Few companies are as undervalued in the stock market as Tembec (OTCPK:TMBCF). Based on a discounted cash flow model, a fair value for the stock is approximately U.S.$8.50 per share vs. a current market price of around U.S.$2.70 on the Pink Sheets. Tembec is a Canadian company and the primary market for the stock is the Toronto Stock Exchange. All dollar amounts in this article are Canadian dollars unless otherwise indicated.
Tembec is a forest products company that produces a number of different products. Almost all of its manufacturing operations are located in the Canadian provinces of Quebec and Ontario with the main exception being a dissolving pulp mill in France. For the fiscal year ended September 28, 2013 sales were $1,534 million, and sales mix by product was as follows: dissolving pulp (mostly specialty cellulose) 30%, paper pulp 25%, lumber 23%, coated bleached board 13%, and newsprint 9%.
In my valuation model I use actual results for the fiscal year ended September 28, 2013 as a base period. Cash flow from operating activities for this base period was $36 million, and capital expenditures were $127 million, so free cash flow was negative $91 million. Furthermore, from this base level of free cash flow I subtract $13 million, which is my estimate of the cash flow that was generated in the fiscal year from a pulp mill that was sold in May 2013. This adjusted level of free cash flow of negative $104 million is what the company might generate each year going forward assuming no change from what occurred in fiscal 2013. From this base level of adjusted free cash flow, future annual free cash flows can be estimated by reflecting changes to the base level.
In my forecast for the next five years, changes in free cash flow from the adjusted base amount can be summarized as follows.
· Increased cash flow in the forest products segment will be generated from lumber prices that are significantly higher than in the base period.
· Increased cash flow in the specialty cellulose pulp segment will result from realizing the benefits of heavy capital spending in fiscal 2012, 2013, and 2014.
· Cash flows will decline by relatively small amounts in the paper pulp and paper segments.
· After increasing slightly in fiscal 2014, capital spending will decrease by a large amount in subsequent years relative to the base period.
· Cash contributions to the company's pension plan will be significantly lower than in the base period.
· Changes in non-cash working capital will be a modest source of cash flow in fiscal 2014 and thereafter be relatively insignificant.
The following is a summary of free cash flow in my model that reflects all of these changes.
Free Cash Flow
Free cash flow starts to become very positive in fiscal 2015, and my model shows a $195 million improvement from 2013 to 2015. The components of this improvement are as follows.
· $67 million more cash from the forest products segment
· $36 million more cash from the specialty cellulose pulp segment
· $2 million less cash from the paper pulp segment
· $4 million less cash from the paper segment
· No change in corporate cash expenditures
· $80 million more cash because of lower capital spending
· $24 million more cash because of lower contributions to the pension fund
· $6 million less cash because of higher working capital
Company management has provided guidance related to the estimates of $36 million more cash from the specialty cellulose pulp segment, $80 million more cash because of lower capital spending, and $24 million more cash because of lower contributions to the pension fund.
Perhaps the most controversial part of my forecast is the assumption of significantly higher lumber prices in fiscal 2014 through 2018 compared with actual lumber prices in 2013. Specifically, I assume that lumber prices will be U.S.$50 per MBF higher in fiscal 2014 vs. what they were in 2013, and that they will be U.S.$100 per MBF higher in fiscal 2015 through 2018 than in 2013. I also assume that the benefit of higher lumber prices will be offset somewhat by higher stumpage fees for timber. My bullish outlook for lumber prices is based on the following market fundamentals.
U.S. housing starts are forecasted to be about 900 thousand units and 1.2 million units in 2013 and 2014 respectively. Beyond this, starts should continue to rise for a number of years to 1.5 million units, which are considered to be a normal level of new home construction to support population growth, household formation, and demolitions. Furthermore, within five years annual housing starts should increase to well over 1.5 million units in order to compensate for many years of under-building.
At the same time that housing starts are rising and creating demand for lumber, exports of lumber to China should continue to be a major source of demand. Currently the annual amount of lumber that is being exported from North America to China is equivalent to almost 300 thousand U.S. housing starts. Also, it is notable that this is a relatively new form of meaningful demand for lumber. It was only as recently as 2009 that exports of lumber to China from North America started to increase to significantly high levels.
On the supply side one particularly notable constraint on lumber production is a sizable decline in the availability of logs in British Columbia stemming from beetles killing a large amount of standing timber. The magnitude of this problem is very large, and there are estimates that harvest levels in the interior of British Columbia could be reduced by more than 30% from current levels. From the time the problem started about 10 years ago till it runs its course, more than half of the commercial forests in British Columbia, the largest lumber producing province in Canada, will be lost to the beetle infestation.
Also, in Eastern Canada harvest levels are being reduced by 20% to achieve a more sustainable rate of timber growth. This affects Tembec's lumber production. However, my modeling reflects a reduced level of production.
In a discounted cash flow model that does not reflect any lumber price increase in fiscal 2014 through 2018 vs. 2013, I calculate a discounted present value of approximately U.S.$3.00 per share. This is not much higher than the current stock price. However, the assumption of no increase in lumber prices is very unrealistic.
Alternatively, in a discounted cash flow model that does reflect U.S.$50 per MBF higher lumber prices in fiscal 2014 and U.S.$100 per MBF higher prices in 2015 through 2018 vs. 2013, the discounted present value per share is approximately U.S.$8.50. In both of these discounted cash flow models a terminal value for the stock at the end of fiscal 2018 is calculated using an enterprise value to trailing EBITDA multiple of 6.0, and a discount rate of 13.0% is used to calculate the present value of the future cash flows.
I believe Tembec's stock is significantly undervalued because so few investors are aware of how much the company's free cash flow can increase over the next several years. As this awareness grows the stock price has the potential to more than triple from its current level.