Clearwater Paper: An Undervalued Spin-Off

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 |  Includes: CLW, IP, PCH, WPP, WRK
by: Deep Value Diver

Clearwater Paper (NYSE:CLW) is a small cap paper company that makes 56% of the private label tissue (toilet paper, paper towels, napkins, etc.) products sold in the U.S., premium paperboard for packaging, and a very small amount of wood products. The company was spun out of Potlatch (NASDAQ:PCH) in December.

I think Clearwater Paper's common equity is conservatively worth somewhere between $25 and $35 per share, based on earnings power and free cash flow. In addition, the company is likely to receive refundable tax credits this year equal to $14 per share pre-tax. They have already been approved for and received the first $16.7 million, or $1.45 per share, for a five week period from late January through February.

First, I think it is important to discuss Clearwater Paper’s operating leverage. This company does roughly $1.2 billion in annual revenue, had raw materials/labor/other op. ex., excluding depreciation, (hereinafter “input costs”) at 90.2% of sales in 2008, and has only 11.5 million shares outstanding. With that size revenue base, massive leverage to input costs, and relatively low share count, it doesn’t take much of a change in margins to materially impact the bottom line. In fact, looking at 2008, for every 1% drop in input costs as a percent of sales it would have dropped $1.12 per share to the bottom line. Granted, there are some pro forma adjustments that need to be made due to being an independent company for the first time, but I think this gives a sense of the operating leverage of the business. This was the original thesis on which I first bought the stock in January.

Input costs averaged 87-88% of sales in 2006-2007 and spiked to over 90% in 2008 due to raw material cost inflation, resulting in the company’s worst recent year for margins and earnings. Multiple price increases in the latter half of 2008 were not enough to stem the tide, but those pricing gains coupled with significantly falling input costs led to the company to completely crush expectations in Q1 of this year. The company earned $1.19 in EPS and $2.71 in free cash flow (CFO-capex) in the quarter. For perspective, it did $0.15 in EPS in Q4 2008, $0.20 a year ago in Q1 2008, and was projected to earn $0.35 by the sole sell-side analyst.

While the company is likely benefiting from a “sweet spot” for margins as higher pricing and lower costs generate lots of cash, I believe this can continue more or less through year-end. Pricing gains will likely moderate in the second half of this year, but falling costs should provide benefits through year-end as Q1 of this year was the first quarter to see benefits from them.

I’m not going to try to estimate earnings or free cash flow with precision because input costs are volatile and even the slightest change in margin assumptions can wildly impact per share results. Management has acknowledged that modeling the company is a challenge. I do think it is unreasonable to assume less than $2.50 in EPS this year, to which I can apply an unreasonably low 10x multiple to reach my conservative low end equity value of $25.00 per share. For what it is worth, the only sell-side analyst that covers CLW has EPS estimates of $2.98 and $3.08 for 2009 and 2010, respectively.

At $21.00, the enterprise value, including pension and OPEB liabilities, is roughly $492 million. If one annualizes the $37 million of EBITDA the company earned in Q1, that would result in a 3.3x EBITDA multiple. IP, MWV, and WPP trade at roughly 5.8x, 5.5x, and 8.0x EBITDA, respectively. While annualizing the Q1 figure is aggressive, you could haircut the annualized figure by a third and the EBITDA multiple would still rise to less than 5.0x. Applying 5.0x, 5.5x, 6.0x, 6.5x, 7.0x, 7.5x, and 8.0x multiples to the “haircut” EBITDA figure would result in equity values of $23, $28, $32, $37, $41, $46, and $50 per share, respectively.

While I have no idea what the right EBITDA multiple is, I do believe Clearwater Paper is relatively well positioned versus its paper and forest products peers, many of whom produce products facing severe pressure including lumber, building products, newsprint, uncoated free sheet, and expensive coated papers. Clearwater’s two main business lines are private label tissue, which is a booming business these days as consumers seek lower priced alternatives to branded products, and premium paperboard, which while seeing lower volumes and a lower backlog is still a profitable business. I would argue Clearwater Paper deserves an EBITDA multiple closer to the upper end of the 5x-8x range rather than the lower end. WPP has an 8.0x multiple, and CLW’s business mix and profitability is superior to WPP’s, in my opinion. Even at a conservative 6.0x, I estimate the equity would be worth $32 per share.

