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CFA Institute Research Challenge

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Consumer Goods, Paper & Paper Products Industry

New York Stock Exchange

Date: 1/6/2015 Current Price: $46.14 Recommendation: Sell

Ticker: CLW 1 Year Target Price: $41.19

Market Capitalization: 52 – Week Range $39.81-75.69 Book Value per Share $25.69 Beta .68 Shares Outstanding 18M

Company Overview: Location: Spokane, Washington Industry: Paper and Paper Products Company Website: clearwaterpaper.com

Analysts: Investment Research Advisor: Bhanu Adhikari Cai, Vinson Carmelo DeLeon Vanessa Ibarra Ava Le Derrick Woodbury

This report is produced solely as part of an educational program. The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable; however, the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. This information does not constitute investment advice, nor is it an offer or solicitation of an offer to buy or sell any security. In regards to any potential investment, you should consult an investment consultant and/or conduct your own primary research.

Company Background Primary Businesses

The primary businesses of Clearwater Paper includes pulp and paperboard production which holds 40% of 2014 net sales, as well as consumer products which holds 60% of 2014 net sales. Clearwater Paper Corporation is among the largest manufacturers in North America for both of the previously stated segments. Bleached Paperboard Business

Bleached paperboard manufactured by Clearwater Paper holds the fifth largest capacity in North America with 12% of the market share. They are also the largest manufacturer of Solid Bleach Sulfate Paperboard (SBS) in the United States. This business includes producing the finished paperboard and selling the product to companies who will turn the paperboard into finished containers for their own products. These products include but are not limited to consumer goods, pharmaceuticals, food, and liquid containers. The top ten customers of Clearwater account for 50% of paperboard shipments. Consumer Products Business Clearwater Paper Corporation also has one of the largest consumer product manufacturing businesses in private label tissue. Clearwater paper puts much of their effort towards assuring competitive quality and value of tissue in all of the different types of private label products they offer. The three largest customers they retain for these products consists of Safeway, Albertsons, and Kroger. Business with the three of those companies makes up almost a quarter of the total revenue for Clearwater Paper. The amount of business Clearwater receives from these companies mirrors the time they have had together. Clearwater has been supplying those three companies for over 25 years. Also to be noted, Clearwater has an average customer relationship span of 19 years.

Industry Research Competitive Rivalry in the industry We believe the competitive rivalry in the industry is high. Clearwater Paper Corporation is competing with good standing in Western U.S.A. but facing high competition on Mid-West and East U.S.A. CLW Corporation’s major competitors on consumer branded tissue and private level products are Procter & Gamble, Georgia-Pacific, Kimberly Clerk, International Paper, MeadWestvaco, and RockTenn. Most of the major competitors are larger in size and have significant market share in U.S. We assess the threat of competition as high. Threat of new entrants The threat to new entrants for this industry is moderate. Despite the capital-intensive manufacturing process of private label tissue and bleached paperboard products, foreign manufacturers of paperboard from Asia are increasing and expected to increase their presence in the U.S market. Long-standing customer relations with some contact customer can decrease certain level of the threat. Another strength for reducing threat of new entrant is strategically positioned pulp and paperboard facilities for efficient distribution and availability of corporation’s manufacturing

inputs. We assess a moderate threat of new entrants due to some barriers to new entrant to the industry. Bargaining Power of Customers Customers have a high bargaining power. Clearwater Paper Corporation has to deal with retailers and other institution such as airports, hotels, restaurants, and office building for both of its Consumer product and Pulp and paperboard business segments. Those institutions have huge buying power. Buyers can choose competitors’ products and service for better quality or price. We assess high bargaining power of consumer. Threat of Substitutes There is a low threat of substitutes in this market. Clearwater Paper Corporation’s pulp & paperboard and consumer products are basic goods. There are very few substitutes for their products. Still there are threats of substitutes from larger competitors’ products with possible new technologies improvement due to their operational advantages. Also use of toilet paper and other tissue paper can be replaced by air drier. We access the low threat of substitutes in near future because CLW products do not have perfect substitutes. Bargaining Power of Suppliers Suppliers in this market have a moderate level of bargaining power. Principal raw material used is wood fiber consisting of pulp and chips, sawdust, and logs. Clearwater Paper Corporation limits some level of bargaining power of suppliers by owning and operating a wood chipping facility located in Clarkston, Washington. The suppliers of other inputs such chemicals in the production of pulp and paper, caustic, polyethylene, starch, sodium chlorate, latex and specialty process paper chemicals has high bargain powers.

