A Good Investment Opportunity in the Pulp & Paper Industry

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I like to screen for stocks which have experienced significant fall on the market in the past half a year. The fall of the share price makes investment costs lower, enhancing investors’ returns in the future as long as the business and its assets remains intact. Domtar Corp (NYSE: UFS) has decreased by nearly 18.5% since the beginning of the year, underperforming the S&P 500’s gain of more than 13.2%. Interestingly, Domtar is in the portfolios of famous investors Ray Dalio and Joel Greenblatt. Is Domtar a good buy now? Let’s find out.

A cash cow with conservative balance sheet and cheap valuation

Domtar is the manufacturer and distributor of fiber-based products including packaging papers and communication papers. It operates in three main business segments: Pulp and Paper, Distribution and Personal Care. Most of its revenue, $4.58 billion, or around 80% of the total revenue, were generated from the Pulp and Paper segment. The Distribution segment ranked second with $685 million in 2012 revenue. The Pulp and Paper segment was the main income generator, contributing $361 million in profits while the Distribution segment’s income was a negative number of $(16) million.

What I like about Domtar is its consistent positive cash flow generating capabilities. In the past five years, Domtar’s operating cash flow fluctuated in the range of $197 million to nearly $1.17 billion. In 2012, the company's operating cash flow came in at $551 million while its free cash flow was $315 million. Domtar employed a reasonable amount of leverage. As of March 2013, it had $2.84 billion in equity, $513 million in cash and more than $1.1 billion in debt. The company's goodwill and intangible assets stayed at $565 million. Consequently, its tangible book value was nearly $2.28 billion.

Recently, the company has agreed to acquire Associated Hygienic Products (AHP), the biggest maker of store brand infant diapers in the U.S. The total value of the transaction is $272 million. The acquisition of AHP will allow Domtar to expand its footprint in the personal care business. AHP delivered around $320 million in sales with an EBITDA (earnings before interest, taxes, depreciation and amortization) of $31 million. The company expects that the acquisition will deliver synergies of $10 million.

Domtar is trading at around $68 per share, with a total market cap of $2.3 billion. The market values Domtar quite cheaply at only 3.9 times its trailing EBITDA. What might also make Domtar interesting to income investors is its decent dividend yield at 3.3%.

Are International Paper and MeadWestvaco more attractive?

Compared to its peers such as International Paper (NYSE: IP) and MeadWestvaco Corporation (NYSE: MWV), Domtar is extremely cheap.

International Paper trades at $45.10 per share, with a total market cap of more than $20 billion. The market values International Paper at 8.75 times its trailing EBITDA. The company is considered one of the biggest global paper and packaging company, operating in many regions around the world including North America, Latin America, Europe, North Africa and Asia. It has 28 pulp, paper and packaging mills, 187 converting and packaging plants and 18 cycling plants. Most of its EBITDA, 55% of the total company’s EBITDA, were generated from the company's Industrial Packaging segment while the Printing Papers contributed 31% of the total EBITDA in 2012.

Looking forward, International Paper will maintain its balanced use of cash, with systematically return cash to shareholders. The company reported that it would maintain sustainable dividend with the rate of 30%-40% of its total free cash flow. International Paper pays a decent dividend yield at 2.7% to its shareholders, with the payout ratio of around 54%.

MeadWestvaco trades at $34.70 per share, with a total market cap of more than $6.1 billion. The market values MeadWestvaco quite expensively at 9.7 times its trailing EBITDA. The company is also a global packaging company, serving a lot of famous brands in the healthcare, food & beverage, home & garden and tobacco industries. The two biggest income contributor segments were Food & Beverage, with $309 million in profit and Specialty Chemicals segment, with $224 million in operating income in 2012.

The company has been working on an overall overhead cost reduction plan, with the expectation to reduce its annual costs by $65 million to $75 million by the end of 2014. MeadWestvaco intends to streamline its operations and consolidate its G&A functions across its operations. In 2013, the company estimated to realize around $25 million to $30 million in benefits from that cost savings plan.

MeadWestvaco is also a good dividend payer, offering a 2.9% dividend yield to its shareholders. The payout ratio is quite high at 106%, however. This means that the company pays dividends that are higher than what it has earned in the past twelve months.

My Foolish take

A long-term investor should consider Domtar as an investment opportunity. With the ability to generate a consistent cash flow, a conservative balance sheet, the highest dividend yield among its peers, a potential cost and operational synergies from the AHP acquisition and its low valuation, the company could deliver a sweet total return on the market to its shareholders in the near future.

Anh HOANG has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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