We view the equity at $6.65 as an even better bargain than before. First, and most importantly, we believe fundamental downside risk is limited. The current $302 million market capitalization is a discount of approximately 19% and 12% below what we estimate book value and tangible book value, respectively, will be at the end of the current quarter. This valuation is far too low for a company with low cost of production assets, large market shares within high margin niche paper products, and the highest normalized margins in the industry. Further, management undoubtedly has created value through efficiency enhancements and capacity expansions since acquiring their facilities. Additionally, KapStone acquired both of their facilities at purchase prices below replacement cost. Therefore, the current market cap represents a meaningful discount to an already conservatively stated tangible book value, in our view.

Second, the key driver of KapStone’s business recovery – pricing – is currently in the process of improving. As a non-integrated producer, KapStone realizes the impact of changes in its product pricing immediately, which explains the rapid margin compression the company has endured over the last twelve months. However, the company’s margins will expand as its prices rise, just as quickly as they contracted when its prices fell. Importantly, KapStone’s pricing, in terms of average revenue per ton, bottomed in Q3 and is poised to improve, perhaps significantly so, during the next several months. Industry capacity closures are rapidly tightening the linerboard market, which has led to price increase announcements by producers for domestic and export linerboard across the board.

Presently, KapStone’s largest and lowest margin product line is linerboard, so imminent linerboard price increases are the single best cure for the company’s depressed margins. We estimate that every $50/ton price increase for linerboard will add an incremental $30-$36 million to annual run-rate EBITDA. We believe the current market price of KapStone shares implies no meaningful recovery in industry pricing, which we believe to be inconsistent with current developments.

Third, KapStone’s share price has declined by 19% since October 5^th, which is the date the largest shareholder, Elm Ridge Capital Management, LLC, began selling. In contrast, the S&P 500 and two paper industry ETFs, WOOD and CUT, have appreciated by approximately 5%, 5% and 2%, respectively, over the same time period. With insiders holding approximately 40% of the company’s shares, Elm Ridge holding 9.99%, and many seemingly long-term value oriented institutions holding shares, we believe the effective float is limited. Consequently, a major holder like Elm Ridge who chooses to sell shares can create significant downside pressure on the stock price. This is a factor that is both temporary and non-fundamental. Many of our best investment opportunities present themselves when we can identify both a) a large mispricing and b) a specific non-fundamental reason why the mispricing exists. We believe this is one of those opportunities.

Two important recent capacity closures are:

i.       Linerboard – On October 22^nd, International Paper (IP) announced the permanent closure of its containerboard mills at Albany, OR, Pineville, LA, and the previously idled No. 3 machine at its Valliant, OK mill, effective mid-December. IP’s closures will remove about 1.4 million tons of linerboard capacity. On October 28^th, West Fraser announced the permanent closure of its Eurocan mill in B.C., which will remove about 330,000 tons of linerboard capacity, effective January 31^st. Collectively between the two companies, over 1.7 million tons are being permanently closed, which represents almost 5% of North American capacity, which should push the industry operating rate into the mid-90% range – a level at which price increases historically have been successful.

ii.     Kraft Papers – West Fraser’s Eurocan closure will also remove about 150,000 tons of kraft paper capacity, which will contribute to a tighter overall market, despite being a higher grade kraft than KapStone’s. Consequently, we believe KapStone’s previously announced $50/ton kraft paper price increase will be successfully pushed through either December 1^st or in early 2010. This price increase should add about $15-$16 million to annual run rate EBITDA, in our view.

Additionally, more industry capacity closures are likely in 2010. Higher cost mills will no longer be economically motivated to run without the benefit of the Alternative Fuel Tax Credit (AFTC), which is set to expire at the end of this year. Further, many believe Smurfit-Stone Container is likely to announce significant permanent capacity closures in January when its Chapter 11 reorganization plan is due to be filed. Without naming names, CEO Roger Stone believes there could be another million tons of containerboard capacity that could close in the coming months, which would represent another near 3% of the North American market. The containerboard industry operating rate has the potential to reach the high-90% range in 2010, in our view.

Due to the lean inventory conditions, many companies have announced price increases in recent months. Some of them include:

1. On Oct. 15^th, Klabin (Brazil) announced a €40 price or $60/ton price increase on kraft linerboard in Europe, and $30/ton increase in Africa and Asia, effective this month. This is on top of the $60/ton, $40/ton, and $30/ton increase in Asia, Europe and Latin America, respectively, from earlier this year.
2. On Nov. 5^th, Smurfit-Stone Container announced a $50/ton containerboard price increase for Mexico, Central America and South America, effective Dec. 1^st.
3. On Nov. 9^th, Pratt Industries announced a $50/ton containerboard price increase to Latin America, effective Dec. 7^th.
4. On Nov. 16^th, Longview Fibre announced a $50/ton price increase on linerboard and medium, effective Jan. 1^st. Longview is the 12^th largest North American containerboard producer with capacity of about 600,000 tons.
5. On Nov. 20^th, Europac (Spain) announced a €60/ton price increase on linerboard, effective Jan. 1, 2010. This is on top of the €60/ton price increase implemented in September. Europac cited a shortage of kraft linerboard production in Europe and declining imports from the U.S.
6.  On Nov. 23^rd, Georgia-Pacific (G-P) announced a $50/ton and $70/ton increase on liner and medium for the East Coast and West Coast, respectively, also effective Jan. 1^st. G-P is the 2nd largest North American containerboard producer with capacity of about 4.2 million tons.
7.  On Nov. 23^rd, IP informed its Mexican customers of a $50/ton price increase for linerboard and medium, effective Dec. 15^th. This price increase follows the company’s previously announced $50/ton price increase for Latin America.
8.  On Nov. 24^th, Pratt Industries announced a $50/ton and $70/ton price increase on containerboard to East Coast and West Coast customers, respectively. Pratt is the 6^th largest North American producer (1.15 million tons) and the third domestic producer to announce the increase.

