Description

Clearwater Paper Corp. (CLW) is a good business (EBITDA / assets > 11% for the last five years) at a reasonable price (less than 5.6x trailing twelve month EBITDA, 10.4x 2008 free cash flow, 1.6x tangible book value).  On these metrics, CLW is trading at 30% to 50% discount to its competitors. There are, however, two issues which make CLW an extraordinary value:

1. CLW is earning $455,000 per day tax-free courtesy of the alternative fuels clause contained in 2005 federal highway legislation and modified in a 2007 energy bill. CLW has participated in this program since late January 2009 and, year-to-date, has earned $74 million from it. These earnings are not included in the above EBITDA and free cash flow valuation calculations, but are included in the enterprise value calculation.  The tax credit earnings have cut CLW’s debt in half year-to-date and, if they continue through year-end, the company’s debt will be eliminated.

1. Unlike other paper companies, CLW’s business is thriving and its 2009 earnings, excluding the effects of the aforementioned tax credit, are likely to be significantly higher than its 2008 earnings.

Background

Founded in 1927, CLW makes tissue paper  ($37 million ’08 operating earnings) and solid bleach sulfate (SBS) paperboard ($19 million ’08 operating earnings). CLW also has a small lumber business which lost $14 million during 2008. CLW was spun off from Potlatch Forest Products Corp. on 12/16/08. Potlatch shareholders received one CLW share for every three and a half shares of Potlatch held.  Please see the exhibits beginning on page six of this document for market data on CLW’s two lines of business: tissue and SBS.

Valuation

CLW is trading at 10.6x 2008 free cash flow, 1.6x tangible book value and 7x 2008EBITDA while its peers are trading at 13x free cash flow, 2.7x tangible book value and 9x EBITDA (CLW is lagging on a PE basis). Adjusted for estimated cash received via their participation in the alternative fuels tax credit program (late January 2009 to present) and a debt refinancing completed June 9, CLW’s current market capitalization and enterprise value are $421 million and $525 million respectfully.  The following table outlines their current capital structure and valuation:

CLW Valuation & Capital Structure

CLW’s valuation also appears quite modest in relation to their installed property, plant and equipment (PP&E).  For instance, the ratio of CLW’s gross PP&E to enterprise value currently is 3 while the average ratio for its competitors is 1. On this basis, CLW’s equity would more than triple to reach parity to its competitors.  Interestingly, CLW has one of the least amounts of financial leverage in the industry and, depending on how long the alternative fuels tax credit lasts, may be debt free by year end.

While CLW’s valuation is compelling based on 2008 results, it appears to be extraordinary based upon recent developments.  For instance, during 1Q09, CLW generated $15 million of earnings, $23 million of free cash flow and $37 million of EBITDA.  Annualizing these numbers (for the most part, CLW’s business is not cyclical) suggests that CLW is trading at 6.9x earnings, 4.5x free cash flow and 3.6x EBITDA.  We have not included earnings from alternative fuel tax credits in this calculation, but we have reduced its enterprise value by $74 million based upon their earnings from the tax credit through 7/3/09 (thus reducing the EBITDA multiple).  So what has changed since 2008?  CLW was able to increase its pries during Q109 to compensate for higher raw material and energy costs which occurred in 2008. How can CLW raise prices in such a miserable business environment?  The answer lies in CLW’s two business lines:

1. Toilet paper – CLW makes 56% of the private label tissue (toilet paper, paper towels, napkins) sold in grocery stores in the U.S. It turns out that toilet paper demand is quite stable despite turbulent economic conditions.  In fact, there is some evidence that private label tissue, CLW’s market niche, actually is benefiting from the economic turndown.

2. Juice boxes – CLW supplies 12% of the solid bleached sulfate paperboard (SBS) consumed in the U.S.  SBS is a high grade packaging material and CLW caters to users who demand the highest grades of SBS (juice and milk producers, pharmaceutical companies and high-end printing applications such as the covers of annual reports). CLW’s SBS is of such high grade that it is even exported to Japan, a notoriously discriminating market.  To date, CLW’s SBS business performed well during the current economic turmoil and, to the extent the dollar falls in value, one would expect export demand for their SBS to grow.

