Domtar: Here Comes The Recovery, Dividends Should Follow

Domtar: Here Comes The Recovery, Dividends Should Follow

When the Covid-19 pandemic and resulting economic fallout started to hit the global economy the paper company, Domtar (UFS) responded by completely suspending their dividends. Whilst this was undoubtedly painful for their shareholders, at least not all hope was lost with them being well-positioned to reinstate them again in the future. This article provides a follow-up analysis to my previous article by reviewing their progress plus providing a brief recap of the original analysis for any new readers.

Executive Summary & Ratings

Since many readers are likely short on time, the table below provides a very brief executive summary and ratings for the primary criteria that was assessed. This Google Document provides a list of all my equivalent ratings as well as more information regarding my rating system. The following section provides a detailed analysis for those readers who are wishing to dig deeper into their situation.

Domtar ratings

Image Source: Author.

Detailed Analysis

Domtar cash flows

Domtar notes 1Image Source: Author.

Instead of simply assessing dividend coverage through earnings per share, I prefer to utilize free cash flow since it provides the toughest criteria and best captures the true impact to their financial position. The extent that these two results differ will depend upon the company in question and often comes down to the spread between their depreciation and amortization to capital expenditure.

The original analysis found that their dividends were previously fundamentally affordable and sustainable when operating conditions were normalized, given their very strong average coverage of 247.85% during 2017-2019. This importantly means that once their operating conditions recover, they should easily be capable of reinstating their previous dividends and if interested in further details, please refer to my previously linked article.

When looking at their performance from the first nine months of 2020 investors could be forgiven for initially thinking that they have already recovered, after-all, their operating cash flow of $276m is only a whisker behind their $282m during the equivalent time in 2019. Unfortunately, once removing the impacts of working capital movements the situation is not nearly as favorable with their operating cash flow actually being down a very significant 49.50% year-on-year. Thankfully they have started seeing green shoots during the third quarter of 2020 with month-on-month improvements, as the slides included below display.

Domtar paper and pulp segment

Image Source: Domtar Third Quarter Of 2020 Results Presentation.

Their core pulp and paper business segment has seen their latest EBITDA make solid progress recovering approximately halfway, their results for the third quarter of 2020 reached $98m, which is up $32m versus the second quarter but still $29m down year on year. Since there should be a strong positive correlation between changes in EBITDA and changes in operating cash flow across time, this bodes well for reinstating their dividends in the future.

When looking ahead any further sustained recovery would likely require Covid-19 cases to be brought under control, thereby allowing economic activity to continue recovering. Whilst no one can say for certain, the worst seems to have passed and given the recent early-stage distribution of vaccines it seems that operating conditions have a good probability of largely normalizing within one to three years. This thereby gives them very solid prospects to reinstate their dividends providing that their financial position remains healthy.

Domtar capital structure

Image Source: Author.

Their capital structure instantly appears quite healthy with a large portion of equity versus debt and has also remained steady across time, which most importantly continued during the first nine months of 2020. Thanks to the dividend suspension and their working capital draw, their net debt has actually slightly edged lower by $6m during this same period of time despite the severe downturn, plus they have also built a desirable cash balance of $218m to boost liquidity. It was also positive to see that they have only taken a $111m impairment thus far, which is relatively small and indicates that management feels confident in the value of their assets and by extension, their ability to recover. All of these factors help position them well to not only survive this downturn but recover their previous dividends relatively soon.

Domtar leverage ratios

Domtar notes 2

Image Source: Author.

When reviewing their financial metrics it appears that their leverage has remained only moderate despite the impact to their earnings from this downturn, as primarily evidenced by their net debt-to-EBITDA and net debt-to-operating cash flow both sitting between 2.01 and 3.50. Although it should also be mentioned that their interest coverage of only 0.19 is extremely low and would normally indicate very high leverage, but it should not prove problematic since it results from a severe downturn that appears to be recovering.

Since their net debt has not increased, their leverage should fall back into the low territory as their earnings continue recovering. This means that they have very solid prospects to reinstate their dividends within the next one to three years at the most, as in theory there should be no fundamental issues blocking them from taking this action.

Domtar liquidity ratios

Image Source: Author.

The benefits of their previously mentioned higher cash balance are apparent with their cash ratio climbing to 0.31 from only 0.08 at the end of 2019, which along with their very high current ratio of 2.28 has pushed their liquidity into the strong territory. If required during an emergency, their liquidity can be supported by their credit facility that still retains $649m available. Whilst they are facing a $300m debt maturity in 2022, they are fundamentally viable and thus it seems reasonable to expect that they can refinance if required, especially with their credit facility not maturing until 2023 providing additional flexibility.

Conclusion

Whilst they are yet to see a full recovery, it was very positive to see their earnings beginning to rebound in the third quarter of 2020 and even more importantly, their financial position has not deteriorated. This means that they are still well-positioned to reinstate their dividends in the future but seeing as these would only provide a moderate yield on current cost of slightly under 6% versus a high yield of over 7% previously, I believe that a neutral rating is now appropriate versus my previous bullish rating.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Credit: SeekingAlpha

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