Again, the expiration of the AFTC at year-end likely will lead to further capacity closures, which should cause further price increases. Interestingly, during the Q3 conference call, Roger Stone indicated his belief that overall pricing could approach year ago levels by the end of 2010. Importantly, Stone stated he is bearish on the macro economy and that the pricing gains he foresees are due entirely to paper industry specific capacity closures. Given his experience and credibility within the industry, this view should not be overlooked. Pricing alone had a negative $28.5 million year over year impact to Q3 EBITDA, which implies that the pricing recovery Stone sees will represent an incremental $114 million of annual run rate EBITDA by the end of 2010. Add that to Q3’s $35 million annual run-rate and KapStone would generate almost $150 million of EBITDA—without any improvement in mix. That level of EBITDA would result in a stock price in the mid-teen range, in our view.

As for mix, the company’s normalized revenue mix is about 30% linerboard, 32% kraft papers, 30% saturating kraft, and about 8% Kraftpak. Saturating kraft and Kraftpak are both higher margin products followed by kraft papers, followed by linerboard, of which export linerboard is the lowest margin. Over the past twelve months, as demand for its higher margin products declined with the economy, KapStone filled the hole with linerboard, including export linerboard. Consequently, the overall revenue mix has a higher percentage of lower margin product than is typical. This negative mix shift alone negatively impacted Q3 EBITDA by $11 million year over year, which implies an incremental $44 million of annual run rate EBITDA once normalized mix returns. While we have little insight into the timing of when this normalized mix will return, we are confident it is a matter of when and not if.

As for valuation, KapStone is trading at about $348 per ton on an EV/ton basis, which is an enormous discount to its peers, some of whom trade over $1,000 per ton. This incredibly low valuation implies that current depressed EBITDA levels are certain to last in perpetuity, which is inconsistent with current pricing developments, in our view. If we add Q3’s $35 million annual run-rate EBITDA to an incremental $15-$16 million and $30-$36 million for the $50/ton kraft paper and $50/ton linerboard price increases, respectively, we reach about $80-$87 million of annual run-rate EBITDA. We subtract $2 million of interest expense, $12 million of taxes, and $22 million of maintenance capex, which leaves us with an estimated $44-$51 million of levered free cash flow, which represents a 14%-16% current free cash flow yield. If the improvements stopped here, we would expect the shares to trade between $6.78 and $10.11, assuming 7x-9x free cash flow, which implies no fundamental downside from current levels. Importantly, though, we are becoming increasingly confident that improvements will continue. If Stone’s prediction on pricing ends up being accurate, we believe $150 million of EBITDA and about $90 million of free cash flow would be reasonable estimates in 2011. Based on 7x-9x free cash flow, those results would result in a $14-$18 per share stock price, in our view.

While we are not relying on Stone’s prediction in our investment thesis, we are instead relying on a $110-$150 million EBITDA range, which we consider to be an appropriate mid-cycle EBITDA range. While we make no attempt at precision, we view the array of potential outcomes as significantly skewed to the upside. Additionally, the Biomass Crop Assistance Program (BCAP), the cellulosic ethanol black liquor tax credit, and the potential permanent closure of Stora Enso’s Kotka Mill represent three free call options, each of which has potential to be material, although we assume no benefits.

To conclude, KapStone’s product pricing is clearly improving and more industry capacity is likely to close, which should lead to further price increases, yet KapStone shares are reflecting none of these improvements. In fact, KapStone shares are available in the market at a price 12% below tangible book value, despite efficiency enhancements, capacity expansions, and overhead cost reductions that have further lowered the company’s breakeven point. At the current level, we believe the odds are highly skewed in our favor, given what we view as an asymmetric outcome for KapStone shares. We believe this investment opportunity exists at this even better price due to Elm Ridge’s documented selling of shares, which as a temporary and non-fundamental reason, provides us with the opportunity to increase our position at even more favorable prices.

Disclosure: Long KPPC

Disclaimer: This is neither a recommendation to buy nor sell any individual security. The research found on our site is our original research, which we believe to be accurate, but may contain errors or omissions. The market price of any security we recommend may rise or fall. Please do your own research before making an investment decision.

This investment opportunity exists for three primary reasons. First, outstanding warrants that had the potential to add 37 million shares to the prior 28 million share base created a technical overhang in the stock.  With the exercise of 17 million of these warrants and the expiration of the remainder on August 17^th, this technical overhang is diminishing. Second, liquidity fears created by acquisition-related leverage sent the market capitalization to as low as $30 million earlier this year, far below investable levels for the vast majority of institutional investors. Third, the company has had limited exposure and investor interest due to its former microcap status, very limited and volatile trading history, and complex financial statements. For these reasons, we believe KapStone has been overlooked and underfollowed.

We are especially attracted to KPPC because these factors are largely related to temporary and technical market dynamics. For example, the recent warrant expiration has removed the enormous technical overhang on the stock.  We expect the stock to increasingly trade on fundamentals going forward.  As an added benefit, the partial warrant exercise created 17 million new shares, which along with the recent price appreciation, increased the Company’s market capitalization from $140 million on August 17^th to today’s more liquid and investable $348 million. Further, with a materially improved liquidity position, comparable year over year results that begin in the current quarter, and a more compelling fundamental story to tell, the company’s investor exposure should increase going forward.

