- Material leverage to uncoated free sheet pricing strength still not reflected in 2014 consensus estimates.
- Despite recent stock appreciation, shares remain cheap, likely even cheaper than when the stock was $80 (now over $100).
- Strong FCF generation could result in accelerated share repurchases and expansion of higher margin Personal Care segment.
- Valuation becomes quite compelling when factoring in FCF deployment, implying 30%-50% upside potential.
2014 is poised to be a banner year for Domtar (NYSE:UFS), a leading North America producer of uncoated free sheet paper ('ufs') , driven by considerable pricing strength for the commodity product. Following years of pricing weakness, momentum has clearly shifted, the direct result of the permanent closing of nearly one million tons/year of industry capacity. Although shares of UFS have risen from ~$65 to just over $100 since International Paper (NYSE:IP) announced a mill closing with 765,000 tons/year of capacity, valuations suggest the shares remain cheap when using consensus estimates. Further, given the degree of earnings leverage tied to ufs pricing, current consensus estimates for 2014 still don't seem to fully reflect Domtar's earnings potential. Led by the substantial pricing power in 2014, UFS' free cash flow generation should see meaningful improvement. Whether this cash flow is deployed via an accelerated share buyback plan or used to expand its more stable and higher margin Personal Care segment, resulting valuations are quite compelling. As such, there appears to be ample room for further upside to the share price, likely in the range of 30%-50% from current levels.
Significant Earnings Leverage
UFS has material exposure to changes in ufs pricing, particularly in the commodity grades, used to make business paper, converting and publishing products and commercial paper. Given a $10/ton change in ufs price, UFS' EBITDA exposure is $33 million. Excluding UFS' specialty grade of ufs, (found in 'other') the company's EBITDA exposure is $28 million (see Table 1).
Table 1: UFS EBITDA Sensitivity to Key Products
In October 2013, a $60/ton price increase for commodity-grade product was announced, with implementation expected to start in 1Q14. More recently, a second, $70/ton price increase has been announced, with implementation expected as early as 2Q14. Combining these two increases, UFS' incremental EBITDA is $364 million. Conservatively, assuming a 90% operating rate and just half the price increases go through, the incremental EBITDA contribution is still a meaningful $286 million (see Table 2).
Table 2: UFS Incremental EBITDA Assuming Price Increases ($; mm)
2014 Consensus Estimate Still Too Low; Shares are Still Cheap
However, despite a consistent trend higher in the 2014 consensus EBITDA estimate since IP's announced capacity curtailment, the incremental increase is still just over half of the EBITDA contribution capable in the 'conservative' scenario depicted in Table 2. Assuming another $122 million of upside, the 2014 EBITDA consensus estimate should trend to over $1 billion.
Further, despite over 50% share price appreciation since early September 2013, the current EV/forward-year EBITDA multiple is just 4.7x, only fractionally higher than the stock's 4.5x multiple in late September 2013. Using the 'conservative' EBITDA calculation, the shares are actually now cheaper than they were when the stock was ~$80, at just 4.1x (see Table 3).
Table 3: UFS Upside to Consensus Estimate and Valuation ($; mm)
Strong Free Cash Flow Creates Compelling Valuation
The next leg to the UFS story (and resulting upside to further price appreciation) is rooted in the company's free cash flow potential. Even after accounting for a 10%+ increase in capital spending and a dividend increase, UFS can potentially generate free cash flow (after dividend payments) of over $400 million (see Table 4). With this cash, the company could choose an accelerated share repurchase initiative or pursue additional acquisition opportunities in its Personal Care segment. In either situation, the potential for further upside to the share price is meaningful. Historically, the shares have typically traded in an EV/forward-year EBITDA multiple range of 4.0x-6.0x (see Chart 1). As the company continues to increase its overall earnings contribution from the higher growth and higher margin Personal Care segment, its average valuation multiple should expand over time.
Table 4: UFS Cash Flow History and Outlook ($;mm)
Chart 1: UFS Stock Price and Historical EV/EBITDAe Multiple
First, if UFS pursues an accelerated share buyback plan, it could buy back nearly 4 million shares (over 11% of fully diluted outstanding share count). Assuming the shares are repurchased evenly over the course of the year, the average share count is reduced by ~2 million. In such a scenario, the resulting EV/EBITDA multiple would have to fall below 4.0x to arrive at a lower share price versus current levels. At just 5.0x, the stock would be worth $140, resulting in over 30% upside to the share price. As of the end of 2013, the company had $121 million remaining on its existing share repurchase plan (see Table 5).
Alternatively, Domtar could deploy its cash toward further expansion of its Personal Care segment. This strategy should translate into multiple expansion over time given Personal Care's relatively more favorable growth prospects and operating margin potential. Currently, management expects to achieve a goal of $300-$500 million of EBITDA contribution from Personal Care by 2017. Two meaningful acquisitions made in 2013 should result in 2014 EBITDA of $150-$200 million for the segment, up from $80 million in 2013. Even without any additional acquisitions, the segment has the potential to represent almost 25% of overall EBITDA by 2015, versus just 8% and 12% in 2012 and 2013, respectively (see Chart 2). Any additional acquisitions would obviously boost the segment's EBITDA contribution and potentially result in reaching the target EBITDA a year or two ahead of the current goal. If the stock's EV/EBITDA multiple range expands to 5.0x-7.0x, (versus the current 4.0x-6.0x) the stock would be valued at ~$165 using the mid-point of the new range, resulting in over 50% upside versus current levels (see Table 5).
Table 5: UFS Valuation Analysis ($; mm, ex. price)
Chart 2: UFS Personal Care and Paper EBITDA Margin and Personal Care % of Total EBITDA
Disclosure: I 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.