Ladies and gentlemen, thank you for standing by, and welcome to the Clearwater Papers Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] I would now like to hand the conference over to your host today, Investor Relations, Mr. Sloan Bohlen. Thank you. Please go ahead.

Thank you. Good afternoon and thank you for joining Clearwater Paper's second quarter 2020 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 second quarter of 2020 will be released shortly after today's market close or were released shortly after today's market close. You will find a presentation of supplemental information, including a slide providing the company's current outlook which is posted on the Investor Relations page at our website, clearwaterpaper.com. Additionally, we will be providing certain non-GAAP financial 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 this slide, we are going to incorporate it by reference into our prepared remarks. 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, Clearwater Paper had an outstanding quarter driven by continued strength in our tissue business, stability in paperboard and excellent operational execution. On a consolidated basis, the company reported net sales for the second quarter of $480 million and adjusted EBITDA of $79 million, which represents growth of approximately 6% and 78%, respectively, over last year. Our Consumer Products division drove results with both higher sales and production volumes to meet increased tissue demand. Lower input costs, particularly in pulp, were also a tailwind on a year-over-year basis. Together with our customers, we were able to rationalize our SKU offering, which increased throughput to meet elevated demand. Our supply chain team worked closely with customers to fulfill orders with a depleted inventory position after the consumer driven pantry loading in March. I will speak in more detail to industry conditions in a minute, and Mike will provide some additional context on operating leverage in his comments. Another important update in the quarter is that we are at full production run rate for our new Shelby paper machine, which is on target with our mid-2020 expectation. We remain on track to achieve the full benefits of the Shelby investment, which include achieving full run rate on converting equipment, increased sales and supply chain benefits by the end of 2021. Overall, we continue to realize the benefit from the Shelby investment and are utilizing the resulting free cash flows to delever our balance sheet and increase value for equity holders. Our paperboard division produced a stable quarter in Q2, managing through uneven end market segments. Our backlogs were above seasonal averages at the beginning of the quarter, but are now in line…

Thank you, Arsen. Please turn to Slide 7. The consolidated company summary income statement as depicted for the second quarter as well as the first half of 2020 and 2019. In the second quarter, diluted net income per share was $1.36 per share and adjusted EBITDA was $79 million. The corresponding segment results are on Slide 8. Our paperboard business continues its steady EBITDA performance, while consumer products benefited from significant sales growth and fixed cost leverage associated with production growth and favorable input costs. Please turn to Slide 9 where you will notice that we will speak about our performance a little differently than before. In addition to addressing second quarter performance relative to the first quarter of this year, we will also compare the current quarter with the quarter from a year-ago. In the second quarter of 2019, we started Shelby II and incurred, as anticipated, start-up costs related to inefficient staffing, lower production throughput, higher waste and other costs. While we're not providing a specific dollar amount for these costs, the Shelby ramp is an important factor in our performance improvement. We are benefiting from the volume increases related to the production ramp, which is helping meet some of the COVID-related demand and incremental volume from new customer programs. Partly offsetting the upside on volume and our cost structure is a mildly negative price/mix experienced during this time frame. Slide 10 is a good representation of the impact of COVID demand on our cost structure. While higher sales had a positive impact on our financials, our costs were significantly lower. The fixed cost leverage was the most significant driver as we produced almost 2 million cases more in the second quarter versus the first quarter. In addition to the improved cost leverage, we also experienced cost benefits…

