Clearwater Paper Corporation (CLW) Earnings Call Transcript & Summary

Hi everyone, this is Debbie Jones from Deutsche Bank, the paper and packaging analyst here. Today we are happy to have Clearwater joining us for our virtual conference. We have Arsen Kitch, President and CEO; and Mike Murphy, Senior Vice President and CFO, joining us. We are going to start today with a high level overview from Arsen, and then we are going to move into Q&A. [Operator Instruction] And with that, Arsen, please take it from here.

Thank you, Debbie. Let's do quick introductions. We're a relatively new management team. So I'd like to introduce ourselves personally, and my name is Arsen Kitch, President and CEO. I've been with the company for about 7 years, most of that time in various finance roles. And most recently, last 2, 2.5 years as the General Manager for our consumer products or tissue business. Previously, I spent time with KKR Capstone, Nestlé and Frito-Lay. I'll let Mike spend a few seconds introducing himself, but he's been here with us for about 2 months as our CFO.

Thanks, Arsen. Prior to joining Clearwater, I have been in the industry before. I Was the VP of Finance at KapStone Paper and Packaging and also the Treasurer at Boise, Inc. Prior to that, I was an Investment Banker at JPMorgan for a number of years covering the industry. And so I'm excited to move back in the industry and excited to be here at Clearwater with Arsen and our team. So with that, I'll turn it back over to Arsen.

Thanks, Mike. A brief overview of our business, about $1.8 billion of revenue across 2 businesses in attractive segments of the paper industry. The first one is our tissue business. We are -- we have a leadership -- we're a leader in the U.S. private brand and tissue market. We manufacture and sell a complete line of at-home retail tissue products. We do have a national footprint, and we do manufacture and sell all quality tiers. We have about a 16% market share, if you look at the private label providers, and we're one of the larger ones in this space. The private brand share of the overall market has risen to about 32%, and has some way to go to catch up with some European countries where private branded share's north of 50%. Our paperboard business is the other one, is the other side. It's a top 5 SBS player. We are nonintegrated. And we're focused on high end -- the high-end packaging segment of the market with relatively stable end market segments. We do have a new investor presentation out there. And so our value proposition is listed out on Slide #4. But to give a quick recap. Again, I mentioned we're a leading private brand provider. We do think that there is a long runway to continue to grow private branded share in the U.S., and this industry or this space is economically resilient just due to the need-based nature of tissue. Our paperboard business, again, services diversified end market segments. It's got a well invested national footprint. We do focus on non-integrated customers, and we do have a strong service and quality proposition for those customers. And last but not least, we're well positioned for trends towards sustainable packaging and food service products. Our near-term strategy is relatively simple. We are -- we aim to prioritize free cash flow to reduce debt. And we're going to do that through achieving benefits from our Shelby expansion, improving our operations, managing working capital and having prudent conservative capital allocation across our business. So Debbie, I think those are the brief comments about the company and our value proposition. We'd be happy to take some questions.

Okay. Great. I wanted to start, if I could, addressing the update that you made this morning around your guidance and the underlying business. If you could just start by telling us what you're seeing from a demand perspective in each of your businesses? And then the components that drove you to be able to push your Q2 guidance up versus your prior expectation. That would be great.

Yes. Sounds good. So we'll start with our tissue business. What -- and we talked about this in our Q1 earnings call. March -- in March, what we saw was demand in the overall market was up over 90%. April had moderated to about 40%, and it continues to moderate into May. What we did see is -- what's exceeded our expectations is demand is staying fairly strong for us. So in April and May, our sales are up 30% versus 2019 averages. And we're also seeing the substantial benefit from our improved production run rate and how that's translating into our cost structure. So that's on the tissue side of the business. In paperboard, we're seeing a relatively stable demand pattern. Some of the strength in our core end market segments like food and pharmaceutical packaging is offsetting some of the recessionary impacts that we're seeing in more discretionary parts of our SBS business. And Mike, I don't know if there's anything else you'd like to add?

I think we also have some good variances on the input costs, so some favorable kind of tailwinds there as well relative to initial expectations.

And along the lines of how your customers are doing. Can you talk about what they're telling you about their planning going into Q3 here and how they're trying to prepare for an unknown demand trajectory?

