Things Become A Little Clearer For Clearwater

| About: Clearwater Paper (CLW)
This article is now exclusive for PRO subscribers.

Executive summary:

  • Investors should look for further gains in Clearwater Paper as margins continue to expand.
  • Clearwater continues to grab market share in the private label tissue market.
  • I see the company completing its $100 million share repurchase program this year and paying a dividend next year.
  • Shares remain cheaper than other paper companies trading at 13.7x earnings.


Watching the paper industry over the past few years has been exciting. One of the most notable players has been Clearwater Paper Corporation (NYSE:CLW). The move over the years has been impressive. With such an impressive move, the question becomes, what gets the stock even higher? What I know for sure is that the demand for the likes of bath tissue won't decline anytime soon. The population in the U.S. and globally will continue to grow, continuing to drive the demand for paper.

While the stock has been on a tear, the company's addressable market continues to grow and its market share expands. As a result, the company should continue its trend of outperforming the broader market. It remains one of the premier paper companies in North America, with a stronghold in the tissue market, from facial to bath tissue, and paper towels and napkins.

The company posted rather robust 4Q earnings, helping drive the stock to multi-year highs. Full year 2013 sales came in at $1.9 billion, with 4Q sales driven higher given a 2% rise in the average selling price per ton for tissue and paperboard.

The biggest news for 4Q being that EPS, coming in at $1.96, blew through consensus by 40%. Quarterly adjusted EBITDA came in at $65 million, close to a quarterly record. And its EBITDA margin was 13.9%, up from the 8.8% in 3Q. The surge in the stock hasn't been irrational exuberance, rather, Mr. Market's realization that the company continues to find new ways to drive the top line while also expanding margins.

The fourth quarter meant margin improvement in both its segments

If we look across Clearwater's revenue lines, its consumer products net sales were actually down 12% quarter over quarter. The biggest culprit for the decline was a 4% fall on shipment volume. However, the operating margin was up to 6.2%, up 100 basis points sequentially. Clearwater is getting the benefits of margin expansion from lower costs and a better product mix. Costs for pulp are coming down, meanwhile, their mix of sales on the retail side are rising, which happen to carry higher prices.

Its other segment, pulp and paperboard division, also saw sales lower during 4Q, down 4% sequentially. Yet, the operating margin for this segment was an impressive 20%, compared to 8% during 3Q. The segment also managed to turn out a 23% EBITDA margin during 4Q, a record high. The large jump came with the absence of a large maintenance cost, with the next major maintenance not scheduled for 1H 2015.

Market share gains and margin expansion drives earnings growth

Clearwater recently launched a new TAD (through-air-dried) bathroom tissue product line, which was shipping to over thirty customers at the end of 2013. The retail sales rates appear to be picking up and have led to an overall expansion in its tissue customer base.

The beauty of TAD is that it commands a higher price per ton, versus conventional. As TAD replaces conventional in the market place we should see some higher revenues and margin expansion. The record level EBITDA margins during 4Q were partially driven by the increased mix of new TAD products.

On the cost front, I'd look for cost reduction to continue, helping further expand margins. Clearwater reduced costs by $17 million in 2013, but 2014 could be even better, with $20 million to $30 million, driven by the shutdown of the Thomaston facility.

The paperboard segment also holds a lot of promise. The division generates operating margins that are nearly double its consumer products segment. With another price hike already set for 2014, that profitability could be even higher come the end of 2014. Investors should look for demand to remain at high levels, supporting the price hikes, and ultimately getting Clearwater's gross margins back up to the mid-teens. Along those lines, Clearwater has already put in place a $50 price increase across all its paperboard grades at the end of 1Q 2013. Thus, the year over year number in 1Q 2014 should come in rather strong.

On the flipside, the company has a WACC that's down nicely from a year ago, thanks to the refinancing of a 10% plus senior note, now carrying a 4.5% rate. Less money spent on interest expense should yield more cash in investors' hands. The company just authorized a $100 million share buyback program, a program I look to be completed by the end of 2014. Assuming that only accounts for 50% of its cash flow, 2014 free cash flow margins come close to getting back to its historical free cash flow margin of 10%.

Win-win, market share gains and margin expansion

The U.S. tissue market is a slow growth market one, expected to grow roughly 2% in 2014, in-line with historical standards. However, part of what Clearwater is doing is looking to grab more of the market share with new products. During 2013, Clearwater snatched up an additional 120 basis points in private label tissue market share, putting its ownership at 27.5%.

The other driver that Mr. Market is likely underappreciating is that the private label tissue market is growing faster than national brands. For 2013, U.S. retail tissue cases shipped were up 8.7% on the private label side, and 2.8% on the national brand side. Increasing its leverage to the private label market is a big positive. There appears to be a number of contracts that continue to come up on the private label side. As Clearwater bids for these, and presumably continues to win, the margin expansion should further accelerate.

Show me the money

With Clearwater having more than doubled the return of the S&P 500 over the last year, it's tough to make the case that Clearwater is underappreciated. That becomes even truer considering the stock is up 20% year to date alone. However, with its level of cash flow generation steadily on the rise, that means more money for shareholders. The plan is to use some 50% of discretionary free cash flow going forward on share buybacks.

With its high levels of free cash, and some of the other major paper companies paying dividends, it's not unreasonable to question Clearwater's need to start paying a dividend in the near future. However, for the time being, investors will have to settle for a $100 million share buyback program. Which isn't so bad, considering it's nearly 7% of its market cap.

Even still, the timeframe for a dividend payout looks to be sometime in 2015. The company's long-term grow should remain to return somewhere around 50% of its discretionary cash flow to shareholders, which could be in the form of dividends in 2015, or a mixture of dividends and buybacks.

Bottom line

Two big names are already in the stock, including Steve Cohen and his SAC Capital, with an 8.5% stake, and Steve Major's Corsair Capital, with a 3.85% stake. Insiders also own a combined 3% stake in the company. Shares of Clearwater still remain cheap compared to other paper companies. Clearwater is trading at 13.7x earnings, whereas International Paper trades at 15.7x, Kimberly-Clark trades at 19.3x, and Orchids Paper Products trades at 19.3x.

All in all, I think Clearwater is a great play on the continued rise of the global population. Clearwater also has its own growth levers that it can pull internally, which can help it beat analysts expectations over the interim. Using a long-term free cash flow growth rate of 3%, which is half its historical average, and a 10% discount rate suggests a fair value of $89.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.