Stock Analysis: Domtar (UFS)

Domtar (UFS: $1.70) is a manufacturer and marketer of uncoated freesheet paper in North America. The Company also manufactures papergrade, fluff and specialty pulp. This is not to be confused with newsprint where the demand is steadily declining and there seems to be no light at the end of the tunnel. Uncoated freesheet is the paper that you and I use in our printers, envelopes and books. Look around you and you will see a lot of it lying around, we will always need it! use it! Do you remember how much it cost you the last time you purchased a stack? How many times have we heard the phrase, "blah is not worth the paper it is written on"? It is definitely an expense for corporate America but one that does not hold much weight in terms of cost; it will probably be the last thing that is cut from corporate and household budgets alike.

Industry:
Demand is decreasing because of the digitization of everything. We don't need as much paper anymore - we use the internet, use kindle/iphone to read e-books, advertisers/retailers are not demanding much paper for pamphlets/catalogs. The demand has been declining at a 2-3% rate since 2000, I expect the demand to be flat to slightly positive going forward. The good thing is the industry saw this coming - they consolidated! Domtar is the largest producer of Uncoated Freesheet Paper in North America with market share of 34%; while International Paper has 26%, Boise Cascade has 9%, Georgia Pacific has 7% and Glatfleter has 4% market share. The top 5 companies control more than 80% of the market and that means a lot of pricing power.

Uncoated Freesheet paper is a commodity market. In a commodity market where price determines market share, it is important to be the low cost producer - Domtar is! The price setting mechanism at the margin is the cost of production of the highest cost producer. 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. Aldabra (a blank check company for UFS) notes that there hasn't been a new mill built in the last 12 years. Aldabra estimates that it is paying about $1.625 billion to purchase manufacturing assets that would cost in excess of $4 billion to build new. In other words, returns on capital for new capacity are so low that it's economically impossible to build new capacity. These costs create high barriers to entry making it unlikely that new players will emerge. In essence the view is this:
(1) New competitors will not come in as there are high barriers to entry
(2) The industry has consolidated and collusion can take place in terms of price increases
(3) Yes, demand is declining but prices can be passed to the customers (the view is that this is akin to the tobacco industry where they initiated price increases to combat declining demand - keeping the top line fairly constant)

Company Valuation:
Domtar has a market capitalization of $870 million and EV of $2.8 billion for a ttm EV/EBITDA of 3.5x. Domtar is producing around $800 million in EBITDA/year, which I will assume as fairly constant as the lack of demand in the short term will be taken care of by the savings from the synergies from the merger (yes synergies are real here!). Domtar's capex is around 30% of the D&A expense and it has been aggressively paying down debt (does not have immediate maturities) from the cash flow generated. We can value Domtar anywhere between 6-8x EBITDA conservatively and at those valuations I get around $5.20/share - $8.26/share.

I also did a DCF on this and without posting my model here - assuming no growth, capex equal to 30% of D&A and a 10% WACC I get around $7-8/share. Domtar also has some NOL's (from years of losses) which I will not bring into the equation to be conservative. What I guess I am trying to say here is that Domtar is grossly undervalued and it is obvious! It can be an absolute home run if the competitors keep behaving rationally - keep demand and supply in check and Domtar keeps paying down debt.

But I am not buying and here's why:

(1) A major major assumption is that the competitors will behave rationally and keep demand and supply in check. It has been happening, but will it keep happening? Game theory says otherwise!
(2) They only have pricing power to a point. According to some experts, it costs about 10%-20% more to import uncoated freesheet paper than to manufacture it domestically. So firms have room to raise prices but not by much - eventually imports will start kicking in!! The only thing that is keeping the industry profitable is consolidation. If there is excess supply, they will again be led back to their old unprofitable ways. Also in a soft market if the suppliers hold the line, firms from Asia or Latin America who themselves might be facing economic headwinds might 'dump' their paper in the NA market.
(3) Abitibi-BoWater is marketing a new kind of paper made from mechanical pulp. They also commissioned a study which found that this paper has a lower environmental impact than the paper from traditional chemical pulp.
(4) This is a company (and industry) that has huge operating leverage and in a scenario where soft demand persists the fixed costs will eat into any profits they might make. Although Domtar is a low cost producer and the price is essentially set by the high cost producers; the price of uncoated freesheet paper has to be around $ 500-$550 (it is at around $1000 right now) for them to break even.

In essence, I don't see what the team at Baupost is seeing. They have a 7.9% position in Domtar and are one of the biggest shareholders so they must be really convinced? Does anyone else see things differently?

Disclosure: No Position