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July 2013 Summary Review- Full Review to Clients Only

August 4th, 2013

In the News

I have been reading a number of articles lately on the subject of share buybacks, the works of both highly placed academics and practitioners. Yet, in no analysis have I seen the authors adjust for (1) an upward shift to cost of capital resulting from the equity impact including increased leverage and impaired credit, (2) superior utilization of that cash which could improve return on capital (3) excess tax benefits[1] resulting from share based compensation listed under financing activities in the statement of cash flows that should be moved to operating activities and (4) reduction in financial flexibility.  I have written previously that while buybacks may improve upon GAAP numbers such as return on equity it does not change return on invested capital as it neither improves free cash flow nor adds to capital.

Regarding the trillion or so dollars held by US corporations overseas, an analyst should not assume this cash is available for share buybacks as most of it won’t see the light of day in the US, even given a drop to a 28% tax rate put forward by the administration this week and other credits which could bring the rate down even further. Such cash is, most often,  better used for overseas expansion where the taxes have already been paid and could raise the firms’ return on capital by being deployed in faster growing economies or new acquisitions.

Lastly, Detroit proved that pension liabilities still matter. Even for strong firms, the liability impacts fair value. This month, portfolio holding Lockheed-Martin reported a very strong quarter, and would have reported considerably further strength if their cash contribution was level with last year. Unfortunately, the firm, although not mentioned in its press release, most likely has at least seven such years of stepped-up contributions ahead of them, given the enormity of their unfunded liability. Nonetheless, its shares are trading very near to its all-time high.


In these reports, it is important I comment on a position that has lagged the benchmarks. Several of the holdings of prior comment have been acquired, and almost all have had very strong runs in excess of the benchmarks, such as Google, EBay and Nu Skin (latter two since sold) as well as the entire insurance space.

In March, I illustrated a cash flow worksheet on Bed, Bath and Beyond, which at the time was being heavily sold by investors after reporting a weaker than anticipated quarter. In reality, a single quarter has a quite minimal impact on the actual valuation for most firms with a long history of  generating normalized and adjusted free cash flows with low cost of capital. BBBY shares now trade near its all-time high.

And so, on July 12th, when Domtar (UFS) announced weaker than expected results its shares fell to a 52 week low, and have only modestly rebounded since, down 16.8% for the year.

UFS, under a purchase (accounting) with no retroactive subsequent adjustments and $300MM in goodwill (subsequently written off), acquired the Weyerhaeuser fine paper business in 2006 with shares and debt assumption ($1.6bn), becoming the largest integrated manufacturer and marketer of uncoated paper in North America and the second largest in the world. They own or license 16MM acres.

Table 1 shows why UFS shares have declined, yet even so, continues to produce acceptable free cash over two, three and four year periods. Its free cash flow stability index (shown as its standard deviation/average) of .6 is above average but not unacceptable. For example, International Paper’s free cash flows have a stability index of .41.

Exhibit 1          Stability of Free Cash Flows-Three Year Average



As shown in exhibit 2, there is a strong association between UFS’s 3 year average free cash flows and market value. Free cash flows in the table are not adjusted for tax subsidies related to alternative fuel credits, which biased 2010 results.  In that year UFS received a $368MM cash refund, the impact of which has been somewhat minimized in both the three and four year averages. An additional credit of $198MM remains for 2009 which could be released this year pending audit. No credits were claimed for 2012. SG&A has been influenced by stock based compensation which is adjusted into our models.

For our positive thesis to hold we would need to see a continuation of the growing three year average free cash flow, which will not occur on an adjusted basis until sales begin to improve. The firm could, however, adjust discretionary spending to mitigate further erosion in sales until economic strength reconvenes. Yet, to delay equity investment in a strong credit cyclical firm like UFS until a positive turn is underway when the market value is long term attractive is a common error most responsible for missing the greatest jump in share price.

Exhibit 2           Three Year Average Free Cash Flows versus Market Value




As shown by Exhibits 1 and 3, UFS is unlikely to struggle servicing its debt, with very strong fixed charge cover. Maturity structure is well spread out. Total debt (including leases) has increased just 3 of the past 10 years. Our cost of capital model penalizes firms which require frequent trips to raise capital either to maintain or grow free cash flows.

