domtar corporation: paper gains or losses? - super absorbent polymer used in agriculture
The world's largest coating-free paper company is trying to find growth to offset the decline in core business demand.
More recently, analysts have raised the company's optimism about management's M & A strategy, the diversity of revenue sources, and record dividends and buybacks.
As the share price fell close to 52-week lows year-to-
Many investors may want to invest in a potential turnaround.
We advise investors to avoid this company because it faces bigger challenges than many people think, it lacks the basic qualities of excellent investment, according to the current valuation, better investment opportunities can be found elsewhere.
The pulp and paper industry consists of factories that convert wood fibers into Cork pulp, hardwood pulp and fluff pulp.
The pulp is then processed into paper for the manufacture of products such as newsprint, uncoated tissue paper, Bristol, personal care products (
Toilet paper, diapers, etc. )
And countless other products we use every day.
The industry benefits from high entry barriers in capital-intensive and heavy forms of environmental regulation.
Due to weakening demand, threats from foreign imports and the emergence of online services, sales may decline in the coming years.
Source: ibisworld in other words, the industry is highly competitive and the pricing power is weak.
Most of the products have been commercialized and the buying mood is low.
In this case, all kinds of players have suffered, or have been taken away privately (New Page Corp.
Privatized by Cerberus Capital Management)
Or went bankrupt recently (
Determined forest products)(IBIS World).
Domtar is an integrated pulp and paper producer, leading the way in a declining market.
The company converts wood fiber into pulp and will further process it into paper products.
Excess pulp not used internally is sold to the market.
The company is the leader with eight uncoated sheets of paper.
Market Share (6%)IBIS World).
In structure, 85% of production is used for communication paper and 15% for special and wrapping paper (
Overview of Domtar Q2).
This brings a problem as the communication paper is expected to drop by 3-4% per year (IBIS World).
The good news is that management is trying to solve this problem by increasing the production of professional wrapping paper (
Stronger profit margin)
Building influence in the personal care industry (Domtar 10-K 2013).
Looking at 10 of 2013-cost upgrades and profit dropsK and 2014 10-
Qs, we note the reasons for the decline in revenue.
Due to bad weather in the first quarter or the resolution of the 2013 lawsuit, some of the drag on profitability may be temporary, but many are worrying.
Increase in input costs (
Driven by fuel and electricity costs)
The increase in freight and sales costs and the loss of tax credits for alternative fuels all affect future revenue.
2014 in the second quarter, the decrease in demand led to an increase in idle time (
About 51000 tons)
This means that the cost is dispersed on a smaller basis, thereby increasing the unit cost (10-Q, Q2 2014)
And slimming profits.
Management is back to start as demand drops
Use or close facilities.
This increases the cost of layoffs, loss of equipment disposal (
In addition to pulp and paper production, specialized equipment is unlikely to have much value)
Environmental obligations (
The allowance has been reflected but may exceed expectations)
And any other cost of downtime.
Through MD & A, we note that about 50% of the 9400 employees joined the Union.
Of these employees, 1800 will negotiate a collective agreement this year, and other negotiations will take place between 2015 --2017.
This can lead to an increase in labor costs, even if it's just inflation.
If the increased cost cannot be passed on to the consumer, the profit will be compressed.
The decline in demand, intensified competition from abroad (Chinese)
Competitors, as the dollar strengthens and wages fall, consumers are unlikely to tolerate a sharp rise in prices.
They can increase at most by a slight increase.
Given that Domtar is unable to achieve a full price increase for F14Q2, it seems realistic to see a slight tightening of profits.
Customer risk domtar faces significant customer risk.
About 35% of total revenue comes from 10 big customers (Domtar 10-K).
Financial firms also said 10% of total revenue came from Staples (NASDAQ: SPLS).
When we consider the problems of the bookmakers themselves and their plans to close the store on a large scale, Domtar may be affected by the decline in demand from the largest customers.
In addition, Staples has the ability to bargain with Domtar and has the potential to force Domtar to take price concessions to maintain the order volume.
The story is not optimistic for Domtar, but the company is looking for hope of growth.
The company does not have an economic moat and does not seem to be able to continue operating for a long time
Term in current state.
They are faced with problems of increased costs, reduced demand, unionized labor, and virtually no product difference.
There seems to be no potential for outstanding returns.
Can the transformation plan drive growth and make it an investment-worthy project?
Personal care: the diversity of excellence or the waste of wrong capital?
The personal care unit is mainly composed of adult incontinence products and baby diapers.
These products are made of highly absorbent fluff pulp and super absorbent polymer produced by Domtar.
The management strategy is to leverage the aging population while gaining greater influence in Europe.
The personal care sector currently accounts for 10% of total revenue, but EBITDA is 23% (
Q2 tar Q2 panel).
This shows that profit margins are healthier than core businesses.
However, this does not mean pushing personal care to success.
Incontinence in adults (NYSE:AI)
Domtar is now competing in a centralized business where 90% of the market has been controlled by 5 of the largest companies in the last 10 years (Domtar, 10-K 2013).
