A high return of capital should outweigh a low return on capital in the case of Domtar at current prices.

 

In 2006, Domtar completed the acquisition of the Weyerhaeuser Fine Paper Business, which gave the company the #1 market share in North America for uncoated free sheet paper; this was a very important transcation for the company (and industry) as it turned the industry into an oligopoly.  Domtar is currently operating 10 paper mills with uncoated free sheet capacity of about 3.9mm tons and has the #1 market share in North America with about a 35% share; International Paper is #2 with about 25% share and Boise is #3 with about 10% share.

 

Domtar has three segments: (i.) Paper, which includes the uncoated free sheet manufacturing and pulp businesses, (ii.) Paper Merchant, which runs warehouses and distributes both Domtar paper and that of competitors, and (iii.) Wood, which the company has an agreement to sell and should close in the coming months.  The Wood business has been a money loser (even from an EBITDA perspective) over the past few years and the company will realize about $95mm in net cash proceeds from the sale.  The Paper Merchant business is not meaningful a cash flow perspective, but is noteworthy because sales of Domtar paper are much higher through this channel that with other distributors.

 

The biggest negative for the business overall is the structural industry decline of units of uncoated free sheet paper, which is due to increased use of computers, email, ipad, etc.  The management team pegs the decline in units at about 4% per annum, which we think is a reasonable estimate.  On the other hand, the consolidation of the industry has provided pricing power to the remaining players in the industry.  In fact, in one of the most difficult business environments in recent history (2008-2009) prices actually went up, which is shocking to anyone following the industry over time.

 

While the pure uncoated free sheet business has remained steady at about $200mm of EBITDA per quarter, the pulp business has been wildly volatile.  The pulp business lost about $75mm per quarter in the first half of 2009 and was positive by about $30mm in the 3/10Q.  The decline was primarily due to one of the sharpest declines in pricing ever in that industry.  The company has about 1.7mm ADMT per year of pulp in excess of the company's internal requirements, which causes the swings in profitability.

 

Net debt peaked in 2007 at about $2.4 billion following the Weyerhaeuser transcation and has steadily declined to about $1.3 billion at the end of the 3/10Q.  This can partially be attributed to strong cash flow from operations over that time frame, but also partially due to black liquor tax credits that the company received as a nice gift from the government.  I won't get into the mechanics of the credit (google it), but it bacially provided the company with about $500mm in cash, of which the company will receive $350mm in the 6/10Q.  (Also noteworthy, the company is getting about $75mm from the Canadian government in tax credits to use to upgrade facilities.)  The company is using this cash initially to pay down debt; following a recently completed debt tender, the company should have ~$950mm of debt that is all senior notes (no bank debt) with most of the maturities after 2013.

 

Current sell-side estimates for EBITDA for 2010 and 2011 are about $1.0 billion and $900mm respectively.  We think the normalized over the next few years is about $775mm less $175mm maint capex gets you to our normalized pretax unleveraged cash flow of about $600mm.  If you assume interest expense is $100mm and taxes of $125, the real free cash flow is about $375mm or about $8.75/share.  What are they going to do with all this cash if their debt is fixed for several years (and at their target leverage)?  Return it to shareholders.  The company reinstated its' dividend at $1.00/share annually and has a $150mm authorization to buy back stock, which we think will be utilized in the near future (and probably increased).

 

We think that under 6x after-tax normalized free cash flow in a relatively unleveraged company even for a paper company with declining units is cheap.

 

improving return on capital with the sale of the wood business

significant cash flow ahead with most returned to shareholders

an extremely low multiple to expected cash flows