Domtar (UFS) a Potential Dividend Grower

30 Sep 2015 16:25
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logo_UFS.gif

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Domtar (UFS) is a fairly recent dividend grower drawing interest of investors with a 4% dividend yield. With a lack of long term dividend growth history, the questions on the table are; 1.) Is the dividend safe? and 2.) Can dividend growth continue into the future?
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Yes the Dividend is Safe

Domtar is a Canadian based company and is the second largest paper mill supplier in North America. Their largest competitors are International Paper (IP) and privately held Georgia-Pacific. The paper industry as a whole has been experiencing declines in sales at a rate of 3% to 5% a year and Domtar is no exception. Though paper sales are declining, the paper business is very mature and generates significant cash for Domtar.

In 2014 Domtar had $5.5B in sales, $634M funds from operations and paid $84M in dividends leaving a cushion of $550M and a dividend payment that is well funded.

2014 2013 2012
Funds from Operations $634M $411M $551M
Dividends Paid $84M $67M $58M

To compensate for the industry decline in paper, Domtar has slowly been transforming and diversifying into consumer products related to their paper business.

Growing the Business

In 2011 Domtar started down a path to diversify their business to replace declining revenues and to provide new avenues for growth. Domtar had to be considerate in their choice so as not to alienate existing customers of their paper and pulp business. Another consideration was not to enter into markets already crowded that would limit growth. International Paper and Georgia Pacific had already moved into these market segments with items like napkins, paper towels, paper plates and cups. These markets were not just crowded with low growth but also had slim margins.

Instead Domtar focused on long term growth and determined their best alternative was to acquire the U.S. business Attends in 2011 (the largest and leading adult incontinence diapers in North America) and closed on the Europe Attends business in 2012.

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The acquisition of Attends solved two criteria for Domtar; growth and product alignment. The growth factor was a bet on an aging population that will see increased demand for incontinence products. In regards to alignment, as demand decreased on the paper pulp side of the business they converted the excess capacity into making fluff pulp which is used in the manufacture of diapers (baby & adult) and feminine products.

The acquisition of Attends was just the start of their new Personal Care business. In 2012 EAM was acquired (a leader in absorbent technologies) followed by a 2013 acquisition of Associated Hygienic Products (largest U.S. manufacturer of private label infant diapers) followed by a 2014 acquisition of Spanish company Indas (leading brand of adult incontinence in Spain).

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Even though the paper products industry is in decline Domtar did not ignore that piece of the business which generates the bulk of their free cash flow. In 2013 they acquired the Xerox’s copy paper business and the deal also included the brand label “Xerox Paper” to further solidify their position as a leading supplier of paper goods.

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In all Domtar has spent $1.8 billion dollars in acquisitions since 2011 and their CEO John Williams has told investors that the company has allocated an additional $1B for future acquisitions and the goal of 65% of future revenues to come from Pulp, Personal Care, and Specialty Packaging.

With all of the acquisitions Domtar has stabilized their sales and have a portfolio of products for growth. But the most interesting aspect is the percentage of sales for personal care products which has them moving slowly away from the Materials sector and into the Consumer sector.

2014 2013 2012
Sales $5.56B $5.39B $5.58B
Personal Care % of Sales 16.68% 10.5% 7.1%

Room for improvement

With Domtar slowly moving into the Consumer sector they are starting to play with the big boys like Kimberly Clark (KMB) and Procter & Gamble (PG). While their financials are pretty solid for a materials company they are not up to par with consumer companies and I have identified areas where I’d like to see Domtar improve over the coming years.

  1. Receivables Turnover Rate - Domtar’s ability to convert receivables into cash sports a ratio of 7.35 pretty good but when compared to PG ‘s 12.27 its paltry. If Domtar wishes to continue to be a dividend high flyer they need to convert their receivables at a faster rate to grow free cash flow. An acceptable target would be to improve to 8 times a year or better.
  2. Return on Assets - In 2014 Domtar drastically improved their return on assets from 1% to 7%. This has to be maintained going forward and an improvement is just icing on the cake.
  3. Gross Profit Rate - Domtar sports a 21% profit rate but if you compare it to KMB at 35% and PG at 48% it is easy to see they have a ways to go. Going forward I would like to see them grow this to 30%.
  4. Interest Rate Coverage Ratio - Though Domtar does not have a lot of debt it is rather expensive with a ratio of 3.53 versus PG at 19.92. Domtar has been improving on this front from year to year and needs to continue down this path through a combination of growing earnings and retiring more expensive long term debt to get to a factor of at least 5.

Conclusion

  • Domtar’s current dividend is safe and they have a growth path.
  • Moving more into the consumer market will require continued improvements to their financials.
  • Domtar would be a good small position to add to your portfolio. Would not initiate a major position until they have more dividend growth history and improved conservative set of financials.

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