Welcome to Clearwater Paper Corporation Third Quarter 2017 Earnings Conference Call. As a reminder, this call is being recorded today, October 19, 2017. I would now like to turn the conference over to Ms. Robin Yim, Vice President, Investor Relations of Clearwater Paper. Please go ahead.

Thank you, Bryan. Good afternoon, and thank you for joining Clearwater Paper's Third Quarter 2017 Earnings Conference Call. Joining me on the call today are Linda Massman, President and Chief Executive Officer; and John Hertz, Chief Financial Officer. Financial results for the third quarter were released shortly after today's market close. You will find a presentation of supplemental information, including an updated outlook slide, providing the company's current outlook as to certain costs, pricing, shipment, production and other factors for the fourth quarter of 2017 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 material provided on our website. I would like to remind you that this presentation contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 as amended. These forward-looking statements are based on current expectations, estimates, assumptions and projections that are subject to change, and actual results may differ materially from the forward-looking statements. Factors that could cause actual results to differ materially include those risks and uncertainties described from time to time in our filings with the Securities and Exchange Commission, including our Form 10-K for the year ended December 31, 2016, and Form 10-Q for the quarters ended March 31 and June 30, 2017, as well as our earnings release and supplemental information. Any forward-looking statements are made only as of this date, and the company assumes no obligation to update any forward-looking statement. John Hertz will begin today's call with a review of the financial results for the third quarter, and then Linda Massman will provide an overview of the business environment and our outlook for the fourth quarter of 2017. And then we'll open up the call for the question-and-answer session. Now I'll turn the call over to John.

Thank you, Robin, and welcome to everyone attending this call. As discussed in our October 3 press release, we did see headwinds in the third quarter that caused us to preannounce that our third quarter results would be below our outlook due primarily to three factors, one was incremental repairs during a scheduled major maintenance at our Lewiston, Idaho, mill, which led to a 3-day delay in the start-up of paper machines; two is the hurricanes in the South that caused logistical issues, resulting in higher transportation costs and delayed shipments; and three was the continued robust market demand for pulp, which kept prices elevated throughout the quarter. These factors contributed to our revised expectations for the quarter, resulting in third quarter adjusted EBITDA of $38 million, which is in fact below our original outlook range for the quarter but at the high end of our pre-announcement expectations. Despite these headwinds, we had several favorable developments during the quarter. As you are aware, in 2015, we launched a 3-year strategic plan aimed at generating between $115 million to $145 million in cost savings. During the quarter, we completed the 2 most significant projects within that plan. Together, we expect that those initiatives will result in identified annual savings of $50 million to $55 million on a full run rate basis beginning in 2018. First, construction on the continuous digester in Lewiston was completed, and it began operating at the end of the third quarter. It's running well, and the first pulp samples have been of good consistent quality. The benefit of the new digester is that it is expected to produce an incremental 50,000 tons of higher-quality pulp per year, and we now expect to be 100% vertically integrated in softwood pulp on the tissue side. We expect to see…

Thanks, John. Hello, everyone, and thanks for joining us today. Just want to let you all know, I have a little bit of bronchitis, so I'm struggling with my voice just a little bit today. If I have any trouble, I'll just pass it to Robin, who can finish our prepared remarks, and then I'll come back for Q&A. Today, I'm going to provide some additional commentary on the third quarter, then I'll take a look at the market environment and what we expect for our business segment. Finally, I will tell you what we expect for the balance of the year. The retail landscape continues to evolve, and with these changes, we see both opportunities and risks. With regard to challenges in the retail environment, in the third quarter, our largest tissue customer made the decision to go from a sole-sourced model to a multisource model for their private label tissue supply beginning in late Q1 of 2018. We will continue to be the largest supplier of that customer, particularly in the ultra-quality tier products, however, we will lose certain conventional premium value and economy SKUs starting in 2018, some of which we had intended to let go. We have already replaced approximately a quarter of the lost volume, and our sales team has been working diligently to replace the remaining volumes. We continue to expand our presence in the growing club, e-commerce and newer limited assortment distribution channels, and we added a new grocer in the Northeast. This reinforces our belief that we must continue to lower our operating cost to compete, particularly in the consumer tissue market. As John discussed, we completed 2 significant components of our strategic plan that together are expected to yield $50 million to $55 million of cost reduction per year as we…

[Operator Instructions]. And our first question will come from the line of Steve Chercover with D. A. Davidson.

