Clearwater Paper Corp Q1 FY2021 Earnings Call

Thank you, Christine. Good afternoon, everyone, and thank you for joining Clearwater Paper's first quarter 2021 earnings conference call. Joining me on the call today are Arsen Kitch, President and Chief Executive Officer; and Mike Murphy, Chief Financial Officer. Financial results for the first quarter of 2021 were released shortly after today's market close along with the filing of our 10-Q. You will find a presentation of supplemental information including a slide providing the company's current outlook posted on the investor relations page of our website at clearwaterpaper.com. Additionally, we will be providing certain non-GAAP information in this afternoon's discussion. A reconciliation of the non-GAAP information to comparable GAAP information is included in the press release or in the supplemental information provided on our website. Please note, Slide 2 of our supplemental information covering forward-looking statements. Rather than rereading the slide, we are going to incorporate it by reference into our prepared remarks. And with that, let me turn the call over to Arsen.

Good afternoon and thank you for joining us today. Please turn to Slide 3. As you saw from our press release, the financial performance for the first quarter was strong despite some challenges impacting both of our businesses. On a consolidated basis, the company reported net sales for the first quarter of $426 million and adjusted EBITDA of $54 million. A few highlights to mention. Our paperboard business continued to experience strong demand, particularly in our folding carton segment. Based on that strong demand, we announced and began to implement price increases across our SBS product portfolio. Our operations were affected by the February cold weather event in the South. Natural gas curtailments impacted production and increased energy prices. Collectively, this negatively impacted our adjusted EBITDA by approximately $6.5 million. Our tissue business saw lower orders and shipments reflecting overall market trends. IRI market data showed a nearly 20% decline in overall tissue dollar sales in the first quarter of 2021 as compared to the fourth quarter of 2020. Consumers were de-stocking their pantries and retailers were working through elevated inventory levels. With a decrease in demand, our production outpaced sales, resulting in above-target inventory levels. We're taking downtime on our assets to reduce and manage inventories, particularly with today's elevated pulp prices. With regards to our balance sheet, we used the free cash flows generated during the first quarter to reduce our net debt by $21 million. We're experiencing significant cost inflation and a temporary decrease in tissue demand. Mike and I will discuss both in detail later in our prepared remarks, including actions that we're taking to address these market-driven headwinds across our businesses. As noted over the previous quarters, we remain focused on our top priorities during COVID: the health and safety of our people and safely operating our assets to service customers. Our people’s focus has been key to our success and will continue to be so. In partnership with local health agencies, we have offered onsite COVID vaccinations across several of our facilities, and we're continuing to offer a $200 incentive to each employee to become vaccinated. Let's discuss some additional details about both of our businesses. Please turn to Slide 4 so that I can share a few comments on our paperboard business. As you recall, we estimate that approximately two-thirds of paperboard demand is derived from products that are more recession resilient and one-third is driven by more economically sensitive or discretionary products. We continue to observe strength and demand from our folding carton customers and are starting to see a recovery in foodservice segments. Demand for food packaging products and retail paper plates has remained healthy throughout the pandemic. We're also pleased with the market reception of our sustainability-focused brands of NuVo Cup and ReMagine folding carton. Both are playing a role in our favorable market position. Our strong order book, which predates industry supply disruptions, continues to be robust. We are diligently working to implement the previously announced price increases. Fastmarkets RISI, a third-party industry publication, has recognized a $50 per ton increase in folding carton and a $20 per ton increase in foodservice grades in its March and April publications. During our fourth-quarter earnings call, we noted that the cold weather event in the South impacted operations at our Cypress Bend Arkansas Mill. This resulted in a $6.5 million direct impact on our adjusted EBITDA. I want to, again, thank our team for their actions to minimize the impact at our mill and for quickly resuming operations to service our customers. While the weather event primarily impacted the first quarter, other potentially longer-lasting impacts on input costs are included separately in our revised inflation expectations.