On an EV/revenues basis, Clearwater is trading at only 0.39x. IP, MWV, and WPP are trading at 0.77x, 0.65x, and 0.56x, respectively. While the higher multiples for the larger competitors probably make sense due to economies of scale and fixed cost leverage, WPP ($374 million market cap; roughly $1.2 billion revenues) is a similar size as CLW. WPP makes tissue products, printing/writing papers, and specialty products in 28%, 32%, and 40% of revenue proportions. While WPP’s tissue business is profitable, it is also its smallest business. Printing/writing and specialty products, which account for over 70% of revenues, are both currently unprofitable. On the other hand, CLW is very profitable in tissue, which is about 45% of revenue, and profitable in paperboard, which is about 51% of revenue. Wood products, while a struggling business line, is only about 4% of revenue. Applying WPP’s EV/revenue multiple to CLW would result in a CLW equity value of $40 per share.

Clearwater Paper’s free cash flow, simply defined as cash flow from operations minus capex, was $31 million in Q1. While annualizing that run rate is probably aggressive, it would result in $124 million of free cash flow on a $243 million market cap and roughly $500 million enterprise value. Free cash flow, adjusted lower for an incremental $10 million of SG&A expenses for being an independent company, would have been $62.4 million, $81.9 million, and $14.7 million in 2006, 2007, and 2008, respectively. Those figures amount to $5.42, $7.11, and $1.28 per share, based on today’s 11.514 million diluted shares.

The only sell-side analyst covering CLW is the analyst at Davidson, who in his model indicates $5.45 and $8.88 of free cash flow per share in 2009 and 2010. The 2010 calculation includes $36 million of cash coming out of inventories, the reason for which I’m unaware. Excluding that $36 million, would result in $5.73 of free cash flow per share in 2010. Importantly, this analyst is excluding any benefits from tax refunds or the likely debt refinancing from his numbers. Applying a 10x multiple to any of those free cash flow figures can result in equity values far north of the current $21 stock price. Depreciation and amortization is running north of capex, which I believe is due to major capital improvement projects that were completed in recent years.

In sum, while it is difficult to offer any precision on valuation, I believe it is unreasonable to value CLW at anything less than $25 per share. I don’t think it takes any crazy leaps of faith to reach equity values far north of that, primarily due to the company’s incredibly low share count.

Debt Refinancing

Clearwater has $100 million of debentures coming due 12/31/09. The interest rate is currently 12.5%, which is based on Potlatch’s credit rating. Under the terms of the spin-off agreement, Clearwater must use “commercially reasonable efforts” to refinance or pay it off. If they can’t on reasonable terms, then Potlatch will assume the debt and Clearwater will owe Potlatch 12.5% plus 100 bps for the first year.

However, Clearwater will have no problem refinancing this piece of debt at a much lower interest rate, sometime over the next few months, even if it doesn’t get a single dime more in tax credits, in my opinion. The company has $33 million of cash on hand, including the $16.7 million just received for its first tax credit, and had EBITDA of $37 million in Q1 alone, which would be enough to service 6% interest on the $100 million for more than 6 years. Assuming the company can refinance the debt at a 6% rate, it would amount to an annual $6.5 million in pre-tax savings, $4.0 million after-tax, or about $0.34 to EPS. At a conservative 10x multiple, this would amount to an additional $3-$4 per share to the equity valuation.

In addition, the company plans to pay off the remaining $40 million balance on its revolving credit facility, which is priced at a weighted average interest rate of 6.75%. Paying off the $40 million outstanding (as of 3/31/09) would result in annual savings of about $2.7 million pre-tax, $1.7 million after-tax, or about $0.15 to annual EPS. Clearwater’s $33 million in cash and short-term investments, plus cash generated throughout the year, will make repaying the $40 million outstanding on the revolver all but assured, in my view.

