Monday, November 02, 2009

Domtar (NYSE:UFS): Actionable Call Alert!

Domtar (NYSE:UFS) is getting a lot of love from several tier-1 firms this morning after the co reported stronger than expected results Friday morning:

- J.P. Morgan is upgrading DFS to Overweight from Neutral with a $50 price target (prev. $40) saying they are pleased with UFS’s robust cash flow, its financial flexibility, production discipline, and cost containment commitment.

Demand improves but outlook remains cautious. Despite 3Q’s strong q/q demand improvements, management provided a cautious UCFS outlook for FY10 given that prebuy (ahead of the recent price increases) may have contributed to the 5% q/q increase. JPM's forecasts for UCFS shipments for FY10 remained unchanged (3% y/y increase) given a limited outlook for UCFS by UFS and its competitors and what could be a slow recovery in white collar unemployment. However, management believes pulp prospects remain strong and Chinese demand does not appear to be tapering. Firm's forecast assumes pulp shipment declines of 6% q/q in 4Q09 (given 3Q09’s drawdown of inventory) and a 2% y/y decrease for FY10. Even at these levels FY10 shipment/capacity rate would equate to a healthy ~96%.

Significant FCF generation persists. UFS continued to generate another quarter of strong FCF, which totaled $220mm, as the company reaped benefits from its prudent working capital management. Additionally, the company will receive the remainder of its fuel credit cash payments (~$320mm) in 2010 (due to a change in tax reporting), which provides a boost to next year's FCF. Furthermore, the company's $150mm monetization plan continues to move forward and its 3.0x net leverage goal appears to be ahead of schedule.

Upgrading to Overweight. Following UFS's exceptionally strong 3Q, continued balance sheet strength, robust cash flow, and improving margins (JPM expects pulp EBITDA to turn positive next quarter) along with a compelling valuation on a 2010 EBITDA basis (3.0x versus its peers at 5.8x), JPM believes an Overweight
rating is appropriate.

- CSFB is actually even more positive than J.P. Morgan raising their target to $70 (prev. $55) and rather strongly reiterating Outperform rating.

Third Quarter Was "All Real" — Domtar reported $1.32 in operating income in the third quarter, beating CSFB's Street-high $0.60 estimate and the consensus' $0.29. Free cash flow was huge, allowing for a net debt reduction of $237mm ($5.49 per share), of which only $3mm ($0.07) was from alternative fuels mixture ("black liquor") credits. Firm notes that depreciation was $1.80 more than capital spending. Annualized net debt reduction (excluding black liquor credits) was over $21/share in the third quarter -- half of Friday's closing stock price. They are raising their EPS estimates for 2009, 2010 and beyond.

Enterprise Value Still Way Down — In July 2007, Domtar traded for $135/share and had (at June 2007) $57/share in net debt -- for an enterprise value of $192/share. At Friday's closing price and the September 30th net debt of $37/share, Domtar had an EV of just $78/share -- 60% less than in mid-2007. With over $10/share in US and Canadian fuels credits to be received in 2010 and 2011, they see net debt falling by another $20/share by the end of 2011. If Domtar's EV were to remain at $78/share, this would mean that Domtar's stock would still rise by 50%.

Raising Target Price to $70 — CSFB is raising theior target price by $15, to $70, and, of course, maintain their Outperform rating (established on June 1st). Domtar is producer of mainly softwood pulp with most of this production dried as uncoated business papers. They see North American uncoated prices moving up with the price of market pulp (where demand is growing), allowing Domtar to earn about $11/share at the next cyclical peak. They do not believe most of the Street understands Domtar or the magnitude of its upside potential given its significant cash generation.

- RBC Capital is out upgrading UFS to Top Pick with $70 target (prev. $50)

Domtar's had a great run! How high can it go? - On a valuation basis, the company continues to trade at a significant discount to International Paper (IP), currently at trading at 5.7x the 2010 consensus ($600MM) versus 6.2x for IP. While RBC believes that IP should trade at a premium, IP's higher debt levels and lower paper & pulp margins suggest that it shouldn't be a significant one. They would expect Domtar's 2010 consensus to move into the $700MM to $800MM range, or the equivalent of a 4.2x to 4.8x multiple. This would imply a target of $45 to $57 per share.

What really gets us excited about Domtar is the de-leveraging story - Combining $150MM in expected asset sales, $140MM in Black Liquor tax credits in Q409 with RBC estimate of $375MM in FCF equals $665MM in potential debt reduction over the next 12 months. At the end of Q3, Domtar had $1.581 billion in net debt. Using the multiple range of 4.2x to 4.8x, a share price of $60 to $72 is possible. If they assume IP's valuation premium should only be 0.5x, then the potential rises to $90 per share. While these "potential target" scenarios might seem ridiculously high, from the perspective that the stock traded above $130 less than three years ago, they appear reasonable.

Cash to shareholders - After debt reduction, RBC suspects Domtar may then start to return cash to shareholders, likely through the re-instatement of a dividend, starting at $1 annually.

Notablecalls: Wow - the J.P. Morgan upgrade looks nice but do read the comments from CSFB. It really feels like the Street has overlooked this one for quite a while. The $10/share in US and Canadian fuels credits is the icing on the cake, the cherry on top, the olive in UFS' Martini!

Notice how the stock held despite the huge sell-off we had on Friday? With the general market up close to 1% this morning UFS is ready to rocket.

I think that if the market holds, Domstar (UFS) has $1.50-2.00 pts of upside in it today. If I were more bullish I'd say $45 level will get play today.

I'm calling this one Actionable LONG here.

PS: I'm hearing Raymond James is upgrading UFS to Outperform this morning.

1 comment:

bl said...

looks like you attracted a crowd at the open and at 10 est. nice