Seeking Alpha

Deep Value Diver's  Instablog

We are two research-oriented, risk averse, deep value investors.
My blog:
Deep Value Diver
  • KapStone Paper: Adding to Our Position
    This is an update to our long KapStone Paper and Packaging (KPPC) investment thesis, which we articulated on our investment idea website, http://www.deepvaluediver.com on September 11, 2009. The stock was trading for $7.66 per share at the time.
    We view the equity at $6.65 as an even better bargain than before. First, and most importantly, we believe fundamental downside risk is limited. The current $302 million market capitalization is a discount of approximately 19% and 12% belowwhat we estimate book value and tangible book value, respectively, will be at the end of the current quarter. This valuation is far too low for a company with low cost of production assets, large market shares within high margin niche paper products, and the highest normalized margins in the industry. Further, management undoubtedly has created value through efficiency enhancements and capacity expansions since acquiring their facilities. Additionally, KapStone acquired both of their facilities at purchase prices below replacement cost. Therefore, the current market cap represents a meaningful discount to an already conservatively stated tangible book value, in our view.
    Second, the key driver of KapStone’s business recovery – pricing – is currently in the process of improving. As a non-integrated producer, KapStone realizes the impact of changes in its product pricing immediately, which explains the rapid margin compression the company has endured over the last twelve months. However, the company’s margins will expand as its prices rise, just as quickly as they contracted when its prices fell. Importantly, KapStone’s pricing, in terms of average revenue per ton, bottomed in Q3 and is poised to improve, perhaps significantly so, during the next several months. Industry capacity closures are rapidly tightening the linerboard market, which has led to price increase announcements by producers for domestic and export linerboard across the board.
    Presently, KapStone’s largest and lowest margin product line is linerboard, so imminent linerboard price increases are the single best cure for the company’s depressed margins. We estimate that every $50/ton price increase for linerboard will add an incremental $30-$36 million to annual run-rate EBITDA. We believe the current market price of KapStone shares implies no meaningful recovery in industry pricing, which we believe to be inconsistent with current developments.
    Third, KapStone’s share price has declined by 19% since October 5th, which is the date the largest shareholder, Elm Ridge Capital Management, LLC, began selling. In contrast, the S&P 500 and two paper industry ETFs, WOOD and CUT, have appreciated by approximately 5%, 5% and 2%, respectively, over the same time period. With insiders holding approximately 40% of the company’s shares, Elm Ridge holding 9.99%, and many seemingly long-term value oriented institutions holding shares, we believe the effective float is limited. Consequently, a major holder like Elm Ridge who chooses to sell shares can create significant downside pressure on the stock price. This is a factor that is both temporary and non-fundamental. Many of our best investment opportunities present themselves when we can identify both a) a large mispricing and b) a specific non-fundamental reason why the mispricing exists. We believe this is one of those opportunities.
    Two important recent capacity closures are:
    i.       Linerboard - On October 22nd, International Paper (IP) announced the permanent closure of its containerboard mills at Albany, OR, Pineville, LA, and the previously idled No. 3 machine at its Valliant, OK mill, effective mid-December. IP’s closures will remove about 1.4 million tons of linerboard capacity. On October 28th, West Fraser announced the permanent closure of its Eurocan mill in B.C., which will remove about 330,000 tons of linerboard capacity, effective January 31st. Collectively between the two companies, over 1.7 million tons are being permanently closed, which represents almost 5% of North American capacity, which should push the industry operating rate into the mid-90% range – a level at which price increases historically have been successful.
    ii.     Kraft Papers - West Fraser’s Eurocan closure will also remove about 150,000 tons of kraft paper capacity, which will contribute to a tighter overall market, despite being a higher grade kraft than KapStone’s. Consequently, we believe KapStone’s previously announced $50/ton kraft paper price increase will be successfully pushed through either December 1st or in early 2010.This price increase should add about $15-$16 million to annual run rate EBITDA, in our view.
    Additionally, more industry capacity closures are likely in 2010. Higher cost mills will no longer be economically motivated to run without the benefit of the Alternative Fuel Tax Credit (AFTC), which is set to expire at the end of this year.Further, many believe Smurfit-Stone Container is likely to announce significant permanent capacity closures in January when its Chapter 11 reorganization plan is due to be filed. Without naming names, CEO Roger Stone believes there could be another million tons of containerboard capacity that could close in the coming months, which would represent another near 3% of the North American market. The containerboard industry operating rate has the potential to reach the high-90% range in 2010, in our view.
    Due to the lean inventory conditions, many companies have announced price increases in recent months. Some of them include:
    i.                     On Oct. 15th, Klabin (Brazil) announced a €40 price or $60/ton price increase on kraft linerboard in Europe, and $30/ton increase in Africa and Asia, effective this month. This is on top of the $60/ton, $40/ton, and $30/ton increase in Asia, Europe and Latin America, respectively, from earlier this year.
    ii.                   On Nov. 5th, Smurfit-Stone Container announced a $50/ton containerboard price increase for Mexico, Central America and South America, effective Dec. 1st.