Thank you, Arsen. Please turn to Slide 6. A consolidated company summary income statement shows the first quarter as well as the first quarter of 2020. In the first quarter, our net income was $12 million, diluted net income per share was $0.71 per share and adjusted income of $0.69 per share. The corresponding segment results are on Slide 7. Our pulp and paperboard business was impacted by the weather event while consumer products saw lower demand, partly offset by the benefits from the Shelby expansion. Before we speak in more detail about our divisional performance, I wanted to remind you of some of the changes that we started making last quarter and how we portray our financial bridges. Previously, we had shown the impact of production volume changes and associated fixed cost leverage impact in our cost category. We have modified that approach and are including production volume changes in our volume category. We believe that this change will enable investors to better understand sales changes as we expect to produce similar quantities of product that we sell, which will all be in the volume category. In tissue, production exceeded sales in the first quarter of 2021, and the reverse was true in the first quarter of 2020, which complicates comparisons to prior periods. The cost category will better reflect the changes from raw material input pricing and inflation. We also made a change related to our paperboard business and the presentation of our volume and sales price to remove the impact of our contract sheeting business. This contract sheeting business is a service and distorts our sales price of our base paperboard products. Additionally, as a reminder, we have moved our bale pulp sales to external customers back to the producing segment, from the consumer products division to the pulp and paperboard division. We've also started transferring baled pulp from our pulp and paperboard division to the consumer products division at market price. We believe this change will better reflect the economics associated with the business. These accounting changes have taken effect with our first-quarter 2021 reporting, and the prior periods have been recast. As a reminder, we filed the recast numbers as part of our 8K associated with our fourth-quarter earnings announcement where we recast the prior three years as well as the past eight quarters.

...and I would like to discuss the actions that we're taking across the company to combat higher inflation and lower tissue demand. In our paperboard business, we're focused on implementing the previously announced paperboard price increases, and maximizing production to meet demand. In our tissue business, we're working with customers to offset higher costs through previously announced price increases and upcoming product changes. We have a robust pipeline of new tissue volume and are actively pursuing additional sales opportunities. Across both businesses, we're working through ways to reduce costs, both in the short and long-term. From looking at our network cost structure to optimizing pulp mix to lower variable costs, we're managing our cash flows by taking significant downtime across our tissue operation and a careful slowdown in planned capital expenditures in 2021. At the beginning of the second quarter, we also launched a transformation effort focused on improving our core operations in the medium to long term. The transformation team is made up of dedicated internal resources, supported by a top-tier consulting firm, aimed at achieving the full potential of Clearwater Paper over the next several years. The team is now focused on identifying and evaluating opportunities for improvement across the company. I look forward to discussing this effort with you in the upcoming quarters. We have and will continue to take appropriate actions to position our business for the future while balancing the needs to respond to current market conditions.

Your first question comes from Mark Wilde from BMO Capital Markets.

I wondered if you could, first of all, just help us on the roll-through of that SBS pricing increase, how you would think about the cadence.

Mark, I think we've talked about it previously being calling it about two quarters to get the price increase fully through. And extending your question a little bit further, we have about a quarter to a third of our business that's directly tied to that to the receipt fast markets index price.

Okay. The rest of it is not contractually tied, but that should move with the announced price increases, or what the trade papers are showing. Is that correct?

That's correct.

Okay. Michael, can you help us understand the cost impact of lower sales and the significant production cuts based on the second-quarter bridge you presented?

When you say the second-quarter bridge, is it the second-quarter outlook commentary?

Yes. Yes.

Sure. I think, Mark, just to do the math for the benefit of the people on the phone, you start with just over $54 million via the Don the second quarter and add back $6.5 million of the weather event that we would not see repeating. So we're just north of $60 million. Take the outage costs, call it $22.5 million, the midpoint of the range. Take the inflation $11 million, the midpoint of the range after that. And you're left with a number in the high $20s millions. And so if you say, 'Hey, we're approaching breakeven. What does that all mean?' A positive there is some of the benefits from the paperboard price increase, and then the rest of that is the cost, both sales declines and maybe more materially, the volume or production declines that we're going to experience within the quarter. Another way to kind of think about it is, rewind the clock to last year, we're producing 15.9 million in the second quarter of last year. This year, we're going to take over a third of that production capacity down. It's a lot of fixed costs that we're going to need to absorb here in the quarter.

Okay. All right. That's really, really helpful, Michael. Can you talk about what you're doing, in terms of whether it's tissue pricing, sheet count, whatever, to sort of mitigate the impact of these rising costs? It seems like among the branded players, there's a pretty wide dispersion of strategy. Some people have announced hikes and some people have done nothing.

