Let’s walk through your thesis on Domtar.
JS: We saw Domtar’s buying last year of Weyerhaeuser’s fine paper business as a transaction that could create a lot of value. It combined the #2 and #3 players in uncoated freesheet paper – the best example being office copy paper – to create the new market leader, ahead of International Paper. Domtar and IP now have a combined 60% market share, with 75% of the market held by the top four players.
What has to happen as uncoated freesheet demand slowly declines is that industry capacity needs to be taken out of use, either by mothballing mills or by taking increasing downtime. It needs to happen in an orderly way, so no one competitor feels they are being taken advantage of or are ceding share by trying to rationalize the supply side of the market.
If we’re right that demand decreases at 3% or so per year – for perspective, the actual number since 2000 has been an annual decline of 1.7% – this business ought to be able to offset volume declines with price increases, resulting in very healthy cash flow for the major players.
We take it the stock market is skeptical the orderly scenario will play out.
JS: If demand declines at a more rapid rate than we expect, it’s certainly imaginable that an orderly competitive dynamic could break down. If that happened and everyone in the market said they weren’t going to lose share, you could see prices fall to the point at which the highest-marginal-cost producer starts shutting down capacity.
Our view is that demand won’t dramatically decelerate and that the chances for reasonable behavior go up as the number of players competing decreases. Helping in that regard is the fact that uncoated freesheet is purely a North American market – you’re not going to see paper being shipped in from China.
Do the paper manufacturers have much pricing power?
JS: Uncoated freesheet represents a relatively small and insignificant cost in the value proposition of most of its users. Karen and I don’t know how much we spend on copy paper and I can’t imagine getting a call from our COO asking if we want to cut back on our purchases of it because Staples is increasing their price 10%. We are not alone in that response and that’s why we believe the demand for this kind of paper is relatively inelastic. We’re not suggesting that the Internet or electronic data storage isn’t a threat to paper. It is and that’s what’s behind the overall decline in demand. But we do believe that the decision to buy paper at any given time for office use or to send a mailing is only marginally connected to the price of paper. That gives manufacturers, if they behave rationally, some leeway in raising prices.
The classic example of this type of dynamic playing out is the tobacco business, which has made an a lot of money over a lot of years by more than offsetting volume declines with price increases. That’s a better business – I may need paper, but not like a smoker needs a cigarette – but we think the model will be similar.
Is Domtar getting hit by increasing input costs of its own?
JS: Rising raw materials costs hurt them, but they are an integrated producer and produce all the pulp they need, something that smaller competitors can’t do. They are also able to offset some of those cost increases by cost savings associated with the Weyerhauser purchase. They estimate $200 million in annual savings from integrating the businesses, and so far are more than on track for hitting that.
The stock, now around $6.90, has continued to fall since the acquisition. Have you been buying more?
JS: We've increased our position by 150% in the past few months. The company has succeeded in putting through price increases, but they lag input cost increases so the market was disappointed with the most recent earnings report. Assuming the company doesn’t pass through any further price increases, we estimate it should generate about $1 billion per year in earnings before interest, taxes, depreciation and amortization. Maintenance capital spending is around $150 million per year, so they should generate $850 million in pre-tax, pre-interest cash flow. Putting an 11% free cash flow yield on that – less debt and adding the value of a net operating loss carryforward that will save on future taxes – results in a per share equity value of around $10.50. We think that’s conservative because it doesn’t build in further price increases, but we’re holding that as an offset to the risk that the market becomes disorderly.