Fundamentally, KapStone is both the highest quality and cheapest paper and packaging company of which we are aware. This discrepancy cannot persist, in our view. KapStone is a low cost producer of various paper grades and has the highest EBITDA margins in the industry. Founder and CEO Roger Stone and son-in-law, Matt Kaplan, are an extraordinarily well respected, high quality and owner-oriented management team with decades of accumulated industry knowledge and experience. Insiders own 25% of the company, including 13% between Stone and Kaplan, who recently purchased another 100,000 shares on the open market. Management’s five-year goal at inception was to create a $2 billion revenue company through intelligent acquisitions. Today, KapStone generates roughly $700 million of revenues and is soon to have an underleveraged balance sheet in what we believe will be an increasingly favorable environment for acquisitions.

Company Background

KapStone is a small-cap paper company formed by Stone and Kaplan as a SPAC in 2005. Stone-Arcade Acquisition Corp, as it was originally called, acquired International Paper’s (IP) kraft papers business (“KPB”) in early 2007 and later tripled the size of the company by acquiring MeadWestvaco’s (MWV) Charleston, S.C. kraft division (“CKD”) in 2008. KapStone took on significant leverage to make the latter acquisition, which in retrospect was ill-timed. The subsequent deterioration in economic conditions caused major liquidity and debt covenant concerns among investors, driving the stock to as low as $1.05 per share in February 2009.

The original acquisition, the KPB business, is an incredibly high margin business. It consists of an unbleached kraft paper facility in Roanoke Rapids, N.C. with 420,000 tons of high quality linerboard and kraft paper production capacity and an inflatable dunnage bag business, which was divested on March 31, 2009. Roanoke Rapids is a business that had a 22.3% EBITDA margin and 19.8% ROIC in 2007 and a 25.0% EBITDA margin during the first six months of 2008. These are the highest margins we are aware of in the paper industry. The facility is able to generate such high margins because it is a low cost producer due to its access to structurally lower wood fiber costs in the U.S. southeast, its favorable energy profile (energy usage is 60% self-generated and 25% from cheap coal), and its very well maintained and highly efficient operations. IP invested roughly $40 million into upgrading the facility, including $17.5 million in high ROI capital projects, in the three years before selling it to KapStone. The capital investments from IP combined with present management’s upgrades and optimizations have created a facility with sustainable, high margins, in our view.

The second acquisition, the CKD business, consists of an unbleached kraft paper mill and cogeneration facility in Charleston, S.C., a lumber mill in Summerville, S.C., and five chip mills located throughout S.C. The mill has three paper machines that have the capacity to produce 833,000 to 882,000 tons of saturating kraft, linerboard, and kraft papers in total. CKD had a 15.6% EBITDA margin and an estimated 8-9% ROIC in 2007. Since then, the facility has undergone numerous efficiency enhancements, which we expect to be evident in financial results next year.

The combined company would have had a 2007 pro forma EBITDA margin of 17.8% (18.1% including synergies) and an estimated ROIC in the low-teens. At the time of the CKD acquisition in April 2008, Stone stated that he would be disappointed if the company couldn’t increase EBITDA margins for the combined entity to at least 20.0% after synergies, high return capital projects, and optimizing the machine schedules. While the world has changed since then and demand for many paper products is weaker than it had been, a 20% EBITDA margin on the $745 million of 2007 pro forma revenues would yield $149 million of EBITDA. We are convinced the Company can generate margins in this range in a stable macroeconomic environment. On the Q2 2009 call on July 30^th, Roger Stone expressed confidence that the company would return to that EBITDA level, but declined to predict when. If the Company were to earn $149 million of EBITDA, the stock would likely trade well north of $15 per share. This illustrates a bull-case scenario that we are not relying on in our investment thesis.

Paper Industry Background

Paper making is a tough business. It is capital intensive, cyclical, and vulnerable to swings in raw material costs. The key to sustainable, long-term profitability is being a low cost producer. KapStone is exactly that due to its two highly efficient manufacturing facilities, its access to high quality, low cost southeast wood fiber, and its favorable energy profile with 60% self-generated power at Roanoke Rapids and an on-site 100 megawatt cogeneration facility at Charleston.

Notably, the industry currently has unprecedented pricing power. Many paper companies historically owned their own trees, which often led to high levels of production even during economic downturns because no significant cash outlay was required to obtain the wood. During the ensuing economic recoveries, pricing power was nonexistent due to the resultant bloated inventory levels. In recent years, many paper companies have divested their timberland assets, notably IP, and rationalized a significant amount of production capacity. This has led to much more responsible levels of production. After struggling with overcapacity for years, the industry has finally created a lean inventory environment, which has created pricing power throughout the industry.

Price Hikes

Due to the current lean inventory environment, the three largest U.S. producers of kraft papers, KapStone, Longview Fibre, and Georgia-Pacific, have each announced a $50 per ton price hike. According to management and industry trade publications, the price hike is likely to be successful. Management indicated the price hike would add $15 million to annual revenues and operating income beginning in Q4. Further, export linerboard pricing is starting to tick higher and domestic pricing could follow suit.

Saturating Kraft Market Developments

KapStone holds a 60% market share of the U.S. saturating kraft market and a 40% global market share. KapStone, IP, and Finland’s Stora Enso collectively produce 75% of the world’s needs. Interestingly, Stora recently announced restructuring plans due to its uncompetitive cost structure and plans to divest its Kotka mill and Malaysian facilities, which produce the company’s saturating kraft paper, among other products. This is the second time Stora Enso has tried to sell these assets, and if unsuccessful again, we believe those facilities will be permanently closed. Importantly, Stora’s unprofitability in this product is not an indictment of the product or of its demand, but of Stora’s high wood cost environment. Finland itself has high wood fiber costs and Russian wood duties have reduced affordable imports, making Stora’s production unprofitable – permanently so in Stora management’s view.