I think we're all looking at the same kind of hazy crystal ball looking out into the future. We've been -- our customers and we've been very focused on making as much product in our tissue business as possible and getting that over to our customers to service their surge in demand. I think the key there is how much of that away-from-home demand that has shifted to at-home how much of that demand will stay in at-home and for how long? And at this point, there's lots of folks speculating and trying to guess but it's unclear. What we have said previously is we have confidence in our tissue business for balance of the year, and we do think that we'll see higher demand as the country is unlikely to normalize back to pre-COVID conditions here in the next several months. But it remains to be seen how much of that lift we see in our tissue business in the next couple of quarters.

Okay. And if we could just shift to demand trends in paperboard. Could you talk about what you're seeing in food and pharma and how that's kind of offsetting some of the other weakness? What specifically are the categories that are underperforming? And is this just a short-term thing? Or is this something that you think will pick up as we begin to open up a little bit more as an economy?

So Debbie, thanks for the question. We're not an end converter. And so our visibility into the end market usage of our products is less good than some of our peers, who do have folding carton operations. Our sense is that the commercial print sector is down as would be expected. And then food service, where we do have some visibility into it, is down as well. We just -- we lack some of the exposure that others have in the category, offset by that on the strength side of things in the center aisle in that freezer section. That market has been a good market for us thus far in the second quarter.

Oftentimes, you talk about the quality of your paperboard product and the benefit of not having an integrated business. Can you address specifically what the quality enables you to do, and the benefit of not having an integrated business.

I'll start with the non-integrated part. So there's a large portion of SBS demand that's -- that goes towards smaller independent converters that are not integrated. They -- frankly, their preference is -- their preference -- and what they're looking for is a good, stable, long-term partner, that's going to be there with them through the ups and downs in the market. And that's what we're able to deliver. We're able to deliver a service model and a focus with those independent converters that I think is unique in the space. In terms of the quality characteristics that they value things like printability, and just the consistency in which that paper runs, that board runs in their operation. And because we're squarely focused on them as the independent converter, we're able to deliver that solution to them. And that has been our value proposition to our customers.

And can you talk about the supply-demand dynamics in the SBS business? I realize that COVID could change things over time, but kind of your general sense of underlying trends there on the supply side specifically?

So on the supply side, Debbie, we saw the movements by both Georgia-Pacific rationalizing the Crossett mill and Sappi adding in the Somerset Mill, adding capacity there. They were largely offsetting moves. So those have been the headlines out there in terms of movements on the supply side of things. In terms of -- I think what we're experiencing at the moment, we'd characterize it as somewhat stable demand, at least for the portion of the market that we're serving. I think we're cognizant of the fact that we're in a recession. We put in the investor deck that we put on our website this morning, some historical trends. So you can look back at 2008, 2009 time frame. You see the downturns that we saw back then. This may be a different recession than what we saw back then, but we just wanted to make sure that people were armed with some of that historical data for both the production. And I think you can infer the demand decline that occurred back then.

Okay. And I wanted to ask because not every SBS producer focuses on pep stock, and that is something that you do produce, and there is a product, the NuVo cup, that I noticed. You mentioned the 32% of recycled fiber. And I had always thought that something around the 25% range with what consumers would allow or at least the FDA. So I was just wondering if you could talk about how you're able to get to that level. And how -- what the feedback has been thus far?

So I think we have unique capabilities on one of our paper machines to be able to add that in a middle ply layer. And so the recycled content is not touching the outer ply -- or not touching the outside of the container. So that's, one, a unique manufacturing attribute that we have. Two, we're using FDA qualified or certified clean recycled fiber. So it's something that our customers and the end consumers can get comfortable with. We've met initially at the beginning of the year with great reaction there at, Debbie, to this product. I would say, given its exposure to food service, that tailed off pretty rapidly as COVID-19 pandemic took hold. It's a product that we're very optimistic about going forward. But obviously, it's on a different trajectory today than it was back in January and February.

All right. And you mentioned today the kind of the moderating cost environment. I was just wondering if you could give us an update on this business, what you're seeing there?

In NuVo or paperboard?

I'm sorry, in paperboard.