So my first question has to do with these charges from Long Island and Oklahoma. When I looked at your Q3 '17 outlook, you were looking for $100,000 from Oklahoma, and it ended up costing you $5 million plus another $3.5 million in Q4. So I mean, how did it go from - up by 80x? And is it really capped?

Yes, I mean, the - when we initially shut it down, we had the lease still outstanding, so that wasn't part of the initial shutdown cost. We found an opportunity to mitigate 6 years' worth of cash outflows associated with the continuing lease payments, cost us a little bit upfront. But as I said in my remarks, from an NPV standpoint, we're $11 million to $13 million ahead over the time frame.

Well, I mean, as I recall, when you shut Oklahoma City, which was a new facility if I'm not mistaken, you indicated that it was going to increase your freight costs, but might you have been better to just continue operating it?

No, no. When you look at the wage savings that we get off that, it far exceeds the incremental transportation costs.

And Steve, that was one of the facilities that we acquired and actually, through some of our efforts of trying to gain efficiencies across our network with our converting, really presented itself the opportunity to reset our converting asset network and move a lot of that volume to other facilities.

And it's a legacy Cellu Tissue mill that was definitely a high-cost operation.

Okay. Well, all right, so when you pre-released on October 3, did you have any idea that you would be getting a $2.4 million federal tax benefit?

Yes.

So would it have been appropriate to indicate that, that was part of your equation since you knew it was coming to you?

Well, I think we focused on why we're going to be below so - and we were still below with that.

Yes, no, but the thing is, you make it sound with the tax benefit that, okay, well GAAP was a nickel, but we would've earned $0.32. I'm not sure if that's the right number either.

I mean, yes - I mean, you guys usually focus on EBITDA. So that's kind of what the prerelease was about.

Okay. So I'm going to ask a third one, and I won't get back in the queue. What is this relationship with A.T. Kearney going to cost?

Yes. So Steve, at this point, all I'm going to talk about with regard to A.T. Kearney is we hired them for their expertise in helping organizations benchmark themselves across the industry and other participants that might be of similar size and complexity. And they're really helping us find ways in which we can drive efficiencies and reduce costs. And the impact will obviously be on the positive side, and we'll give some guidance to that as we know more.

But doesn't it make sense to speak to people like that before you embark on a project like the Shelby expansion? Like to know if you're actually - if your cost structure's in line with your comps before you embark on a project of that magnitude?

Yes, given our current environment and the focus on all of our cost structure, I mean, obviously, we know we're in the throes of completing our Shelby project. But this A.T. Kearney project is really focused on SG&A, and we think it's valuable to bring in some external viewpoint to make sure that we're looking at all costs and all ideas, and all of those are considered before we move forward with how we're going to best structure the company.

I mean, our SG&A spend for the last 2.5, 3 years has not been where we want it from a financial model standpoint. And so we felt it's time to take more action in order to be able to kind of get that more in line.

And our next question will come from the line of Paul Quinn, RBC Capital Markets.

It appears that financials are moving around quite a bit. I mean, you sort of came out with the prerelease guidance on October 3. You said, $8 million to $9 million down from the - your previous guidance of $40 million to $46 million in the quarter, and then you hit the higher end of that. What is - what happened between, I guess, October 3 and the next 2 weeks that caused it to be on the high side?

I think the biggest variable there, Paul, is when you've got a major maintenance that is completing right at the end of a quarter, there's a lot of, I'll call it, complexity that goes into finalizing all that, all gets closed out and what gets inventoried and what doesn't get inventoried. So that was a big kind of swinger in terms of where we could have ended up in the range that on October 3, we were probably a week from having closed that all out.

Yes, it seems like a lot of the other companies I cover straddled maintenance over quarters, so they're able to get all those costs sort of done well in advance of the quarter-end? Maybe that's something you'd consider going forward.

Well, yes. We just - I mean, we don't always have them end right at the end of a quarter. That's the way this one played out.

Okay. And then just referring to the changing retail network on tissue, and it sounds like you're making some progress making up the volume of the customer you lost, but can you give us a feel for what kind of contracts and volumes are coming up over the next 12 months? And do you expect this to repeat going forward? And sort of what progress you think in terms of getting the full volume recovery back? Is that going to be over the next year? Is that going to be done in the next 6 months or...

