Domtar Corporation is North America’s leading manufacturer of uncoated free sheet paper and the second largest in the world. They are based in Montreal, Canada with the majority, 8 of 10, production plans located in the United States and employ over 8,500 people. They have developed a business model that includes designing, manufacturing, marketing and distributing paper and pulp products. In 2007, Domtar Inc combined Weyerhaeuser Company (WY) to form the present Domtar Corporation.
At Durig Capital, we have developed a process to review, select, purchase and monitor corporate bonds on an ongoing basis. Enclosed is our review, along with supporting documents, showing why we believe this corporate bond makes sense in clients’ portfolios. We reviewed thousands of separate corporate bond listings to find what, we believe, is currently the best corporate bond for investors. The following includes our selection criteria.
Step 1 – Yield Curve at 3-7 Years Out
Lately, we have been recommending bonds on the shorter end of this spectrum as recent global events have rapidly raised volatility in the markets. With the numerous uncertainties that have arisen, we have taken a stronger focus on keeping maturities shorter.
Another factor that we have been monitoring closely is the rate at which the US government is spending. This may affect the long term real purchasing power value. Currently, congress is attempting to avert a government shut down by passing a federal budget. On Tuesday March 15, 2011, they passed a continuing resolution that would reduce spending by $6 billion for the next three weeks. This seems like a step in the right direction however one must take this number in perspective—the day the bill passed the US Federal deficit grew an astounding $72 billion. $6 billion in savings over three weeks is peanuts compared to daily deficits reaching above $72 million. It seems like the big issues have yet to be tackled. To help defend against the possible long term decline of the real value, we have recommended and implemented a double strategy; keeping maturities in the near term to reduce risk and allocating a portion of investors’ portfolios into foreign denominated fixed income to help enhance the yield.
Step 2 -The company must be profitable
Domtar Corporation produced revenues of $5.85 billion in 2010. With the mature industry they are in, profit margins are typically narrow. They were able to produce profit margins of over 10%, which are the highest since the 2007 inception. Part of this is attributed to one time occurrences such as previous tax losses and property, plant and equipment sales. In situations such as this we like to look at operation income which was $568 million or about $13.15 per share. They are very profitable and we like to see this.
Hidden Value—-What are they doing with the profits
As of June 2010, the company has instituted a quarterly dividend of $0.25 per share. Last year they paid $0.75, initiated in Q2, to share holders for the year or $32.4 million based on average shares outstanding. In 2011, management has stated that they should continue with this payout rate which would mean about $43 million for the entire year. When management initiates a dividend, it may be interpreted that they have ample cash generating abilities. We reviewed a Blyth Inc’s debt issue that also paid dividends to equity holders and the position has done quite well for investors. This is good news for fixed income investors.
Step 3- How about those interest coverage ratios
Being able to pay interest expense from operating income is an important on going concern. Domtar Corp earned $603 million from operations in 2010. Associated with this, they had $155 million in interest expense. This means on a pretax basis they earned enough to cover interest expense 3.89 times. We reviewed an American Railcar bond issue recently and they had operational income of 2 times interest expense. Domtar has quite a strong ratio for a firm in a mature industry.
Step 4 – Debt to cash ratio.
We usually find firms that have enough cash on hand to repay long term debt to help insulate fixed income investors against losses were difficulties to arise however this does not mean that losses may not occur. In Domtar’s year filings they had $530 million of cash and $825 million of long term debt outstanding. This means that although they have a good portion of their debt covered with cash, they do not have all of it covered. They have reduced debt on the books from 2009 to 2010 by $876 million. Although we like companies that have enough cash on hand to cover debt, the long term debt reduction by more than 50% is a good sign as far as we are concerned.
Step 5 – We like companies that have flexible balance sheets
Having a flexible balance sheet is important were the firm to encounter difficult economic times. We like finding issuers that have manageable levels of debt because a sudden economic downturn may not affect a firm’s bottom line as much. We have seen numerous firms in the past two years that were loaded with debt close up shop and disappear. Domtar has one of the better balance sheets we have reviewed. For every one dollar of debt on the books, they have $2.13 of assets.
Step 6- We like high yields
The Domtar Corporation has a yield to maturity of 4.527%. Although investors would need to pay a premium to par value (over 10%), the annual income may be attractive to investors seeking current income for the next four years.
Flexibility of issuer
If this particular issue does not fit investors fixed income ladders, Domtar has other issues. After reviewing Domtar’s financials, we believe each has there own merits depending on ones needs.
Additional risks to consider
As the electronic communication in the United States increases, there will be less of a need for paper. This may hamper margins and hurt companies that produce paper in the long run. Paper is not needed as much as it was in the past however we believe there will always be a need for paper in the future. In the investment industry, although paper consumption has been reduced, there are still multiple items that hard copies are needed for.
Timber products are the main input into paper production. Demand for timber products has been low lately and basic economic theory suggests that when demand is low prices are low. The recently released housing numbers were at 25 year lows. Should housing start numbers start increasing this may put upward pressure on the main input of Domtar’s products. Timber related commodity prices may have adverse affects on profitability margins.
These notes are denominated in US Dollars, however the corporate headquarters are located in Canada. Income statements, balance sheets and cash flow statements will be affected should the currency exchange rate change. This may have affects on ratios discussed above in different ways with taxation rates being a great concern.
Regulatory environments are constantly changing. Were Domtar or suppliers not be able to harvest leased timber land due to changing regulations, this could cause a lack of raw material input.
There is interest rate risks associated with all fixed income notes. The base level interest rate, called the Fed Funds rate, has been at historic lows for some time. Should interest rates rise, investors principal may be affected adversely. Although this is a shorter term note, the price may fluctuate should interest rate change.
This should not be considered a complete list of risks but just a few. Suitability for each investor should be reviewed on a case by case basis. Please contact a Durig Advisor to assist in the review process.
We believe that we found a good bond here. With the their great ability to generate cash from operations, four year maturity, decent yield, and solid cash position, this bond should be considered for one’s fixed income portfolio. Although this issue is has a Ba2/BBB rating, we believe it is well positioned and have included it as a position in our fixed income portfolios.
Yield to Maturity 4.527%
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Disclosure: Durig Capital clients currently own these Domtar bonds.
To know more about this Domtar bond call our fixed income specialist at 971-327-8847
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