Saturating kraft is an 885,000 ton worldwide market. While there are no published industry statistics for this niche specialty grade, it appears to be growing 2-3% per year. KapStone’s 40% global share means the Company is responsible for about 350,000 of those tons; however, KapStone has swing capacity to produce up to 523,000 tons or 59% of global demand should the opportunity present itself. Should Stora Enso close its production, KapStone would be in an enviable competitive position to absorb the available market share in light of the tight supply environment. Charleston is also a major international shipping port, making it ideal for exporting saturating kraft. Given KapStone’s small size and the magnitude of this market share opportunity, developments along these lines would be materially positive for KapStone. We are not relying on this scenario playing out in our investment thesis though, but instead view it as a free call option. Should it occur, there would be modest upside to our estimated intrinsic value range.

Alternative Fuel Tax Credits

KapStone is scheduled to receive about $175 million in total from the Alternative Fuel Tax Credits this year, of which $70 million has been received through the end of Q2. The tax credits were implemented as a tool to encourage companies that use diesel fuel to substitute some portion of alternative fuels into their production. Many paper companies have been using a natural by-product of their production called “black liquor” as a fuel for years, and realized they could qualify for the tax credits if they mixed in a small portion of diesel fuel into their production process. While legislators never intended for paper companies to qualify for and receive these tax credits, the paper companies have a duty to shareholders to take advantage of them. There had been some controversy in the Senate over whether the paper companies deserved these credits and whether they should be cancelled early, but the chatter appears to have died down in recent months. The Senate has much bigger issues to address, notably health care, so we expect the tax credits to expire as scheduled at year-end. Even if the tax credits are cancelled early on October 1, 2009 with the fiscal 2010 Obama budget, we do not believe we are paying for them at the current price anyway. In addition, there had been some uncertainty as to whether paper companies would owe income taxes on the tax credits received, but it now appears that they will be tax-free.

Importantly, we believe there is industry capacity that is likely to be permanently closed once these tax credits expire. The tax credits encourage otherwise unprofitable capacity to continue to produce paper in order to receive the credits. It is difficult to predict which companies, which machines, and which specific paper grades will see reduced capacity when the tax credits expire. Some machines have the ability to produce multiple products, and therefore any closures are likely to reduce the capacity for multiple paper grades. This can only benefit KapStone, which has profitable production without the tax credits and will not be closing capacity.

In light of this, we expect plenty of potentially interesting assets to be shown to KapStone management in the coming quarters. As self-proclaimed “value buyers” with a significant amount of skin in the game (13% ownership), Stone and Kaplan’s extensive experience should allow them to opportunistically identify and acquire quality assets on the cheap that they could upgrade or optimize to maximize returns. Due to Roger Stone’s lengthy industry experience, he has unique insight into the quality and value of much of the industry’s paper production facilities and paper machines, some of which may be acquisition opportunities. We view Stone and Kaplan’s experience as an important competitive advantage. KapStone’s balance sheet has transformed from a major weakness to a major strength at exactly the right time, in our view. 

Valuation

We believe KPPC shares currently are worth somewhere between $11 and $15 per share, primarily based on our conservative DCF and supported by various other metrics.

Asset Value – KPPC is currently trading at about 0.8x of our estimated year-end book value. This is an attractive valuation for a low cost producer with the highest EBITDA margins in the industry. Given the partial warrant exercise, high visibility cash flow from the tax credits, and free cash flow from operations, year-end book value should approach or surpass $9.00 per share. Most industry peers currently are trading between 1.3x – 2.0x book value, which if applied to KPPC, would imply a fair value range of $11.70 – $18.00 per share by year-end.

In addition, applying 1.0x the tangible book value of the acquired property, plant, and equipment in 2006 and 2008, and deducting year-end net debt, we estimate tangible NAV to be $7.90 per share, which is higher than the current stock price. This is an incredibly conservative valuation metric, as it fails to give the company credit for any of the high ROI capital projects completed since the acquisitions were made, including capacity expansions, machine optimizations, and efficiency gains between the two facilities. This measure of tangible NAV is a rock bottom valuation floor that is lower than current liquidation value, in our view. In addition, management completed its annual impairment test in Q4, during the throes of the downturn, and concluded no impairment had occurred. See the Appendix for our NAV calculation.

While new capacity buildouts would be a concern in some industries, we believe the industry is highly unlikely to build out material net new capacity. The industry has been plagued with overcapacity issues for years and has only recently closed the necessary capacity to enable a more balanced supply-demand environment. Consequently, it is unlikely that industry players would reverse course, invest substantial sums of capital and time into significant net new capacity, during a recession no less, that would crush the hard earned pricing power now finally being realized. In fact, as previously mentioned, we expect further industry capacity reductions, if anything, after the tax credits expire.