Yes. So a couple of different questions in there, Paul. With regard to contracts, we do have them staggered, I think, pretty well over the course of multiple years, so we don't have any big multiple contracts expiring at the same time. We will target doing that. So this should be it from a contract life perspective, but that doesn't mean that customers can't go out to bid and make choices as to how they want to procure products with regard to their own time line. So that's always a possibility, although not expected at this point. And then with regard to replacing the lost volume, we replaced 1/4 of it, which I think is a tremendous effort on our sales team, and kudos to them for acting on this so quickly. The remaining volume, I'm confident we can replace it. But the time frame in which we can do so, I think, is what's difficult to predict right now. And I think I need to give the sales team a little bit more time in the marketplace before I can accurately predict how long we think it'll be.

Any assessment on the margin impact on the replaced volume?

It's hard to know. It depends on what channels we're going to move into and what the product mix is going to look like. I will tell you that when we look at customers and our interaction with them, we do have our margin model, and we have a certain expectation for what our margins should look like, and that won't be any different on a go-forward basis.

And our next question will come from the line of Adam Josephson with KeyBanc.

Linda, I hope you get better soon.

Thanks, Adam. Just disinfect the room with me.

Just one more on this tissue, the tissue customers. Obviously, you're doing the Shelby expansion. You're adding 70,000 tons of ultra-premium capacity. Can you just help us with what type of business you're losing and why one shouldn't be concerned that you could end up with overcapacity, given that you're adding significant capacity at the same time as you've lost what sounds like a sizable chunk of business?

Yes. So Adam, that's a great question. As we talked about in our prepared remarks, we are seeing growth and a better product mix out to ultra-product on the sell side. We have every reason to believe that's going to continue, and therefore, that extra capacity in Shelby is absolutely necessary. And part of why we saw a little bit of volume pullback in Q3 was just the availability of some of the ultra-product on our end and making sure we can ship to all the customers who want it. Really the product that we did not continue on with this customer was the conventional premium and economy value products. So we still have a very firm belief that ultra-quality tissue is what's going to continue to grow. We've seen it grow at a much faster pace than conventional capacity, and we think our assets are lining up very nicely to take advantage of that market trend.

Okay. And just one other on tissue and then one other, if you don't mind. Your margins have obviously been under pressure this year. Your input costs have been rising, and you haven't been able to offset that. What - and I know you've hired a consultant, you're doing on other initiatives. But what gives you confidence that over the long term, you're going to be able to offset any cost inflation with higher prices, just given how competitive the tissue market is, not only in terms of what your customers are dealing with and the extent of the capacity being added?

Yes, I think in the long run, if we focus there first, at least history would say that supply and demand match up pretty well in this marketplace. Now clearly, as we move into '18 and '19, we see quite a bit of supply coming online, and that's where you start seeing just a little bit more competition and whatnot. So I think from our perspective in the long run, we're focused on providing the right quality of products to our customers, what they want to have on their store shelves. We provide a lot of good information as to how to maximize their profitability in this largest non-food private label category that they manage in-store. And quite frankly, it's an important product segment, whether you're a brick-and-mortar or e-commerce. So I think we feel very confident that in the long run, this will all play out pretty well. In the short run, like we said, there might be some volatility as we see some of the supply come on in bigger chunks.

Right. And John, just one on cash. Just a couple of cash flow questions. You're pushing up $40 million of CapEx. Just remind me what led to that. And then working capital was a huge source of cash through 9 months, about, I think, $44 million. I know you talked about, on the last call, about reducing DSOs and extending payables, are you doing even more of that? And then what do you expect your cash taxes to be this year and next year, just given how high your CapEx will be?

Okay. I'll try to step through all that, and if I forget anything, call it out. So from the cash tax standpoint, basically, from this point going forward over the next 1.5 years to two years, we're pretty much a 0% cash taxpayer, given the amount of capital that's come online in bonus depreciation. On the working capital front, a lot of effort around working capital, primarily in the days payable outstanding piece of working capital, and that's everything from identifying terms with vendors that aren't industry average and pushing those out to supply chain financing type arrangements, but a lot of effort there. I think in the near term, inventory is going to be a little harder for us. This is typically a time period where we start to build inventory on the tissue side so that we don't have big service issues when we get into the busier part of the following year. But focusing on the working capital knob is going to be a continuing exercise for us. In terms of kind of capital outlay and the timing of all that, that's something we're managing very closely in terms of both when we sign up to take the capital and what that means to the overall plan to be able to go to start-up in Q1 as well as payment terms and those kinds of things. And so we're actively managing the cash flow. I think we've had about $186 million of cash flow from operations if you look back over the last four quarters, which is healthy. And we're actively managing as we move through this kind of uptick of CapEx to ensure that we are - have breathing room underneath our debt covenants.

