Moody's is overstating the credit risk of Domtar Corporation (NYSE:UFS) with its Baa3 rating. Our fundamental analysis highlights a much safer credit profile for UFS, whose strong cash flows cover all their obligations including debt maturities, except in 2022. Moreover, their sizable expected cash build should allow them to service all obligations including debt maturities in 2022. We therefore rate UFS three notches higher at an IG3- credit rating, or an A3 equivalent using Moody's ratings scale.
Cash bond markets are also slightly overstating credit risk with a cash bond YTW of 3.840% relative to an Intrinsic YTW of 3.140%, while CDS markets are accurately stating UFS' credit risk with a CDS of 191bps relative to an Intrinsic CDS of 187bps.
Cash Flow Profile
We produce a Credit Cash Flow Prime chart for Domtar Corporation, as we do for every company we evaluate. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Credit's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.
The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.
If the company generates and has cash levels that are above their obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, they can allow assets to age a little longer, or they can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service their credit obligations?
UFS' cash flows would be able to exceed all obligations including debt maturities in each of the next several years, excluding 2022 when they face their material $300mn debt maturity. That said, their sizable expected cash build would allow them to service all obligations including debt maturities in 2022. Furthermore, the company has a robust 567% recovery rate on unsecured debt, driven by the firm's strong asset backing. Considering their robust recovery rate, and cash flows that consistently exceed all operating obligations, UFS should have the ability to access credit markets if necessary.
Like most people, senior executives and board members do what they are paid to do. This is why UFS' Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Our Incentives Dictate Behavior™ analysis focuses on UFS' senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.
UFS management's short-term incentive compensation is based on the achievement of EBITDA, health & safety targets, customer service and quality index, and pulp productivity. Meanwhile, their long-term incentive compensation is composed of restricted stock units (RSUs), stock options, and performance share units (PSUs), that are based on return on invested capital (ROIC), new business EBITDA, and relative total shareholder return (TSR), a non-financial metric.
This compensation framework should focus them on improving asset utilization and margins, while also driving them to seek growth for the business. Overall, this framework should drive management to focus on improving their weak ROA', which should lead to improved cash flows available for credit holders, further reducing credit risk.
We provide analyses of companies' statements on earnings calls, termed Earnings Call Forensics. This analysis is meant to help assess a management team's confidence in their conference calls when discussing certain areas of the business such as operations, stability, strategies, their ability to manage business risks, and especially, their liquidity and solvency.
In the case of UFS, the analysis of their Q4 2015 earnings call highlighted highly questionable markers from management. Management appears concerned about the sustainability of cash flow growth, and about paper shipment growth going forward. They also appear concerned about continued pricing pressures, and about the effect of adding an extra paper mill.
Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. UFS' credit risk is being overstated by Moody's and slightly overstated by cash bond markets. Given UFS' strong cash flows relative to all obligations including debt maturities, sizable cash build, robust recovery rate, and favorable management alignment, ratings are expected to improve while cash bond market spreads are expected to tighten once the company's fundamentals are recognized.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Melvin Yubal. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.