Thanks, Mike. Let's turn to Slide 16. I would like to reiterate our investment proposition, which we discussed on our previous earnings call and mentioned to investors throughout the quarter. First, we believe Clearwater Paper is very well positioned across two attractive and complementary businesses. Our Consumer Products division is a leader within the growing private branded tissue market. From our advantage point, we believe the key strengths of this business are the following. First, we have a national footprint with an ability to supply a wide range of product categories and quality tiers, which is an attractive sales proposition to our customers. Our expertise in manufacturing, supply chain and transportation is a key differentiator, especially during challenging times like today. Second, there are long-term trends away from branded products to private brands. This is amplified during recessions. Private brand tissue share in the U.S. has risen to over 30% in 2019, up from 18% in 2011. While these trends are impressive, we are still a long way from where many European countries are where private brands represent over half of total tissue share. Lastly, tissue is an economically resilient and need based product. Historically, demand has not been negatively impacted by economic uncertainty. Turning to our paperboard division. We believe that the key strengths of this business are the following. First, we operate well invested assets with a geographic footprint, enabling us to efficiently service customers on both coasts. We have a diverse customer base that serve end markets that have largely stable demand. Second, not being vertically integrated enables us to focus on independent customers with unparalleled service and quality commitment. Lastly, we believe the business is well positioned to take advantage of trends towards more sustainable packaging and food service products. Our paperboard business has demonstrated an ability to generate good margins and solid cash flows. Overall, our large capital investments are behind us, and we're prioritizing cash flows to reduce debt as we demonstrated in the second quarter with a net debt reduction of approximately $100 million. We intend to continue to do so by delivering benefits from our Shelby investment, continuing with operational improvements, aggressively managing working capital and prudently allocating capital. We believe that this strategy is the best way to create value for equity and debt holders in the near-term. I also want to add that we prioritize the sustainability of both the products we make and the way we make them, which is a key part of our investment proposition. Before we take your questions, I want to express my deepest gratitude to how our employees have responded to the COVID-related issues that are impacting our personal and professional lives, and to our customers, vendors and local officials who continue to work together with us in partnership to navigate continued uncertainty. So with that, we will end our prepared remarks and take your questions.

[Operator Instructions] Your first question comes from the line of Adam Josephson. Your line is now open.

Arsen and Mike, good afternoon.

Good afternoon, Adam.

Good afternoon, Adam.

Congratulations on a nice quarter. A couple on SBS, and then I'll ask one or two on tissue. On the inventory issue in 2Q, I don't recall hearing anything a year ago about the treatment of consigned inventory artificially boosting volumes in the release or on the call last year. I appreciate that you guys were not in your same positions a year-ago. But can you just help me understand what happened and why there was no mention of this a year ago, if it was a big deal affecting volumes?

So I think, Adam, to answer your question directly, and then I'll pull back a little bit, roughly 5,000 tons got recognized into revenue in the second quarter of last year. I can't speak to why it was not called out specifically back then. When we look at the period year-over-year, both from a quarterly standpoint and a 6-month standpoint, we don't see huge differences, but that was one thing that popped out when we were looking at the data that we wanted to make sure that we called out. We do have some mild negatives in the quarter, primarily in the commercial print industry in the second quarter of this year that's showing up a bit in our Manchester Industries business as well as a little bit in the foodservice business, but we've had pretty stable volumes year-over-year when you isolate that, I call it, movement from inventory to revenue last year.

Got it. Thanks, Arsen. And just also on SBS, you're seeing largely stable trends, and you characterized the industry as largely stable. As you know, industry backlogs are multiyear lows. Your two largest competitors have both announced the market downtime in the third quarter, owing to weakness in commercial print and cup stock. What gives you confidence that market conditions in SBS will hold up through year-end, given everything we are hearing and seeing?

So I can't speak to our competitors, but what we will tell you is we started with backlogs, we started in the quarter with backlogs that were higher than historical averages. We’ve normalized towards the end of the quarter at towards historical averages, and we’ve held around those averages through the month of July. So our end market segments, the strength in folding carton and food packaging applications appears to be offsetting some of the weakness in commercial print and foodservice. Although it's pretty hard to predict how this plays out for balance of the year. But as of right now, we're seeing relatively stable backlogs that are comparable to historical averages.

Got it. Thanks, Arsen. And on the tissue side, can you just talk about what you were thinking 3 months ago when you gave the EBITDA guidance of $50 million to $55 million. And then obviously, you upsized it quite a bit and then you beat even that much higher range. I mean presumably at the time -- I mean, not presumably, you knew how the tissue demand was in May and potentially into June. And yet, obviously, you are -- you ended up dramatically raising your guidance, I guess, because that the impact of a higher production on your fixed cost is much greater than what you were expecting. But what exactly was so much -- played out so much differently on the tissue side than what you were expecting, given how positive you were on tissue demand trends even back then?

So two things. So when we provided that guidance, what we knew is what March and April looked like. May and June were still a bit unknown to us. And we were anticipating June demand to start slowing down considerably, and it didn't. June demand was still very strong, and our volumes were very high, up quarter-over-quarter. That's the first piece. The second piece is our production was able to keep up with those elevated quarters. So we shipped 16 million, and we produced 15.9 million. And the benefit -- the cost benefit of that increased production was very substantial. So I think there were two positive surprises for us: it's the continued strength in demand heading into June as well as our ability to produce to those orders as well as the cost absorption positives that we experienced.