Industry Life Cycle Maturity Stage In U.S market, paper & paper products industry is in the maturity stage of its life cycle, but it is still in growth stage in its respective international market. In recent years U.S paper and paper product industry has slow sales growth and low profit margin because this industry has a long history of providing products since 20th century. Now there are many competitors in the paper & paper product industry creating product differentiation with

high promotion and advertisement. We assess paper & paper products to be in the maturity stage of its life cycle in the U.S market. In international markets, especially in emerging markets, paper & paper products are in growth stage. Economic situation of developing counties are improving and they are consuming more of those products. Developing countries used other alternatives for paper & paper products for example; people in less developed country’s use water instead of toilet paper, and use durable clothes as towels instead of tissue paper. Stable Growth and Demand of Tissue Market Clearwater Paper Corporation focuses on tissue paper business in its consumer products division. The tissue market has grown an average of 1% - 2% annually since 1996, which is consistent with U.S population growth. In 2015 it was expected to increase tissue demand index to 143 from demand index of 141 in 2015, which is proportion to the expected population growth in 2016 to 324 million from 321 million in 2015.

Company Strengths High Quality Products Pulp & Paperboard products are at a high quality for printing. They are durable, yet, flexible for transforming into finished products for their customers. These paperboard products are also offered in various sizes and thicknesses. The consumer products offered by Clearwater Paper are of high quality that match leading brand name products. These products are also offered in various grades of quality for different price ranges. Clearwater Paper's consumer tissue paper products are 100 percent private label products. Long-Standing Relationships Clearwater Paper has created flourishing, long-standing relationships with their customers for both, their pulp and paperboard products, as well as their consumer private label products. The consumer product business supplies three major national grocery brands. The paperboard business' largest 10 customers account for more than half of the shipments of the business. Many of their top tissue customers have been associated with Clearwater for more than twenty years. Strategic Plant Locations The geographic strength of Clearwater Paper reaches throughout the United States. In regards to Clearwater Paper's Pulp and Paperboard business, the Lewiston, Idaho facility is the only coated solid bleach sulfate (SBS) paperboard mill in the Western United States. This allows them to have reduced transportation costs to the Western United States as well as Asia. There is also another Clearwater Paper pulp and paperboard mill in Cypress Bend, Arkansas that assists the Lewiston mill reach

customers throughout the whole United States. This mill's primary focus is to the Midwestern and Eastern United States.

The consumer products segment holds most of the company's sales. This fact directly complements the reasons for having seven mills scattered throughout the United States dedicated to providing customers with their private label consumer products. Due to the light weight nature of tissue paper, it is necessary that Clearwater Paper have multiple mills throughout the U.S. in order to maintain lower transportation cost and still be able to reach a broad amount of customers nationwide. This is precisely the methods that Clearwater is utilizing.