Yes. In paperboard, again, we'd characterize it as pretty stable at the moment, better than what we thought about a month ago. Both from a demand standpoint, demand seems to be holding up. And from a cost standpoint, our costs have moderated a little bit since we talked last about them. In particular, I think the fiber basket in the Pacific Northwest has gotten a little bit better, which should help us. And we're continuing to see low fiber costs in the southeast as well as low fuel prices out there to -- on the freight front to get our products to our end customers. So all in all, a stable demand picture with the benign cost environment at the moment.

Okay. And then just along those lines, I mean, obviously, there's been a lot of uncertainty. I think people were concerned about the health of their customers. What have you been seeing there in terms of their ability to keep manufacturing and to kind of keep the process going smoothly?

We're -- we don't have the same food packaging exposure that other substrates have. So we don't have that direct exposure to protein, which has been a concern for some of the other packaging companies out there. And so while we have had customers who've had issues. And we've had an issue or 2 as well. It hasn't been an overly negative impact on the demand picture or our ability to service our customers.

Okay. And I'm going to shift over to the tissue business now, if that's okay. I wanted to start by getting an update on the Shelby ramp and how that's been going in the last few months.

Yes. So we're on track to ramp the Shelby paper machine, as we previously discussed, here midyear this year. We anticipate to get the full sales run rate by the end of next year and the full financial benefit in 2022. So we're on track on the paper machine. We're also on track to achieve the $55 million to $65 million of EBITDA impact from the investments. So pleased with our progress so far. Of course, there's ups and downs when it comes to launching an asset of this size, but pleased with the work that the team has done to stay on track.

And if you look at the tissue business overall, a lot of times, I think people ask you the question about the ramp of new supply in the industry and how you think about that and how that impacts you. So I was hoping that you could address that question as well.

Yes. If you think just a very broad, big rounded numbers. The market is -- let's round up, it's about 10 million tons. You can look at various growth trajectories and demand growth, but it roughly tracks with population growth historically. So call it, a machine, 1.5 machine is needed every year to keep up with demand. If you assume -- and the machine does 70,000, 75,000 tons, you need about 1 to 1.5 machines a year to keep up with demand. This year, if you look at RISI, I think, it's -- they're estimating 225,000 tons or, call it, I mean, around about 3-ish machines coming online. So it does on that incremental last ton, last case, it does when you have capacity influx, it becomes a very competitive market as we go through the various mid-cycles with our retailers. And you've seen that over the last several years, I think, with some pricing pressure on the tissue side of the business with the capacity that's been coming online. That being said, the tissue market, you can look at it as a ultra part of the tissue market and the [ premium slash value ] part of the tissue market. There's been pent-up demand for ultra products, which is where we're aiming the Shelby machine at in the long run. So we do think there's good runway for us to get the benefits out of that machine because we do think the demand will be there as consumers shift their preference to private brands.

All right. And so my next question, I probably would have led with this if it wasn't for your update this morning, but obviously, both of you are relatively new in your positions here and both have strong backgrounds in the fiber-based business. I was wondering if you could talk about your expectation around any -- the ability to kind of change strategic priorities for the company, operational strategies. Mike, you come from KapStone, which a lot public investors knew very well. How does that kind of prepare you for your role to move to Clearwater?

Yes. So probably a couple of different ways to answer that. So let me start, and then I'll hand it off to Mike. Our near-term strategy is pretty clear, and it's to generate cash flows, prioritize cash flows to pay down our debt and get towards that 2.5x ratio of debt to adjusted EBITDA. And we have strategies in place around that from the Shelby expansion to driving operational improvements, working capital and very prudently allocating capital expenditures over the next several years. So I think that strategy is pretty clear, and I think we are laser-focused on that strategy. I think longer term, there's some interesting strategic questions in this business. And what I would tell you is, nothing will be off the table when it comes to shaping this business to maximize shareholder value in the long run, but that's the work that Mike and I will be doing here in the near term as well. So Mike, any thought?

Sure. And Debbie, you alluded to it before at KapStone. We have opportunities there to try to figure out what the strategy was going to be. I think credit to Roger Stone and Matt Kaplan, they had a very solid view. I think coming in here, it's helping Arsen and our teammates understand longer term, where do we want to be. But in the shorter term, we're going to be very focused on paying down the debt so that we have the ability to grow or change the company in the future, however we see fit.

