Domtar Corporation: Paper Gains Or Losses?
Domtar Corporation (NYSE:UFS) is the largest uncoated free sheet paper company in the world, and is struggling to find growth to offset declining demand in the core business. Recently, the company has been upgraded by analysts on optimism over management's M&A strategy, diversification of revenue streams, and the dividend and buyback record. With shares dropping closer to their 52-week lows year-to-date, many investors might be tempted to invest in a potential turnaround.We recommend that investors avoid this company, as it faces greater challenges than many perceive, it lacks the fundamental qualities of an outstanding investment and at its current valuation, there are better investment opportunities to be found elsewhere.The Pulp and Paper IndustryThe industry consists of mills that convert wood fibers into softwood pulp, hardwood pulp and fluff pulp. Pulp is then processed into paper, and used to manufacture products such as newsprint, uncoated free sheet paper, Bristol, personal care products (toilet paper, diapers, etc.) and countless other products that we use on a daily basis. The industry benefits from high barriers to entry, in the form of capital intensity and heavy environmental regulation. Sales are likely to decrease in the next few years due to weakened demand, the threat of foreign imports, and the emergence of online services.Source: IBISWorldIn other words, industry competition is fierce and pricing power is weak. Most products have been commoditized and have low buying sentiment. Various players have suffered in these conditions and have either been taken private (New Page Corp. was taken private by Cerberus Capital Management) or recently come out of bankruptcy (Resolute Forest Products) (IBIS World).Domtar a Leader in a Declining MarketDomtar is an integrated pulp and paper producer. The company converts wood fibers to pulp and further processes into paper products. Excess pulp that is not used internally is sold to the market. The company is the leader in uncoated free sheet paper with 8.6% market share (IBIS World). In terms of structure, 85% of the production goes to Communication Paper and 15% is Specialty and Packaging Paper (Domtar Q2 Fact Sheet). This poses a problem as Communication Paper is expected to decline 3-4% per year (IBIS World). The good news is that management is trying to solve the problem by increasing their production of Specialty & Packaging Paper (stronger margins) and building a presence in the Personal Care industry (Domtar 10-K 2013).Cost Escalation and Declining ProfitsWhile looking at the 2013 10-K and 2014 10-Qs, we note the cause of the earnings decline. Some drags on profitability may be temporary, due to bad weather in Q1, or resolution of a lawsuit in 2013, but many are worrisome. Increased input costs (driven by the cost of fuel and electricity), increased freight and selling costs and the loss of the Alternative Fuel Tax Credit all impact future earnings. In Q2 2014, decreased demand led to greater idle time (approximately 51000 tons), which meant that costs were being spread over a smaller base, thus increasing unit costs (10-Q, Q2 2014), and slimming margins.With declining demand, management has been re-purposing or closing down facilities. This has increased costs for laying off workers, losses on disposal of equipment (specialized equipment is unlikely to have much value outside of pulp and paper production), environmental obligations (already reflected in allowances but they could surpass expectations), and any other shutdown costs.Looking through the MD&A, we note that roughly 50% of the 9400 employees are unionized. Of these employees 1800 of them will be negotiating their collective agreements this year, with other negotiations occurring between 2015-2017. This can potentially lead to increased labor costs, even if it is just inflation pegging. If this increased cost cannot be passed on to the consumer, margins will be compressed. With falling demand, and greater competition from foreign (Chinese) competitors, due to a strong USD and lower wages, it is unlikely that consumers will tolerate much of a price increase. At best they may be able to pass on minor increases. Given that Domtar was unable to realize a full price increase in F14Q2, it seems realistic to see slightly tighter margins.Customer RiskDomtar is exposed to significant customer risk. About 35% of total revenue comes from the 10 largest customers (Domtar 10-K). The financials also state that 10% of total revenue comes from Staples (NASDAQ: SPLS). When we consider Staples' own troubles and its mass store closure plan, Domtar could suffer declining demand from their biggest customer. Furthermore, Staples has bargaining power over Domtar, and could potentially pressure Domtar to take price concessions in order to maintain order volumes.Fundamental WeaknessThe story is not promising for Domtar, but the company is looking to pivot in hopes of finding growth. The company has no economic moat and does not appear to be able to continue business long-term in its current state. They face increasing costs, decreasing demand, a unionized workforce and virtually no product differentiation. This does not appear to have the potential for outstanding returns. Can the transformation plan fuel growth, and make it a worthy investment?Personal Care: Brilliant Diversification or Misguided Waste of Capital?The Personal Care unit consists primarily of adult incontinence products and infant diapers. These products are made with highly absorbent fluff pulp, which Domtar manufactures, and super absorbent polymers. Management's strategy is to take advantage of an aging population, while at the same time gaining a greater presence in Europe. The Personal Care division currently represents 10% of total revenues, yet 23% EBITDA (Domtar Q2 Factsheet). This indicates healthier margins than the core business. However, this does not mean that the push into Personal Care will be successful.Adult Incontinence (NYSE:AI)Domtar is now competing in a concentrated business, in