Domtar (NYSE:UFS) jumped the most it has in four years on news International Paper (NYSE:IP) is closing a mill in Alabama reducing North American capacity by at least 7%. Despite the big jump September 11, Domtar's stock is still in negative territory year-to-date. Is Domtar suddenly a buy?
Three years ago I discussed the reasons why I thought Boston based Baupost Group's $225 million investment in Domtar would pan out for Baupost's billionaire founder, Seth Klarman. I reasoned that Klarman's second-quarter holdings report would shine a light on the direction of Domtar's stock: If he was still holding the 2.68 million shares it would demonstrate confidence in the company. Unfortunately, Baupost's Q2 holdings report showed the sale of 850,000 shares; another one million shares in the third quarter and the remaining 800,000 shares in the final three months of 2010.
You can't blame Klarman for selling. By the end of 2010, Domtar stock was trading at $75.92, 25% above Baupost's break-even price of $60.82. Klarman had held Domtar stock for most of four years by the time he unloaded the remaining shares. Sure, it broke through the $100 mark five months later in 2011, but hindsight's 20/20.
Put yourself in Klarman's shoes today. Would you buy at this point? For starters, the 7% reduction in the North American capacity for white paper, commonly used for copiers and printers, reduces the downward pressure on pricing at a time when demand continues to dwindle. This gives this part of Domtar's business a little breathing room.
Where the company has changed considerably is in its personal care segment, which didn't exist when Klarman exited at the end of 2010. In 2011, Domtar acquired Attends Healthcare, a manufacturer of adult incontinence products, for $315 million. It followed that up with two smaller acquisitions and then paid $272 million in May to buy Associated Hygienic Products, the largest supplier of store brand infant diapers in the U.S. Suddenly, its personal care segment was a real and growing part of its overall business. By 2017, it anticipates personal care will contribute $200 million in annualized EBITDA, representing one-third of its current EBITDA. By 2017, it wants to be generating between $300 million and $500 million annualized EBITDA from businesses that are growing like its personal care segment. While it might not generate nearly as much revenue as its paper business, it makes up for it by bringing the profits. And that's what's been lacking in recent years.
Domtar's current enterprise value is $2.8 billion, 4.8 times EBITDA. Its three peers: International Paper, MeadWestvaco (NYSE:MWV) and Weyerhaeuser (NYSE:WY) have an average multiple of 11.5, more than double Domtar. In terms of return on assets none of its peers are more profitable than Domtar and yet it's pulling up the rear. Another important metric is net debt as a multiple of EBITDA. Domtar's net debt position is $668 million or a multiple of one compared to an average of 2.7 times for its three peers. Procter & Gamble (NYSE:PG), the maker of Pampers, has an enterprise value of 12.7 times EBITDA. If Domtar's personal care segment hits its $200 million goal for annualized EBITDA by 2017, it will have an enterprise value equal to the entire company in 2013. Can you say spin-off?
While its last two quarterly reports are a very real reminder that Domtar's not out of the woods just yet, its free cash flow generation is so strong it's likely to continue growing its annual dividend payout, which currently sits at $2.20 yielding 3.1%—and that's after its 10% surge.
I see an undervalued stock that seems to be slowly getting itself ready to grow once more. Investors will eventually get on board; perhaps even Seth Klarman. Regardless of what he does, I think the 10% pop September 11 is just the beginning of a leg up to $90 and beyond.
Should you buy? Definitely.
Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.