Description

Clearwater Paper Corp (NYSE: CLW)

In our shop we have recently been looking for names that to well regardless of the developments in the economy. Clearwater paper (CLW) seemed to fit that bill .  Clearwater is organized into two segments, Consumer Products, which produces and sells private label tissue paper, and Pulp and Paperboard, which both produces paperboard used in high-end packaging, and the pulp input to produce both tissue and paperboard. CLW currently trades at $23.67 and we wrote the analaysis below before last week the stock was at $27.27, for a market cap of $449 MM and an enterprise value of $1,155 MM versus TTM EBITDA of $175 MM. All of the numbers below in this write up are based on that higher price.  CLW is pretty narrowly followed with 3 amalysts and has about 1/3 of its shares owned by indexes. With this thin stock which only trades an average of 163,000 shares a day, a 1% draw down in the market leads to about 59,000 shares or about 1/3 of the average daily shares traded to hit. We see that the intense current market volitility has likely had a disporporatinate inpact on CLW because of its lack of active manager interest and large exposure to indexes.

We believe there are several idiosyncratic catalysts not priced into the stock. We also find the position attractive for its countercyclical nature, as the business should perform particularly well in the case of a recession. Clearwater has struggled since the stock hit an all-time high of $75 in January of 2015. Since then CLW has fallen into the $20’s due to a number of issues:

1. Tissue price declines resulting in a $40 MM headwind;

2. Paperboard price declines due to Chinese competition and a weak dollar costing $80 MM in lost profits;

3. Higher expenses from transportation, as well as wood fiber and pulp inputs, resulting in a headwind of $48 MM;

4. Loss of sole source status with Kroger, CLW’s largest tissue customer, resulting in a $25-30 MM headwind.
   

These issues have more than offset the company’s efficiency initiatives announced in 2014 that were originally projected to increase EBITDA by $115-145 MM.

Many of these headwinds have recently started to abate and Clearwater is likely to see accelerating benefits from several capital projects as they ramp up over the next 4-6 quarters.  We believe there is more than 100% upside even if only half of the catalyst we expect occur. We also believe Clearwater shares possess a margin of safety, as a fire-sale liquidation would yield values significantly higher than the current share price.

In the table above (which we preparesd when CLW was at 27.27 now is at 23.67), we outline the bull, bear and base case we see for Clearwater over the next twelve months.  Each of the puts and takes to our analysis are numbered and we provide greater detail in order below following a description provided for each of Clearwater’s segments.

Consumer Products: The Tissue Business  

Clearwater’s consumer products business produces private label tissue for at home use. Clearwater is one of the largest private label tissue producers in the US. Historically, this business was perceived as being the growth driver for Clearwater. The private label tissue business is characterized by its stable demand and counter cyclical characteristics.

CLW Tissue Assets:

Pulp Input Costs Leading to Industry Capacity Reductions

Pulp is the largest input cost to tissue manufacturing, and because of the persistent increases in pulp prices, US tissue manufacturers have suffered significant margin pressure over the last few years. Many tissue manufacturers are now at a point where they are not meeting cash costs, especially those focused on the lower end of the market that is in oversupply.  As a result, it is likely that those market participants with higher costs of production will have to exit the market until prices can rise sufficiently to offset higher costs. Orchids Paper (NYSE: TIS) is on the verge of bankruptcy while both Kimberly Clark and Georgia Pacific have formally announced the closure of plants. Though we have not quantified this in our price target, plant closures should provide longer term support for Clearwater’s tissue business.

Loss of Kroger included in 2018 EBITDA Base

Clearwater’s strongest channel has been grocery which represented 82% of Clearwater’s tissue sales in 2011.  Clearwater’s previous initiative to become a national supplier stretched its logistics, leading to excess shipping costs. Prior to 2011, Clearwater was principally focused on the West Coast where it provided nearly 80% of all private label tissue in the region, because of the advantaged locations of its Lewiston Idaho and Las Vegas plants.  