which 90% of the market has been controlled by the 5 biggest players over the last 10 years (Domtar, 10-K 2013). This market has two segments: retail and institutional. Domtar generates 85% of its AI revenue from institutional sales(Seeking Alpha, Q2 2014 Earnings Call Transcript). Two problems arise from this institutional strategy. First, these sales are extremely sensitive to government spending on health care. Second, without long-term contracts, Domtar could be undercut by larger players with greater production and distribution capabilities. This could force price drops and lost sales. The remaining 15% of Domtar's AI sales are through the retail channel. This is unlikely to become a major source of revenue. Established players like Kimberly-Clark (NYSE:KMB) have network advantages with strong distribution and customer relationships that will provide them with favorable shelf space. They also have established international brands, such as Depends and Poise. On top of this they have huge marketing budgets. At the same time, Procter & Gamble (NYSE:PG) is re-entering the segment with their Always brand and investing $150M in marketing to gain a meaningful share of the market (AdvertisingAge).Infant DiapersDomtar entered the US infant products business through the AHP acquisition. The company manufactures store brand diapers. On the surface, this private label strategy appears more favorable than going up against branded products. In fact, the top 2 branded manufacturers control 80% of the total market. The rest of the private label manufacturers, including Domtar, compete for the remaining 20% of the market. In terms of growth, management expects demand in the US to be flat (10-K 2013). With flat demand, they would need to either increase revenues through higher prices, or steal market share by slashing their prices. The question is, can they actually increase prices? From their 10-K: "The [infant diaper] business is focused around a small number of large retailers that control the majority of the volume in North America which is driven by multi-year contracts, and leads to the competitiveness and volatility in the industry." Customers (large retailers) have high bargaining power, and in the tough retail business, they will most probably be against any increases. Additionally, a pricing war would most likely be won by larger competitors.Mergers: a Flawed StrategyWhile there is much uncertainty, what is clear is that UFS will need significant investment and time to become a major player in the Personal Care industry. Domtar faces challenges in integrating the acquired companies. There have been recent headwinds in the Indas acquisition through higher than expected startup costs, and the loss of 2 major customers during the transition of ownership of that business. Currently capacity constrained, the company expects benefits from this acquisition to appear in the Q4FY14.Much of the lost revenues from Pulp & Paper is being offset by acquisitions, but this is not sustainable. M&A means premiums, restructuring costs, and integration costs. Furthermore, there is a limit to how much and how fast Domtar can buy earnings to offset the decline. Investors can reallocate capital more easily and less costly than Domtar can buy their way into the industry.Price-to-Book a Misleading Measure of ValueLooking through prior articles on Domtar, many investors have been hanging their hats on the company's low Price-to-Book ratio. As of September 10, 2014, the company is trading at a P/B ratio of around 0.86 (assuming a market cap of 2.43B). Taking this number at face value is a serious mistake made by many investors. One must understand what the company is putting on their books, and a better ratio would be the price-to-tangible-book ratio.[(Assets - Liabilities) - Intangible Assets] = Tangible Book ValueGoodwill should be removed as it reflects the premium paid on past deals and not necessarily what can be received from a liquidation, while the other intangibles are primarily brand names and trademarks. Trademarked names for a declining commodity do not seem like a sellable asset in a liquidation. We calculated 2 different Price-to-Book Ratios:a) Removing Goodwill: June 30 2014 --> 2.430/2.171 = 1.12b) Removing ALL intangible assets: June 30 2014 ---> 2.430/1.523 = 1.60Following the logic other investors have been using, using tangible book value would indicate an overvalued stock, by either 12% or 60% depending on your opinion of intangible assets. That's a big difference compared to the "16% upside based on book value" others have been praising.Debt Situation AnalysisAs of Q2 2014, the company has around $1.4B of long-term debt on its balance sheet. Major uses of this debt are: general corporate usage, acquisitions and refinancing of prior issues. The company's most recent debt issuance ($250M Nov. 2013) was rated BBB- by Standard & Poors. This is considered the lowest investment-grade and should be cause for concern. If the core business continues to deteriorate, or if there are downturns in the economy, costs of debt could rise substantially. Of course, these are "what-if" scenarios, but as investors we must have an idea of all the risks pertaining to the company. There are two areas that require further attention on the Liabilities section of the balance sheet:1) There are off-balance sheet commitments such as operating leases on Property, Plant & Equipment, which should be added back to debt, with the accompanying operating expense becoming an interest expense.Source: Domtar Corporation 10-K 2013While we believe the company should be able to make these payments, they are commitments that could become serious problems if any liquidity problems were to arise in the future. As their borrowings increase, they may need to seek more off balance sheet financing, at higher costs and perhaps with more restrictive covenants.2) The company may have breached a covenant on the Bank Credit Facility (FY2013)There are two covenants for the Amended Bank Credit Facility (p.128, 10-K 2013)1) Interest coverage ratio of not less than 