Is Domtar Corp. the cheapest stock in Canada? Perhaps not the most inexpensive, but few companies boast its combination of low price multiples, long-term earnings growth and healthy cash flow that’s being shovelled back to shareholders in the form of dividends and share repurchases.
So what’s the catch? Domtar is in the paper business; specifically, it’s North America’s largest producer of “uncoated free sheet” paper (hence the ticker symbol UFS). Demand for that paper, used in office copiers and magazine publishing, among other things, has averaged annual declines of 5.4 per cent over the last five years, notes RBC Dominion Securities analyst Paul Quinn. Project that forward a couple of decades, and Domtar’s primary business disappears – perhaps taking the company with it.
Those who believe that, however, are overlooking some mitigating factors that work in Domtar’s favour. The company is a producer of pulp, historically choosing to make paper rather than products such as tissue and towels; that stance is changing. In fact, the company is taking it a step further, purchasing the Attends line of adult diapers, allowing it to channel its pulp production directly into a name-brand consumer product that promises high single-digit growth.
The wind-down theory, however, is probably the only way to explain the company’s valuation. Domtar trades at a ratio of just over three times enterprise value (market capitalization plus debt) to EBITDA (earnings before interest, taxes, depreciation and amortization). For comparison, just 3 per cent of the companies on the Toronto Stock Exchange are cheaper by this measure. Domtar’s trailing price-to-earnings ratio is under six, according to Standard & Poor’s Capital IQ.
At the same time, however, the company’s annual EBITDA growth averages more than 27 per cent over the last five years; the company has gone from annual EBITDA of less than $800-million (U.S.) in 2007 to about $1.1-billion in 2011.
Much of that money is coming back to shareholders. The company recently added $400-million to a share-repurchase program that started in 2010, bringing it to $1-billion. Analysts Daryl Swetlishoff and David Quezada of Raymond James say the program could take out 15 per cent of Domtar’s outstanding shares.
At the same time, they estimate, the company could double its current dividend of $1.40 per share and still pay out less than half of its free cash flow. (Raymond James has made Domtar one of 10 stocks on its Canadian “Best Picks for 2012” list, with a target price of $125, about 45-per-cent higher than today’s prices.)
Mr. Quinn of RBC says Domtar and competitor International Paper acknowledge, albeit quietly, the sales declines in their core business; Domtar “is attempting to look for acquisitions with business in positive demand growth, and the Attends acquisition marks the first step in this strategic shift,” he said.
Worried about indiscriminate deal-making? The balance sheet is pristine: The company had about $850-million in debt but $461-million in cash at Sept. 30, for a net debt figure of just under $400-million – roughly four months’ worth of EBITDA.
And Mr. Quinn says Domtar is looking for transactions under $1-billion that are close to home in North America. “We believe that the right transaction can reposition the company’s current inexpensive valuation to one that is closer to its peers,” he says.
That valuation wouldn’t need to rise much. Mr. Quinn acknowledges Domtar should trade at a multiple below the low end of the typical U.S. paper-and-forest products trading range, which is 5.5 times to 7.5 times EBITDA, because of North America’s weak economy and its decline in paper consumption. So he applies a multiple of five – and gets his own $125 target price, based on his 2012 forecast. “[It’s]still quite an inexpensive valuation for a low leverage, strong free-cash-flow producer like Domtar, in our opinion.”
In mine, as well.