EV/EBITDA –We view unlevered pre-tax operating cash flow (EBITDA) as a sub-optimal valuation method because it fails to account for companies’ various maintenance capex requirements. Compared to peers, KapStone has relatively low maintenance capex requirements, an advantage which is masked in any EBITDA-based valuation. In addition, as an unlevered metric, EBITDA fails to give KapStone credit for its extraordinarily favorable credit agreement, which currently offers the Company financing at a 2.9% rate that is expected to fall to 1.9% by the fourth quarter. Further, due to acquisition-related accelerated depreciation for tax purposes, KapStone will not be paying cash taxes for at least the remainder of this year. EBITDA fails to give KapStone credit for all three of these advantages and therefore is poor metric with which to value the Company. [Note: KPPC is trading at 4.5x-5.4x our estimated EBITDA range and 4.5x 2010 consensus EBITDA versus the 6.0x-7.0x multiples of lower quality peers.]

DCF – We believe it is most appropriate to value KapStone equity using levered after-tax free cash flow discounted at a reasonable rate of return. We prefer an 18-month DCF, given the high visibility into near-term cash flows much of which is from tax credits, and a wide terminal value range to avoid implying an unrealistic level of precision. For our terminal value, we use a long-term low and high end free cash flow assumption of $50 and $80 million, respectively, which implies a wide EBITDA margin range between 13% – 20%. For perspective, the consensus 2010 EBITDA margin is 17.6%. We assume $22 million of depreciation and amortization is offset by $22 million of maintenance capex on a long-term basis, which is conservative, given that current D&A is roughly $50 million. We conservatively use a 15% discount rate and a 2% long-term growth rate, which results in an equity valuation range of $10.69 to $15.00 per share, as can be seen in the table below.

Exhibit 1: KPPC Per Share Equity Valuation Sensitivity to Terminal Year FCF and Discount Rate

The per-share equity valuations above are calculated after deducting the present value of the maximum earn-out payments potentially due to International Paper in 2012.

EV/Ton – KapStone currently is trading at $424 per ton of production capacity on an enterprise value basis. While there are no perfect comps, as no company has the same business mix and margin profile, a comp table we have put together in Exhibit 2 shows a group of 7 paper companies trading in a range of $517 to $1,434 per ton. Verso Paper (VRS) and Wausau Paper (WPP) are the two lower valued companies on the list at $517 and $583 per ton, respectively. Both of these companies are much lower quality companies than KapStone, in our judgment. Verso is an enormously leveraged company that has been burning cash for almost three years, while Wausau has been unprofitable in recent years. While consensus numbers should be taken with a grain of salt, we have included consensus 2010 EBITDA margins to highlight the quality gap between KapStone and its peers.

Exhibit 2:  Enterprise Value per Ton of Production Capacity Comp Table

We find it difficult to reconcile that KapStone is trading at just $424 per ton, an enormous discount to even the worst companies in the space, while simultaneously having the highest margins, the best balance sheet, and an enviable competitive position. Applying the $517 per ton implied by the valuation of Verso, a serial cash burner, to KapStone results in a $10.32 per share equity value.  In reality, we believe KapStone’s production is much more valuable than that of Verso.  This exercise simply illustrates the attractiveness of KapStone’s current market valuation.

P/FCF – We expect an undiscounted $130 million of free cash flow to accrue to equity holders in Q3 and Q4 of this year and about $175 million in total over the next four quarters. That implies a forward free cash flow yield of 50% on the current $348 million market cap. Clearly, that level of free cash flow is not an ongoing number since the majority of it is due to the tax credits, which are scheduled to expire at year-end. However, we view the prospect of essentially recouping 50% of our initial investment within the first year as very compelling.

So Why Is It So Cheap?

Small Market Cap – KPPC began trading March 1, 2007 and had a market capitalization that ranged between $200 and $300 million in 2007 and most of 2008. Soon after levering up to acquire CKD, the economic downturn negatively impacted end demand for KapStone’s products, which ultimately created liquidity and debt covenant fears and sent KPPC’s market capitalization to as low as just $30 million in February 2009. This market cap left the stock far removed from the investable universe for the vast majority of the investment community and left the already underfollowed company even more so.

Warrant Overhang – Due to the company’s SPAC origins, there had been 28 million shares and about 37 million warrants outstanding before August 18^th, 2009. This created a massive technical overhang on the stock at $5.00, despite significant positive fundamental developments. About 17 million of the 37 million warrants were exercised upon expiration, which provided the company with $85.2 million of cash and increased the share count to 45.4 million shares. We view the partial warrant exercise as the best possible outcome.  It provided some cash to delever the balance sheet and avoided the majority of the potential dilution. With the warrant overhang recently lifted, we expect the shares to increasingly trade on fundamentals.

Rapid Deleveraging Underestimated – The market does not appreciate the rapid debt reduction currently underway, which should increase equity value materially. Kapstone’s $479 million of debt at Q3 2008 has quickly turned into $250 million of debt as of August 18, 2009 and should approach $150 million by the end of this year. The $85.2 million of cash received from the partial warrant exercise and about $175 million ($70 million received through 6/30/09) from the tax credits, assuming they continue as scheduled through year-end, will likely be used for debt reduction. The liquidity concerns that decimated KPPC shares earlier this year are no longer an issue, in our view. We expect Stone and Kaplan to utilize the soon to be underleveraged balance sheet to opportunistically acquire additional manufacturing assets.

Recent Operating Improvements Underappreciated – KapStone cut production in Q4 and Q1 to match output with demand, which brought the company’s operating rate to the low 70% range. The industry-wide production cutbacks brought inventories to unsustainably low levels, which has created a restocking snapback and pricing power. Consequently, in mid-June, KapStone was able to bring all five paper machines back on-line (previously running four), increasing the company’s operating rate to 100%. It is important to note that the company’s operating rate is typically about 95%, indicating that there is not significant downside to “normalized” rate. Management noted its current backlogs are as high as they have ever been since acquiring CKD, which was acquired during good times. Due to the high fixed cost nature of the business, we believe the significant profit swing from running in the low 70%’s to running full is not appreciated by the market. See the Appendix for a graph of historical tons sold.