In Q3 2017, Clearwater announced that its largest tissue customer, Kroger, would move from a single source model to a multi-source model for private label tissue.  We believe the resulting loss of business was approximately 15% of Clearwater’s consumer products sales. Clearwater indicated that they would likely replace 60% of the lost sales by year end. Though this caused a significant headwind for Clearwater and will result in a $25-$30MM decrease in our base level EBITDA for 2018 relative to 2017, we believe it will allow Clearwater to shift to a more regional geographic focus which will mitigate what we believe are significantly elevated shipping costs.

Tissue Segment Catalysts

1. Shelby Expansion

In February of 2017, Clearwater announced its intention to spend $340 MM to expand its Shelby NC plant by investing in a new paper machine, converting lines and warehouse. Clearwater anticipates the new 70,000-ton New Tissue Technology (NTT) machine should begin production in Q1 2019 and ramp over 18 to 24 months.  Once the machine is fully productive, we believe Clearwater will close its least efficient plant in Neenah WI. Clearwater projects that once the NTT machine is fully ramped, the Shelby expansion will generate $60 to $65 MM of incremental EBITDA. For our base case, we anticipate that the Shelby expansion will generate $20 MM in additional EBITDA over the next twelve months.

In connection with the Shelby expansion, Clearwater added two converting lines in its Shelby plant in the 3rd quarter of this year, which should materially reduce their shipping costs. For 2018, transportation expenses have been a significant drag on operating margins for Clearwater.  When the new converting lines are up and running, we believe that they will be able to discontinue producing converted tissue product (think plastic wrapped tissue from the store) in their Lewiston plant for shipment to the East Coast.  Instead Clearwater will ship parent rolls (large rolls of paper to be converted into final product) to the Shelby plant for conversion and delivery to customers in the South East. This change would represent a significant reduction of transportation expense because it costs $180 per ton to ship parent roll tissue from Lewiston to Shelby vs. $800 per ton to ship converted cases. The company has indicated that 15,000-40,000 tons of converted capacity is shipped from Lewiston to the East Coast. We believe avoiding the cost of shipping converted product will yield an annual savings of $10 to $25 MM. We think those savings are included in Clearwater’s projected incremental products to be produced by the Shelby expansion.

2. Continuous Digester and Pulp Costs

In September of 2015, Clearwater announced they would construct a continuous pulp digester at the company’s Lewiston, ID plant for a total cost of $160MM.  Clearwater’s management projected the project would yield $30-35 MM in incremental EBITDA. In addition to savings from lower energy costs, the new digester will produce an incremental 50,000 tons of pulp. Pulp is the largest input cost for tissue producers and typically represents 70% of the cash costs of tissue production.

At the time the project was announced, softwood pulp prices were $840 per ton which suggested the project would yield $42MM in incremental EBITDA. Today the price of pulp is $1,230 per ton which now implies a benefit from the digester’s incremental pulp yield of $61.5MM. Construction was completed in Q4 2017. The digester is expected to fully ramp by the end of 2018.

At full run rate, Clearwater will be 64% integrated for pulp costs, up from 46%, putting the company at a significant cost advantage to other tissue producers. In an environment of high and rising pulp costs, CLW should be positioned to ultimately take share and capture higher margin as competitors raise prices to recoup lost margin. In our base case we project that Clearwater will receive an incremental $34 MM benefit from the digester in 2019.

3. Tissue Price Increases

After holding prices flat for five years to fend off private label competition, Kimberly Clark, P&G and Georgia Pacific raised prices for tissue in the summer of 2018.  Private label players like CLW are now following suit. The price increases are necessary because of increased pulp costs.

We’ve confirmed that price increases are flowing through to private label manufacturers at an accelerated rate in the scanner data. We believe every 1% increase in tissue prices will result in $7.5MM of incremental EBITDA for Clearwater. Under our base case we assume 3% in price increases and $15MM of incremental EBITDA for 2019.

Pulp and Paperboard Segment: SBS Paperboard

Clearwater’s Pulp and Paperboard segment produces both pulp and paperboard out of Clearwater’s Lewiston, Id plant and its Cypress Bend, Ar. Plant. The production of SBS paperboard in the United States is relatively concentrated with the top five producers controlling 94% of the market.

