A company’s book value is derived by summing up all of its assets and subtracting all its liabilities. This is, arguably, what would be left after a total liquidation of the company. Some investors focus on book value when investing because it is an accounting look at what one is buying without the bias of investor sentiment. To this end, it is as close as one can get to a pure picture of what a company is worth, keeping in mind, of course, that accounting isn’t exactly a pure science.
Generally speaking, a stock trading near or below book value is of the most interest, since such a company can be bought for close to or, better yet, less than what it is “worth” — at least by one measure. Clearly, investors looking at this largely value-oriented metric prefer buying a dollar of assets for less than a dollar.
It may seem odd to suggest that this is even possible, since efficient market theory dictates that arbitrage investors should quickly move in and bid up prices to the point where there is no longer a discount to book value. However, many of the companies that trade close to or below book value trade at such low valuation levels for a reason. Moreover, the total liquidation of a company isn’t a simple undertaking, so that quick money is far from assured. Thus, investors need to carefully research such companies and make sure that any risks are fully understood before investing.
To help value-oriented investors find companies that are trading near or below book value, a weekly screen listing such companies is included in the Summary & Index section of The Value Line Investment Survey. The screen shows the 100 companies with the widest discount to book value and includes Value Line’s proprietary Timeliness and Safety ranks, as well as recent price, book value per share, the percentage discount to book value, Beta, P/E, and dividend yield. Basically, that is everything one needs to start the research process.
Below is one of the more interesting investment candidates from the list, Domtar Corp. (UFS).
Domtar is the largest uncoated white paper producer in the U.S., a leading pulp maker, and a new entrant into the personal care/hygiene markets. The core business is Pulp & Paper, which accounts for some 90% of EBITDA or $700 million on a trailing twelve-month basis.
All of that has come from the Paper segment, since the Pulp unit is unprofitable at the moment. The Pulp unit went from a historical run rate of $250 million, to breakeven three quarters ago due to cyclicality. Although the segment should slowly recover, its sensitivity to business conditions adds more variability to Domtar’s earnings. Specifically, management estimates that world chemical market pulp demand will grow at a 1.3% to 1.5% annual rate through 2017.
Taking a look at the core Paper unit, around 15% of its operating profits come from specialty and packaging papers used in everyday items, from tea and popcorn bags, to gum and fast food wrappers. Other packaging and medical applications are also primary end markets. These products are expected to grow in line with GDP for the foreseeable future.
The remaining 85% of the Paper unit’s sales come from communications paper used for publications, envelopes, and printing documents. This unit has been declining around 3% per year since 2000 due to peoples’ rising preference for digital information consumption. We expect this rate to remain fairly consistent over the long-term.
The fact that Domtar’s core business is in decline is the primary explanation for why its stock is currently trading at a wide discount to book value. Nonetheless, the company still has solid long-term growth prospects thanks to its recent foray into the adult and infant diaper markets.
Together with UFS’ paper distribution business, the Personal Care unit has reached a $75 million EBITDA run rate, or roughly 10% of the total. This includes the recent $275 million acquisition of Associated Hygienic Products (AHP), the largest store-brand infant diaper producer in North America. AHP sells its products into such major retail outlets as CVS (CVS), Wal-Mart (WMT - Free Wal-Mart Stock Report), Sam's Club, Food Lion, Publix, Whole Foods Market (WFM), and Kroger. It currently generates $31 million of EBITDA, should be profitable right away, has low need for capital investment, and ought to eventually produce annual synergies of $10 million.
The prospects for the generic baby diaper market are attractive. Indeed, five years ago generics made up about 16% of the $5 billion baby diaper market versus the current 20%. Including adult diapers, the total market is expected to expand 7% worldwide through 2015. Domtar looks to be generating $300 million-$500 million in EBITDA from the unit over the next 3-5 years.
In the meantime, UFS is committed to returning the majority of its cash flow to shareholders. Over the past two years it has returned 78% of its cash through dividends and share repurchases, and is committed to returning over 50% for the foreseeable future. Although the company prefers buybacks over dividends due to the increased cash flow flexibility they enable, UFS has raised its dividend by 120% since its inception in 2010. The current yield is a healthy 3.4%. While taking care of shareholders is a priority, acquisitions remain very much in focus for Domtar as well.
Similar to any stock on the widest discount from book value list, these shares are susceptible to wide swings in price (as evidenced by low marks for Stock Price Stability). Therefore, they are likely best left to more risk-tolerant investors. Nonetheless, we think the valuation is attractive here and suggest investors consider this well-run paper company.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.