Thanks. Just last one on just the topic of guidance. So just given what happened in 2Q and the extent to which you put up just dramatically higher EBITDA than what you were guiding to, what is your confidence level in your third quarter guidance range? And do you think it's worth giving EBITDA guidance even for the current quarter, given what seems to be a lack of visibility?

Adam, it's Mike. I definitely appreciate the spirit and the intent of the question, and I'm not going to accuse you of not asking for guidance. I think part of what Arsen's commentary was is we learned what we were capable of doing. It's one thing to see it in theory, it's another thing to see it show up on the bottom line, and that's what happened in the second quarter. I think, again, we are pointing to the third quarter, it's largely going to be a function of demand now that we know what we are able to do on the production side of things. And we are calling for the markets to cool off a little bit. Just given the read of what we have in July, I think tissue is coming in a little bit stronger than we would have anticipated and PPD is kind of in that same ballpark as we expect it to be. So that’s what gives us some comfort. But yes, we are -- yes, I understand, again, the spirit and the intent of your question.

I appreciate it, Mike. And I guess, just last one on tissue pricing. Your price/mix was a drag year-over-year, and it was pretty flattish sequentially. And I think some investors would have expected you to get more price just given the extraordinary demand that you saw in the last couple of quarters. Can you just talk about the relationship between demand and pricing in this industry and how your pricing mechanism works and whether you will eventually get pricing as a result of this exceptional demand that you've seen since March?

Adam, generally speaking, we don't talk about future pricing, but let me just comment on the pricing mechanisms in tissue. They are not -- these are not a dynamic spot market prices. These are generally agreements with set pricing that are renegotiated on a regular basis. So as we look into the future, we certainly have market channel volume strategies around our agreements of how we plan to reshape our business in the future, but we are not going to comment on future pricing.

Thanks, Arsen. Appreciate it.

Your next question comes from the line of Kurt Yinger from Davidson. Your line is now open.

Yes. Thanks and good afternoon, everyone.

Good afternoon.

Hey, Kurt.

I just -- hi. I just wanted to start on the guidance. So if we were to try to think about the impact of cost absorption in tissue as demand normalizes, I mean, is that really the biggest driver in the $10 million EBITDA decline Q3 versus Q2, or are there any other big moving factors we should be aware of?

I think that, together with freight costs. So we had an interesting dynamic in the second quarter, where we were shipping direct to customers more so than we usually would, which had a lot of freight costs down. As we rebuild inventories to service our customers at the level they're used to being serviced at, that's going to add back some costs to our freight. And then we have some other kind of puts and takes in there, but those are the two biggest drivers.

Got it. Okay. That's helpful. And I guess kind of sticking with that input cost, I mean how should we think about fiber and maybe energy in the second half? Should those continue to be pretty nice tailwinds, at least on the fiber side?

Yes, if you look at the latest forecast, the public forecast that are out there, pulp pricing is expected to be largely flat, maybe down slightly in the second half versus the first half. I think other input costs around energy, they're relatively benign transportation as relative to benign. We are experiencing an interesting dynamic with some of our what fiber costs in the paperboard business with lumber mills ramping up to meet increased demand. We're seeing more chips available, more residuals available to us. So that could provide a tailwind for us in the second half, but largely benign with maybe some upside on the residual cost and paperboard.

Got it. Okay. And then if we were to look at SG&A up, I guess, about $6 million year-over-year, what were kind of the biggest components in that increase?

Sure. One that we are happy to talk about is employee bonus or compensation related to the outstanding performance. And so we had the appropriate accrual in the first quarter, but when you have this amount of beat, if you will, in the second quarter, we were accruing at a much higher level for the rest of the year and there's a one-time catch-up that you need. We also had some higher than normal professional services fees flowing through during the second quarter. Those were the two primary components.

Got it. Okay. Yes, I guess the first one is not really a bad problem to have. Okay. And then, I guess, lastly, you kind of outlined the major maintenance schedule here for 2021. I mean are there any smaller projects or impacts we should be mindful of kind of entering the second half? Any sort of deferred maintenance activity just given the strength here in the first half?

We do those pretty regularly. And we do have, in addition to maintenance, minor hick ups that will happen along the way. But nothing that I would call out that would be truly noteworthy.

Okay. That’s helpful. All right. Thank you. I will turn it over.

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

Good afternoon, Arsen. Good afternoon, Michael.