And our next question will come from the line of Dan Jacome with Sidoti.

Just two quick questions. I'm just trying to draw a time line in my head with all this information on kind of - can you supply us with information on what came first? Did you go to A.T. Kearney first and then you learned that one of your large customers is going to multisource? Or did it happen the other way around? I'm just curious. And then my second question was, should we expect any change in your conversations with lenders and covenant and things of that nature based on the news of this large customer? And that's about it.

Yes. So I'll take the first question. We absolutely constantly look at our operating model and look for ways in which we can become more efficient and remain competitive in the marketplace. And we've seen the market become more competitive, we've talked about on the last couple of calls. And so we had absolutely reached out to A.T. Kearney, and the work was already started before we knew about the lost volume with this large customer.

Okay, great. And then on the debt side, anything we might expect there?

No. Like I said, I gave you kind of our forecast where we'd be from a debt ratio standpoint, kind of peaking in Q1 and going down thereafter. And like I said, we're actively managing all aspects of that. And so I don't think there's going to be anything different as a result of anything.

And our next question will come from the line of Chip Dillon with Vertical Research.

Obviously, and you might have answered this and I might have missed it, but did you give a 2018 CapEx number with the $40 million deferral on Shelby #2? And just remind us sort of how '19 CapEx would look? Because I suppose with the start-up in the first quarter, there'll be some CapEx on that bleeding into 2019. So can you give us sort of a range of what we should be thinking about for CapEx next year and in 2019?

Yes. So I'll start with 2019 and short of any alternative decisions made between now and then, we should see ourselves dropping back to our, call it, steady-state CapEx, which we've been saying is about $50 million of maintenance CapEx, maybe that goes up a little bit with Shelby 2, and about $25 million of strategic. So call it, $75 million to $80 million in 2019. With the pushout of the $40 million into 2018, we'll be probably north of 250 - be between $250 million and $300 million, I would say.

Okay, that's helpful and then in terms of the net debt peaking at the end of the first quarter. Unless you plan to spend a highly disproportionate amount of this $250 million to $300 million in the first quarter, I mean, is that the case? Because it's hard to see how you won't be - I mean, let's just say, you spend proportionately, which would be $65 million a quarter across the year, you're sort of implying that you're going to have $65 million of free cash each and every quarter beyond the second - well, I guess technically not. But you're saying that you're going to have at least that much overall in the back half of the year, or said differently, that would be around $195 million in cash flow above, I mean, in cash from operations, even if we assume no working capital increase in the back 9 months. And I just want to make sure we hear that right. So again, you have to have $195 million cash from operations unless you're spending a lot in the first quarter in order for your net debt to peak at the end of the first quarter.

Yes. So one of the dynamics you got to understand going on, Chip, is on a last 12-month basis, the ratio is calculated. And if you look back 4 quarters, we've got 2 quarters, Q2 and Q3, where we had major maintenance outages. Q2 in Arkansas; Q3 in Lewiston. So as we move into Q2, the Arkansas outage drops off, and we don't have any major outages in 2018. So that's an instant $8 million to $10 million, everything else equal, improvement in EBITDA. And then it's $20 million in Q3 that goes away. You get the multiple on top of that, you can see where that starts to have a more dramatic impact on the actual leverage ratio calculation.

I see. That makes total sense. So the absolute level of net debt may continue to climb but because of the - you're dropping off these bad 2017 quarters, the ratio should go down, that I get. Yes, that's very helpful. And I guess the last question is, it's interesting that year after year, we look at the AF&PA surveys. And despite just the many, many announcements we hear about tissue capacity coming on, it just doesn't seem to grow that fast. And it's obvious that, of course, shutdowns aren't announced in advance, but of course, capacity growth is. But as you think about the next couple of years, and you have Shelby 2 coming on, you have a very strong position, and yet you have all these guys, and I won't name them all, but you know who they all are, just tons of people building TAD capacity, and you have the whole foods impact, et cetera, and grocery, although there are a lot that are expanding, especially family ones, Wegmans, Publix, you name it. I mean, how are you thinking about the marketplace between all these forces?