    iii.                  On Nov. 9th, Pratt Industries announced a $50/ton containerboard price increase to Latin America, effective Dec. 7th.
    iv.                 On Nov. 16th, Longview Fibre announced a $50/ton price increase on linerboard and medium, effective Jan. 1st. Longview is the 12th largest North American containerboard producer with capacity of about 600,000 tons.
    v.                   On Nov. 20th, Europac (Spain) announced a €60/ton price increase on linerboard, effective Jan. 1, 2010. This is on top of the €60/ton price increase implemented in September. Europac cited a shortage of kraft linerboard production in Europe and declining imports from the U.S.
    vi.                  On Nov. 23rd, Georgia-Pacific (G-P) announced a $50/ton and $70/ton increase on liner and medium for the East Coast and West Coast, respectively, also effective Jan. 1st. G-P is the 2nd largest North American containerboard producer with capacity of about 4.2 million tons.
    vii.                 On Nov. 23rd, IP informed its Mexican customers of a $50/ton price increase for linerboard and medium, effective Dec. 15th. This price increase follows the company’s previously announced $50/ton price increase for Latin America.
    viii.               On Nov. 24th, Pratt Industries announced a $50/ton and $70/ton price increase on containerboard to East Coast and West Coast customers, respectively. Pratt is the 6th largest North American producer (1.15 million tons) and the third domestic producer to announce the increase.
    Again,the expiration of the AFTC at year-end likely will lead to further capacity closures, which should cause further price increases. Interestingly, during the Q3 conference call, Roger Stone indicated his belief that overall pricing could approach year ago levels by the end of 2010. Importantly, Stone stated he is bearish on the macro economy and that the pricing gains he foresees are due entirely to paper industry specific capacity closures. Given his experience and credibility within the industry, this view should not be overlooked. Pricing alone had a negative $28.5 million year over year impact to Q3 EBITDA, which implies that the pricing recovery Stone sees will represent an incremental $114 million of annual run rate EBITDA by the end of 2010. Add that to Q3’s $35 million annual run-rate and KapStone would generate almost $150 million of EBITDA—without any improvement in mix. That level of EBITDA would result in a stock price in the mid-teen range, in our view.
    As for mix, the company’s normalized revenue mix is about 30% linerboard, 32% kraft papers, 30% saturating kraft, and about 8% Kraftpak. Saturating kraft and Kraftpak are both higher margin products followed by kraft papers, followed by linerboard, of which export linerboard is the lowest margin. Over the past twelve months, as demand for its higher margin products declined with the economy, KapStone filled the hole with linerboard, including export linerboard. Consequently, the overall revenue mix has a higher percentage of lower margin product than is typical. This negative mix shift alone negatively impacted Q3 EBITDA by $11 million year over year, which implies an incremental $44 million of annual run rate EBITDA once normalized mix returns. While we have little insight into the timing of when this normalized mix will return, we are confident it is a matter of when and not if.
    As for valuation, KapStoneis trading at about $348 per ton on an EV/ton basis, which is an enormous discount to its peers, some of whom trade over $1,000 per ton. This incredibly low valuation implies that current depressed EBITDA levels are certain to last in perpetuity, which is inconsistent with current pricing developments, in our view. If we add Q3’s $35million annual run-rate EBITDA to an incremental $15-$16millionand $30-$36million for the $50/ton kraft paper and $50/ton linerboard price increases, respectively, we reach about $80-$87 million of annual run-rate EBITDA. We subtract $2 million of interest expense, $12million of taxes, and $22 million of maintenance capex, which leaves us with an estimated $44-$51million of levered free cash flow, which represents a 14%-16% current free cash flow yield. If the improvements stopped here, we would expect the shares to trade between $6.78 and $10.11, assuming 7x-9x free cash flow, which implies no fundamental downside from current levels. Importantly, though, we are becoming increasingly confident that improvements will continue. If Stone’s prediction on pricing ends up being accurate, we believe $150 million of EBITDA and about $90 million of free cash flow would be reasonable estimates in 2011. Based on 7x-9x free cash flow, those results would result in a $14-$18 per share stock price, in our view.
    While we are not relying on Stone’s prediction in our investment thesis, we are instead relying on a $110-$150 million EBITDA range, which we consider to be an appropriate mid-cycle EBITDA range. While we make no attempt at precision, we view the array of potential outcomes as significantly skewed to the upside. Additionally, the Biomass Crop Assistance Program (BCAP), the cellulosic ethanol black liquor tax credit, and the potential permanent closure of Stora Enso’s Kotka Mill represent three free call options, each of which has potential to be material, although we assume no benefits.
    To conclude,KapStone’s product pricing is clearly improving and more industry capacity is likely to close, which should lead to further price increases, yetKapStone shares are reflecting none of these improvements. In fact, KapStone shares are available in the market at a price 12% below tangible book value, despite efficiency enhancements, capacity expansions, and overhead cost reductions that have further lowered the company’s breakeven point. At the current level, we believe the odds are highly skewed in our favor, given what we view as an asymmetric outcome for KapStone shares. We believe this investment opportunity exists at this even better price due to Elm Ridge’s documented selling of shares, which as a temporary and non-fundamental reason, provides us with the opportunity to increase our position at even more favorable prices.
    Disclosure: Long KPPC

