Domtar (UFS) – A paper company with strong cash flows

April 6, 2011

Since my last foray into the paper industry with Boise Inc., I thought it would be appropriate to review the rest of the sector. After some searching, I have settled on Domtar (UFS).  Domtar is the largest producer of uncoated freesheet paper in North America, and also a producer of wood pulp, with operations in several locations in the United States and Canada. The company was formed in 2006 to purchase Weyerhaeuser’s fine papers division, which transaction was consummated in May of 2007. Obviously, the timing of the deal was not the best, as the firm has had to recognize significant goodwill and asset impairments since that event. However, these impairments are noncash expenses, and Domtar has produced an attractive record of free cash flows since the acquisition, with free cash flow yields of above 11% even during the difficult 2008-2009 period. Also, the company has on its balance sheet over $500 million in excess cash, out of a market cap of $3.85 billion.

Furthermore, Domtar has not shied away, as many acquirers do, from the usually necessary process of whittling down of unneeded or underperforming assets following an acquisition. In fact they have shut down several underperforming paper mills in Mississippi, in Saskatchewan, Ontario, and Quebec, and in California. The company has also repurposed its plant in North Carolina to produce purely fluff pulp in response to market demand. Finally, the firm has sold off its wood and lumber products business since the acquisition. In fact, as recently as last week Domtar announced the closing down of a papermaking line at its plant in Arkansas.

As a result, the company has been able to maintain a high level of free cash flows throughout the 2008-2009 period despite a lowering of demand, and 2010 was a dramatically impressive year for Domtar, with free cash flows of $583 million, equal to almost 1/6 of the firm’s entire market cap. However, this may be the result of a fortunate confluence of circumstances, where sales prices increased without the cost of inputs catching up and therefore the 2010 results are perhaps atypical. Domtar has recently been using its impressive free cash flow to pay down its debts, having paid back $917 million in 2010 and $400 million in 2009.

Turning to the figures, I would first like to address the excess cash level. A common measure of a firm’s excess cash is the total cash and investment on the books, minus the extent to which current liabilities exceed current noncash assets. (Of course, cash being described as “excess” does not mean that a company could instantly declare a special dividend of all of its excess cash without its liquidity suffering; it merely means that a purchaser of a company’s stock is allocating part of his or her purchase price to cash that is not encumbered by any pressing need. Therefore, the purchaser may be said to “claw back” that amount from the purchase price, while the remainder is allocated to the actual capital assets of the business. A business that is strongly cash flow positive (and as a value investor, those are the only kinds of business I like investing in) may be expected to produce the cash to address its noncurrent liabilities out of its future earnings, and the extent to which the company’s prospects indicate that they can do it governs whether the excess cash as calculated is really excess, which in Domtar’s case I believe it is. This analysis also requires a determination that a company’s debts are manageable, which again is true in Domtar’s case; interest is covered over four times in each of the last four years surveyed).

For Domtar, based on its latest balance sheet, the firm has $530 million in cash and $1.47 billion in noncash current assets (of which $1.25 billion consist of receivables and inventories, rather than the more nebulous categories of “deferred taxes” and “other”), set against $725 million in current liabilities. As a result, noncash current assets exceed noncash liabilities and therefore all $530   million in cash may be considered excess. Taking $530 million off of the market cap of $3.85 billion leaves $3.32 billion representing the market value of Domtar’s capital assets.

In terms of earnings, in 2010, Domtar’s sales were $5.85 billion and operating earnings as reported came to $603 million. However, because of noncash impairments resulting from plant closures, and other closure- and restructuring-related costs, $77 million in expenses should be considered noncash and/or nonrecurring. This produces $680 million in income from operations, which, after interest expenses of $97 million, leaves $583 million in pretax earnings, or $379 million applying a 35% tax. (In fact, Domtar reaped a tax windfall in 2010 and 2009 for operating loss carryforwards and a tax credit for black liquor, a byproduct of producing paper pulp that makes an excellent fuel and which qualified for an alternative fuel subsidy from the US government in 2009. However, the subsidy has expired, and for purposes of forecasting Domtar’s earnings power, it would be preferrable to apply the statutory, rather than the historical, tax rate).

Furthermore, as with many companies, Domtar has an additional source of free cash flow in that its depreciation charges of $395 million have exceeded its capital expenditures of $153 million. This leaves $242 million of additional cash flow to Domtar’s owners, producing total free cash flows to equity of $583 million. This represents a free cash flow yield of 17.6% based on the $3.32 billion market value of Domtar’s operating assets. This source of free cash flow is presently untaxed, although eventually the gap between depreciation and capital expenditures may be expected to resolve itself at which point this will no longer be the case. However, Domtar is still in the process of whittling away at its underperforming assets to increase its competitiveness and therefore the current levels of capital expenditures may be considered reasonable for longer-term estimates. Therefore, at the current rate of capital expenditures the gap will take many years to close, during which time the excess depreciation will continue to be tax-free.

For 2009, sales were $5.47 billion and reported operating earnings were $615 million. However, this was the year of the black liquor tax credit, which contributed $497 million in nonrecurring extra income, which was offset by $125 million in impairment and restructuring charges. Therefore, actual operating earnings were $243 million, before interest expenses of $121, leaving $122 million in pretax earnings, or $79 million after taxes. Excess depreciation that year came to $299 million, producing free cash flow of $378 million.