Competitive Strategy Private Label Focus Clearwater Paper Corporation has many products that rival their competition. For example, their consumer products offered and the quality that is attached to them. But Clearwater Paper also has competitive strengths in regards to production. Clearwater unlike many of their competitors produces much of their own pulp. Other companies, outsource most, if not all pulp from companies in order to produce their finished products. Whereas, Clearwater paper, only has to insource minor amounts for production. Clearwater Paper has determined to enact consist of growing their tissue business, as well as maximizing the profitability of both, their paperboard and tissue businesses. Clearwater Paper's macro strategy is to create and increase shareholder value. Growing Tissue Business Some of the goals Clearwater Paper have set to grow their tissue business are to lead private label in quality. They wish to expand to more locations geographically, as well as diversify their customer base. Maximizing Profitability of Paperboard Businesses In order to maximize the profitability of paperboard and tissue businesses, Clearwater Paper plans to improve the sales mix of their products. They also are taking steps to reduce various costs within their company. Clearwater Paper is working on finding new ways to become more desirable through improvements of their products quality. They have also taken other investment actions to maximize the profitability of their businesses. For example, Clearwater Paper has announced that they will be investing $160 million in their Lewiston, Idaho mill. The finished product of this investment is a continuous pulp digester. This will reduce air emissions, reduce cost of wood supplies used in pulp production, and produce higher quality pulp. Location Strategy There are seven facilities of Clearwater Paper Corporation scattered throughout the United States. Their biggest, being located in Lewiston, Idaho. Due to their more lucrative business in private label consumer products, Clearwater Paper aims to expand geographically to meet the

needs of private label customers all around the United States while cutting transit cost that are attached to shipping their products. The company has opportunity to gain market share in the tissue paper market throughout the United States, more specifically, the Eastern United States. Clearwater Paper is contemplating options to open more mills on the East coast. At this time, Clearwater Paper has only one facility on the East Coast located in Shelby, North Carolina that provides private label products to customers in that section of the country. This strategy would better enable Clearwater to meet demands of present customers and give them the opportunity to add East coast retailers to the customer base. Enacting in these options would help Clearwater Paper achieve more market share through a larger customer base from manufacturing and sales at more locations. This strategy would also further the reduction of transportation costs of materials of outsourcing and finished products to be sent to customers.

Financial Analysis Free Cash Flow Analysis Clearwater seems to be showing small improvements in its yearly free cash flow over the next few years. Growing from $82 million to $157 million (estimated). There was relatively small growth in operating income. However there seems to be a steady demand growth in tissue in the range of 2%. Also their pulp sector will become more efficient over the next few years with the installment of a continuous digester. This will increase CAPEX in 2016 and 2017, however the new machinery produces more output with the same amount of input allowing Clearwater to increase inventory. The excess pulp can in turn be used to reduce their tissue expenditures. Please refer to appendix two for the free cash flow analysis. ROE versus Competitors

ROE for Clearwater at 3.6% versus the simple industry ROE average of 12.7% is low. Clearwater Paper simply cannot compete with its competitors in offering any return on its equity to its shareholders. However, ROE will most likely fluctuate over the next few years due to increasing financial leverage and a decreasing asset turnover ratio.

Economic Value Added Clearwater had a total equity of $497,537, total long-term debt of $575,000, a tax rate of 37%, a discount rate of 11.2%, and a cost of debt 6.78%. Using these factors we derived their ROIC of 12.7% and WACC of 9.4%. Therefore the economic value added is 3.3%. This is their highest true economic profit when compared to previous years. Forecast Model Clearwater’s revenue fell from $1,967 million in 2014 to $1,746 million in 2015. However total revenue growth is expected to grow at a slow but steady pace of about 1-3% in the next few years. Their revenue growth is closely tied to population growth. This information entitles us to assume that there will not be any substantial revenue growth over the next 3 to 4 years. They completed a repurchased program, which minimized their outstanding shares to 18 million. There are no indications of Clearwater disbursing dividends to shareholders’ nor any indication of increasing their outstanding shares. From this we forecasted that their EPS would increase over the next few years by from 3.76 in 2015 to 4.69 in 2018 mirroring their steady increase in net income. Please see appendix three for the financial forecast.

Stock Valuation Analysis Discount Cash Flow (DCF) Model Since the current stock price is $46.14 and the number of shares is 18million, the market value of the firm’s equity is $830.52 (46.14*18 million). The market value of the firm’s debt is $575 million.