The market is divided into two parts: retail and institutional.
85% of Domtar's AI revenue comes from institutional sales (
Ask for Alpha, Q2 2014 Income Phone Report Card).
There are two problems with this institutional strategy.
First, these sales are extremely sensitive to government spending on health care.
Second, there is no long time
Long term contracts, large businesses with greater production and distribution capabilities may weaken Domtar.
This may force the price to drop and the sales to drop.
The remaining 15% of Domtar's AI sales are sold through retail channels.
This is unlikely to be a major source of income.
Veteran players like KimberlyClark (NYSE:KMB)
With a strong network advantage of distribution and customer relationships, this will provide them with favorable shelf space.
They have also established international brands such as Depends and Poise.
Besides that, they have a huge marketing budget.
At the same time, P & G (NYSE:PG)is re-
Enter this segment with their consistent brand and invest $150 in marketing to gain meaningful market share (AdvertisingAge).
Didiapersdomtar entered the US infant products business through the acquisition of analytic hierarchy process.
The company makes Shop brand diapers.
On the face of it, this own brand strategy seems to be more advantageous than competing with brand products.
In fact, the top two brand manufacturers account for 80% of the market.
Other private label manufacturers, including Domtar, compete for the remaining 20% of the market share.
In terms of growth, management expects US demand to be flat (10-K 2013).
In the case of low demand, they either need to increase their income by raising prices or steal market share by cutting prices.
The question is, can they really raise the price? From their 10-K: "The [infant diaper]
The business is concentrated around a small number of large retailers that control most of North America, driven by multiple retailers
Lead to competitive and volatility in the industry. " Customers (Large retailers)
They are most likely to oppose any growth in tough retail business.
In addition, larger competitors are likely to win the pricing war.
Merger: this is a flawed strategy, and while there is a lot of uncertainty, it is clear that UFS requires a lot of investment and time to be a major player in the personal care industry.
Domtar faces challenges in integrating acquired companies.
Recently, there has been a headwind in the Indas acquisition, as the start-up costs are higher than expected, with two major customer churn during the transition of ownership of the business.
Currently with limited capacity, the company expects Q4FY14 to benefit from this acquisition.
Most of the loss of pulp and paper revenue was offset by the acquisition, but this is not sustainable.
M & A means premium, restructuring costs and consolidation costs.
In addition, there is a limit on the amount and speed at which Domtar purchases revenue to offset the decline.
Investors can re-allocate capital more easily and cheaply than Domtar buys the way they enter the industry. Price-to-
Through previous articles on Domtar, many investors have been wearing hats on the company's low prices --to-Book ratio.
As of September 10, 2014, the company's price-earnings ratio was around 0. 86 (
The market cap is assumed to be 2. 43B).
Calculating this number at face value is a serious mistake made by many investors.
People have to understand what the company has put on their books, and the better ratio is the price. to-tangible-book ratio. [(Assets -Liabilities)-
= Tangible book value goodwill should be removed as it reflects the premium paid by past transactions, not necessarily the premium available for liquidation, while other intangible assets are primarily brands and trademarks.
In liquidation, the name of the registered commodity does not appear to be an asset for sale.
We calculated two different prices. to-Book Ratios:a)
Elimination of goodwill: June 30, 2014--> 2. 430/2. 171 = 1. 12b)
Delete all intangible assets: June 30, 2014---> 2. 430/1. 523 = 1.
60 according to the logic that other investors have been using, the use of tangible book value will indicate that the stock is overvalued by 12% or 60% based on your opinion on intangible assets.
This is a big difference compared to the "16% increase based on book value" that others have always praised.
The company's debt status analysis for the 2014 quarter showed that it had about $1 in assets. 4B of long-
Regular debt on the balance sheet.
The main use of this debt is: General corporate use, acquisition and refinancing of previous issues.
The company recently issued a debt ($250M Nov. 2013)was rated BBB-
S & P.
This is considered the lowest investment.
Attention should be paid.
If the core business continues to deteriorate, or if the economy declines, the cost of debt may rise sharply.
Of course, these are "what-
But as investors, we have to understand all the risks associated with the company.
There are two areas that need further attention in the balance sheet liability segment: 1)There are off-
Balance sheet commitments, such as operating leases of property, factories and equipment, should be recharged to the debt and the accompanying operating expenses will become interest expenses.
Source: Domtar Corporation 10-
K 2013 while we believe that companies should be able to pay for these payments, these commitments could be a serious problem if any liquidity problems arise in the future.
As borrowing increases, they may need to seek more off-balance sheet financing at a higher cost, and perhaps a more stringent contract. 2)
The company may violate the agreement of the bank credit arrangement (FY2013)
There are two conventions on the revised bank credit arrangement (p. 128, 10-K 2013)1)
Interest coverage not less than 3to-12)
The leverage ratio must be maintained at a level not greater than 3. 75-to-
Look at 10-
K 2013, as we calculated at 1, the company appears to be in breach of the deed of keeping interest coverage above 3. 89.