For 2008, sales were $6.39 billion and reported operating earnings were $-437 million, but this year included noncash and/or nonrecurring impairments and restructuring charges of $751 million, producing actual operating earnings of $314 million, before interest expenses of $132 million, leaving $182 million in pretax earnings, or $118 million after taxes. Excess depreciation in that year was $300 million, producing free cash flow of $418 million.

Domtar’s acquisition of Weyerhaeuser’s fine papers division occurred in May of 2007, but the firm was kind enough to include pro forma earnings in its 2008 10-K. For 2007, sales were $5.95 million, reported operating earnings were $270 million, before $31 million in noncash or nonrecurring events, producing actual operating earnings of $301 million. Interest expense that year was $142 million, leaving $159 million in pretax earnings, or $103 million after earnings. Excess depreciation that year came to $355 million, producing $458 million in free cash flow.

In 2006, Domtar’s business was still inside Weyerhaeuser, and curiously the financial reports do not allocate any interest expense to it. At any rate, sales were $3.31 billion and reported operating earnings were $-556 million, before noncash or nonrecurring impairments and other items of $701 million, leaving $145 million in actual operating earnings, or $94 million after taxes. Excess depreciation came to $247 million, producing $341 million in free cash flow.

2010 2009 2008 2007 2006
Sales 5850 5465 6394 5947 3306
Reported operating income 603 615 -437 270 -556
Impairments, restructuring & other nonrecurring 77 -372 751 31 701
Operating income 680 243 314 301 145
Interest expense 97 121 132 142 0
Pretax earnings 583 122 182 159 145
After-tax earnings 379 79 118 103 94
Excess depreciation 242 299 300 355 247
Free cash flow 583 378 418 458 341

So, what can we take away from these figures? The paper industry is a cyclical industry, and, according to Damodaran in his useful toolkit, The Dark Side of Valuation, it would be unwise to base our valuation on the most recent year even if it was not an unusually good one, but to look at the performance over a broad cycle. Unfortunately our data do not cover an entire business cycle. However, I would say that 2010 was a very good year, with sales increasing 7% and cost of sales actually declining 1%, according to the firm’s 10-K, a situation that may not continue through 2011 and thereafter in an environment of rising costs. By contrast, 2009 was no doubt a period of unusually weak demand owing to the financial crisis and its aftermath (although in 2009 the firm still produced $378 million in free cash flow, which, when set against the $3.32 billion price the market is setting on Domtar’s capital assets, is still a free cash flow yield of 11.4%).

If I had to pick a single figure for Domtar’s earnings power, I would say that it lies between those two extremes. At any rate, if we average the 2007-2010 free cash flows we get $459 million per year, which, set against the $3.32 billion market cap after removing excess cash, produces a yield of 13.8%, which I find very attractive.

I conclude, then, that Domtar has strong earnings power and as long as its management can continue to adjust to changing economic conditions by adapting its productive capacity, it should continue to produce high levels of free cash flows for its owners. As such, I can recommend as a portfolio candidate.

2 Responses to “Domtar (UFS) – A paper company with strong cash flows”

  1. Hi,

    I understand you are trying to calculate excess cash. However, you ignore long term debt. In my calculation of enterprise value, I take the market cap and add all debt ( ST debt + LT debt) and subtract cash and investments. This is the value someone has to pay to acquire the firm.

    If you want to ignore the LT debt, then why are you subtracting excess cash from Market Cap? Just leave it as Market Cap to Free Cash Flow for your P/FCF multiple or FCF yield.

    Coming back to Domstar, its even cheaper than where it was when you wrote it. What do you think about it? Are these operating margins sustainable?

  2. As I understand it, the reason for calculating enterprise value net of cash is that it allows us to assess the market value of a business’s operating assets, and thus the return we can expect based on the operating earnings and cash flows of a business, not counting interest and other investment income earned. However, once we have done that we still have to consider what to do with the cash. To the extent that the cash is excess, and not necessary for the business’s near-term cash needs, and that the business is prospectively cash flow positive meaning that future cash needs can be met by future income, the economic owner of that cash is the equity holder. The situation would be otherwise with a company like, say, Revlon, where there is excess cash according to my calculation but the company’s heavy debt load would require the use of that cash to pay down debts. As I said in my seekingalpha article comments, debt should be considered only to the extent that it has to be paid back; if the debt is a stable and permanent part of the capital structure the excess cash need not be used to pay it back.

    You do have a point that the prospective yield to an equity holder is free cash flow to market cap, but I think the current buildup of excess cash is temporary and the result of the mood of the times and of course our tax laws relating to offshore income for some companies. I predict that shareholders will lose patience with this arrangement and call for special dividends or share buybacks so that the excess cash situation will resolve and the two yields will be brought more in line. When that happy day occurs the equityholders will have the cash and the high-yielding assets, and, if we limit our focus to companies that are cash flow positive and not wasters of money, we may be assured that the cash will not diminish in the meantime.

    As for Domtar, even in 2009 its free cash flow was $378 million, although $300 million came from excess depreciation. If we treat excess depreciation as taxable, the free cash flow would be closer to $278 million, which even without taking excess cash into account is a yield of over 10%. This lower level of capital investment does not seem to have had a major effect on sales, although they are slightly down from last year, and Domtar has on the whole not, as many companies do, engaged in acquisitions as a substitute for capital expenditure. So, I think that my investment thesis is intact.

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