Short History and Complex Financial Results – A number of factors create complexity in KapStone’s financial statements and complicate the task of understanding the Company for potential investors.  First, year-over-year comparisons have not been meaningful for several quarters due to the “game changing” acquisition of CKD last year.  Second, recent sequential comparisons have not been relevant, because the dunnage bag business cannot be treated as a discontinued operation.  Third, a number of one-time expenses, including acquisition-related overhead expenses, have negatively impacted recent results.  Fourth, the timing of the income statement recognition of the tax credits is affected by the fact that the Company accounts for its inventory on a FIFO-basis.   Finally, the mid-quarter partial warrant exercise has materially altered the capital structure and share count. KapStone is the epitome of a small and underfollowed company undergoing material change, which the market is often slow to recognize.

So Why Will the Discount to Intrinsic Value Close?

Warrant Overhang Lifted and Liquidity Increased – The partial warrant exercise immediately increased the share count and float (insiders owned about 40% of the shares; now 25%) and increased the market cap from $140 million to the current $348 million over about three weeks. The increased liquidity and market cap should boost investor interest. Given management’s growth through acquisition strategy and rising market cap, we expect additional sell side coverage in the coming quarters.

Balance Sheet Weakness Now A Strength – As an increasing number investors do the work on KapStone, they are likely to realize the balance sheet has turned from a weakness into a strength.

Inflection Point in Operations – A major inflection point in underlying business results occurred in late Q2. KapStone brought all 5 machines back online in mid-June, increasing its operating rate from roughly 70% to 100%. We believe the current market price is materially underestimating the magnitude of the profit swing from running at 70% to running at 100%. Paper making is a high fixed cost business, so the large improvement in the operating rate should have a material, positive impact on KapStone’s margins.  We expect the P&L impact will manifest itself with a lag of 3-5 months due to the fact that the Company accounts for its inventory on a FIFO-basis.

In addition, dramatically lower raw material costs for wood fiber, caustic soda and natural gas, none of which are hedged or bought forward, should benefit margins materially in Q3 and beyond. Gradually declining acquisition related overhead costs and the potential for the Q4 price hike should also boost margins.

Conclusion

We believe KPPC shares are a compelling and timely investment opportunity, trading at a 30-49% discount to our estimate of intrinsic value. Importantly, we believe this opportunity exists for non-fundamental reasons, which should allow the stock price to approach our $11 – $15 intrinsic value range over a reasonable time frame. We expect a virtuous cycle to develop between KapStone’s market capitalization and the level of investor interest, which should serve as a catalyst to a revaluation of the Company’s shares. Most importantly, we view an investment at the current price as a low risk, high reward proposition with an attractive margin of safety and an extremely low chance of permanent loss.

Disclosure: Long KPPC

Appendix

Business Mix and Market Share

The company’s business mix is currently about 40% linerboard, 26% kraft paper, 25% saturating kraft, about 8% unbleached folding cartonboard, known as KraftPak, and 1% lumber.

KapStone has just over 2% market share of the U.S. linerboard market, an estimated 20% of the U.S. unbleached kraft paper market, 60% of the U.S. saturating kraft market (40% global share), and 20% of the U.S. unbleached folding carton market (“KraftPak”). Saturating kraft and Kraftpak are higher margin products than kraft papers and linerboard, the latter which is more of a widely made commodity than the other products. 

Product End Uses

Linerboard is primarily used to manufacture cardboard boxes.

Kraft papers include multiwall kraft paper, specialty converting, and bag and sack. Multiwall is used for shipping sacks for pet food and litter, agricultural products, cement, lawn and garden fertilizer bags, grocery bags, and other specialty products. Converting products are used in wrapping paper, wax paper packaging, tape and label backing, and poly-coating and laminating applications. Bag and sack kraft papers are high quality and used in retail shopping bags, fast-food carry out bags, and grocery sacks.

Saturating kraft is a specialty paper that provides impact resistance and thickness to the surfaces of high-pressure laminate products, such as laminated kitchen countertops, flooring, doors, furniture, vertical panels, shelving, circuit boards, roof and wall sheathing, siding, and audio equipment.

KraftPak is used for beverage, gift boxes, take-out cartons, retail food, and quick serve cartons.

NAV Calculation

We estimate NAV by giving the company credit for: 1) the book value of acquired property, plant and equipment (“PP&E”) as of the respective acquisition dates in 2007 and 2008; 2) less the book value of divested PP&E related to sale of the dunnage bag business; 3) other net assets, including net working capital but excluding goodwill and intangibles, as of 6/30/09; 4) an estimated current cash balance; 5) total debt, provided by the company on 8/18/09; and 6) a small pension and post-retirement liability.

This is a conservative exercise.  KapStone paid low multiples of EBITDA for each of its acquisitions (3.3x and 5.8x), and has since invested in the acquired facilities to optimize and expand production capacity. This measure of NAV is lower than current liquidation value, in our judgment.

Exhibit 3: KPPC Current and Estimated Year-End NAV

Exhibit 4: KapStone Paper Tons Sold Per Quarter

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I think Clearwater Paper’s common equity is conservatively worth somewhere between $25 and $35 per share, based on earnings power and free cash flow. In addition, the company is likely to receive refundable tax credits this year equal to $14 per share pre-tax. They have already been approved for and received the first $16.7 million, or $1.45 per share, for a five week period from late January through February.

