Description

Clearwater Paper (NYSE: CLW) is an integrated manufacturer of tissue and packaging materials operating two segments: Consumer Products (tissue) and Pulp and Paperboard (packaging).  CLW’s stock declined by 75% since early 2017 driven by a litany of market-related and self-inflicted issues within its tissue business where segment operating income went from +$71M in 2016 to -$4M on an LTM basis.

  Source: SEC Filings. Data as of Q2 2019

With a clear earnings inflection in site, we believe shares should be worth $28+/share, driven by significant free cash flow generation and debt paydown in the next few years.

Rising Pulp Costs

 

 

Source: Cascades September 2019 Investor Presentation

 

Recently, pulp prices reversed with a YTD decline of ~20%.  As the principal input cost in the tissue making process, lower pulp prices will provide a cost benefit going forward. 

 

Falling Selling Prices

While pulp prices rose throughout 2017/2018, CLW’s price for its retail tissues declined 2%, falling from $2,757/short ton in 2016 to $2,703/short ton in 2018.  CLW could not pass through higher raw material costs due to competitive dynamics, including pricing promotions from branded competitors and incremental capacity from private label peers. 

However, pricing power has since been restored as the industry experienced consolidation and capacity reductions, including the bankruptcy of CLW’s closest peer Orchids Paper (reference our 2017 short thesis on VIC).  Moreover, the branded competitors (Kimberly Clark, Procter & Gamble) announced price increases at the end of 2018, which were followed by private label players.

Y/Y % Increase in Tissue 

YTD CLW’s retail tissue prices are up 2%+.  With CLW’s price increases combined with falling pulp prices, there is a clear path for tissue operating margins to materially expand to a more normalized MSD to HSD range.

Kroger Volume Loss

In Q3 2017, CLW revealed that its largest customer, Kroger, moved from a sole-source model to a multi-source model for its tissue beginning Q1 2018.  This resulted in a 40-50% decline in sales with KR.  Sales to KR were $265M in 2016, accounting for 28% of segment sales.  By end of 2018, the Kroger business was running at a $150M run rate.

At this point, CLW fully cycled out of this volume reduction, so it will no longer be a headwind.  Based on our industry conversations, there are indications that a portion of this KR business will come back to CLW but VIC members should corroborate that independently.

Maintenance Schedule

CLW has regularly scheduled maintenance outages at its Arkansas (every 24 months) and Lewiston (18 months) mills, with costs ranging from $15-30M annually.  The timing and magnitude of these outages impacts the predictability of earnings and often weighs negatively on quarterly results.   In 2019 alone, EBITDA will be reduced by $23-27M in comparison to 2018 when there were no major outages.

Source: Clearwater Investor Presentation

As we look to 2020, there are no major maintenance outages scheduled for the Arkansas mill.  This will alone will provide a $7-8M y/y benefit to 2020 EBITDA

Project Delays and Cost Overruns

In early 2017, CLW announced a $330-340M expansion project at its Shelby, North Carolina facility.  The objective of the project was to add 70,000 tons of premium-tissue capacity in the East Coast while lowering transportation costs.  Since then, cost estimates for the project ballooned to $420M (an $80-90M increase) and the timeline shifted out by a year.  

The project is still expected to contribute $55-65M in incremental EBITDA upon completion but is currently operating at a loss.   Paper production on the Shelby machines started in Q2 2019, with startup costs alone dragging EBITDA down by $3.6M during the quarter.  Given the 12-18 month ramp up phase, we believe CLW can reasonable add $20M (a third of its $55-65M target) in Shelby EBITDA in 2020.  Incrementally, as the Shelby facility moves from losing money in 2019 to making money in 2020, the year-over-year EBITDA contribution can reasonably exceed $25M.  Wall street consensus for 2020 EBITDA implies $27M of growth.  With $7-8M coming from lower maintenance alone, combined with the Shelby machines going from a loss to a profit, the market is substantially understating CLW’s 2020 earnings potential.

Debt, Capex and Free Cash Flows

Clearwater spent nearly $1.5B in capex in the past decade, with a quarter of this dedicated to the Shelby expansion described above.  As a frame of reference, CLW’s market cap is $270M.  In other words, the market values CLW equity at a 35% discount to its Shelby expansion project.

A combination of weak financial results and elevated capex strained CLW’s balance sheet, with debt levels rising from $705M in 2016 to $907M currently.  Meanwhile, CLW’s leverage ratio (net debt to EBITDA) went from 3.0x to 5.0x, requiring a credit amendment to relax covenants. 

CLW’s major capital expenditures are now complete.  Per guidance, capex is expected to be at a $60M annualized run rate in 2H 2019, 2020, and 2021.  This compares with an average of $200M in annual capex for the past four years.   This drastic reduction in capex creates significant room for free cash flow generation and debt paydown.  By our estimate, we believe CLW can generate its entire market cap in free cash flow in the next three to four years.  Additionally, we believe CLW can reduce its leverage by 1.0x annually, returning to a 2.50-3.0x leverage profile by 2022.  CLW recently refinanced its debt, eliminating a leverage covenant.  It also has no debt maturities until 2023, providing ample time for CLW to clean up its balance sheet.

Valuation

Market expectations are underappreciating CLW’s earnings potential.  Our base case 2020 EBITDA exceeds consensus by more than $20M.  Even if CLW maintains its 6.5x multiple, shares are worth $28/share, presenting 70%+ upside.  Orchids Paper was purchased for 5.0x out of bankruptcy, so we feel the 6.5x multiple applied is conservative.

Risks

We believe the risks associated with an investment in CLW are low because the major risks have already materialized:

·         Customer concentration: already lost 40-50% of business with largest customer (Kroger)

·         Elevated capex and project delays: Shelby project complete and is ramping. Annual capex ~$60M going forward.

·         Covenant breach and leverage: No debt maturities until 2023. Refinanced debt, eliminating a leverage covenant. Given reduced capex, there is a clear path to deleverage. 

·         Project Execution: no major capacity additions currently planned, mitigating risk of operational mishaps

·         Industry Capacity: no major U.S. capacity additions.  Demand growth exceeding supply growth

·         Management turnover: New CFO as of April 2019

Other risk mitigating factors

·         Insider buying: CEO purchased shares in May 2019

·        Share repurchases: repurchased $360M of stock from 2013 to 2016, which is ~$100M more than the current market cap.  With large capex now complete, resumption of share repurchases likely

·         Low expectations: 2 buys / 2 holds / 1 sell.  1M shares sold short.  2020 EPS expectations down 66% YTD.

Catalyst

• Incremental EBITDA from ramping Shelby facility
• FCF generation leading to deleveraging
• Upward earnings estimate revisions