Friday, February 15, 2013



JONATHAN CALLAHAN, CFA 

SUMMARY

Client-Centric Portfolio Manager - with broad industry experience and deep understanding of investment markets, economic concepts, and the complex inter-relationships that generate excess returns and mitigate portfolio risks.

Fundamental, Value-Oriented, Investment Analyst - with a consistent record of outperformance driven by a galvanized commitment to the investment process, the conviction to challenge consensus thinking, and a unique ability to synergistically leverage research insights and identify signals that drive outperformance within different industries.

Solid New Business Development and Relationship Managment Experience - with the empathetic communication skills, strong client-facing presentation abilities, and a genuine fiduciary approach that builds trust and naturally fosters growth in assets under management. Dedicated to creating client experiences that are “beyond expectations”

Solution-Oriented, Tech-Savvy, Investment Professional - with history of taking on “utility player” roles and having technical skills, investment knowledge, and initiative to implement solutions that help achieve organizational goals and improve effectiveness of investment management and marketing communication processes

CORE COMPETENCIES

Portfolio Management -EquityResearch-AssetAllocation-SRI/Impact InvestingBusiness Development - Relationship Mgmt.-Client Review- Financial Planning Performance Attribution - Consultant-RFP - Newsletter Writing - CRM-Web2.0


  EXPERIENCE

Business Development Associate

Commercial Property Consulting Group
April 2012 – November 2012 (8 months) Madison, CT

Supported marketing/sales efforts of company that specializes in cost segregation, a comprehensive study enabling commercial real estate investors to maximize tax savings by investing in energy efficiency, sustainable development, and general capital improvements. Identification of qualified commercial real estate investors ($10mm) networking, cold calling, and researching appraisal data. Developed relationships with centers of influence - CPA's, Building Contractors, and Commercial Lenders.

Associate Portfolio Manager, Investment AnalystBank of America Merrill Lynch
December 2010 – March 2012 (1 year 4 months)
Performed a multi-dimensional role for a team of advisors on Merrill Lynch's proprietary portfolio management platform. Developed client & prospect relationships, performed various functions such as preparation of investment proposals, retirement planning, cash flow forecasting, and demonstration of investment discipline and process. Made significant enhancements to the existing investment processes, that not only increased the bandwidth of the research infrastructure and made accretive impact on performance. These included implementing a global equity and fixed income valuation tools, earnings quality screening, and CFROI assessments. Also recommended and implemented a proprietary "risk indicator" to our asset allocation process that signifantly reduced the portfolio volatility and preserved client capital during times of market turbulence.

Director, Sr. Investment Analyst
Crestwood Advisors
April 2004 – April 2009 (5 years 1 month)
Hired to institutionalize the firm’s "core-equity" investment discipline, a large-cap value strategy emphasizing valuation, profitability, and earnings quality. Was responsible for the output of investment research team, directed weekly investment committee meetings, had oversight of process, which included: universe screening, fundamental analysis, due diligence, valuation, and security selection. Also evaluated and recommended active and passively managed mutual funds, ETF’s, and other investment vehicles used in our core-satellite strategies. Served on asset allocation committee and was responsible for determining strategic asset class weightings and presenting tactical recommendations based on economic/cyclical indicators and asset class fundamentals. Was lead portfolio manager on several of firm’s largest client relationships and was responsible for the communication of investment strategy to sales team and client base.

Equity Analyst

Evergreen Investments

2000 – 2003 (3 years)
Primarily responsible for coverage of consumer discretionary sector holdings in the small & mid cap universe. Performed all screening, due diligence, recommendations, and maintenance research . Maintained earnings, cash flow, and valuation models on each holding and regularly reported to the investment committee. Extensive participation in meetings with corporate management teams. Some stocks under coverage included: Harley Davidson, Callaway Golf, Fortune Brands, Jack-In-The-Box, Prime Hospitality, Harrah's Casino's, Brunswick, TJ Maxx, Ross Stores, Ocular Sciences, Apogee, American Woodmark, Neilsen Media.

Institutional Marketing Assoc. & Performance Analyst

Evergreen Investments

1998 – 1999 (1 year)
Responsible for all performance calculations, attribution analysis, portfolio commentary, as well as the maintenance of all composites in accordance with AIMR policies Served as the primary liaison to the institutional consultant community & managed all aspects of RFP process.Creation of all client review and new business presentations. Served as the firms primary representative in both Level II AIMR & SEC Audits. Successfully led the integration process between Kaplan and Evergreen as all performance and marketing functions were consolidated within the parent company, reported to most senior level executives at firm

Portfolio Associate

State Street Bank

1997 – 1998 (1 year)

CERTIFICATIONS


Chartered Financial Analyst,  
  • CFA Institute
  • August 2004
  • Series 7 (2011)
      Series 66 (2011)

