Elie Rosenberg is a value investor based out of Dallas, Texas. He is the founder and editor of Value Slant
Clearwater Paper (CLW) is a very intriguing paper and packaging stock that offers a way to capitalize on the still growing private label trend, as well as some company specific catalysts. Offsetting that attractiveness is exposure to commodity risk due to their fluctuating manufacturing input costs.
Seth Klarman: Investors Can No Longer Rely On Mean Reversion
"For most of the last century," Seth Klarman noted in his second-quarter letter to Baupost's investors, "a reasonable approach to assessing a company's future prospects was to expect mean reversion." He went on to explain that fluctuations in business performance were largely cyclical, and investors could profit from this buying low and selling high. Also Read More
CLW operates in two business segments:
- Consumer Products Division- manufactures tissue products such as toilet paper, paper towels, and facial tissues for private label (store) brands. Their largest customers include Kroger and Safeway. Following the acquisition of competitor Cellu Tissue at the end of 2010 they are the largest retail private label tissue manufacturer in the US.
- Pulp and Paperboard Division- manufactures solid bleached sulfate (SBS) paperboard, a type of premium paperboard used in high end packaging for a variety of graphic intensive applications. This division also processes paper pulp, which is used as the basic substrate for both segments of the company.
The growth side of their business is the tissue segment. The US tissue market has been a steady 2% grower for a number of years as it grows with the population and not GDP. And within that expanding market the private label share has been growing. For example, private label paper towel share has gone from 17.8% in 2002 to 31.8% since 2010. While the common perception may be that the surge in private label popularity stems from consumers trading down in a recession, this does not appear to be the case. The turn to private label has been strong since the early 2000s. It has more to do with the increased focus on quality and branding on the part of private label manufacturers and retailers than simply with a temporary trade down to a cheaper product. While consumers have benefited from brand level quality at lower prices, retailers have benefited from the much higher margins they enjoy on private label sales. There still appears to much room for private label penetration, with private label still only representing 28% of retail tissue sales in the US versus more than 60% in Europe.
Clearwater has a very strong competitive position within the private label niche. The large national retailers need a sophisticated partner who can provide brand-like quality and manage a large set of product offerings, and there is no other company focused on retail private label with the scale of CLW. Clearwater’s traditional base has been the west coast where they have 91% market share in the private label grocery tissue category. In December 2010 they bought competitor Cellu Tissue for $530 million, which doubled their tissue segment sales. The acquisition was somewhat expensive at 8.7X trailing EBITDA of $62 million, but it did make strategic sense and there are expected to be significant cost savings through synergies. The primary motivation for the deal was to establish a stronger foothold in the eastern US. Additionally, Cellu Tissue has a stronger presence in mass merchandisers and dollar stores, while CLW has focused on grocery stores. CLW hopes to introduce its higher end product lines into Cellu Tissue retail channels.
The second large growth initiative on the tissue side is the construction of a $270 million greenfield plant in Shelby, North Carolina, which is scheduled to be fully operational by the end of next year. This plant will house a state-of-the-art TAD (through-air-dried) paper machine that is used to manufacture ultra premium tissue grades (you know, the really fluffy ones) as well as seven converting lines. There is intense demand for the ultra premium grades from retailers as private labels continue to penetrate the higher end of the market. There is 350,000 tons of TAD capacity that is scheduled to come online in the next two years. But with the tissue market growing by 150,000 tons or more a year there does not appear to be a risk of overcapacity at this point.
The primary difficulty with the business is that CLW does not have any pricing power, as they can only price at a discount to the national brands. The brands have been reluctant to raise prices since 2008 despite rising input costs. The brands finally announced a price increase this summer, and CLW plans to implement a 2.5% price increase on its retail tissue (about 60% of its tissue business, the rest being “away from home” tissue for public venues and machine glazed paper).
On the paperboard side the company’s strategy is to maximize their existing assets and lower costs. The US SBS paperboard market has witnessed consolidation over the past decade with the top 5 manufacturers now controlling 85% of capacity. Demand is more linked to the macro economy than on the tissue side, but still fairly steady (industry volumes did fall about 10% in 09 but rebounded in 10). Prices has moved up strongly since 2006 and rose through 08/09 as the industry players have been very rational in their capacity decisions.
Prior to the Cellu Tissue acquisition, CLW needed to procure 85,000 tons of paper pulp externally per year. As Cellu Tissue was not vertically integrated that number has risen to 400,000 tons or 32% of CLW pulp requirements. Market pulp pricing is extremely volatile and sensitive to the global economy. Pulp pricing cratered in 2008 to mid 2009 then shot up through mid 2010. Pricing moderated slightly and then began another rally at the beginning of 2011, hitting record highs in June. Over the last few months pricing has initiated a sharp downward trend once again, with the benchmark NBSK grade down $100/ton off the summer highs. This volatility is difficult for CLW to manage as they cannot dictate pricing in either of their segments to respond to changes in pulp input costs, although they can hedge somewhat by selling more pulp externally if prices rise. However, falling pulp prices are a boon for CLW as neither tissue nor SBS pricing tend to fall with pulp.