In sum, the almost inevitable refinancing of the $100 million debentures and the repayment of the $40 million revolver will add $0.34 and $0.15 per share to annual EPS, or $0.49 per share in total. Neither of these two events is contingent upon receiving even another dime of refundable tax credits from the government, in my opinion. Applying a 10x multiple to the savings would result in about $5 to the equity value.

Refundable Tax Credits

Clearwater Paper is likely to receive as much as $164 million in refundable tax credits from the government this year due to its status as an “Alternative Fuel Mixer.” There is some controversy in the Senate over the legitimacy of the paper companies qualifying for these tax credits. However, I believe the most likely outcome is that they won’t be renewed at 12/31/09 when they expire, or in a slightly worse outcome, the Obama administration will exclude the paper company tax credits with their 2010 budget, which would go into effect October 1, 2009.

Clearwater Paper should receive $0.50 per gallon of alternative fuels used in production, and they use 300-400 million gallons of it per year. They have already been approved for and received the first tax credit check, which was for $16.7 million. This represented the tax credits for the production for the 5 weeks from the last week in January through the end of February, and management articulated to me that this is the rough run-rate I should expect over the course of the year. $16.7 million over 5 weeks is $3.34 million per week of production, which amounts to $164 million pre-tax assuming 49 weeks (excluding the first three weeks of January). Assuming they are repealed beginning October 1, 36 weeks would amount to $120 million pre-tax.

While the company is yet to determine the taxability of these refunds, it appears that they will be taxable. $120 to $164 million should amount to $90 to $123 million after-tax, assuming a 25% tax rate. On a per share basis, this is $7.51 to $10.68 per share, of which the first $1.09 has already been received. The company will continue to apply for the tax credits every couple of weeks or so, and will file an 8-K each time it receives a check.

Essentially, the tax credits were implemented as a tool to encourage companies who use diesel fuel to substitute some portion of alternative fuels into their production. Many paper companies have been using a natural by-product of their production called “black liquor” as a fuel for years, and realized they could qualify for the tax credits if they mixed in a small portion of diesel fuel into their production process. While they are an unintended consequence of the legislation, the paper companies have a duty to shareholders to take advantage of them, in my view. This is a controversial issue in the Senate, as some Senators want to revoke the credits while others want to extend them to help a struggling industry. While there is certainly uncertainty over the issue and the impact it will have on Clearwater Paper, I don’t believe any of it is priced into the stock at current levels. In addition, there have been other rumblings about extending some other sort of aid to the paper companies, which could continue beyond this year, whenever these tax credits end.

Conclusion

I believe CLW is conservatively worth somewhere between $25 and $35 per share, based on its current operations alone. The very high likelihood that the company refinances its debt and pays off its credit facility in the coming months should result in another $5 per share to the equity value, in my view. In addition, refundable tax credits worth about $11 per share after-tax should result in a stock price near $41 on the low end. While the tax credits may be cancelled, I do not believe I’m paying for any of them at the current stock price. I view buying at this price as buying an already undervalued company with a free (and reasonably high probability) call option representing the $11 per share in tax credits. Or put another way, buying the stock at $21 is akin to buying dollar bills for somewhere between $0.51 and $0.70, in my opinion. Using baseball terminology, I view CLW as a home run or a grand slam, either of which I can live with.

Catalysts

Clearwater will file an 8-K every time the company receives a tax credit from the government, similar to the one filed on May 8, 2009. If the company continues to apply for the tax credits every couple of weeks, then I would assume the checks should arrive on a similar timetable, assuming no legislative changes.

In addition, I believe the company is highly likely to announce the refinancing of its $100 million of debentures, which will serve as another catalyst. Further, the Q2 earnings release, which is likely to be in late July, should show another solidly profitable quarter for the company and could serve as another catalyst to show that the Q1 results were not a one-time fluke.

Disclosure: Long CLW.