    Monday, April 30, 2012

    SCREENING UPDATE

    Although this has been refined over the years, this is the general framework that I typically follow, and is the product of multiple years of back-testing work that I have done, combined with ideas that I have “borrowed” and weaved together from various studies published by investment guru's that have been highly influential in the formation of my investment discipline. In my opinion these collective bodies of work empirically demonstrate which metrics/factors work best in various market environments, and identify investment strategies that, when applied systemically, challenge the theory of efficient markets, and illustrate opportunities for investors to consistently “beat the market”. Most notably, Benjamin Graham’s Intelligent Investor, the Fama & French Multi-Factor Approach, the annual “Black Book Study” published by Sanford Bernstein, as well as some lesser known, but similarly convincing studies done by Jim O’Shaughnessy "What Works on Wall Street" (Multi-Factor), Mebane Faber (Momentum Approach) “Earnings Quality & the Accruals Anomaly”, (Sloan& Richardson), CSFB-HOLT (CFROI), and Joel Greenblatt’s “Magic Formula” (Value). -


    I’ll try and summarize my approach which I have found to be a successful, robust starting point to identify opportunities. I generally run 3 filters:


    1) Primary Universe Screen, followed by a more in-depth,
    2) Fundamental Screen, and finally a
    3)Technical/Momentum Overlay.


    The primary universe screen I think is a very simple screen that I use across all core strategies (value, growth, dividend) and is just a very basic filter of stock characteristics that prudent investors should demand from any stock they own:


    1. Market Cap minimum of $2 Billion.2. Stock trading at earnings yield > than yield earned on 10yr Investment Grade Corporate Bonds. If corporate's yield 3%, this suggests we pay a forward P/E no higher than < 33X. 3. Earnings expected to grow at a rate higher than inflation over market cycle. 
    4. Company generates Return on Invested Capital exceeding cost of capital (also normalized, 5yr) (I use 6% if WACC is unavailable) 
    5. Company generates cash internally – positive free cash flow. 6. Earnings Quality > Ranks above bottom quartile


    Next, the most comprehensive screen is the fundamental and earnings quality screen. I will typically break out 3 Core Equity Strategies (Core Value, High Quality Dividend, and Core Growth)and if possible, break out by sector in order to make more meaningful comparisons (Financials, Cyclicals, etc.)


    Core Value – More emphasis on free cash flow, EV/EBITDA, and price/earnings multiples, especially relative to its historic multiple. Less concerned about ranking within sector, more concerned about ranking vs. market averages.
    1. FCF Yield > Market Average
    2. EV/EBITDA < Market Average 3. Forward P/E < 1.0X Historic Relative Multiple* 4. P/EG Ratio < 2.0X 5. Historic EPS Growth > 8%
    6. Historic 5YR ROIC > 10%
    7. Earnings Quality > Sector Average Ranking
    *(use P/B, P/S, P/CF if more appropriate)


    Growth/Momentum - More emphasis on expected earnings and ROIC growth vs. sector averages. Also, demand higher EPS consistency, and top quartile rankings. Only valuation filter is P/EG
    1. Expected LT EPS Growth > 12%
    2. Expected LT EPS Growth > Top Quartile of Sector
    3. EPS Growth Trend > Accelerating faster than Sector Average
    4. EPS Consistency > Market Average
    5. ROIC > 15%
    7. ROIC Trend > Positive
    8. Earnings Quality > Sector Average Ranking
    9. P/EG Ratio < 3.0X High Quality Dividend - More focused on historic trends (indicating a willingness to pay), financial strength and consistency (indicating a capacity to pay dividend (FCF & Payout), and expected growth trends 1. Dividend Yield > 1%
    2. Expected LT EPS Growth > 10%
    3. FCF Yield > Market Average
    4. Payout Ratio < 80% 5. EPS (DPS if Possible) Consistency > Market & Sector Average
    6. ROIC > 12%
    7. Earnings Quality > Market Average Ranking


    The last set of screens would be technical (earnings and price momentum screens), which I use as a “trading” overlay as they can provide good insight as to the timing of stock purchase. My personal approach, is to use a somewhat contrarian strategy here, buying value when it moves and buying momentum when it is weak.


    Within the value stock candidates, identify weak long term performance coupled with strong near term performance, or a relative performance reversal. Similarly, we want to identify stocks that have been taken to the "woodshed" with negative EPS revisions, and are seeing a reversal in EPS revision trends. This way we avoid “value traps”. Having followed this approach at the beginning of the year, we would have been seeing attractive entry points for homebuilding stocks, which had finally, after 5 years of price and earnings declines, were finally showing strong signs of a price reversal coupled with estimates that had been overly pessimistic. The group is now up over 80%.


    Among growth, finding just the opposite, strong LT performance, with weaker short term performance, may provide attractive entry point for a high quality company taking a breather. In this way we are avoiding buying a “top”. If recent YOY EPS trends remain solid, we should be less concerned with sentiment trends, unless there is a dramatic or structural change in the company's future growth prospects. If we were to have followed this approach, high quality, high growth stocks that were in simply in a consolidation phase, such as AAPL would have looked attractive 6 months ago, penetrating its lower bollinger band, on low volume, for no particular fundamental reasons.

