It’s always a fun challenge picking just one stock to follow over the course of the year. This year is particularly exciting because the market has just reached a mode of transition: as we pivot away from a zero interest rate environment, new pockets of value will begin to emerge while some of the past decade’s high-flyers will see incremental drag.
Last year, ABM Industries, Inc. (ABM) made sense because it had growing earnings and was reasonably valued when a lot of valuations were somewhat stretched. But as the market adapts to tightening economic policy, I’m fairly certain we’ll see more volatility in the coming months—so I’m leaning toward a similar strategy again with my pick for 2016, Domtar (UFS).
Domtar is the largest producer of uncoated free sheet papers, which are generally used in printing and other communication applications in North America. The company also operates a personal care papers business (primarily adult diapers) that is growing at a nice pace, now constituting approximately 20% of the company’s operating income.
What I like most about this stock is that it’s so cheap on a number of valuation metrics. The shares trade at just 5.0X trailing EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortization), which compares favorably to other forest product companies.
Plus, UFS generates about $150-$300 million in free cash flow a year, which is substantial compared to its $2.3 billion market capitalization. The company has used this free cash flow to finance stock buybacks and to pay dividends in recent years. The share count is down 30% since 2010 and the company offers a dividend yield of 4.4%.
Earnings have come under pressure this year, as the company’s pricing has felt the strain of increased imports. On the bright side, I think uncoated paper could see more stable demand going forward due to the rise of the digital age, and it was encouraging to see Domtar’s shipments remain flat. I’m confident UFS stock will see EPS rise to $3.20 next year, with free cash flow greater than this amount by as much as $1 per share, as depreciation and amortization should continue to exceed capital expenditures.
The wild card that could add extra value for UFS shareholders is Domtar’s personal care business. Management indicated in its third-quarter conference call that the company recently won major contracts for this business, so I believe growth should continue nicely. Since businesses of this type are afforded much higher multiples than paper companies, the stock should receive higher multiples as personal care becomes a larger part of the profit mix.
Put that all together and you’re left with a company that offers an attractive dividend yield with plenty of headroom for share prices to move higher. If we can avoid a global recession and paper prices stabilize, I fully expect UFS stock to reach new highs in 2016.
Hilary Kramer is the editor of GameChangers, Breakout Stocks Under $10, High Octane Trader,Absolute Capital Return and Value Authority. She is an accomplished investment specialist and market strategist with more than 25 years of experience in portfolio management, equity research, trading, and risk management. She has extensive expertise in global financial management, asset allocation, investment banking and private equity ventures, and is regularly sought after to provide her analysis on Bloomberg, CNBC, Fox Business Network and other media.