Yes. Let me take that one, Mark. So across both of our businesses, price is determined by supply and demand. And so if you look at the paperboard market dynamics, they're quite favorable, and I think you're seeing that reflected in the price increases that we've announced and are implementing. Frankly, that's less so in tissue, with a slowdown in consumer demand and some of that inventory overhang that we're seeing. We're working through this, customer by customer. Don't have specific additional comments on what that would mean for us on the tissue side, but we're working through this with our customers. That's on the pricing end. On the product changes, on sheet counting, I would say the majority of our customers follow what we call an NBE strategy, which is national brand equivalent, so they aim to have their private branded products closely resemble branded products. And so we're working through product changes with our customers to follow that NBE strategy here in the upcoming quarter, so that's certainly something that we have done and we will continue to do. But from a pricing perspective, I think in the long haul, it's that supply and demand equation that's going to drive price in both of our businesses.

Okay, I have a question regarding a recent announcement about another SBS producer acquiring a significant independent carton producer with around seven facilities. Can you let us know if you currently have any SBS volume with that specific carton producer?

I don't think we're going to quantify that, and if it is, it's not large exposure. I think if we step back and look at our strategy and where we are in the market, we continue to be positioned well with independent converters. Especially through a time like this, where demand is really strong, and it takes a strong relationship and partnership with an SBS producer to continue to service these independent converters. So I think we're well positioned, and I think our exposure is fairly limited.

Your next question comes from the line of Adam Josephson from KeyBanc.

Arsen, one more on the tissue production cut in 2Q, and you mentioned that you think there's over a month's worth of inventory. Are you anticipating that the downtime you'll take will be sufficient to fully clear that overhang by the end of the second quarter, or is that still not clear to you?

I think what's somewhat unclear is exactly how much that overhang is out there between consumers and retailers, but let me provide a little bit of data that we're seeing. So we saw consumers pull back, call it right around 20% in Q1. We're starting to see some positive signs in April, with consumer demand picking up and returning back to pre-COVID levels. I think that suggests that the consumer is de-stocking, and may have largely destocked in Q1. Retailers pulled back their orders in Q1, we think they had well above target inventory levels at the end of Q1. They're still working through those, and I think that's reflected in our April order book, which was 3.1 million cases, well below where we've been historically. So I think it's unclear exactly how long it takes to play through this overhang. We contemplate that by the beginning of the second half, we'll start to realize some sort of normal in this space, but it really depends on exactly what those consumer and retailer shopping and ordering patterns look like. The downtime we're taking serves two purposes. Number one, it's to match up with demand in the second quarter, which is weak, but also to start reducing some of our own inventory overhang in our system. And frankly, with record pulp prices, this is the right time to take these curtailments across our system and not make inventory that we don't need at high pulp prices, and paying to store it. So I think it's the right decision. It does create the fixed cost absorption issues within the quarter, but it's the right business decision.

Yes, understood. And speaking of high pulp prices, my second question... I asked you three months ago what you made of what was going on, because it seemed to me like demand wasn't very good, and yet pulp prices were hitting all-time highs in China. And here we are three months later, you're having to take issue downtime; printing and writing demand remains weak globally, the shipment data hasn't been good, and yet pulp prices keep going higher. Do you have any better sense of what is driving this record surge in pulp prices in China, and then by extension elsewhere, and where do you see this going?

I think we've stopped trying to predict where pulp prices are going to go this year. There's a number of factors, and they're out there in the industry publications so we don't need to revisit them. If you look at the forecasts that are out there for the second half, they're indicating some softening of pulp prices. Still at really high levels, but a softening from these peak prices, both in softwood and hardwood grades. So hard to predict, but I think the forecasts out there are anticipating some easing in the second half.

Right. No, two others. One is if you look at your consumer products segment over the years, the high was $150 million of EBITDA a few years ago and then it fell all the way to, call it, $60 million, and then it nearly tripled last year. What would you consider normal, to the extent there is such a thing? Just given the dramatic volatility and the profitability of that segment over the years, it's really hard to determine what's normal, and I would love any thoughts you have along those lines.

There are several variables to consider. Firstly, we learned last year about the importance of volume and our ability to absorb fixed costs throughout our system. This experience is a key part of our long-term strategy. We have the volume aspect, followed by pricing trends we've observed over the past few years, as well as the volatility primarily in pulp prices, which affects transportation and other input costs. Over the last few years, this volatility has been influenced by these factors. Currently, we are going through an adjustment period following a strong 12 months post-COVID, coinciding with peak pulp prices. These elements have been driving our business performance over the years. While I won't attempt to predict what normal conditions might look like, our focus remains on improving the business structurally in the long run. We are committed to leveraging the benefits of the Shelby expansion while making informed decisions regarding products, customers, channels, and our cost structure. We are concentrating on the aspects we can control, even as we remain mindful of the market challenges and opportunities we may encounter.