Hey, good afternoon, Mark.

Two questions for me. Mike, I wonder if you could just give us a little more color on where you see the working capital opportunities that you flagged in the presentation and sort of order of magnitude on them. And then we just had another big East Coast private-label or private brand producer announced a couple of new machines. So I guess, I wondered how directly you competed with them? And maybe if you could just deal with the issue of incremental capacity still coming into the private-label market.

Sure. So I'll handle the first one on net working capital. Arsen will talk about tissue. So -- and my net working capital commentary, Mark, it was -- it maybe backward looking to the second quarter, which is, I hope, covering your question. But we had a net working capital benefit in the second quarter of just under $45 million. The biggest benefit there was accounts receivable -- trade accounts receivable coming down by approximately $21 million. We had inventory coming down in the quarter as well, close to $5 million. AP, accounts payable and accrued liabilities went up by $15 million. I would point out to you, Mark, that if you look at our capital structure, we make our bond interest payments in the first and the third quarter. That's a cash payment of about $14 million. So we are a beneficiary of that from a working capital standpoint in the second quarter. We will be again in the fourth quarter, but in the third quarter, just expect to change by that order of magnitude.

Okay. That’s helpful. Yes, all right.

Go ahead. Anything else on the working capital?

No, I was just going to say, kind of looking forward, maybe you could talk about any additional opportunities you see on the working capital side?

We had started off the year, Mark, thinking that we would need a use of working capital of $20 million to $25 million. We withdrew that from our guidance last quarter. We are still trying to sort through what’s the right inventory level that we need to service our customers appropriately. I think in the paperboard business, we understand that and we are pretty close to that level. I think in tissue, we understand it, but we are still operating at a pretty low level. And so the expectation I would have for the back half of the year is that we are going to build inventory. And so we're a net consumer of net working capital.

Okay. All right. Fair enough.

So, Mark, on the tissue capacity, and I will stay away from commenting on specific announcements by competitors, but more general comments about tissue capacity. The market is about 10 million tons. It grows largely with population. So you see about 100,000, call it, 100-ish thousand tons a year of additional capacity needed to meet demand. That's one to two additional paper machines per year to keep the market -- to keep the balance between supply and demand. So if you look at this year, there's approximately 200,000, 250,000 tons of capacity that's coming online. Next year it's somewhere in the 150,000 to 160,000. And then beyond that, in '22, '23, it's still largely unknown. That's how I would think about the supply and demand. You need about 100,000, maybe 150,000 tons a year to keep -- to keep the market -- that to keep up with demand. In terms of competition, it's a highly competitive market, it has been for a number of years. So I would say we -- you should expect us to be competing across the board. We are a national player across multiple quality tiers, across all channels so we are constantly competing with many players in this market.

Okay. Just one other question. You mentioned the ramp up in kind of chip supply with kind of more lumber production. I think this is particularly acute over in the Pacific Northwest. Does that wind up rippling back to you guys in the intermountain region at all or not?

It does. And Mark, we have some flex capacity as it relates to our fiber within that footprint. So we consume both softwood chips and sawdust. On the softwood chips, we have the flexibility to pivot to have up to 50% of whole lot chipping. We were close to that level in the first quarter. Now obviously, that -- given what’s happened in that fiber basket, we are able to swing much lower. And so as you well know, the chip pricing is a lot lower than the whole log pricing that we get.

Yes. The lumber guys on the coast are moaning this. That's it for me.

Our next question comes from the line of Paul Quinn from RBC Capital Markets. Your line is now open.

Yes. Thanks so much. Good morning. Sorry, afternoon, Arsen and Mike. It's been a long day here. I guess I will start with Shelby II. You've mentioned you're hitting the run rate. What kind of mix improvement can we see in the next number of quarters or years?

It's a good question. So we are doing right now. So there's two things happening. So number one, right now, our demand in tissue, you may expect, has far exceeded our historical averages. And frankly, has been exceeding our multiyear projections with the Shelby ramp. So what we are trying to sort out right now is what does -- what do the next few quarters look like from a volume perspective, and how do we mix out that machine? Right now, every case coming off those lines is spoken for, and we are selling it. And the sales team is working right now on a multiyear strategy of how do we improve the mix on that machine to more ultra as it is an ultra capable machine. So it's a bit of a complicated answer. There is a short-term, meet the elevated demand and make as many as possible and then long-term, trying to figure out where does demand -- what does this growth settle out at, and then how do we mix out that machine from a customer and a product perspective to maximize profitability.