So the total enterprise value of the firm is $1400 million. The total equity and debt is $1405million. 60% of company financing comes from equity (total equity/ total equity and total debt), the same 40% comes from debt (total debt/total debt and total equity). According to S&P 500 index (on 2/11/15), the long term market risk premium is 6%, longer risk free rate is 4%, the market expected return = long term market risk premium + longer risk free rate = 6% + 4% = 10%.

We believe the stock price has high volatility being a small cap company, so we use the beta of 1.2. Under the CAPM (Capital access pricing model) the cost of equity with beta of 1.2 is 11.2% (4%+1.2*6%). The interest expense in 2014 is $39 million. The total debt is $575 million. The cost of debt is 6.78% (the total expense/total debt).

By using all the information above, the weighted average cost of capital will be 9.4%. (60%*11.2%+40%*6.78%). We estimated the 5 year growth rate for this firm is 9.0% and estimate the long term growth rate to be 4%. The firm’s estimated EBITDA in 2015 is $208 million. The estimated income tax expense is $30 million. The estimated capital expenditures are $100 million. Using the DCF model in appendix 4, we can find the fair value to be $40.54 per share. High PEG Ratio Clearwater Paper has a PEG ratio of 3.87 versus the simple industry average PEG ratio of 2.92. Using this as a benchmark to value the company’s performance it is considerably high. This confirms that our analysis of the stock is overvalued. P/E Valuation for CLW Because CLW does not pay a dividend, and is expected to have low (1- 2%) revenue growth, conventional valuation measures like DDM, RIM produce unreliable results. CLW is looking to increase profitability through operational efficiency and margin improvements; so, we conducted financial ratio analysis of more established and larger competitors to derive a reasonable present value. Here is a compilation of data for the primary competitors of CLW:

Peer Group Comparison As of 1/5/15 WRK IP WY CLW Simple Avg of Competitors Price 45.49 37.99 29.90 46.30 - Market Cap 11.58B 15.75B 15.26B 0.823B 14.20 P/E (ttm) 15.53 18.04 27.48 51.85 20.35 Forward P/E 12.92 9.82 20.62 11.05 14.45 PEG 1.64 1.32 5.79 3.87 2.92 P/S 1.02 .69 2.13 .46 1.28 P/B .99 3.59 3.13 1.76 2.57 ROE 8.1% 18.6% 11.3% 3.6% 12.7% LT Debt/Equity .48 2.04 1.11 1.30 1.21 Div Yield 3.30% 4.63% 4.15% - 4.02% Beta 1.32 1.43 1.11 .68 1.29

As shown, CLW represents a comparatively good value in terms of its P/S of .46, likely due to comparatively thinner margins. The company’s P/B also appears comparatively attractive, especially given their modest Debt/Equity. Trailing P/E for the company is much higher than their competitors; and so, with robust growth expected over the next 5 years, we based our financial ratio valuation on the forward P/E.

Because CLW is a micro-cap, albeit with a comparatively low beta, we believe this warrants additional margin of safety compared to competitors. Also, we consider Weyerhaeuser to be an outlier in our forward P/E comparison, so we calculated the average forward P/E of Westrock and

International Paper to be 11.4. A discount factor of 12.5% was used to give sufficient margin of safety, leaving a target forward P/E of 10.0. This translates into a price target of $41.83.

Based on the DCF model price of $40.54 and the P/E model price target of $41.83 we achieve our one year average target price of $41.19. This target price is below the current price of $46.14.