Okay. I wanted to address a strategy question around kind of keeping the tissue and the paperboard business together. Maybe if you could start by talking about why it is together in the first place for those who may be newer to the company and just kind of address the synergies with the 2 businesses.

It's good question. I think it's been a question since this company spun out of Potlatch back in late 2008. The 2 businesses are -- they share a very large site. They share our largest site, which is in Lewiston, Idaho, where we have a pulp mill, we have SBS assets as well as tissue paper machines as well as converting lines. So that is the site where those businesses share assets. And furthermore, the paperboard side of the business, we are long in pulp. And so the pulp in Lewiston is provided to the tissue side as well as dried and shipped at times across our system. So the integration is really at our Lewiston, Idaho site around the infrastructure as well as pulp supply. And to a lesser extent, the pulp is also shipped across our system. So really when it comes to the 2 businesses being joined and the synergies, they're really -- they're very much Lewiston -- they're Lewiston-focused. And Mike, I don't know if there's anything you'd...

I think it was well said. So that's the connection point.

I think what we said for -- as a company for a long time, we'll look for ways to maximize shareholder value. And so nothing is going to be off the table, but that's the -- those are the synergies between the 2 businesses.

Okay. And I apologize if this is something that you've talked about in the past, but I did notice in today's release there was a comment about, you're continuing to explore the optimization of the pulp assets at Lewiston, but you don't believe a project will produce incremental financial benefits, I'm reading from your release. So as previously anticipated. Could you just kind of clarify where that's coming from?

Yes. So it's a capital investment that we made starting, I want to say, 2015, I think it wrapped up in '17 and it's to upgrade -- is to invest in the Lewiston pulp asset. So it's a Lewiston pulp optimization. We built a continuous digester as well as some polysulfide plant and other assets in Lewiston. We anticipated approximately $30-ish million of benefit or impact from that project. We've achieved $10 million through various cost savings that are being driven by the asset. And what we previously said is, we've so far been disappointed about the results in terms of yield and throughput from that project. And I think what you saw this morning is we anticipate retaining the $10 million worth of benefit achieved, but we do not anticipate getting any incremental or any additional benefit on top of that for that project.

Okay. A couple of more questions, and then we'll move on to any sent questions to me. I wanted to talk about your debt reduction plan and kind of what you think the biggest risks are to that plan? And then when realizing this is maybe a while away, but what does this give you the flexibility to do once you get there?

Sure, Debbie. So our target here is to have an adjusted -- sorry, net debt to adjusted EBITDA ratio of 2.5x. We've got some prepayable debt currently a term loan. That's prepayable at par. And one of our notes that has a call price -- a fixed price call that's going to step down to par in February. So we do have the ability to go out and efficiently retire debt so long as we continue to generate strong free cash flows. Our current game plan on strong free cash flow front is to hold our CapEx really kind of at a normal level, no big projects. This year, it might be a little bit lower than normal in the $45 million to $50 million category. We don't have any outages this year. So that's a reasonable number for maintenance spend. I think, typically, and probably going forward, $60 million will be a better number to be using in a model. Again, a lot lower than what we had spent previously on both the Lewiston pulp optimization project and Shelby. So that will help us generate some of that free cash flow to again prioritize to repay the debt. I think as we get closer to that 2.5x ratio, we're going to have to start talking about what that medium- to longer-term strategy is. But at the moment, we're a little bit north of 4.5x. So it may take us a little while to achieve that goal.

Okay. And there actually was one investor question around looking at free cash flow for the full year, especially given kind of what you're now expecting to do for the first half in EBITDA? And I think there is some optimism about improvement. I was wondering if you could just kind of walk us through the big buckets that you're willing to share that you're kind of comfortable with at this point.

Sure. I think we touched a little bit on the CapEx bucket that's out there. We did pull back from our guidance that we've given, but we previously had talked about that we were not anticipating being a cash taxpayer this year on the federal level. That may change if our business continues at the rate that it's at here in the second quarter. We did talk a little bit about interest expense being -- I'm going to use a round number, closer to $50 million. Those are kind of the bigger categories that we're able to talk about now. EBITDA, it's one of those that we don't have a great crystal ball at the moment. We may address later in the year, but that would be the other key puzzle piece. And then we've talked previously about working capital. We expected a ramp on the year. We stepped back -- it was a ramp of about $20 million to $25 million. We stepped back from that prediction in our first quarter earnings call, just given that we had depleted inventory pretty substantially in the first quarter. So we just weren't sure how quickly we're going to rebuild the inventory that we thought we were going to need.