CLW also has a small lumber business which lost $14 million pre-tax during 2008.

Good Business

Business quality may be defined as a business’s ability to earn a return on capital over time, i.e., higher returns on capital over longer periods of time are characteristics of higher quality businesses.  The following table shows the returns earned by CLW since 2004:

CLW Return on Assets

CLW’s returns averaged more than 11% since 2004 and, more importantly, are likely to remain above this average in coming years.  We can make this assertion because, as mentioned above, 2008 was a particularly difficult year due costs increasing faster than CLW was able to increase their prices, a situation which has been remedied.  The below average returns produced during 2004-05 may be explained by CLW’s installation in 2004 of new equipment to make high-grade paper towels in its Las Vegas facility.  CLW’s paper towel business subsequently grew and the wisdom of this investment was corroborated by their higher returns earned in 2006 and 2007.  While 11% return on assets is not outstanding, it is respectable and we therefore conclude that CLW is a good business.

Tax Credit

An alternative fuel tax credit provision originally appeared on page 802 of the Safe Accountable Flexible Efficient Transportation Equity Act – a Legacy for Users, known by its acronym, the SAFETEA-LU act or simply the 2005 highway act. (The bizarre acronym resulted from the bill’s sponsor, Representative Don Young, wish to pay tribute to his wife, Lu – I suppose it is the thought that counts). The tax credit was originally intended to encourage operators of vehicle fleets to use alternative fuels, however, Congress extended the credit to manufacturers and other non-transportation applications in the 2007 energy bill. The legislation provides tax credits of 50 cents per gallon of alternative fuel burned by companies; alternative fuels specified in the modified legislation included biomass-based fuel.  

The paper-making process starts with wood (logs, woodchips and sawdust).  Paper products are made from the cellulose fibers (pulp) contained in the wood, but the wood contains many other chemicals including lignin, which has high energy content.  The Kraft process is used to separate the cellulose from the lignin and other chemicals.  The mixture of lignin and other non-cellulose byproducts of the Kraft process are called black liquor. Black liquor contains more than half of the energy content of the wood feedstock.  As a result, pulp mills have been using black liquor as a fuel to heat their steam boilers since the 1930s.

During 2008, paper industry executives began to realize that black liquor fit the definition of a biomass-fuel (as defined in the 2007 energy bill) and began applying for the alternative fuel tax credits. CLW management got on board in late January 2009. Every two weeks CLW reports to the Internal Revenue Service (IRS) how much “alternative fuel” they burned.  The IRS reviews the calculation and cuts a check to CLW for 50 cents per gallon of alternative fuel burned. CLW burns about 350 million gallons of black liquor annually and has collected about $74 million year-to-date ($455,000 per day).  Though subject to dispute, generally speaking, tax credits are not subject to federal income taxes. 

The alternative fuel tax credit program expires on 12/31/09, but it may end sooner for pulp mills. There is a movement in Congress to disqualify paper companies from participating in this program since pulp mills have been using black liquor as fuel for decades. The most likely scenario is that the program will be curtailed on 9/30/09 when the government’s fiscal year ends. The following table shows the economics of the tax credit for CLW.

Economics of the Alternative Fuel Tax Credit for CLW

In conclusion, the data indicate that CLW is a good business trading at a modest valuation with a solid balance sheet. It also appears that CLW’s business is likely to generate solid returns, regardless of the macro economic environment.  Finally, the alternative energy tax credit program has vastly reduced CLW’s net debt position, thus significantly reducing its enterprise value. For these reasons, we plan to purchase CLW shares in the near future.

Tissues Suppliers to U.S. Grocery Stores

U.S. At Home Tissue Market,

Consumption by Product

U.S. Retail Tissue Channels

Solid Bleach Sulfate (SBS) Producers, Market Share

Uses for SBS

Catalyst

• Continuation of the alternative fuel tax credit through 9/30/09 (possibly longer).
• Continuation of earnings similar to 1Q09 (implies CLW is trading at 5.2x earnings).
• Initiation of a dividend.