No Matter How Bad It Gets, Consumers Will Still Buy Toilet Paper

• Marilyn Alva
• On 6:00 pm EDT, Wednesday October 28, 2009

Some people prefer the forest to the trees.

If you're a tree person, you might prefer Clearwater Paper (NYSE:CLW - News) to its former parent, Potlatch (NYSE:PCH - News). Both are based in Spokane, Wash.

Until its spinoff last December, Clearwater comprised the pulp-based manufacturing businesses of the 107-year-old integrated forest-products company Potlatch.

Nearly four years ago, Potlatch converted to a timber real estate investment trust, or REIT. The spinoff allowed it to become more of a pure-play timber REIT, focused on growing trees and managing land holdings.

REIT investors weren't much interested in Potlatch's paper manufacturing arm, even if it did make recession-resistant products such as private-label bath tissue and napkins.

"It's a good niche within the paper industry," said analyst Steven Chercover of D.A. Davidson & Co. "Demand for tissue is not really impacted by the economy or technology."

But it also was a more traditional, taxable business line inside a supposedly tax-efficient REIT, which pays out most taxable income to shareholders and deducts those dividends from corporate taxes.

"It makes no sense to have such a taxable asset in a tax-efficient vehicle," Chercover said.

Investor Interest

Clearwater may not have been appreciated when it was part of Potlatch, the REIT, but it has drawn investor interest as a stand-alone company. The firm's stock has climbed to near 50 from its IPO opening price of 14 in December. What's more, profit has shot up like a seedling on steroids.

In its first quarter as a public company, earnings soared nearly 500% from the year-earlier quarter to $1.19 a share. Second-quarter earnings came in at $1.52, a 245% jump.

Third-quarter results will be reported early Thursday. Analysts polled by Thomson Reuters forecast earnings of $1.21 a share vs. 8 cents a year earlier.

Clearwater says it's the biggest private-label tissue manufacturer in the U.S., making 56% of all private-label tissue sold to grocery stores. Its top customers include Albertsons, Supervalu (NYSE:SVU - News) and Kroger (NYSE:KR - News).

That core business accounts for a little less than 50% of total sales but more than 70% of company profits.

If taxes figured into Clearwater's spinoff, they have also played a big role in its brief history as a public company.

Clearwater qualified for refundable federal tax credit payments this year as an alternative fuel mixer for producing energy at its pulp mills. It uses "black liquor," a thick byproduct from its pulping process, to heat its boilers.

The firm recorded $76.4 million in tax-credit income during the second quarter for the period from late January to June 30.

Ian Zaffino, an analyst at Oppenheimer & Co., figures that credits will translate into another $15 million a month through the end of the year, when the benefit is set to expire.

"They will be left with no net debt and a great balance sheet," he said, noting that the funds could be used to pay down debt, make an acquisition or add plant capacity.

Clearwater's plants are running at near 100% capacity.

"They've sold every square of bathroom paper they can make," Chercover said.

Management has said it's looking to expand its private-label consumer products deeper into the eastern U.S., where they aren't as well penetrated in grocery stores as they are in Western states.

While analysts aren't too concerned about the loss of tax credits, those polled by Thomson Reuters estimate that earnings next year will dip 10% from this year's level to $4.44 a share. This year's profit is seen rising 477% vs. 2008 to $4.96 a share.

"Clearwater Paper was around a long time before these tax credits, and they will be around after these tax credits go away," Chercover said.

The division with consumer tissues and related products is doing the best of any. In the second quarter, segment sales totaled $139.4 million, up 13% from a year earlier. Total revenue in the quarter rose only slightly, to $316.9 million from $316 million.

The gain in consumer tissues was largely due to 7% higher net selling prices and a 6% bump in tons of finished goods shipped, for a record 51,727 tons.

The company's main rivals in this segment are big national-brand companies such as Kimberly-Clark (NYSE:KMB - News), Procter & Gamble (NYSE:PG - News) and Georgia-Pacific. Clearwater generally prices its premium private-label products 5% to 10% below national brands.

"In tissues, it's been taking market share from the branded companies," Zaffino said. "Because in bad times people go for the cheaper, private-label tissue paper. But it's high-quality tissue paper and once people are exposed to it, they will probably stay with it."

Clearwater's other main segment, pulp and paperboard, hasn't fared as well because it's more sensitive to economic swings. High-grade paperboard is sold to makers of milk cartons, juice containers, paper cups, frozen dinners, and cosmetic and pharmaceutical packages, among other items. Premium bleached paper is also used for greeting cards and cover stock for annual reports.

Pulp and bleached paperboard sales in the second quarter fell 6% from the earlier year to $174.4 million, in large part because of lower paperboard shipments and a 32% drop in pulp selling prices.

Defensive Issue

The business has staying power, analysts say. "At the end of the day, people are still buying cosmetics, they're still buying frozen dinners, they're still buying greeting cards," Chercover said, and Clearwater has "very competitive assets."

The overall decline in pulp prices was a plus when Clearwater needed to buy pulp for its own manufacturing operations.

Its small wood-products business, which accounts for about 5% of revenue, has been especially hurt by the housing market. Second-quarter revenue fell 40% from a year earlier to $16.6 million.

The tiny lumber business was included in the spinoff because it came with a sawmill in the center of the company's pulp and paper complex in Lewiston, Idaho, providing a good source of chips and boiler fuel.

Improvements in the economy should help the pulp, paperboard and wood products lines, Chief Executive Gordon Jones said in a second-quarter conference call. He will likely update the firm's outlook when it reports third-quarter earnings Thursday.

"The business is at an inflection point," Zaffino said.

Buzz up!