Investment Summary & Recommendation Summary

With a high competitive industry and high bargaining power of customers it is difficult to break entry into the paper and paper product industry. This industry is already in the mature stage of if its life cycle and with the amount of economic risk/industry pricing pressure this company faces this stock seems unfavorable. Clearwater does not pay dividends as do their competitors and is subject to minimal growth. The PEG ratio is high and the ROE is low when compared to the industry and does not favor a sound investment. With Clearwater’s competitors being a more affordable stock and offering dividends with a higher ROE and better margins than Clearwater it is hard to see why purchasing this stock would be a good idea. Recommendation We recommend to sell Clearwater Stock at the current price of 46.14. The stock is overvalued by our models. The volatility of this company seems to be underrated with a beta of .68 which is considerably low. The risks this company faces outweigh the positive factors that the company presents. The growth rate of the company is predicted at too high of a rate and with sales only increasing at the rate of population growth, this small cap company would pose too risky for any significant returns. With this company generating a negative net income in the year 2014, the recommendation to hold off on this stock is high.

Investment Risk Factors Late Stage of U.S Economic Growth Paper & paper products have positive relation with the U. S economy, especially its housing market. Currently, the U.S economy is in a relatively strong recovery position since the recession of 2008. However, with the Federal Reserve raising interest rates and the uncertainty of oil prices these risks pose a threat to the growth of the paper and paper products industry. Operational Risks

A majority of the risk Clearwater Paper faces is operational. They face competitive pricing pressures on their products due to increased capacity as additional manufacturing facilities are operated by their competitors. Changes in transportation costs or possibly disruptions with transportation services. Changes in the availability or cost of wood pulp and wood fiber or possibly labor disruptions. As well as manufacturing or operating disruptions such as IT system failures, equipment malfunction, or possibly damage to manufacturing facilities due to fire or other weather-related incidents. If changes in costs occur for packaging supplies, chemicals, energy, and maintenance/repairs this could prove harsh and effect the company’s bottom line at the end of the fiscal year. Industry Pricing Pressure These risks include but are not limited to events such as changes in international, U.S. economy, or in regions in which Clearwater Paper operates. Any announced price changes for their product that may not be widely accepted. An inability to fund their debt obligations, facing restrictions on their business from terms and debt covenants, and or changes in laws, industry standards, or regulations that affect their business. If any foreign currency were to suddenly appreciate against the dollar than Clearwater may face more import competition from overseas. Other Risks Customer preference also plays a risk if changes in customer preferences occur or competitors have better product offerings. Cyclical industry conditions as well as customer acceptance of timing, and the quantity of purchases through Clearwater Paper’s new through-air-dried or TAD products. There is also a chance that the company may not successfully implement its planned operational efficiencies or its expansion strategies causing even further setback and stagnating potential company growth. Weather also poses a significant risk in some areas where Clearwater Paper has placed its plants, in the Spokane and Lewiston locations, known wind storms have been known to occur as well as significant snowfall which can lead to power outages or delayed transportation shipments.

Disclosures: Ownership and material conflicts of interest: The author(s), or a member of their household, of this report do not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report do not know of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue.

Position as a officer or director: The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company. Market making: The author(s) does not act as a market maker in the subject company’s securities. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with Eastern Washington University, CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.

CFA Institute Research Challenge

Appendix 1

Clearwater’s Balance Sheet Two-Year Comparison

2015 2014 $ Variance

Assets

Cash & Equivalents $128 79 49

Accounts Receivable 148 134 14

Inventory 157 286 -129

Other Current Assets 37 28 9

Total Assets 471 527 -56

Liabilities

Short Term Liabilities 101 0 101

Accounts Payable 61 216 -155

Other Current Liabilities 90 8 82

Total Current Liabilities 252 224 28

Long-Term Debt 574 575 -1

Other Long-Term Liabilities

380 280 100

Total Long-Term Liabilities

954 855 99

Total Liabilities 1,206 1,088 118

Shareholders’ Equity 460 498 -38

Total Liabilities and Equity

1,666 1,586 80

Appendix 2 Free Cash Flow Model

Appendix 3

Appendix 4

Appendix 5

Appendix 6

Clearwater Market Share

Appendix 7

Appendix 8