CLW Pulp and Paperboard Assets

The pulp and paperboard segment is the most profitable of Clearwater’s two segments. This segment produces 100% of the fiber necessary for Clearwater’s SBS paperboard and approximately 50% of its needs for the tissue segment.  Clearwater’s SBS Paperboard is used to make folding cartons, liquid packaging, paper plates and cups as well as for high end commercial printing.

4. Pulp and Paperboard Catalyst: SBS Boxboard Price Increases

Clearwater’s paperboard business suffered from price declines after peaking in late 2014 as the strong dollar made US SBS paperboard less competitive relative to Chinese and European competitors.  More recently, these trends have reversed due to restrictions on the export of US waste paper to China, which has made their exported paperboard produced from recycled waste paper less competitive. Also, the shift away from Styrofoam and plastic in food service has led to increased demand for SBS paperboard. This trend away from plastic and Stryropfoam has been particulary signifcant in Europe and continues to gain steal in the US. NYC has a ban that will go in place for all Styrophome used in food service in January of 2019. In Feburary Mcdonalds said they would phase out all use of styrophome by the end of 2018 and Dunkin Donuts committed to do the same by 2020. SBS paperboard it the most obvious substitute for that volume as a replacement.

Typically, producers announce price increases and the pulp and paperboard news service RISI will conduct a survey and publish the success of producer proposed price increases. This year RISI has already acknowledged $50 worth of price increases and they project SBS prices increases in 2019 and 2020 of $70 per ton (7.1%) and $62 per ton (5.4%) respectively. Clearwater produces 800,000 tons of SBS so every $10 increase in price represents $8.0mm of incremental profits. Clearwater has already started to see price increases in its paperboard business and we anticipate there is more to come. For 2019, our base case assumes that Clearwater will receive $30 MM in incremental benefit from price increases already declared this year and further modest increases next year.

RISI Projected Prices for SBS:

5. Catalyst: SG&A Cost Reductions

In Q4 2017, Clearwater announced an SG&A cost reduction program to remove $20 MM in expenses by the end of 2018.  As of Q2 2018, Clearwater realized a total of $4 MM in SG&A savings. We assume in our base case that Clearwater will realize $10 MM of incremental benefit from the SG&A cost savings plan in 2019.

6. Inflation: $10 to $15MM Annual Headwind

We assume in our base case that Clearwater will suffer from $12.5 MM of cost inflation which

is the mid-point of management’s long-term guidance.

7. Major Maintenance for 2019

Clearwater must conduct major maintenance on its Lewiston mill every 18 months and on its Cypress Bend mill every 24 months.  In 2019 both mills will need to undergo major maintenance which will reduce EBITDA $22-$30 MM. For our base case we assume a reduction of $27.5MM.

8. Sale of Lady Smith Mill

    

   In August, Clearwater announced the sale of its Lady Smith mill for $72 MM. Lady Smith generated $9.2MM in EBITDA over the trailing 12 months.  Lady Smith had 56,000 tons of annual capacity and was focused on selling away from home value tissue.  Clearwater will use the proceeds to paydown debt and provide incremental financing for the Shelby expansion.
   

9. Catalyst: Free Cash Flow Generation and Capital Returns

Since 2016, Clearwater has had negative free cash flow due to higher cap ex investments. Following the completion of the Shelby expansion in Q1 2019, we anticipate that Clearwater will start to generate significant free cashflow. Leverage is likely to be elevated at $680-725 MM in net debt but Clearwater should be able to reduce this quickly as they are not a cash tax payer and maintenance cap-ex is only $50 MM. The incremental EBITDA from the catalysts described so far, would have Clearwater producing $63-$210 MM of free cash flow in 2019 for a roughly 15-50% free cash flow yield at its current price.

Historically, when Clearwater has generated free cashflow it has preferred to buy back stock. From 2011 to 2017 Clearwater repurchased 34% of the total shares outstanding. On the Q2 call, management indicated that they intend to go on a capital expenditure diet following the completion of the Shelby plant.   We don’t anticipate any significant buybacks until leverage is reduced below 3X EBITDA or when net debt is reduced to $450 -$600 MM.

