Domtar: A Well-Positioned Paper Company With Strong Cash Flows

Includes: UFS, WY
by: Geoffrey Rocca

Domtar (NYSE:UFS) 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 (NYSE:WY) fine papers division, a transaction that 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 non-cash 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, 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 non-cash assets. For Domtar, based on its latest balance sheet, the firm has $530 million in cash and $1.47 billion in non-cash 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, non-cash current assets exceed non-cash 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 non-cash impairments resulting from plant closures, and other closure- and restructuring-related costs, $77 million in expenses should be considered non-cash and/or non-recurring. 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 carry forwards 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 U.S. 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 non-recurring 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 non-cash and/or non-recurring 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 non-cash or non-recurring 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 non-cash or non-recurring 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
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 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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.