    Sunday, February 06, 2011

    The Myth of Diversification: Risk Factors vs. Asset Classes
    • In our New Normal world, regime shifts in economic conditions will continue to cause significant challenges for risk management and portfolio construction.
    • On average, correlations across risk factors are lower than correlations across asset classes, and risk factor correlations tend to be more robust to regime shifts.
    • Risk factors provide a flexible language with which investors may express their forward-looking economic views, adapt to regime shifts and diversify their portfolios accordingly.
    The word “risk” derives from the early Italian risicare, which means “to dare.” In this sense, risk is a choice rather than a fate.
                                                                                                                                            –  Peter L. Bernstein
    Diversification often disappears when you need it most.
    Consider this: From January 1970 to February 2008, when both the U.S. and World ex-U.S. stock markets – as represented by monthly returns for the Russell 3000 and MSCI World Ex-U.S. indexes, respectively – were up more than one standard deviation above their respective full-sample mean, the correlation between them was −17%. In contrast, when both markets were down more than one standard deviation, the correlation between them was +76%. (Standard deviation measures the dispersion of a set of data from its mean.) Should we expect similar asymmetry going forward? As our colleague Richard Clarida noted in a recent essay, we live in a New Normal world in which markets oscillate between two regimes: “risk on” and “risk off.” In such a world diversification across asset classes might work on average, but it might feel like having your head in the oven and your feet in a tub of ice: Even though your average body temperature is OK, your chances of survival are low. 
    Investors have long recognized that economic conditions frequently undergo regime shifts. The economy typically oscillates between:
    1.      A steady, low volatility state characterized by economic growth; and
    2.     A panic-driven, high volatility state characterized by economic contraction.
    Evidence of such regimes has been well documented in market turbulence, inflation and GDP growth. In our New Normal world, regime shifts will continue to cause significant challenges for risk management and portfolio construction.
    PIMCO believes asset class returns are driven by common risk factors, and risk factor returns are highly regime-specific. Hence, we believe risk factors – as opposed to asset classes – should be the building blocks for portfolio construction. Risk factors provide a flexible language with which investors may express their forward-looking economic views and diversify their portfolios accordingly.
    Asset Class vs. Risk Factor Diversification
    In a recent analysis, we used monthly data from 1994 to 2009 to compare the effectiveness of risk factor diversification vs. asset class diversification. We recognized that in many periods in our sample, there were no significant events that caused prices to change; hence, returns merely reflected the fact that prices were “noisy.” But in other periods, prices shifted in response to significant events. Therefore, we partitioned returns from this analysis into two sub-samples: one associated with our full sample (1994–2009) and the other associated with specific “regimes” of market turbulence during that same period. (“Regime” is risk-management vernacular that connotes periods sharing specific qualities of risk.) To do so, we used a robust mathematical technique called the Mahalanobis distance, which defines market turbulence based on both volatility and co-movements. Then we computed standard deviations and correlations for each of the samples based on a threshold calibrated to capture the most turbulent periods: The Asian financial crisis, Russian debt default and Long Term Capital Management flameout of the late 1990s; the dot.com bust, 9/11 and credit crisis early this decade; and the most recent global financial crisis sparked by the subprime mortgage fallout. 
    As we expected, correlations across risk factors were lower than across asset classes – hence to diversify across risk factors should be more efficient than to diversify across asset classes. Most importantly, our results revealed the average correlation across risk factors did not increase during market turbulence. Figure 1 shows average asset class and risk factor correlations for the full-sample, calm, and turbulent periods. In quiet times, the average asset class correlation was 30%, compared with 51% in turbulent times. In contrast, the average risk factor correlation remained in the 2% range in both our quiet and turbulent times.