    Disclaimer: This is neither a recommendation to buy nor sell any individual security. The research found on our site is our original research, which we believe to be accurate, but may contain errors or omissions. The market price of any security we recommend may rise or fall. Please do your own research before making an investment decision.

    Tags: KPPC, value, paper
    Dec 01 12:24 am | Link | Comment!
  • Should Liberty Starz Trade at a Discount?

    Many people in the investment community – sell-side analysts in particular – seem to believe that Liberty Starz should trade at a discount to its intrinsic value.  Sell-side estimates of the magnitude of this discount range from 15% to 30%, significant numbers by any standard.  The intellectual underpinnings for these discounts are weak.  All of these analysts attribute their discounts to the fact that Liberty Starz will be a tracking stock as opposed to a traditional common stock.  They appear to rely exclusively on the fact that Liberty Media Corporation’s other tracking stocks have historically traded at discounts to their estimates of intrinsic value.  Few, if any, of the sell-side analysts covering Liberty Media’s Entertainment Group seem to ask themselves why Liberty Media’s tracking stocks have historically traded at some discount to intrinsic value and whether those factors that drove the historical discounts will apply to Liberty Starz.  If one peels back the onion a little bit further than they have, it becomes clear that Liberty Starz should trade at little to no discount to intrinsic value because of fundamental differences between Liberty Starz and Liberty Media Corporation’s other tracking stocks.

    The discounts at which Liberty Media’s tracking stocks have from time-to-time traded can be divided into two parts, one related to their tracking stock structures and another related to their holding company structures.

    A tracking stock structure may give rise to a valuation discount if the “guarantee” of the parent company’s liabilities that are not attributed to the tracking stock has some value.  Tracking stocks are not issued by legal entities distinct from the parent corporation.  As a result, any liabilities of the parent corporation –whether attributed to a given tracking stock or not – have recourse to the assets attributed to that tracking stock.  In other words, from the perspective of a creditor, the tracking stock structure is irrelevant.  Economically, this is very similar to a guarantee of all of the parent’s liabilities.

    In the recent past, Liberty Media’s Entertainment Group and Capital Group tracking stocks have undoubtedly reflected some value for this “guarantee.”  QVC, which is attributed to Liberty’s Interactive Group, had a tenuous liquidity position until very recently when QVC was able to issue $1.0 billion of senior secured notes, extend the maturity of a significant portion of its bank credit facilities, and borrow $250 MM from each of the Entertainment Group and the Capital Group on what appear to be market terms.  With QVC’s liquidity profile substantially improved, none of Liberty’s tracking stocks should be reflecting much value for their “guarantees” at the present time, and as a result, they should all trade at lower discounts to NAV than they have historically.  The Entertainment Group, Capital Group and Interactive Group have equity values of $17.5 billion, $2.3 billion, and $6.7 billion, respectively, based on recent market prices.  These equity values indicate that substantial cushions exist ahead of each tracking stock’s “guarantees” of the liabilities of the others.  To look at the historical discounts that Liberty’s tracking stocks have exhibited and simply apply that discount to Liberty Starz ignores the fact that the “guarantees” that were once a significant issue no longer represent a material liability.