3-to-12) A leverage ratio, that must be maintained at a level of not greater than 3.75-to-1Looking at the 10-K 2013, it appears as though the company had breached its covenant of keeping the interest coverage ratio above 3, as we calculate it at 1.89. Management had stated that they were in compliance with the covenants at December 31, 2013. We would need to receive more clarification on this, as we do not know exactly how they calculated the ratios. On our part, we are following the original coverage ratio (EBIT/Int Exp). Management may be using an adjusted interest coverage ratio of EBITDA/Int Exp. Another possibility is that creditors were not interested in triggering a technical default as long as interest payments kept rolling in. Will they be so forgiving in the future if the ability to make payments declines?Note, the company HAS been in compliance in Q1 & Q2 2014, though just barely. While interest expense actually increased in the first 6 months of 2014 compared to the first 6 months of 2013, the acquisition of Indas brought on a substantial amount of operating income keeping the ratio in compliance. If they are unable to replace operating income lost in the Pulp and Paper segment fast enough, this can lead to a future breach of covenants.The company is in compliance with the financial leverage ratio as of Q2 2014 (2.24)Source: Morningstar via QuestradeCash Flow AnalysisThe term Free Cash Flow seems to be a favorite of management, but this can be misleading. Free Cash Flow also includes net new borrowings. Investors prefer to own companies that have high quality free cash flow; that means it is being generated from operations and not borrowings. Looking at the 10-K cash flow statement, it is clear that Domtar's FCF is low quality. Not only have earnings declined by over 75% since 2011, but the cash generating ability of the business has also suffered dramatically. Domtar is generating 53.5% LESS cash flow from operations. But while cash from operations is dropping investing activities have been rising, and this deficit needs to be funded with debt. Domtar closed 2013 with $655M in cash, but most of this was spent on acquisitions in early 2014. While 2014 operating cash flow is 33.9% better than the first half of 2013, investing activities are up 438%, eliminating cash reserves.Source: Morningstar via QuestradeAlternatives to M&A ProgramWhile the hope is that these acquisitions pay off in the future, do investors really want to bank on hopes and dreams, when the company could have paid a special dividend roughly 8.38$ ($546M/65.1M shares) today, or retired roughly 15% ($546M/$39 share price= 14M shares retired) of shares outstanding? Would this not have benefited shareholders more directly and with more certainty?The dive into Personal Care will require substantial expenditures, both through future acquisitions, and increasing capacity at Laboratorios Indas. Simply put, the company will be splitting its free cash flow budget between the M&A program and returning cash to shareholders, not fully executing on either strategy. With Personal Care currently sitting at 10% of total revenue, the M&A program will need to be a long-term strategy if the company expects to truly balance their revenue streams. This could lead to increased risk through debt issuance, or the dilution of current shareholders through equity issuance. Management gave this response when an analyst asked about the buildup of Personal Care business through M&A and use of leverage:"..And so far, we've made rather a medium-size acquisition. So if we continue in that route, I don't think there's a risk on the balance sheet side. But if there's the right acquisition that's a little bit bigger, we'll have to make our decisions then." (Seeking Alpha, Q2 2014 Earnings Call Transcript)Could shareholders get burned by dilution or increased investment risk? Might there be a better alternative for delivering shareholder returns? We believe the following alternatives are worth examining:1. Stock buybacks: continue to reduce the number of shares outstanding, improves the EPS, reduces the amount of dividends paid out and can be a good investment if management does think the shares are undervalued.2. Industry Roll-up: acquire competitors in pulp and paper, essentially increasing market power, increasing economies of scale and reducing pricing competition.3. LBO or MBO: take the company private to reduce the costs of staying public, shareholders exit at a premium, and management can restructure the firm privately while servicing the debt with cash flow generated by the business. This has been done with many competitors.4. Increase dividends or special dividend: return capital to shareholders and allow them to reallocate to other investments.5. Focus on Specialty offering: continue pulp and paper production, but with a greater focus on packaging and specialty grade paper that has less threat of substitution.Conclusion: Investing is a Relative GameSuccessful investors know that it is a relative game. We can't predict the market or economy. But we can choose the best relative investments available. This is the essence of capital allocation. At a P/E of 14.16, UFS is justifiably cheaper than the S&P 500 (NYSEARCA:SPY) at a P/E of 19.68 (www.multpl.com). When you consider that Domtar is in a declining industry, has no competitive advantage, no pricing power, escalating input prices and a unionized workforce, it is not unreasonable to expect earnings to decline for the foreseeable future. This would either make the P/E multiple expand as EPS falls, or the price would fall, keeping the P/E stable.Now the Personal Care division can expand and make up the lost EPS in the future, but buying growth is not cheap, quick, or risk free. Do not underestimate the risk in Personal Care or the difficulty in integrating acquisitions. Rather, investors should look elsewhere for potential opportunities.Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.Additional disclosure: This article is the work of Giuseppe Farruggia and Costa Tagalakis of Augustus Research Ltd.