Funding improvement to pension plans, its one significant credit issue, is taking place despite reporting a $96MM increase in non-funded status. This comes about from the firm’s more realistic actuarial assumptions and $666MM in company contributions over the past 5 years; its discount rate has dropped to 4.8%  (from 6.3% two years earlier), with plan assets growing to $1.7 billion. The 2012 actual return on the plans ($182MM) plus company and employee contributions ($93MM) exceeded actual paid benefits of $97MM. With 41% of their plans in equities and 59% in debt, funding status could, however, be further strained if interest rates continue to rise and equities markets fell. If UFS were to close out part (or all) of its plans, a logical step, it would lower cost of capital by up to 40 basis points in our model. In any event, given the stronger funding status, firm cash flow should be boosted. This year UFS expects to contribute considerably less than last year (again hoping for aid from financial markets) versus the past 5 years average of $133MM; the contribution is being swayed by the lower production volumes.

They are a member of 7 multiemployer plans with unknown member financial status for at least one of the plans. As contributions into these plans have been small ($6MM/year), I presume the risk is not significant in relation to its cash. One of the plans, however, is in Red (less than 65% funded) Status, yet their contribution to that plan was just $3MM last year. Of late, unions in general have been working with employers to improve funding, including the reduction of benefits.

UFS uses derivatives almost primarily as hedges in currency and natural gas (no losses shown in AOCI).

Their rate of increase in healthcare expenses is moderating although the post-retirement liability rose 9.7% to $124MM over 2011.  Remaining litigation risk relates to various actions on hazardous waste clean-up stemming from 1999, having settled one large suit the past quarter. They continue to take remedial action ($32MM in asset retirement obligations) and I believe the 25 basis add-on to cost of capital recognizes the liability. Relations with unions have been generally satisfactory, although testy at times, including strike votes.

Exhibit 3       Debt Summary



UFS has had an unstable tax rate, not uncommon given the cyclicality of the industry. In four of the past 10 years the cash rate has changed by over 10% from the prior year. Stock based compensation has been minimal, including tax benefits.

Capital spending has more than doubled ($106MM to $236MM) over the past 4 years despite flat sales. Resultantly, our worksheet picks up some of the excess as the firm could reduce this budget while maintaining similar sales, especially with their plants running below normal capacity. The last two year step up in capital spending, acquisitions and joint ventures ($974MM) less disposals ($93MM) has been financed by cash from operations and a debt raise, with only minor balance sheet management. Share repurchases, which have totaled $650MM the past two years, has been a poor choice by its Board, given the needed debt raise, lack of sales growth and cloudy near term expectation.


Other metrics which have caused cost of capital to rise include adjusted cash flow from operations which have benefited from the tax refund, growth rate in free cash flows, inventory accumulation, economic profit/sales LFY of 1.9%, capital spending in relation to sales growth, deterioration of working capital to total debt, stability of cash tax rate (average cash payment of $46MM past 6 years), and productivity. Negative metrics point to the needed reduction in headcount.

Despite the above flags, normalizing UFS’s metrics underlie our faith in its shares. Over the past 3, 5 and 8 years, its normalized return on capital has remained in the high teens with strong, although declining, free cash flows. It easily earns its cost of capital for which there is substantial room for improvement in spite of the current sales stagnation.  If and when the world’s economies perk up, its shares should outperform all benchmarks by a very substantial margin due to significant operating leverage. Other large winning positions in the account have come from similarly depressed conditions and playing “the waiting game.”  I believe the risks are known and accounted for.

A buyout is certainly within the realm of possibility given how several other large paper manufacturers shares have held up which could finance a deal.


Kenneth S. Hackel, CFA

[1] When a restricted stock vests or a nonqualified option is exercised, the amount of the employer’s corporate tax deduction is fixed. At that time it is evident whether the amount deductible on the tax return is greater or less than the cumulative compensation cost amortized (using Black-Scholes) over the vesting period.

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