Yes. And just one last one on your guidance philosophy. All year last year, you were exceeding your guidance pretty significantly. And conditions were quite fluid, but you kept providing quarterly guidance, albeit dramatically exceeding it, and now you're no longer providing quarterly guidance just because conditions remain fluid, but in the opposite direction as last year. So what is your philosophy regarding quarterly guidance? Is that something you plan to resume doing next quarter, or what are you thinking along those lines?

Adam, it's Mike. I'll take that question. I think we mentioned in our prepared remarks that we could approach breakeven EBITDA for the second quarter, and so we think that we've provided that, and in response to an earlier question, we think we helped provide some of the data points to get you there. So that's what we're doing here in the second quarter. In terms of our philosophy, I think given the dramatic changes that the business has gone through quarter to quarter, I think we have to give at least the investment community our expectations of what we think might happen. The biggest variable that we had all last year was demand, and I'm not sure who did a wonderful job of predicting demand in the tissue category. This year, we have both that demand issue and we have the inflation issue, and we're trying to do our best to give you and the investors out there what we think is going to play out here for the quarter.

Your next question comes from the line of Paul Quinn from RBC Capital Markets.

Yes. If I could just try to understand sort of what's happening in the tissue. You described it as two-thirds consumer, and you've got heavy leverage to that component. So the downtime that you're going to be taking in Q2, or the lack of orders, that 22% year-over-year drop in Q1, is that related to people getting back to work and more away-from-home consumption, or is that just a destocking in the consumer channel alone, and you still got this second level drop as people get back to work and consume more tissue at the office?

I think both are playing into it. From the data that we can see out there, there were certainly more shipments of tissue last year than you would expect for consumption growth to absorb, so we think based on that there is at least a month of overhang between consumers and retailers. I think much of the US has been getting back to normal here recently, so I think that's certainly playing into it, but we think there's that inventory overhang that is potentially taking us below 2019 purchasing patterns with consumers, as they work through what's in their homes.

Okay. And then obviously this is an almost 180-degree market turnover over the course of the year. Last year with customers, all of a sudden the allocation on the tissue side, you were able to significantly reduce SKUs; now you've got a period where you're not getting the order files. Are these customers coming back to you and pushing really hard to increase SKUs, which was a significant cost savings to you last year?

No, I think we're working through that, customer by customer. What I said throughout last year is we think SKU rationalization beyond COVID is appropriate for most of our customers. We think that makes their shelves more productive, and it's better for our customers and our consumers. So those conversations are continuing with our customers. We're certainly reintroducing some SKUs as we work through it with customers, but it is our intention, post-COVID, not to return to pre-COVID SKU levels, but obviously our customers have to agree with our position on that.

Sure, Paul. We're still targeting a 2.5x leverage ratio, over call it, a more normalized EBITDA, whether it be of COVID related, or outage related. So that's the target that we're still working towards. And I think we can repeat what we said on the last call, we don't expect to achieve that this year.

Your next question comes from the line of Mark Wilde from BMO Capital Markets.

Michael, I just wondered if we could get some update around that measure and the stimulus bill that would potentially impact multiemployer pensions.

Sure. Thanks for the question. Mark, we look at it, and for the benefit of those on the phone, this is the American Recovery Plan Act, which includes provisions to provide the financial relief for these financially troubled multi-employer plans. I think we're moving from this legislation, which is very welcome, to how does it get implemented? And it's uncertain whether, or to the extent in which the legislation will reduce the amount of liability that Clearwater has to various plans. So like everyone else, we'll assess the impact of legislation. We're waiting for the PBGC rules that will establish the guidelines and procedures for pension plans to apply for funding. The PBGC has until early July to come up with these rules, Mark. After then, I think we'll have clear visibility in terms of what this could potentially mean. But we still need some color, as we would expect various multi-employer funds to apply for that sometime after the rules are outlined for them. And then, some clarity following that, in terms of applying for those potential funds.