Year to Date
The tissue segment has been a disappointment through three quarters of 2011 (the first three quarters since the Cellu Tissue acquisition). While pricing and volumes have come in as expected, margins have declined dramatically. Even backing out one-time Cellu Tissue integration and Shelby start up expense, the tissue segment has done only $75.3 million in EBITDA on $823.8 million in revenue versus $79.1 million in EBITDA on $427.2 million in revenue in 2010. Remarkably, there has been no incremental EBITDA from the Cellu Tissue acquisition. Part of the issue is that Cellu Tissue has lower margin business to begin with, both because they sell lower end products (the average selling price in the segment has gone from $2,621/ton to $2,066/ton) and because they have to buy market pulp. But the main culprit has been a rise in a variety of input costs including transportation, packaging, and chemicals, although notably pulp has been flat on an average basis YoY. The paperboard segment has been the unsung hero so far this year, putting up $96 million in EBITDA through 9 months due to an 8% increase in paperboard pricing vs. $57 million through 9 months in 2010.
There are two major issues to look at in analyzing the potential earnings power of CLW. One is the variety of company specific catalysts that could arrive over the next two years. The other is the potential impact of fluctuations in input costs. I think they will do about $200 million in EBITDA this year (they have done $150 million through 3 quarters ex one-time expenses). As a quick way to think about earnings power we can model any anticipated changes off of that number.
Company specific catalysts:
- CLW recently sold their money losing Idaho lumber mill for $30 million. Management estimates this will add $5-8 million in EBITDA.
- The aforementioned 2.5% retail tissue price increase will be implemented in the current quarter and Q1 of next year. A 2.5% hike on 60% of their tissue business should add $15 million to EBIT.
- Management has guided to $35-40 million in cost savings synergies from the Cellu Tissue acquisition. They have said $15 million on a run rate basis will be in place by the end of 2012 with the rest coming in 2013. In their recent investor presentation they give a detailed breakdown of where these synergies will come from, with some seeming more obvious than others. I think $25 million seem fairly doable so I will give them credit for that with $10 million of the $25 million coming in 2012.
- Shelby plant- The Shelby plant has two converting lines that will be fully ramped by the end of this year. Management has said they will contribute $10 million in EBITDA. The rest of the plant will be up by the end of next year. Management has said that the Shelby plant will provide an IRR almost twice their cost of capital on a 15 year DCF. Assuming a $270 million project cost, WACC of 9%, and a target IRR of 17% yields $59 million in EBITDA. I’ll assume $50 million to be conservative and attribute $10 million to 2012 and the rest to 2013.
These catalysts add $40 million in EBITDA in 2012 to get CLW to $240 million in EBITDA in 2012. They add another $55 million in 2013 to get to $295 million in EBITDA in 2013.
The X factor for CLW is input costs. The largest input is wood fiber, which makes up 25-28% of COGS. For its internal pulp manufacturing, CLW buys wood chips and sawdust where pricing tends to be fairly steady. But they are exposed to 400,000 of external pulp that they have to buy annually. A $50/ton swing in market pulp pricing will generate a $20 million swing in EBITDA. Current pricing is about $50/ton off of the past year’s average so they would be looking at a $20 million positive swing. And while for now it looks like further price declines are in store, the market is very volatile.
The other major inputs are chemicals (11% of COGS), transportation (9%), and energy (8%). Rising chemical and transportation costs that are largely linked to oil have hit them lately.
Changes in CLW’s commodity input costs will not dramatically impact the pricing of their end products. This could be positive or negative depending on which why the input costs go. This lack of linkage between input and output pricing in a sense makes CLW a defensive name. In another recession presumably pulp and oil prices will fall while tissue and paperboad pricing will hold, which would provide a sizable boost for CLW margins (although a probable decline in paperboard volumes would partially offset these gains). On the other hand, if we get a global Bernanke put and commodity prices climb once again then margins will shrink.
For scenario modeling sake let’s assume input costs could swing EBITDA $50 million in either direction. (I think it is reasonable that pulp alone could have a $40 million impact given the volatility in that market.) Here are the EBITDA scenarios:
- The current $43 million in cash interest
- 35% tax rate and $85 million in D&A in 2012 and $95 million in 2013
- Management guidance of $50 million in maintenance capex. CLW will need to spend about $130 million in capex next year to complete the Shelby plant. That spend is not included in this calculation.
- $5 million in pension plan contribution beyond what is accounted for on the income statement. This is a bit of a wildcard depending on how their pension plan does. But this shouldn’t be a huge number.
Here is the current market valuation for CLW:
CLW looks attractive in the low 30s given the stability in their end markets and the earnings growth catalysts, although it is a bit hard to get comfortable with the input cost volatility. However, one can make a strong argument that a downturn in pulp and other input costs from current levels is more likely than an uptick. I would be comfortable buying CLW in the low 30s range given the upside to $50-65 in two years and a worst case scenario of the mid 20s.