Okay. And then maybe just sticking with tissue and just on inventory in the distribution chain as well as the consumer side. Where do you anticipate that is right now? And I guess you are expecting a slowdown in Q4, but where are current inventories at?

So probably the right way to think about that is in-stock conditions and stores. So if you look at April, in the paper space, in stock conditions were somewhere in the 30%, 35% range. They've recovered to about 75% in stock on the shelf. The normal average in consumer products is about 90%. So I think you're starting to see inventory being rebuilt on the shelf, which means it's going to start being rebuilt at our retailer warehouses, and we are seeing some modest increases in inventory in our own system as well. But I would say we are maybe a third of the way there in terms of our recovery for inventory in tissue. So it's going to take us through at least Q4, we believe, to get back in stock, and it's going to be largely dependent on demand. Demand continues to be very robust, I think that recovery period gets the way.

Okay. And then just flipping over to paperboard. You guys and others have signaled commercial print and some areas of foodservice has been weak. Do you think that does recover, or are we going to recover to a lower normal going forward?

So Paul, it's Mike. And I think I've been more focused on the potential of a recession here. At some point, I think my sales team in PPD will accuse me of being the ECB predicting 9 of the last 5 recessions. So I think what we’ve seen in the past is that this market could be down upper single digits, close to 10%. And while the market is stable as we see it and as we are performing, we are also contingency planning to see if the market were to weaken, here is what will happen. I think it's anybody's guess in terms of how the economy is going to play out. So I know that’s not a direct answer for you, but I think so long as we have COVID hanging over us, I think we are going to have limitations on the commercial print demand and limitations on the foodservice demand.

Okay. Fair enough. Excellent quarter. Good luck going forward.

Thank you.

Thank you.

You have a follow-up question from Adam Josephson from KeyBanc. Your line is now open, Adam.

Arsen and Mike, thanks so much for taking my two follow-ups. Arsen, just pointing back to boxboard for a moment, you talked about your lack of integration actually being, in your mind, a competitive advantage. As you know, some of your larger competitors have made a concerted effort to get as integrated as possible. So can you just talk about -- just expand on why that is your strategy and why you think it differs quite considerably from others in the industry along those lines?

Adam, SBS is still -- majority of SBS demand is still non-integrated with independent converters. So we are focused squarely on that market, especially in folding carton. And the value proposition for us -- for them is that we are focused on their needs. And we are there for them whether demand is strong or not. So between our service proposition, our ability to deliver volume and our quality proposition has been an advantage for us because, frankly, if you are an independent converter, you would probably rather not buy from someone who is your competitor. So that has been an advantage. I think as we look into the future, I think we have to continue to reassess what is the right strategy for our paperboard business. But up to this point, we believe it's been an advantage for us.

Got it. Thanks for that. And just -- I know it's early days talking about next year, but you’ve, obviously, maintenance expenses going to be quite a bit higher next year. And then you’ve had this extraordinary year in tissue, obviously. Would you care to share any preliminary thoughts about next year? Is it reasonable to expect this level of tissue performance to persist next year? Is that unreasonable? I guess it all depends on one's view of the economy, as Mike was talking about earlier, but any thoughts you would share with us just about the sustainability of these earnings levels in your mind based on whatever facts you're aware of at the moment?

Adam, I appreciate the follow-up question in light of the earlier question on how confident are you in your third quarter guidance. The -- I think it's too early to tell, Adam. I know that's something that's important to everybody who is on the line and our investors. I think at the appropriate time, we will come back out and talk to you about it. I think in tissue, it's going to be a demand story and how much of this shift of demand has moved from away-from-home to, say, at-home, and how long is that going to sustain and what’s the new normal is. And I think as the year plays out, we will have some better estimates there, but they still will just be estimates. And then as the economy plays out, I think we will be able to update you on the paperboard business. And look, we recognize the importance of the question. I think as you think about a model for us, we would point to that outage number that Kurt had referenced before. So we know that’s going to be different in 2021 than 2020. And we will talk further about refining that estimate here in the hopefully not-too-distant future.

Absolutely. Well, again, kudos on a terrific quarter and best of luck this quarter, both of you.

Thank you.

I don't see any questions in the queue. I will turn the call over to Mr. Arsen Kitch for any closing remarks.

Thank you all again. We appreciate your interest and support, and we look forward to speaking again soon. Have a great evening.