Okay. And then just -- I'll just stick with the same investor question on the market structure in North America, and maybe an expectation that there could be consolidation. Is that something that down the line you would expect to participate in? Is that something that the leverage reduction would give you the flexibility to do?

I think with the leverage reduction, we'd have the flexibility to do that. And I think as Arsen mentioned before, we're going to have to look at everything on how we create shareholder value. And how we might participate in further consolidation in the industry, either as a buyer or a seller.

Okay. I wanted to shift over to sustainability. I did see you had a slide on that in your updated deck. Could you talk about kind of what you think Clearwater's role is in the circular economy? And kind of the questions that you -- I'm sorry, the conversations that you are currently having with your customers around that.

Yes. It's a great question. And if we step back and look at our products, they do provide a more sustainable alternative versus the nonrenewable resources. So wood is the primary raw material in the form of chips, sawdust, pulp, logs and so on. And it's a resource. It's 100% renewable. And it's commonly recycled. We also only procure wood and pulp from sustainable resources. I think our products are inherently renewable and contribute to the circular economy. With that being said, we're also looking at various ways to improve on that, which is you look at the NuVo cup, and we'll be looking at other innovations down the line to potentially add some post-consumer recycled fiber into our products. But I think inherently, we are -- our products are sustainable. And I think our customers and consumers, there's good trends towards that. If you look at packaging, if you look at food service, there's good solid trends in that direction that we'll certainly participate in.

And then just on the sustainability slide that you have, you talked about some of your reduction targets, greenhouse gases, energy, waste, water. Can you talk about how you choose those targets? And if you could just give us a sense of kind of the cost around that and the impact to your business and whether any of them would actually be beneficial to your margins.

Yes. So we -- back in 2012 -- and I'll let Mike jump in. But back in 2012, we've set out certain targets. And through 2018, which is what we reported, we've seen reductions in water intensity and greenhouse emissions. I mean, certainly, there are both environmental and cost benefits of those as we have less water, potentially less energy usage. There are benefits to the business. I think we'll be looking at other ways to optimize and to drive that in the coming years. And Mike, is there...

Yes. Debbie, I don't think that what we're targeting is anything very atypical from the industry as a whole and where the AF&PA has guided us and where I think the industry has moved over the years. And to Arsen's point, there will be some costs here, but there also will be some savings for us. I do want to point out that we did put on our new website, a new corporate sustainability report. And so that's new as of the past month. And so if investors have additional questions, we guide them there.

Okay. [Operator Instructions] I just thought that we could just go back to what we opened up the call with, again, which was your guidance today on Q2 and the underlying drivers. I realized that I didn't get a little bit more specific on some of your -- I guess maybe the range of which what you're seeing with your customers on the tissue business? Is it pretty consistent across various channels? Or is it kind of across the board the same level?

I think if you look back at March, April time frame, it was -- frankly, it was -- you could find patterns in there. I think products were selling across the board, just the incredible demand that was out there. I think as things start to settle out, we'll see patterns. And we'll start to recognize some patterns in terms of our consumers heading back into club stores. Are they comfortable with that? Or are they sticking to their local grocers? So we'll see patterns emerge. I think it's a bit early to call them. I think the biggest question is, as I've talked about earlier, is this really this away from home to at-home. That will be the biggest trend that we're looking out for. In terms of what is the sustained lift that we'll see and for how long. So what I'm looking to see in the next couple of months is a better idea of what this new normal looks like, with this next phase of reopening the country. And then beyond that, I think the question will be, when do we get to pre-COVID levels? And then what is the impact of the recession on consumer buying habits. Historically, we've seen consumers shift to more private brands during these types of economic conditions. So it remains to be seen what that shift looks like, and if that accelerates the growth of private brands across the industry.

Okay. That's helpful. And I see that we don't have any questions in the queue, but we just have a couple of minutes left. So I think that we will end it there. Thank you both for joining us today. We really appreciate it, and I hope to see you next year.

Thank you, Debbie.

Thanks, Debbie.