First, I think it is important to discuss Clearwater Paper’s operating leverage. This company does roughly $1.2 billion in annual revenue, had raw materials/labor/other op. ex., excluding depreciation, (hereinafter “input costs”) at 90.2% of sales in 2008, and has only 11.5 million shares outstanding. With that size revenue base, massive leverage to input costs, and relatively low share count, it doesn’t take much of a change in margins to materially impact the bottom line. In fact, looking at 2008, for every 1% drop in input costs as a percent of sales it would have dropped $1.12 per share to the bottom line. Granted, there are some pro forma adjustments that need to be made due to being an independent company for the first time, but I think this gives a sense of the operating leverage of the business. This was the original thesis on which I first bought the stock in January.

Input costs averaged 87-88% of sales in 2006-2007 and spiked to over 90% in 2008 due to raw material cost inflation, resulting in the company’s worst recent year for margins and earnings. Multiple price increases in the latter half of 2008 were not enough to stem the tide, but those pricing gains coupled with significantly falling input costs led to the company to completely crush expectations in Q1 of this year. They earned $1.19 in EPS and $2.71 in free cash flow (CFO-capex) in the quarter. For perspective, they did $0.15 in EPS in Q4 2008, $0.20 a year ago in Q1 2008, and were projected to earn $0.35 by the sole sell-side analyst.

While the company is likely benefiting from a “sweet spot” for margins as higher pricing and lower costs generate lots of cash, I believe this can continue more or less through year-end. Pricing gains will likely moderate in the second half of this year, but falling costs should provide benefits through year-end as Q1 of this year was the first quarter to see benefits from them.

I’m not going to try to estimate earnings or free cash flow with precision because input costs are volatile and even the slightest change in margin assumptions can wildly impact per share results. Management has acknowledged that modeling the company is a challenge. I do think it is unreasonable to assume less than $2.50 in EPS this year, to which I can apply an unreasonably low 10x multiple to reach my conservative low end equity value of $25.00 per share. For what it’s worth, the only sell-side analyst that covers CLW has EPS estimates of $2.98 and $3.08 for 2009 and 2010, respectively.

At $21.00, the enterprise value, including pension and OPEB liabilities, is roughly $492 million. If one annualizes the $37 million of EBITDA the company earned in Q1, that would result in a 3.3x EBITDA multiple. IP, MWV, and WPP trade at roughly 5.8x, 5.5x, and 8.0x EBITDA, respectively. While annualizing the Q1 figure is aggressive, you could haircut the annualized figure by a third and the EBITDA multiple would still rise to less than 5.0x. Applying 5.0x, 5.5x, 6.0x, 6.5x, 7.0x, 7.5x, and 8.0x multiples to the “haircut” EBITDA figure would result in equity values of $23, $28, $32, $37, $41, $46, and $50 per share, respectively.

While I have no idea what the right EBITDA multiple is, I do believe Clearwater Paper is relatively well positioned versus its paper and forest products peers, many of whom produce products facing severe pressure including lumber, building products, newsprint, uncoated free sheet, and expensive coated papers. Clearwater’s two main business lines are private label tissue, which is a booming business these days as consumers seek lower priced alternatives to branded products, and premium paperboard, which while seeing lower volumes and a lower backlog is still a profitable business. I would argue Clearwater Paper deserves an EBITDA multiple closer to the upper end of the 5x-8x range rather than the lower end. WPP has an 8.0x multiple, and CLW’s business mix and profitability is superior to WPP’s, in my opinion. Even at a conservative 6.0x, I estimate the equity is worth $32 per share.

On an EV/revenues basis, Clearwater is trading at only 0.39x. IP, MWV, and WPP are trading at 0.77x, 0.65x, and 0.56x, respectively. While the higher multiples for the larger competitors probably make sense due to economies of scale and fixed cost leverage, WPP ($374 million market cap; roughly $1.2 billion revenues) is a similar size as CLW. WPP makes tissue products, printing/writing papers, and specialty products in 28%, 32%, and 40% of revenue proportions. While WPP’s tissue business is profitable, it is also their smallest business. Printing/writing and specialty products, which account for over 70% of revenues, are both currently unprofitable. On the other hand, CLW is very profitable in tissue, which is about 45% of revenue, and profitable in paperboard, which is about 51% of revenue. Wood products, while a struggling business line, is only about 4% of revenue. Applying WPP’s EV/revenue multiple to CLW would result in a CLW equity value of $40 per share.

Clearwater Paper’s free cash flow, simply defined as cash flow from operations minus capex, was $31 million in Q1. While annualizing that run rate is probably aggressive, it would result in $124 million of free cash flow on a $243 million market cap and roughly $500 million enterprise value. Free cash flow, adjusted lower for an incremental $10 million of SG&A expenses for being an independent company, would have been $62.4 million, $81.9 million, and $14.7 million in 2006, 2007, and 2008, respectively. Those figures amount to $5.42, $7.11, and $1.28 per share, based on today’s 11.514 million diluted shares.

The only sell-side analyst covering CLW is the analyst at Davidson, who in his model indicates $5.45 and $8.88 of free cash flow per share in 2009 and 2010. The 2010 calculation includes $36 million of cash coming out of inventories, the reason for which I’m unaware. Excluding that $36 million, would result in $5.73 of free cash flow per share in 2010. Importantly, this analyst is excluding any benefits from tax refunds or the likely debt refinancing from his numbers. Applying a 10x multiple to any of those free cash flow figures can result in equity values far north of the current $21 stock price. Depreciation and amortization is running north of capex, which I believe is due to major capital improvement projects that were completed in recent years.

