.60 per share.

Exhibit 17

Source: Capital IQ, SSR Analysis

The company’s strong cash flows have enabled it to make acquisitions in the Personal Care space and pay down debt promptly – Domtar is not highly leveraged. M&A has been focused on the Personal Care space, and there will be further deals to come here.

Exhibit 18

Source: Capital IQ, SSR Analysis

Exhibit 19

Source: Capital IQ, SSR Analysis

Also facilitating Domtar’s strong cash flows – paper manufacturing itself is less capital intensive than metal can, containerboard or plastic packaging production. CapEx has trended higher as acquisitions have been pursued in personal care.

Exhibit 20

Source: Capital IQ, SSR Analysis

Exhibit 21

Source: Capital IQ, SSR Analysis

Optimism

Corresponding to the declining paper volumes seen, Domtar has noted the choppiness of demand which makes visibility very poor in this industry. As such, there tends to be significant volatility associated with the company’s quarterly results. Personal Care is a much more stable business, and we would expect these surprises to moderate in magnitude as the segment grows to constitute an increasingly greater percentage of net sales.

Domtar sits in the very center (best spot) on our opportunity matrix – Exhibit 25.

Exhibit 22

Source: Capital IQ, SSR Analysis

Exhibit 23

Source: Capital IQ, SSR Analysis

Exhibit 24

Source: Capital IQ, SSR Analysis

Exhibit 25

Source: Capital IQ, SSR Analysis

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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