Yes, that's a great question. The way we look at it is the consumer products tissue market, at-home tissue market, is still a great market as far as we're concerned. It grows with population, so as you know, a good 1%, maybe 2% a year, and it is one of the largest categories at any kind of retailer for the most part now, particularly grocery, but we're seeing it also as a very large category in many other channels. We're also seeing a big push towards private label. This is one category where we believe it's really easy to buy, purchase and rebuy private label. And we have worked really hard over the last 3 years taking cost out, making ourselves more competitive with investments in projects and technologies that are going to last a very long time. And as you saw today, we're not standing still. We continue to invest in the ability to maintain our competitiveness, and that will never change here at our culture. And so we think, given that we're one of the largest private brands manufacturers of tissue, we're poised to win. We work with a lot of retailers in every channel. We know the business very well. With a national presence, I think we understand the supply chain challenges and benefits of working with these many different customers. And we're just going to continue to focus on ways in which we can take care of our customers and ultimately be the winner in this market.

Okay. And then just real quickly on the pulp integration, which I think is really important. As you guys, I mean, I guess, pre-Shelby, you could think about you guys as being roughly 400,000 tons. You correct me if I'm wrong. And with the extra capacity at Lewiston, I believe, how much pulp will you be a net buyer of pre the start-up of Shelby #2? Is it - I would imagine it's less - a little less than half, is that fair?

I mean, if you look at it just from a tissue business - because paperboard is pretty much 100% vertically integrated. But if you look at it just at the tissue business, we'll be 100% vertically integrated in the softwood. And things can fluctuate month-to-month, quarter-to-quarter. But let's just say, generally speaking, we're more about half hardwood, half softwood on the tissue side. It depends - if you mix out more in terms of towels, you're more softwood. If you mix out more towards bathroom tissue, more hardwood. So we'll be basically 50% vertically integrated and buying externally 50%.

Okay. And I really appreciate this great information. Last quick question. The tax credit, I mean, if we take it away, you still did $0.18, which is taxing what was left at a normal rate. Could you just again remind me where does that tax credit come from? And is it - you chose to keep it within the adjusted number, is there - is this something that repeats? Or is it one time?

Yes. So the credit itself has to do with some capital improvements that we've made over the last couple of years. And we filed our tax return for 2016 in the third quarter, and that's basically why it ended up showing up, a lot of analysis as to whether or not you need a 1040-A reserve on that or not. And so that happened in the third quarter. When we look at what we adjust out or don't adjust out, we've got some fairly, I guess, kind of clear principles about what we do or don't because it's easy to kind of get sideways in that area. And typically, with tax, we look at it as we adjust out the tax impact of any pretax thing that we adjust out. And then when it comes to things, we look at our tax department, as part of their job is to find R&D credits and different kinds of things like that. And so whether it's an R&D credit or a credit associated with capital or kind of a discrete item related to adjustment of 1040-A reserve, we do not adjust those kinds of things out. Now this one, because it ended up on a GAAP basis swinging us from what would have been a loss to income, we did feel compelled to be very transparent about that and its impact really on our bottom line so that the reader can decide how they want to handle that from their assessment of our performance.

And our next question will come from the line of James Armstrong with Armstrong Investments.

Please feel better soon, Linda.

Thank you. I'm sorry about all the coughing going on in the background.

No, not at all. First question, just a bit of housekeeping. Will there be any leftovers from Oklahoma City in 2018? Or should that pretty much be done by the end of this year?

Yes. So I talked about the $3 million that will hit in Q4, and it should be done.

Perfect. That helps. And normal question from me. What are the biggest drivers between the low end and the high end of your guidance as you look into the next quarter?

I think how the continuous digester ramps is probably the biggest variable.

And market conditions.

And then whether we're talking about paperboard pricing or impact of capacity on the tissue side.

Okay, that helps. One quick one to sneak in. What are you assuming for pulp as we go into the fourth quarter?

Well, everything we're reading right now is it's going to go up some more. So that's what we're assuming.

And that's in your guide, right?

Yes.

Ladies and gentlemen, that does conclude our question-and-answer session. At this time, I will turn the call over to Mrs. Massman for any closing or additional remarks.

Thank you. We look forward to continuing to update you on our strategic priorities and how we are measuring against them, and thank you for joining us today and your continued interest in Clearwater Paper.

Ladies and gentlemen, that does conclude the Clearwater Paper Third Quarter 2017 Earnings Conference Call. We do appreciate your participation.