    The second portion of the discounts that Liberty’s tracking stocks have historically exhibited relates to their holding company structures.  Academics and practitioners attribute holding company discounts to a variety of factors.  The most relevant factor in the case of Liberty Media’s tracking stocks has probably been an over-estimation of net asset value due to the lack of marketability of the holding company’s assets.  For example, Liberty’s Capital Group owns 40% of SIRIUS XM Radio (through convertible preferred stock), a publicly-traded company.  In valuing the Capital Group’s stake in SIRIUS XM Radio, most analysts simply multiply the number of SIRIUS XM Radio shares that Liberty owns by the most recent trading price of SIRIUS XM Radio’s publicly-traded equity.  Such an approach likely over-estimates the value of Liberty’s stake in SIRIUS XM Radio, and correspondingly over-estimates the discount at which the tracking stock trades.  The most recent market price of SIRIUS XM Radio almost certainly reflects a transaction involving only a very small portion of SIRIUS XM Radio’s outstanding shares.  If Liberty were to try to sell its stake in SIRIUS XM Radio, which represents a very large portion of the shares outstanding, it is quite possible that Liberty would realize a lower average price for its large stake than the price realized for a much smaller stake.  Another factor related to the holding company structures of Liberty’s historical tracking stocks that has likely contributed to the discounts they have exhibited is the limited information on all but the largest assets attributed to those tracking stocks.  Consider the Entertainment Group for example.  Prior to certain making certain filings with the SEC related to the planned split-off transaction and merger with DIRECTV, Liberty provided almost no information with which an investor could value Liberty’s interests in the Game Show Network and the Regional Sports Networks with a high degree of confidence.  Clearly, the limited information that Liberty has historically provided regarding many of the assets attributed to its tracking stocks has almost certainly contributed to the discounts that those tracking stocks have exhibited. 

    Liberty Starz, with a 100% interest in Starz Entertainment, LLC as its only significant operating asset, should largely avoid any holding company discount.  As a result of Liberty’s 100% ownership interest in Starz Entertainment, it has access to Starz Entertainment’s cash and does not necessarily need to sell Starz Entertainment to realize its value, so a discount for lack of marketability should not apply.  Furthermore, Liberty provides a good deal of information about Starz Entertainment in its public filings, because Starz Entertainment is one of Liberty’s most significant sources of value.  Correspondingly, Liberty Starz should not experience any holding company discount as a result of limited publicly-available information about its assets.

    Liberty Starz should also trade at little to no discount to intrinsic value for another very simple reason: Liberty management has clearly shown that it is willing to take corporate actions to address any discount at which its tracking stocks may trade.  Liberty has already authorized a $500 million share repurchase program for Liberty Starz, and would likely consider borrowing money to extend its repurchases of Liberty Starz shares to the extent the stock trades at a discount to intrinsic value.  Liberty would also almost certainly consider distributing Starz Entertainment as an “asset-backed” security (i.e. a traditional common stock) or taking some other type of corporate action if Liberty Starz as a tracking stock persistently trades at a discount to intrinsic value.

    In summary, there are three primary reasons why Liberty Starz is different than Liberty Media’s historical tracking stocks and should trade at little to no discount to intrinsic value.  First, while the “tracking stock guarantee” had weighed on the value of Liberty’s tracking stocks in the recent past, the liquidity issues at QVC have been largely resolved and significant equity cushions exist at each tracking stock.  Second, a significant portion of the discounts that Liberty’s tracking stocks have historically exhibited have almost certainly been due to holding company discounts.  With a 100% interest in Starz Entertainment as its only operating asset, Liberty Starz should not be subject to a holding company discount.  Finally, if for no other reason, Liberty Starz should trade at little to no discount to intrinsic value because Liberty management is clearly willing to take aggressive action to address any discount at which the shares may trade.

    The equity of Liberty Starz is currently trading on a when-issued basis under the ticker LSTAV.  At $47 per share, the market’s current valuation of Liberty Starz implies that Starz Entertainment is worth only 4.4x FY09 Adjusted OIBDA and 5.2x FY09 operating income.  If you believe that Liberty Starz should trade at a hefty discount to intrinsic value for some reason, you may consider Liberty Starz’s current valuation appropriate.  Otherwise, you’ll likely find Liberty Starz presents a pretty compelling bargain.
    Tags: LMDIA, LINTA, LCAPA
    Nov 13 01:53 pm | Link | Comment!
  • Clearwater Paper: An Undervalued Spin-Off

     

    Clearwater Paper (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 (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. They earned $1.19 in EPS and $2.71 in free cash flow (CFO-capex) in the quarter. For perspective, they did $0.15 in EPS in Q4 2008, $0.20 a year ago in Q1 2008, and were 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 their 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 they don’t get a single more dime in tax credits, in my opinion. The company has $33 million of cash on hand, including the $16.7 million just received for their 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 their 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 quality 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.

     

    Tags: CLW
    May 22 07:15 pm | Link | Comment!
Full index of posts »
Latest Followers
Posts by Ticker
CLW, KPPC, LCAPA, LINTA, LMDIA
Posts by Themes
paper, value
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.