    Extreme Correlations and Tail Risk Hedging
    Asset class correlations are typically higher than risk factor correlations because most asset classes contain indirect exposure to equity risk. To complicate things, indirect equity risk is like a virus that remains dormant until the body weakens: It tends to manifest itself during extreme market moves. The equity factor exposure is always there, but in normal times investors attribute the returns to real estate or hedge funds or private equity as being the result of good alpha decisions, where in reality they are the result of factor betas like equity; in bad times, they realize they owned equity factor exposure. Investors are often surprised by how seemingly unrelated risky assets and strategies suddenly become highly correlated with equities during a crisis.
    Consider the example of the currency carry trade. According to this strategy, the investor sells low-yielding currencies to invest in higher yielding currencies. In normal markets (and on average), this strategy has the potential to be profitable because the high interest rate currencies have not depreciated enough over a given period to offset the gain from the interest rate differential embedded in the currency forwards. But during “risk off” panics, which are generally associated with significant equity downturns, the carry trade can produce devastating losses. Figure 2 shows how the AUD/Equities and JPY/Equities correlations change as a function of equity market returns. It shows that during market downturns, the AUD becomes highly correlated with equities while the JPY becomes more and more negatively correlated. Because a typical carry trade strategy position would be long AUD and short JPY, this pattern is bad news for an investor with capital invested in both equities and in the carry trade.
    http://www.pimco.com/PublishingImages/figure%20two%20myth%20o%20f%20diversication.jpg
    Unforeseen market crises are often referred to as “tail risk events” because of the way they appear on the bell-shaped curves often used to illustrate market outcomes: The most likely outcomes lie at the center of the curve, whereas the unforeseen, less likely events that can wreak havoc on portfolios are plotted at either end – or tail – of the curve. Figure 3 shows a similar pattern in the tail correlation between equities and total returns obtained from being long corporate bond spreads. The Merton (1974) model explains this relationship based on the firm’s capital structure. This model values equity as a call option on the firm’s assets and debt as a “risk-free” rate (all investments contain risk) plus a short put option, and it can be used to measure embedded equity exposure in corporate bond portfolios. As a firm approaches default, equity shareholders get “wiped out” and bondholders become, essentially, equity holders.  http://www.pimco.com/PublishingImages/figure%20three%20myth%20o%20f%20diversication.jpg
    Overall, our findings reveal that during crises, investors that have not directly diversified their risk factor exposures will find themselves holding two crude asset classes: 1) risk assets and 2) nominally “safe” assets (although all investments carry risk). For tail hedging purposes, these findings can be used to the investor’s advantage. Indeed, proxy hedges such as credit default swap (CDS) tranches and short carry trade positions may be cheaper than equity puts and yet still hedge most of the portfolio’s equity factor risk exposure.
    Putting it All Together
    When they seek to diversify their portfolios, a majority of investors don’t think twice before they average their risk exposures across quiet and turbulent regimes. Consequently, much of the time, investors’ portfolios are suboptimal. For example, during the recent financial crisis, correlations and volatilities across asset classes changed drastically and seemingly diversified portfolios performed poorly.
    Here we’ve introduced a regime-specific approach to portfolio construction and risk management. Our results showed that on average, correlations across risk factors are lower than correlations across asset classes, and risk factor correlations tend to be more robust to regime shifts than asset class correlations. Therefore, a risk factor approach to portfolio construction provides a robust platform for investors to express cyclical and secular macroeconomic views and adapt to regime shifts. Moreover, to view the world in risk factor space may also help investors better understand tail risk and find opportunities for cheap proxy hedging.
    References
    Bender, Jennifer, Remy Briand, Frank Nielsen, and Dan Stefek. 2010. “Portfolio of Risk Premia: A New Approach to Diversification.” The Journal of Portfolio Management. Winter 2010, Vol. 36, No. 2: pp 17-25
    Bhansali, Vineer. March 2009. “The Equity Risk in a Bond Manager’s World.” PIMCO Viewpoints.
    Bhansali, Vineer. 2010. “Bond Portfolio Investing and Risk Management”. McGraw-Hill.
    Bhansali, Vineer. 2008. “Tail Risk Management.” The Journal of Portfolio Management, Vol. 34, No. 4: pp68-75.
    Bhansali, Vineer. 2010. “Offensive Risk Management II: The Case for Active Tail Risk Hedging.” The Journal of Portfolio Management, Forthcoming. Available at SSRN: http://ssrn.com/abstract‌=1601573.
    Bhansali, Vineer and Josh Davis. 2010. “Offensive Risk Management: Can Tail Risk Hedging Be Profitable?” The Journal of Portfolio Management, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1573760.
    Brittain, Bruce, Jim Moore, and Mark Taborsky. March 2010. “Evolving Investment Solutions Confront the Challenges of the New Normal“. PIMCO Featured Solutions, www.pimco.com 
    Chua, David, Mark Kritzman, and Sebastien Page. 2009. “The Myth of Diversification.” The Journal of Portfolio Management, vol. 36, no. 1 (Fall 2009).
    Clarida, Rich. July 2010. “The Mean of the New Normal Is an Observation Rarely Realized.” PIMCO Global Perspectives. 
    De Leon, Bill, Niels Pedersen, Joe Simonian, and Sebastien Page. 2010. “How Much Equity Exposure Does Your Bond Portfolio Have?” PIMCO Internal Working Paper.
    Kritzman, Mark, Sebastien Page, and David Turkington. 2010. “In Defense of Optimization: The Fallacy of 1/N.” The Financial Analyst Journal, vol. 66, no. 2, 
    Kritzman, Mark, and Yuanzhen Li. 2010. “Skulls, Financial Turbulence, and Risk Management.” The Financial Analyst Journal, September/October 2010, Vol. 66, No. 5.
    Merton, Robert. 1974. “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance,29, 449-470.

