Description

Clearwater Paper (“CLW” – $39.50)

A spinoff from Potlatch Corp in 2008, CLW is a leading producer of private label at-home tissue and bleached paperboard in theU.S.We believe CLW’s tissue business is being priced by the market well below its fair value. In addition, we believe we are getting its paperboard business for free. Investors have overlooked this high quality business because of its limited history as an independent company, its aggressive capital spending and a dilutive acquisition. However, we believe market perception is about to change as CLW is approaching an inflection point in its earnings, management quality and capital allocation. We believe the stock could be worth as much as $85 per share on a sum of the parts basis.

Business Summary

The Consumer Products segment is a growing operation in a secularly expanding industry. CLW is a leading supplier of high value private label tissue mainly to grocery stores (71% of mix) and to big-box retailers (16% of mix). Over the last 15 years, demand for tissue in theU.S.has grown at an average rate of 2% annually and private label suppliers have taken significant market share from branded producers in every meaningful category. CLW has a 64% share of private label tissue products sold in grocery stores across the U.S.The tissue business will contribute approximately 80% of CLW EBITDA less Maintenance CapEx in 2013.

The Pulp & Paperboard segment produces solid bleach sulfate paperboard (“SBS”), which is then converted by its customers into high quality food packaging, premium commercial printing, and ultra-smooth folding carton products. Unlike other SBS producers, CLW does not manufacture the packaging end product. This creates a competitive advantage in that CLW is not simultaneously a supplier and competitor to its customers. Essentially all of the pulp produced by CLW is consumed internally (~75% to produce SBS and ~25% to produce tissue products).

Tissue Expansion

Having captured 96% and 72% of the private label markets in the Western U.S. and Midwest, CLW aimed to grow its 36% share of the Eastern U.S.market. This mission propelled the company in 2010 to announce 1) the construction of a new $275m facility inShelby,North Carolina and 2) the $500m purchase of CelluTissue (“CLU”). However, investors frowned upon the idea of leveraging the balance sheet to pursue these endeavors.

Capital allocation by the management team appeared to be ill-advised. CLW’s tissue business was underappreciated and it seemed illogical to double down on it. To add insult to injury, the CLU deal transformed CLW’s 100% pulp-integrated tissue business into one that requires CLW to source one-third of the requisite raw material externally. Due to elevated pulp prices at the time, the deal actually dragged down tissue profits for the first several quarters after the transaction closed. As such, the market perceived management was not working to create shareholder value.

Recent Developments & Outlook

On May 1, 2012 SAC Capital entered the picture after filing a Form 13D. With a 7% stake in the company, SAC is seemingly having an impact on the culture at CLW. Not only has management been more transparent since the 13D filing, but the Board has also hired a new CEO (internal promotion) and a new CFO. We view SAC’s involvement as an inflection point in the focus of management from targeting expansion to being concentrated on shareholder value. For an example, see slide 30 of the company’s September 2012 investor presentation, entitled “…And Drive Value Creation for Shareholders.”

We also believe that due to the upcoming opening of the Shelby facility and the relatively low price of pulp, CLW is on the verge of a ramp in profits that is not fully appreciated by sell-side analysts. Results should also be boosted by the capture of synergies from the CLU deal, which continue to come in above original management guidance. We believe CLW can achieve almost $300m of EBITDA in 2013 (and more in 2014), yet analyst estimates remain at $255m. Our view is that the company should be able to beat expectations in the coming years and that ramping free cash flow generation could be funneled to shareholders through stock repurchases and/or dividends. Management also has the opportunity to enhance earnings and cash flow by refinancing $150m worth of debt currently paying almost 11% interest annually. With a very good business, a good balance sheet (1.6x Net Debt/2013 EBITDA), growing cash flow generation, and a motivated management team, we believe CLW represents excellent risk/reward at the current price.

Valuation

At today’s stock price, CLW is trading for less than 8x 2013 Consumer Products Segment EBITDA less Maintenance CapEx. Our view is that the Consumer Products business is worth 12x 2013 EBITDA less Maintenance CapEx. That multiple is in line with a set of publicly-traded companies in the private label sector. We value the Pulp & Paperboad segment at 7x 2013 EBITDA less Maintenance CapEx, similar to/below other companies in the packaging space. Given SAC’s involvement and recent management commentary, we expect executive decision-making going forward to be focused on realizing the true value of CLW’s stock.

Catalyst

• capital allocation: potential shift from growth/acquisition spend to shareholder friendly buyback and/or dividend program (1H 2013)
• earnings: reporting EBITDA ahead of sell-side expectations when sales from the new Shelby facility begin to flow through (Q2/Q3/Q4 2013)
• increased activism from shareholders if the first 2 catalysts do not materialize as expected or the market ignores the catalysts