Okay. All right. That's fine. Just two other real quick ones. Are you out with a second increase on folding carton grades of bleach board?

Mark, we've announced several price increases to our customers, and we're implementing those previously announced price increases.

Okay. And then I noticed in the deck this afternoon that the net retail sales price of tissue was down about 9% year on year, and down about 20 to 25% from the first quarter 19 levels. I know it's not a big chunk of your business, but what's going on there?

So we combine both parent roll sales as well as away-from-home converted product sales there, Mark. So it can be one of the more misleading figures, where you get a mixed shift, where more parent rolls were sold in the current period than in the previous comparison periods.

Your next question comes from the line of Adam Josephson from KeyBanc.

Mike, just to follow up on that, the leverage question and the normalized EBITDA. So next year should have fairly average outage expenses. I think you're guiding to $19 million to $23 million, and then presumably next year would be a more normalized tissue EBITDA year. Last year wasn't and this year won't be either. So how would you have us think about when you're at normalized EBITDA, consequently, when you've achieved your target leverage ratio to your satisfaction, and consequently will do something with your capital, be it dividends, repurchases, what have you.

Adam, I think that's a good question. I think as we potentially set up expectations for next year, we can try to figure out if that's a good year, as a point of comparison for that 'normalized' EBITDA, from which we can come up with that leverage target. And I like the way that you framed it. So thank you for that.

No problem. And just the CapEx reduction, I know it's minor, but what is that?

We're going through a list of projects for the year, and given some of the headwinds, we're taking a bit of a deeper scrub on which projects we're going to implement and not implement this year. It's a small reduction because I mean we're still able to execute all of our critical projects that we need to execute.

Right. And just one last one, Arsen, on the tissue capacity, can you just remind us what you see coming on this year? And if there's a way for us to, I mean, last year was so anomalous, in terms of tissue demand, so the supply-demand equation was out of whack. And then this year is going to be similarly anomalous, but can you help us level set where you may exit this year, the industry that is, in terms of the supply-demand balance, just based on whatever demand might be by year-end compared to what supply has been added by that point.

Yes. If you look at RISI data on capacity additions, 19, 20, 21, each of those years, if you add it up, there's between 160,000 and 170,000 tons roughly, of capacity that's been added. There's 160,000 that's slated to be added this year, and it's all tag capacity. There's a few other announcements out there for 22, 23, and even for 24. And much of that is ultra-tag capacity as well. So hard for me to say exactly what that supply and demand balance looks like at the end of this year, but hopefully that provides some color, in terms of capacity addition. I think what we said previously, demand grows at roughly one, maybe 2% per year, and on a 10 million ton market, that's a hundred to 200 thousand tons of capacity. So if you look at the last few years, it's been about 160,000 to 170,000 that's been added per year.

Your next question comes from the line of Paul Quinn from RBC Capital Markets.

Yes, so in the bonus round, I just want to ask you about the downtime you're taking on tissue. Is that at a higher cost attributed to a lock of orders, or is that a rotating downtime at all? And maybe you could just help me understand that.

Great question. So we're looking at our demand, we're looking at our inventory, we're looking at where our customers are, and where the orders are. And then we're also looking at the cost structure of the asset. So yes, a lot goes into those decisions. It's not simply a rotating outage across our system. These are targeted downtimes across our system based on inventory, based on demand, and based on cost structure. So, as an example, during the Lewiston major outage, we took downtime in Lewiston, given that the decide was going through a major maintenance outage, it made sense for us to take some downtime at our Lewiston tissue operation, that went along with the major outage in our paperboard business. So we're managing through this pretty carefully.

Okay. So just to pull up on that, what is the most efficient way to do that? Is that a week of downtime or is that two weeks? What is that time that you still got to act and work for us and you were able to bring back the machine to a pretty quick operating capacity after the shut?

Yes, I think it depends on whether it's a paper machine or converting assets. Converting assets, I think can be brought up quicker and go down quicker. Paper machines, you can't do that day in and up one day, down another day. So on paper machines, the tendency is for us to plan lengthier outages. So it really depends on the asset, depends on demand, depends on inventory. So there's not one answer for you, but just hopefully that gives you a bit of flavor for how we think about it.

There are no further questions at this time. I turn the call back over to Arsen Kitch for closing remarks.

Thank you everyone for joining us today.

This concludes today's conference call. Thank you for participating. You may now disconnect.