    Friday, August 06, 2010


    Newfield Exploration Company is an independent oil and gas company engaged in the exploration, development and acquisition of natural gas and crude oil properties. The Company’s domestic areas of operation include the Anadarko and Arkoma Basins of the Mid-Continent, the Rocky Mountains, onshore Texas and the Gulf of Mexico. Internationally, the Company is active in Malaysia and China. During the year ended December 31, 2007, the Company had proved reserves of 2.5 trillion cubic feet equivalents (Tcfe). Those reserves were 73% natural gas and 63% proved developed. The company has operations primarily in four regions.
    Mid-Continent: The Company’s single largest investment area is the Woodford Shale play, located in the Arkoma Basin of southeast Oklahoma. Its activities in drilling led to the leasing of approximately 165,000 net acres. The Company has drilled more than 100 vertical wells and 160 horizontal wells to delineate its acreage position. The Woodford formation is a shale interval that varies in thickness from 100–200 feet throughout its acreage. During 2007, its production was 165 millions of cubic feet equivalent per day (MMcfe/d) gross. The field has thousands of drilling locations. In 2008, the company is going to drill pilots with 40 acre and 80 acre spacing.
    Monument Butte: The Company’s Monument Butte oil field is located in the Uinta Basin of northeastern Utah. During 2007, the field had more than 1,100 producing oil wells and gross daily production was nearly 14,000 barrels of oil per day (BOPD).
    Green River Basin: The Company has acquired interests in 8,000 gross acres (4,000 net acres) in the southeastern portion of the anticline. During 2007, the Company reached an agreement to assume operatorship of its activities in Pinedale. Approximately 13% of the reserves in its 2007, Rocky Mountain acquisition were located in the Jonah field, where Company has identified more than 40 development locations on 10- and 5-acre well spacing.
    Williston Basin: Approximately 20% of the reserves associated with its 2007, Rockies acquisition were located in the Williston Basin. The Company has an interest in approximately 150,000 net acres. The Company’s net production is more than 3,200 BOPD and has benefited from a recent well re-fracture program and new drilling in the Elm Coulee field, a mature Bakken play.

    Growth Catalysts
    ---
    Woodford Shale: Woodford Shale is an unconventional natural gas play. It is NFX’s single largest investment in the last 2 years. It is quite similar to Barnett Shale (TX) but has more silica which means more brittle ground and more efficient drilling. Since 2003, the company has drilled 100 horizontal and 160 vertical wells in the region. For 2008 NFX plans to spend $460 million to drill about 100 horizontal wells. More than half the wells will have lateral completions in excess of 3000 feet. Longer laterals help to improve per unit finding and development costs. This has allowed NFX to reduce cost/ lateral foot by 38% since 2007.    
     At the same time NFX has been increasing production at the Woodford Shale. Company is producing 200MMcf/d in the region which is up from 165MMcf/d at the end of 2007. The company anticipates that by year end 2008, the Woodford will produce 250MMcf/d as the company ramps up its rig count in the play. The increased production and lower development costs for the wells should result in higher ROIC. Woodford Shale has estimated 2.1 to 4.2 potential reserve opportunity.


    Asset base shift: As part of changes to their asset base NFX has shifted to ‘Resource’ plays that cover expansive areas, provide multi year inventories of drilling opportunities and have sustainable lower risk growth profiles. It also sold its shallow water Gulf of Mexico assets in 2007. NFX now has deepwater operations in GoM. The company therefore has longer lived assets and has been able to improve its ROIC. The longer life of its assets has also resulted in better Reserve Replacement Percentage for the company.

     
    Competitive Dynamics
    ---

    Visible growth ahead: Production is expected to increase from all of NFX’s assets. Its steady pipeline of production opportunities has caused NFX to raise its production guidance twice in FY08 and it now expects 25% organic growth in FY08. This production growth is sector leading. 


    Focus on organic growth: NFX has been actively exploring and developing new assets. Growth through acquisitions is getting more and more expensive and risky. Its strategy of growth though ‘Drill bit’ vs ‘Acquire and exploit’ should therefore increase profitability. Newfield has managed to increase its production from all its assets through increased drilling activities. This gives them a competitive advantage against companies that seek to acquire potent assets as such assets are more expensive now and there is always a risk of wrongly estimating the reserves there.

    1st mover advantage in Woodford Shale: NFX was the first in Woodford and it leased the best acreage for an all in cost today of about $550 per acre and drilled the most wells. NFX is at a great point in the development of this play. It has nearly all of our acreage covered by 3D seismic, substantially all of its acreage is held by production and it has thousands of wells to drill that will ultimately take production to multiples of the 250 million cubic feet a day that it will be operating by the end of this year.


    Risks
    ---

    Commodity price correction: NFX’s revenues, profit and future growth depend substantially on prevailing oil and gas prices. Oil and gas prices have corrected in recent weeks due to the slowing economy and strengthening USD.  

    Sunday, April 25, 2010

    MR. MARKET, DON’T FORGET THE TOILET PAPER!

