10/25/2012 10:03 EDT | Updated 12/25/2012 05:12 EST

Strength in Domtar's adult diaper segment doesn't offset pulp and paper weakness

MONTREAL - Strength in Domtar Corp.'s burgeoning adult diaper products wasn't enough to offset weakness in its core pulp and paper business though its third-quarter results handily beat expectations despite a large year-over-year drop in profits and lower net sales.

The personal care products business, including adult diapers, has been growing following last May's acquisition of U.S.-based EAM Corp., which develops and supplies the core material used in feminine hygiene products, baby diapers and puppy pads.

Domtar (TSX:UFS) also bought adult diaper producer Attends HealthCare last year and added the European Attends business early in 2012 in a deal worth $264 million.

The segment earned US$19 million in adjusted EBITDA on US$111 million of sales in the quarter, compared to US$2 million of profits on just US$17 million of revenues a year earlier.

Chief executive John Williams said the segment is experiencing "solid growth" momentum.

"We're also maximizing growth with newer, higher margin and faster product segments, leveraging EAM's research and development capacity," he said Thursday during a conference call.

"Our focus remains on becoming a leader in adult incontinence, taking advantage of market growth and quality merger and acquisitions opportunities to deliver superior returns by building on our business."

Domtar hopes to double the size of its existing personal care business in three to five years and reach US$300 million to US$500 million in annual EBITDA with the help of acquisitions.

The Montreal-based company, which reports in U.S. dollars, said net earnings in the three months ended Sept. 30 fell to $66 million or $1.84 per diluted share from $117 million or $2.95 per share in the same 2011 period.

Sales revenue fell to just under $1.4 billion from $1.42 billion in the same year-earlier period.

Adjusted earnings were $67 million or $1.87 per share, compared with adjusted earnings of $123 million or $3.10 per share in the year-earlier period.

Analysts polled by Thomson Reuters had expected adjusted earnings of $1.62 per share on $1.4 billion of revenues in the quarter. Including one-time charges, it was expected to earn $1.59 per share, down from $2.95 last year.

"Sales volumes in paper were stable quarter-over-quarter, pulp markets are now moving off the bottom, personal care continues to gain momentum and free cash flow was strong," Williams told analysts.

"We're running our business prudently and executing well but we're also laying the platform and the groundwork for initiatives that are going to meaningfully improve our company going forward."

Among the moves is dealing with the declining demand for communications paper by converting its mill next year in Marlboro, South Carolina, to produce specialty and packaging material. The output is destined for Wisconsin-based Appleton Papers, to produce thermal, carbonless, and other specialty paper products.

Company volumes of specialty and packaging material grew by 10 per cent in the quarter and is expected to expand in line with economic output of two to three per cent annually.

He said the quarter was marked by weak paper demand and cyclically low pulp prices. Still, pulp shipments increased from the prior quarter and paper pricing remained firm as inventories decreased by 10 per cent.

For the fourth quarter, the company said it expects paper shipment to decrease compared with the most recent period due to the normal seasonal slowdown.

"In pulp we do believe that prices have bottomed and we will see benefits from our announced pulp price increases," he said.

"In the medium to long-term we continue to believe that the growth in China and similar growing economies will support demand for softwood pulp and further tighten markets as consumers increase their use of tissue-based products."

Paul Quinn of RBC Capital Markets said Domtar's results were a "bit better than expected" as the pulp and paper segment's adjusted EBITDA increased to $193 million during the quarter, up from $184 in the second quarter, but still down from $285 million a year earlier.

"Domtar's paper segment was impacted by higher paper and pulp shipments, lower maintenance and raw material costs. Offsetting these positives were higher lack of order down time in papers and lower prices in both papers and pulp," he wrote in a research note.

Domtar's net debt at the end of the third quarter was $625 million and free cash flow was $85 million. It repurchased about 44 million shares at an average price of $75.42.

Quinn said North American uncoated freesheet markets have weakened lately, resulting in pricing declines over the last two months, ahead of a typical slowdown of activity in the fourth quarter.

Domtar is the largest integrated manufacturer of uncoated freesheet paper in North America and the second largest in the world based on production capacity. It operates 10 pulp and paper mills in North America, including two in Canada, with annual production capacity of 3.9 million tonnes.

It also manufactures papergrade, fluff and specialty pulp and employs 8,700 people.

On the Toronto Stock Exchange, Domtar's shares rose $2.54 or 3.3 per cent at C$79.25 in afternoon trading.