Industry Reports

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080422 Deutsche Bank Report - Domtar's Cost Increases

Deutsche Bank - Equity Research

Domtar {Ticker: UFS, Closing Price: USD 6.65, Target Price: USD 14.00, Recommendation: Buy}.

* Rising raw material costs are squeezing paper industry margins. 

Domtar issued a release today warning of $35-45MM in incremental q/q raw material costs.    Energy, fiber, chemicals and transportation costs are all on the increase.   The Q1 increase comes on top of $21MM in additional q/q raw material costs in Q4.  On an annualized basis, this suggests roughly $120MM (6% of COGS) in annualized cost increases - - - with momentum increasing.

* The challenge for UFS and its peers will be to force through corresponding price increases in the face of a slowing economy. 

While raising prices in a slowing economy is counter-intuitive, industry leaders have few options.  It won't be easy, but it may not be as tough as one might assume.  The combination of recent industry consolidation as well as the falling US$ should help the situation.  In the uncoated free sheet market (Domtar's primary market), where shipments were off 9.6% in Mar. (-3.1% YTD), market downtime or mill closures will almost certainly be required.  Between some of the highest pulp costs in history along with higher energy, chemical and transportation costs, it is hard to imagine that some nonintegrated uncoated free sheet mills aren't sitting precariously on the bubble.  Domtar, International Paper and Boise are the 3 biggest players in uncoated free sheet and control nearly ¾'s of the market.  We could see supply cuts from one or more of them, but we think there are also smaller players who may be forced to shutter capacity.

* We are trimming our estimates to reflect these cost pressures.

Q1E goes from $0.08 to $0.03 and our FY08E from $0.45 to $0.30.  Maintain BUY rating.  Domtar's valuation is the lowest in our coverage universe on several key metrics, including EV/EBITDA and market cap/FCF to equity.