    CLEARWATER PAPER (NYSE:CLW)

    Although Clearwater Paper's stock has been a significant outperformer and recent tax credits have provide a non-recurring benefit to their earnings, at the current $50 stock price, the shares continue to offer value to investors. We argue that although the most recent 12 months EBITDA of 173mm is an anomaly, its capacity to generate higher levels of cash flow has significantly increased and the company is attractively valued on an absolute and relative basis. The company is well positioned to continue to expand market share in a defensive consumer staple industry and has the potential to increase margins further through growth investments in its toilet paper manufacturing technology. Furthermore, the company has some cost saving opportunities and continues to optimize its investment in the slower growing paperboard business and lastly, the eventual stabilization in housing market correction will reverse the profitability headwind pressuring the lumber segment. The combination of these factors suggest investors appreciate the company's ability to expand its earning power and given industry leading returns on capital, clean balance sheet, and solid free cash flow, may once again, Mr. Market may be mispricing the shares of an underfollowed company in the "not so glamorous" toilet paper industry that could be an attractive private equity target, or a smart investment for a shareholder with long term value orientation.


     


     

    company description

    Clearwater Paper Corporation is a producer of tissue and paperboard products in the United States. The company operates in three segments: consumer products, pulp and paperboard, and wood products. It is the largest private label manufacturer of tissue products including toilet paper, tissue, napkins, and paper towels, sold in grocery stores in the United States. The company's paperboard is sold in the packaging industry and it is used by its customers to make packaging for products, including liquids, pharmaceuticals, consumer goods packaging, such as fast food containers and DVD packaging. The company is vertically integrated and produces most of the pulp required in its tissue and paperboard businesses. The company also manufactures wood products, including cedar and lumber products, a business that has been challenged due to the recent weakness in housing market.


    Consumer Tissue

    PRODUCTS

    COMPETITORS

    CUSTOMERS

    CAPACITY

    • Toilet Paper
    • Paper Towels
    • Napkins
    • Procter & Gamble
    • Kimberly Clark
    • Georgia Pacific
    • Kroger's
    • Safeway
    • Albertson's
    • Idaho& Las Vegas
    • 98% pulp processing
    • 100% conversion


     

    The Consumer segment, Clearwater's core business manufactures household private label consumer tissue products and has the highest margins and growth prospects of the three segments. Its products consist of paper towels, napkins and facial and bath tissue and its strategy to offer non-branded products that offer comparable quality & features to the "premium" and "ultra" brands. CLW is the only U.S. consumer tissue producer that manufactures solely private label products and accounts for 56% of all private label tissue products in the U.S. grocery market, and 90% of private label tissue west of the Mississippi River. There are approximately 8mm tons of tissue per year sold in the U.S., of which about 3mm are sold to industrial/commercial users such as hotels and restaurants, and the remaining 5mm are sold to the "Home" market, which is further broken down by "non-grocery-discount" stores such as Wal-Mart, which sells just over half of the "Home" market tissue. The "grocery" channel sells about 2.4mm tons, and about 1/4 of this market is private label. Clearwater holds 56% market share in this category and is significantly larger than its next largest competitor in this highly fragmented market. One risk we would highlight is a relatively high customer concentration, as its 3 largest customers (Kroger's, Safeway, and Albertson's) comprise over 50% of this division's revenue, and just over 23% of total company revenue. That said, the company has significant relationships with these companies and has been supplying them each for over 25 years (top 10 customers average 19yr relationship), and supply chain is very well integrated, making switching costs, while not insurmountable, relatively high.


     



     


     

    Pulp & Paperboard

    PRODUCTS

    COMPETITORS

    CUSTOMERS

    CAPACITY

    • Carton & Packaging
    • Plates & Cups
    • Commercial Print
    • International Paper
    • Mead Westvaco
    • Georgia Pacific
    • Rock-Tenn
    • Paperboard Converters
    • International (20%)
    • Pulp Mills (96%)
    • Paperbrd (93%)
    • Arkansas & Idaho


     

    Pulp and Paperboard segment manufactures and markets bleached paperboard for the high-end segment of the packaging industry and is a leading producer of solid bleach sulfate, or SBS paperboard SBS is a premium paperboard grade that is most frequently used to produce folding cartons, liquid packaging, cups and plates, and commercial printing items. SBS is used to make these products because it is manufactured using virgin fiber produced in a kraft bleaching process, which results in superior stiffness and cleanliness.  This segment also produces softwood market pulp, which is used as the basis for many paper products, and slush pulp, which it supplies to the Consumer Products segment. The company has about 13% of paperboard capacity in the United States. Interestingly, while much of the consumer tissue supplying capacity is concentrated in the Western US, Clearwater's Idaho SBS Paperboard facility is one of only two SBS processing operations in the Western US, making it one of the lowest cost SBS producers for Asian importers. Last year international exports drove about 20% of total revenue. Pricing power is somewhat more challenging in this commoditized business, and relative to the consumer business, is much more cyclical and sensitive to volatility in raw material inputs. Wood Fiber drives about 35% of the total costs of this segment, energy costs account for another 15%, and transportation is another 10% of its P&L. Combined with sluggish top-line growth, 20% higher wood fiber costs and triple digit oil prices were a significant headwind in 2008, when pulp & paperboard segment saw its EBITDA drop by 40% YOY and margins down to 6% from 12% the prior year. This business is a slower growing management is focused on cutting costs, leveraging its existing assets to optimize the business rather than investing in top-line growth. This is a cash cow business that requires minimal capital expenditure and just as its pulping operations feed other segments of the business it's free cash flow can feed growth in higher margin higher growth opportunities in the consumer division.