Management said they had complied with the December 31, 2013 contract.
We need to get more clarification because we don't know how they calculate the ratio.
As far as we are concerned, we follow the initial coverage (EBIT/Int Exp).
Management may use adjusted interest coverage for EBITDA/Int Exp.
Another possibility is that creditors are not interested in triggering a technical default as long as interest is paid continuously.
Will they be so tolerant in the future if the ability to pay falls?
Note that the company has been in compliance in the first and second quarter of 2014, although only barely up to standard.
While interest spending in the first six months of 2014 actually increased compared to the first six months of 2013, the acquisition of Indas brought a significant amount of operating income, maintaining that proportion.
If they cannot replace the operating income lost in the pulp and paper portion quickly enough, this may result in future breaches of the deed.
As of 2014 in the second quarter, the company met the financial leverage ratio (2. 24)
Source: The term Morningstar analyzes free cash Flow through QuestradeCash Flow seems to be the management's favorite, but this may mislead management.
Free cash flow also includes net new borrowings.
Investors prefer companies with high quality free cash flow;
This means that it is generated from operations, not from borrowing.
Look at 10-
K cash flow statement, it is clear that the FCF quality of Domtar is not high.
Not only has revenue fallen by more than 75% since 2011, but the revenue-generating capacity of the business has also dropped significantly.
Domtar is generating 53.
Reduced operating cash flow by 5%.
However, although cash from operations is decreasing and investment activities are increasing, this deficit needs to be funded through debt.
Domtar closed 2013 in cash for $655, but most of them were used for acquisitions in early 2014.
The operating cash flow of 2014 is 33.
2013 9% than the first half of investment activities is up to 438% reduce cash reserve.
Source: Although Morningstar's acquisition through questralternatives hopes that these acquisitions will pay off in the future, do investors really want to pin on hope and dreams? When the company can pay a special dividend of about £ 8. 38$ ($546M/65. 1M shares)
Or retire about 15% today.
$546 M/$39 per share = 14 M stock retired)
Wouldn't this benefit shareholders more directly and definitely?
An in-depth study of personal care will require significant expenditure, either through future acquisitions or by improving the ability of laboros Indas.
In short, the company will allocate its free cash flow budget between the M & A plan and the return of cash to shareholders, but neither strategy is fully implemented.
As personal care currently accounts for 10% of total revenue, M & A plans take a long time
If companies want to really balance their revenue streams, develop long-term strategies.
This may result in increased risk by issuing bonds or diluting current shareholders through stock issuance.
When an analyst asked about establishing a personal care business through M & A and leverage, management gave a response like this: ". .
So far we have done a medium
So if we continue to do so, I don't think there is a risk on the balance sheet.
But if there is a larger acquisition, we have to make a decision. " (
Ask for Alpha, Q2 2014 Income Phone Report Card)
Will shareholders be burned out because of dilution or increased investment risk?
Is there a better option to provide shareholder returns?
We believe that the following options are worth studying: 1.
Stock Repurchase: continue to reduce the number of outstanding shares, improve earnings per share and reduce dividends paid, which may be a good investment if management believes that the stock is undervalued. 2. Industry Roll-
Up: the acquisition of competitors in pulp and paper has basically increased market forces, increased economies of scale and reduced price competition. 3.
LBO or MBO: privatize the company to reduce the cost of listing, exit at a shareholder premium, and management can privately restructure the company while repaying the debt with the cash flow generated by the business.
Many competitors have done so. 4.
Increase dividends or special dividends: return capital to shareholders and allow them to redistribute to other investments. 5.
Focus on professional products: continue to produce pulp and paper, but focus more on packaging and replacement of professional grade paper with less threat.
Conclusion: investing is a relative game, and successful investors know it is a relative game.
We cannot predict the market and the economy.
But we can choose the best relative investment.
This is the essence of capital allocation. At a P/E of 14.
16. it makes sense that UFS is cheaper than the S & P 500 index (NYSEARCA:SPY)at a P/E of 19. 68 (www. multpl. com).
When you think that Domtar is a declining industry, there is no competitive advantage, there is no pricing ability, the input price is rising, the labor union is becoming, it is not unreasonable to expect revenue to fall in the foreseeable future.
This will expand the P/E multiple With the decline of EPS, or the price will drop to keep P/E stable.
Personal care can now expand and compensate for lost EPS in the future, but buying growth is not cheap, fast or risk-free.
Do not underestimate the risk of personal care or the difficulty of integrating acquisitions.
Instead, investors should look elsewhere for potential opportunities.
Disclosure: The author does not hold any positions in any of the stocks mentioned, and does not have a plan to start any positions within the next 72 hours.
The author wrote this article himself and expressed his views.
The author was not compensated (
In addition to Seeking Alpha).
The author has no business relationship with any company mentioned in this article.
Supplementary disclosure: This article is the work of Giuseppe Farruggia and Costa Tagalakis from Augustus Research Co. , Ltd.