Seth Klarman's interest in Canadian pulp and paper company Domtar (NYSE:UFS) is a long one. It goes all the way back to 2007 when it merged with Weyerhaeuser's (NYSE:WY) fine paper business. After the combination, Weyerhaeuser shareholders owned 55% of the company while Domtar's shareholders owned the rest. Trading in the new company began March 7, 2007. Not coincidentally, Baupost's first quarter-holdings report ended March 31, 2007, showed Klarman owning 520,833 shares (adjusted for 1:12 Reverse Split) of Domtar. Today Baupost owns approximately five-times this amount.
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A Tumultuous Three Years
Domtar's stock closed its first day of trading (adjusted for splits and dividends) in March, 2007, at $105.97. Today, it's trading for half that, down 48% over the past 40 months compared to negative 25% for the S&P 500. It appears both Weyerhaeuser and Domtar shareholders didn't do so well from the combination and on the surface, neither did Baupost Group. Klarman averaged down. However, not to the extent that it's put his fund in the black. By my calculations, over the past three years, Baupost Group has bought approximately $225.8 million in Domtar stock and sold $62.8 million for a net outlay of $163 million. At current prices, his 2.68 million shares are worth $147.7 million, leaving Baupost $15.4 million under water at present. The second quarter holdings report should tell us whether Klarman thinks the stock can get to the break-even level of $60.82.
Domtar stock needs to reach $60.82 in order for Baupost to recoup its initial investment in the company. Given Klarman's contrarian behavior, it looks like he plans to maintain the holding for some time. So, what should interested investors do? The first thing is to consider the long-term potential of Domtar's business model. How's it doing today, and what events point to a brighter future. For Klarman, this is a small piece of his investment pie. He can afford a loss. But you can't. Therefore, you need to identify what (if anything) changes the trajectory of its business beyond the usual growth patterns. I, for one, see a business with cash flow that is better than it's ever been. Free cash is 13.3% of sales, higher than any time in the past 10 years. JPMorgan (NYSE:JPM) appears upbeat about the industry as a whole, suggesting in early July that the paper market fundamentals are improving. As a result, it's given "overweight" ratings to Domtar, Mead Westvaco (NYSE:MWV) and Rock-Tenn (NYSE:RKT). In addition, D.A. Davidson upgraded Domtar in early July from "Neutral" to "Buy." JPMorgan's report on the paper market gives it an enterprise value in 2010 that's five-times EBITDA. Domtar's currently sits below three.
The Bottom Line
Unless the economy and stock market fall off a cliff, Seth Klarman won't have to wait too long to start making some money off Domtar. As for individual investors, be prepared for lots of volatility. (To learn more about enterprise value, check out EV Gets Into Gear.)
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