     

      


     

    FUNDAMENTALS & VALUATION

    Perhaps the most compelling aspect of the Clearwater thesis is its attractiveness on fundamental and valuation basis. In absolute terms, as well as relative to its peer group, Clearwater offers a very conservative balance sheet, solid profitability and margins, trading at 3X its earnings and cash flow. Using its "normalized" cash flow generation (5 year average) of $125mm and a market cap of 590mm suggests a slightly higher 5X multiple, although the recent housing crisis combined with high energy and input costs have been considerable pressures on the company over the last several years. Furthermore secular trends in the private label tissue markets, moderating costs, and several company specific initiatives suggest that the last 5 years will soon represent a trough period and earning power and its multiple will expand significantly.


    The most recent years cash flow generation was somewhat of an anomaly and investors should look examine the company's earning power over a multi-year period to arrive at an appropriate estimate of the company's ability to generate profit. For example, 2009 earnings should largely be considered an anomaly because the company benefited from a tax rebate that provided a cash windfall of about 175mm in 2009. A by-product of their pulp-making process known as "black liquor" has a renewable quality that enables it to be recycled in the manufacturing process and recent legislation has allowed the company to qualify for a tax rebate based on its production of this alternative fuel. It is not known whether this will be future sources of tax relief so it is not included in future forecasts, but could be a catalyst if legislative laws continue the tax benefits.


     

    GROWTH CHARACTERISTICS: INDUSTRY LANDSCAPE

    Attractive Market Fundamentals

    Private Label Winning Share from Branded Players: In the United States, about 7.9mm tons of tissues are consumed annually. Of that, about 1/3 is commercial (public restrooms, hotels, restaurants, etc.) and the remaining 5mm tons define the "at home" market, which is further stratified by the discount (Costco/Wal-Mart) and grocery store channel which each sell about 2.5mm tons of tissue per year. Increasingly large supermarket chains are allocating more shelf space to Private Label goods. Retailers are pursuing this strategy because of the improved level of quality that private label goods now offer, and also the increased profitability contribution from private label. The advertising, promotion, R&D, and other expenses that branded consumer product companies incur raise the overall cost structure by 20%-30% over private label manufacturers, whose SG&A lines are not materially impacted by these items. Retailers, on average, earn 10-15% higher gross margins on these products, passing along roughly half the savings to the consumer. Since 2002, private label has won approximately 300bps of market share, growing 8% annually or twice the growth rate of branded segment(4%), and making up 26% of the grocery tissue market (or 19% of total "at-home" market, which includes discount stores, see below). The trend has been to continue to drive quality improvements from private label products, and many of which, such as Clearwater's tissue products, now offer a comparable quality profile to the premium branded products, Charmin© & Cottonelle©.


        Private Label will continue to win market share from national brands for the following reasons:

    • Economics. Retailer earns 10-15% incremental gross margin contribution on private label
    • Negotiating Leverage. Offering non-branded alternatives with comparable quality, provide additional leverage when negotiating with national brands
    • Retailer Brand Enhancement & Customer Loyalty. Offering high-quality private label products can enhance brand recognition and consumer perceptions about their grocery retailer


       


     


     

    Defensive Product Categories


     

    Toilet paper is one of the most inelastic consumer products sold. For obvious reasons, tissue is usually one of the last things consumers tend to cut back on in a weak economy. Even in very weak economies as the below chart illustrates, demand for tissue continues to expand.


     

    GROWTH CHARACTERISTICS: COMPETITIVE POSITION

    • Vertical Integration and High Startup Costs: A typical tissue conversion facility and pulp processing plant with 50k ton annual capacity can cost between 50mm-10mm to build. To maintain cost competitiveness, ensure access to raw materials, and have control over sourcing, manufacturers have vertically integrated operations and most will also invest in on-site pulp processing facilities. Because there are no liquid futures markets or vehicles to hedge price risk of this input, this is an enormous competitive advantage.


       

    • Geography: Because tissue is a bulky, lightweight product, sold at a relatively low price, its freight costs are significant relative to the volume and dollar value of product transported. A $10 case of toilet paper usually has a freight cost of about $1 when distributed to retailers within a 200 mile radius. Delivering the same unit to a retailer over 600 miles away adds $3 in freight costs. This additional surcharge would result in a 20% higher net selling price, significantly reducing merchandise margin. Because of Clearwater's existing conversion facilities in the Midwest and its low cost access to pulp supply (295k ton pulp capacity in Arkansas) are in relative proximity to the Southeastern United States, the economics of entering that market are attractive, and barriers relatively high as new entrants without existing capacity in the region will be at a cost disadvantage (higher freight costs, higher raw material costs)


       