In sum, while it is difficult to offer any precision on valuation, I believe it is unreasonable to value CLW at anything less than $25 per share. I don’t think it takes any crazy leaps of faith to reach equity values far north of that, primarily due to the company’s incredibly low share count.

Debt Refinancing

Clearwater has $100 million of debentures coming due 12/31/09. The interest rate is currently 12.5%, which is based on Potlatch’s credit rating. Under the terms of the spin-off agreement, Clearwater must use “commercially reasonable efforts” to refinance or pay it off. If they can’t on reasonable terms, then Potlatch will assume the debt and Clearwater will owe Potlatch 12.5% plus 100 bps for the first year.

However, Clearwater will have no problem refinancing this piece of debt at a much lower interest rate, sometime over the next few months, even if they don’t get a single more dime in tax credits, in my opinion. The company has $33 million of cash on hand, including the $16.7 million just received for their first tax credit, and had EBITDA of $37 million in Q1 alone, which would be enough to service 6% interest on the $100 million for more than 6 years. Assuming the company can refinance at a 6% rate, it would amount to an annual $6.5 million in pre-tax savings, $4.0 million after-tax, or about $0.34 to EPS. At a conservative 10x multiple, this would amount to an additional $3-$4 per share to the equity valuation.

In addition, the company plans to pay off the remaining $40 million balance on its revolving credit facility, which is priced at a weighted average interest rate of 6.75%. Paying off the $40 million outstanding (as of 3/31/09) would result in annual savings of about $2.7 million pre-tax, $1.7 million after-tax, or about $0.15 to annual EPS. Clearwater’s $33 million in cash and short-term investments, plus cash generated throughout the year, will make repaying the $40 million outstanding on the revolver all but assured, in my view.

In sum, the almost inevitable refinancing of the $100 million debentures and the repayment of the $40 million revolver will add $0.34 and $0.15 per share to annual EPS, or $0.49 per share in total. Neither of these two events is contingent upon receiving even another dime of refundable tax credits from the government, in my opinion. Applying a 10x multiple to the savings would result in about $5 to the equity value.

Refundable Tax Credits

Clearwater Paper is likely to receive as much as $164 million in refundable tax credits from the government this year due to their status as an “Alternative Fuel Mixer.” There is some controversy in the Senate over the legitimacy of the paper companies qualifying for these tax credits. However, I believe the most likely outcome is that they won’t be renewed at 12/31/09 when they expire, or in a slightly worse outcome, the Obama administration will exclude the paper company tax credits with their 2010 budget, which would go into effect October 1, 2009.

Clearwater Paper should receive $0.50 per gallon of alternative fuels used in production, and they use 300-400 million gallons of it per year. They have already been approved for and received the first tax credit check, which was for $16.7 million. This represented the tax credits for the production for the 5 weeks from the last week in January through the end of February, and management articulated to me that this is the rough run-rate I should expect over the course of the year. $16.7 million over 5 weeks is $3.34 million per week of production, which amounts to $164 million pre-tax assuming 49 weeks (excluding the first three weeks of January). Assuming they are repealed beginning October 1, 36 weeks would amount to $120 million pre-tax.

While the company is yet to determine the taxability of these refunds, it appears that they will be taxable. $120 to $164 million should amount to $90 to $123 million after-tax, assuming a 25% tax rate. On a per share basis, this is $7.51 to $10.68 per share, of which the first $1.09 has already been received. The company will continue to apply for the tax credits every couple of weeks or so, and will file an 8-K each time it receives a check.

Essentially, the tax credits were implemented as a tool to encourage companies who use diesel fuel to substitute some portion of alternative fuels into their production. Many paper companies have been using a natural by-product of their production called “black liquor” as a fuel for years, and realized they could quality for the tax credits if they mixed in a small portion of diesel fuel into their production process. While they are an unintended consequence of the legislation, the paper companies have a duty to shareholders to take advantage of them, in my view. This is a controversial issue in the Senate, as some Senators want to revoke the credits while others want to extend them to help a struggling industry. While there is certainly uncertainty over the issue and the impact it will have on Clearwater Paper, I don’t believe any of it is priced into the stock at current levels. In addition, there have been other rumblings about extending some other sort of aid to the paper companies, which could continue beyond this year, whenever these tax credits end.

Conclusion

I believe CLW is conservatively worth somewhere between $25 and $35 per share, based on its current operations alone. The very high likelihood that the company refinances its debt and pays off its credit facility in the coming months should result in another $5 per share to the equity value, in my view. In addition, refundable tax credits worth about $11 per share after-tax should result in a stock price near $41 on the low end. While the tax credits may be cancelled, I do not believe I’m paying for any of them at the current stock price. I view buying at this price as buying an already undervalued company with a free (and reasonably high probability) call option representing the $11 per share in tax credits. Or put another way, buying the stock at $21 is akin to buying dollar bills for somewhere between $0.51 and $0.70, in my opinion. Using baseball terminology, I view CLW as a home run or a grand slam, either of which I can live with.

Catalysts

Clearwater will file an 8-K every time the company receives a tax credit from the government, similar to the one filed on May 8, 2009. If the company continues to apply for the tax credits every couple of weeks, then I would assume the checks should arrive on a similar timetable, assuming no legislative changes.

In addition, I believe the company is highly likely to announce the refinancing of its $100 million of debentures, which will serve as another catalyst. Further, the Q2 earnings release, which is likely to be in late July, should show another solidly profitable quarter for the company and could serve as another catalyst to show that the Q1 results were not a one-time fluke.

Disclosure: I have a long position in CLW.

Date: 5/22/09

Price: $21.08