Sum of the Parts

We  believe the value and quality of Clearwater’s assets create a margin of safety. In 2017, International Paper sold its SBS paperboard business to Graphic Packaging for 8.6X EBITDA.  At a similar multiple Clearwater’s paperboard business would be worth $1,262MM or roughly 110% of the company’s current enterprise value. This is not unreasonable as Clearwater’s margins in the business are better than IP’s. If we include cap ex spent for the Shelby expansion and the two existing Ultra capable TAD tissue machines in Las Vegas and Shelby, while assuming a 20% discount for the equipment, the total liquidation value increases to $1,707MM.  Even backing out the value of the remaining Shelby cap-ex implies a stock price of $59.11 or 123% upside. This is very close to our base case valuation and where the stock was trading in early 2017. This valuation also applies no value to the continuous digester Clearwater has spent $160 MM constructing, and no value for the company’s converting lines and tissue capacity at their Lewiston and Neenah facilities.

We believe that Clearwater would be an attractive acquisition target for many paperboard or tissue manufacturers because of CLW’s dominance on the West Coast where it faces little competition in either segment. In 2012, Steve Cohen’s Point 72 purchased 7.2% of  the outstanding shares of Clearwater for around $32.00 per share suggesting the company break itself up. Ultimately, the question became moot when the stock appreciated considerably and Point 72 exited its position. We think the current low valuation will likely attract activist attention if operations do not improve significantly.

Risks

Increases in tissue supply, particularly in the premium and ultra-categories

Over the past few years, several new or refurbished premium and ultra-quality tissue paper machines have been completed or announced by Clearwater’s competitors, including private label competitors, which will result in a substantial increase in the supply of premium and ultra-quality tissue in the North American market. This growth in supply becomes most acute in 2019 when nearly 300,000 tons of net capacity is scheduled to come on line for a market where demand grows at only 90,000 tons a year. We believe this risk is mitigated because the capacity is likely to come at the expense of branded players who continue to lose share to private label competitors.

The construction and operation of Clearwater’s new tissue making and converting facilities may not proceed at the expected schedule, and may not produce the expected cost savings

The new NTT tissue machine to be installed in North Carolina is highly complex and it can be manufactured by only one company in the world. Installing the machine and building the supporting facilities entails numerous risks and it is possible the machine will be unable to produce ultra grade tissue as expected.

Labor Risk

49% of Clearwater’s full-time employees were represented by unions under collective bargaining agreements. In 2017, the collective bargaining agreements for hourly employees at the Lewiston, Idaho facility, covering 1,010 employees, expired and is currently being negotiated. The agreement is past the resolution date because the parties are at an impasse. Any failure to reach an agreement may result in strikes or other labor actions.

K-Mart and Sears

Sears and K-Mart are customers of Clearwater. Their bankruptcy could lead to lost business and credit risk. We estimate that tehy were small customers and based on our conversations with former employees CLW long ago was taking measures to counter risks associated with a bankruptcy.

New Capacity of SBS Boxboard

Sappi has rebuilt a paper machine at its Summerset Mill in Maine which became operational in the 4th quarter. The Mill has a total capacity of 350,000 ton for SBS Box Board that will ramp up over the next three years.  Clearwater has stated that they have not seen these tons on the market but they would represent roughly 6.0% of total capacity in the US. This is a swing mill that can sell both coated free sheet and some packaging grade.  The free sheet market is very attractive right now because of some mill closures. Both RISI and several market participants we have talked to believe this incremental capacity is likely to be benign. Sappi has signaled that they anticipate the capacity in the new mill to ramp up over 3 years.

Catalyst

Price Increases for SBS that have already been announced and already feeding through the P&L

New price increases for SBS next year

Price increases for tissue that have been announced and should start to benifit Q3 

Additional price increases in tissue as private label follows the branded players

Ramp up of continious digester which has already provided $5 million of benifit YTD and will likley eventually get to a run rate of $50-65MM by the end of the year

Ramp up of new Shelby 70,000 ton NTT machine starting in Q1 2019

SG&A cost cuts of $20MM

Multiple expansion when CLW starts to free again  Q2 2019