    • Consolidation within Branded Segment = Rational Price Umbrella: This is an attractive market structure for several reasons. Because the Branded producers are generally the price setters and private label producers are subject to their "price umbrella", an oligopolistic market structure promotes pricing discipline. The top three players in Branded category, P&G, Kimberly Clark, and Georgia-Pacific are unlikely to engage in a price war, and have a fiduciary duty to shareholders to maximize returns on capital. It is doubtful that Proctor & Gamble would wildly discount its premium brand "Charmin" in the hopes that they drive Kimberly Clark's "Cottonelle" out of the market. Rational pricing is good for the entire category


     

    • Fragmentation within Private Label Segment: While Branded Segment that makes up 70% of tissue sales is dominated by 3 players, the Private Label segment, dominated by Clearwater, is a much more fragmented market. This places Clearwater in an advantageous position for several reasons. Having more than double the market-share of the next private label producer, it has much greater economies of scale, and likely will have production cost advantage over the smaller players. Additionally, its dominance in the private label market presents many M&A opportunities, should Clearwater decide to expand its capacity in other regions of the country

    Company Growth Strategy & Potential Catalysts

    • Geographic Expansion: Company exploring growth investments is the underserved southeastern US region: CLW announced it will build two tissue converting lines in the Southeast, expanding existing production capacity of 210k tons per year, by another 20k tons, or about 10% production growth. This has been announced and likely baked into earnings estimates. This region of the country is significantly underpenetrated and the private label market tends to be much more fragmented and the company believes they can take significant market share in the region by being closer to the customer. As a rule of thumb, customers located outside of 500 mile radius will see freight charges of up to $3.00 per $12.00 case (25% higher end cost), because of its shipping inefficiency (bulky & cheap). In addition to freight costs for finished products, having access to a reliable, low cost source of pulp supply is also key competitive advantage. The 295K ton capacity pulping facility in Arkansas & its relative proximity to Southeastern US, is a key competitive advantage as Clearwater expands in the region



       

    • Mix improvement: The company is also growing its capacity at the high end "ultra" soft market, which will contribute nicely to the segments sales mix, as high end tissue can sell at prices 2x the price per ton of single-ply budget tissue. Specifically, the company is also evaluating the purchase of a TAD paper machine (through-air-dryer technology is required to generate high end tissue) to incorporate into the southeastern expansion. This machine has a capacity of 70k tons per year, which would require an additional 5 conversion lines, in order to ensure the TAD machine is not underutilized, and the fixed costs of the investment are leveraged effectively.


       

    Through Air Drying investments will increase capacity in higher margin "ultra" tissue products, contributing favorable to Clearwater's revenue mix. TAD Technology enhances tissue softness & absorbtion properties by air drying wet tissue rather than the traditional method of pressing & creping together tissue ply

    • Higher quality tissue: over 30% softer and fluffier
    • Better absorbtion properties (50% more liquid absorbtion)


     

    Kimberly Clark, Proctor & Gamble and Georgia Pacific have made enormous investments in TAD technology over last decade. Procter & Gamble and Kimberly-Clark whose product lines are focused on Cottonelle© Premium Charmin© Ultra brand categories have converted 100% of their manufacturing capacity from traditional "Yankee Drum" to "Through-Air Drying"

    Other Benefits

    • Input costs: increased efficiency of fiber use (less fiber per roll required)
    • Significant COGS reduction (fiber=30% COGS)
    • Lower weight/case (lower shipping weight)

    Drawbacks:

    • High capital cost (40% more costly)
    • Higher energy demands (15% of COGS)
    • Yankee produces greater stretch/tensile

    TAD (THROUGH-AIR DRYER)

    injecting hot air and weaving wet tissue ply

    YANKEE DRYER

    traditional method "pressing & creping" wet tissue ply



     



     


     


     


     

    Management Integrity, Shareholder Orientation & Accounting Transparency

    Business is simple to understand and accounting systems are transparent and relatively straightforward. Furthermore, management appears to be focused on creating shareholder value. In evaluating capital projects management maintains a strict policy of requiring a 9-10% investment hurdle rate, and prioritizes its capital spending in a way that maximizes ROI. Additionally, management's prudent balance sheet minimization during a period of uncertainty shows a disciplined, shareholder friendly use of cash flow during a period of credit contraction. A net cash position puts it at an extremely advantageous position relative to competitors who may now lack to the flexibility to finance growth projects, or be forced to pay much higher rates of interest to finance growth initiatives. With its financing now in order, the company is making a measured, thorough evaluation of various growth alternatives, and will soon make more calculated strategic decision about its southeastern growth initiative.


     

    Valuation: Wide Margin of Safety, Conservative Inputs

    Our DCF Analysis assumes a sharply downward sloping growth rate from 10% to a terminal growth rate of 2% as well as a Discount rate of 11% and terminal multiple of 10X. We also used consensus estimates for 2010-2011 and management guidance for capital expenditures. Given these inputs, we arrive at an intrinsic value of $73 for the shares or about 35% premium to current trading price


     

    In conclusion, I believe at the current stock price of around $50 per share, CLW shares offer investors a considerable upside opportunity and also some significant downside protection.