Clearwater Paper Corp (CLW) FY 2021 MD&A

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with our audited consolidated financial statements and related notes that appear elsewhere in this report. This discussion contains forward-looking statements reflecting our current expectations that involve risks and uncertainties. Actual results may differ materially from those discussed in these forward-looking statements due to a number of factors, including those set forth in the section entitled “Risk Factors” and elsewhere in this report. A discussion of the earliest year may be found in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10‑K filed on February 25, 2021.

OVERVIEW

Executive Summary

For the year ended 2021, we reported net sales of $1.8 billion, down from $1.9 billion reported for the year ended 2020. We reported net loss for the year of $28.1 million, or $1.67 per diluted share, compared to net income of $77.1 million or $4.61 per diluted share in 2020. Adjusted EBITDA was $174.6 million compared to $283.2 million reported in 2020. Decreases in Adjusted EBITDA for 2021 as compared to 2020 were primarily driven by reduced demand for retail tissue as consumers and customers destocked their inventories early in 2021 followed by brief periods of demand spikes based upon the impact of COVID-19 through the year. Decreased demand resulted in lower production which in turn drove decreased fixed cost absorption and lower margins. We also experienced negative impacts due to higher pulp, energy and transportation costs. The pulp and paperboard business benefited in 2021 from significant higher sales prices partially offset by major maintenance in our pulp and paperboard operations. See discussion on segment level results regarding sales, operating results and Adjusted EBITDA in “Our Operating Results” below. See Note 16 "Segment Information" of the Notes to Consolidated Financial Statements included in Item 8 of this report for further information.

Drivers

Paperboard Industry Overview

SBS paperboard is a premium paperboard grade that is most frequently used to produce folding cartons, liquid packaging, cups and plates, blister and carded packaging, top sheet and commercial printing items. SBS paperboard is used for such products because it is manufactured using virgin fiber combined with the kraft bleaching process, which results in superior cleanliness, brightness and consistency. SBS paperboard is often manufactured with a clay coating to provide superior surface printing qualities.

In general, the process of making paperboard begins by chemically cooking wood fibers to make pulp. The pulp is bleached to provide a white, bright pulp, which is formed into paperboard. Bleached pulp that is to be used as market pulp is dried and baled on a pulp drying machine, bypassing the paperboard machines. The various grades of paperboard are wound into rolls for converting to final end users. Liquid packaging and cup stock grades are coated, in a separate operation to create a resistant and durable liquid barrier.

Folding Carton Category. Folding carton is the largest portion of the SBS category of the North America paperboard industry. Within the folding carton segment, there are varying qualities of SBS paperboard, as well as competing paperboard substrates that can be substituted for SBS. The high end of the folding carton category requires a premium print surface and includes uses such as packaging for pharmaceuticals, cosmetics and other premium retail goods. SBS paperboard is also used in the packaging of frozen foods, beverages and baked goods.

Liquid Packaging. Liquid packaging paperboard is used in rigid containers including juice, milk and wine sold in supermarket retail channels.

Cup and Plate Category. Cup and plate category is primarily converted into packaging for premium ice cream, hot and cold cups used in quick service channels and commodity focus plates.

Other. Other applications include carded packaging for blister board alternatives (e.g. batteries and lip stick) and bleached bristols which are used to produce premium printing heavyweight paper grades used in commercial application. Bristols can be clay coated on one side or both sides for applications such as brochures, presentation folders and paperback book covers.

The paperboard industry is affected by macro-economic conditions around the world and has historically experienced cyclical market conditions. As a result, prices for products and sales volumes have historically been volatile. Product

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pricing is significantly affected by the relationship between supply and demand for our products. Product supply in the industry is influenced primarily by fluctuations in available manufacturing production, which tends to increase during periods when prices remain strong. In 2021, economic conditions resulting from the COVID-19 pandemic, including increased raw material prices, transportation costs, and consistently strong demand, contributed to increased prices for paperboard products.

Tissue Industry Overview

The U.S. tissue market can be divided into two market segments: the at-home or consumer retail purchase segment, which represented over 70% of 2021 U.S. tissue market sales, and away-from-home segment, representing the remaining U.S. tissue market sales and includes tissue for locations such as restaurants, hotels and office buildings (according to Fastmarkets RISI(RISI) U.S. Tissue Monthly Data, November 2021).

The U.S. at-home tissue segment consists of bath, paper towels, facial and napkin products categories. Each category is further distinguished according to quality segments: ultra, premium, value and economy. As a result of manufacturing process improvements and consumer preferences, the majority of at-home tissue sold in the United States is ultra and premium quality. At-home tissue producers are comprised of companies that manufacture branded tissue products, private label tissue products, or both. Branded tissue suppliers manufacture, market and sell tissue products under their own nationally branded labels. Private label tissue producers manufacture tissue products for retailers to sell as their store brand. We estimate that private brands comprise approximately one third of the total tissue market.

In the U.S., at-home tissue is primarily sold through grocery stores, mass merchants, warehouse clubs, drug stores and discount dollar stores. Tissue has experienced steady demand growth largely due to population growth in the United States. In addition to economic and demographic drivers, tissue demand is affected by product innovations and shifts in distribution channels.

The U.S. tissue industry has experienced an increase in ultra and premium tissue products as industry participants have added or improved through-air-dried, or TAD, or equivalent production capacity as well as added conventional tissue capacity. Demand for consumer tissue products during 2021 was volatile given the early inventory destocking followed by brief demand spikes as COVID-19 continued to impact the U.S. As consumers return to pre-COVID-19 away from home activities, we expect this demand for tissue to normalize and approach pre-COVID-19 levels.

Critical Accounting Policies and Significant Estimates

A discussion of our significant accounting policies and significant accounting estimates and judgments is presented in Note 1 of the Notes to Consolidated Financial Statements in Item 8 of this report. Throughout the preparation of the financial statements, we employ significant judgments in the application of accounting principles and methods. We believe that the accounting estimates discussed below represent the accounting estimates requiring the exercise of judgment where a different set of judgments could result in the greatest changes to reported results. We reviewed the development, selection and disclosure of our critical accounting estimates with the Audit Committee of our Board of Directors. For 2021, these significant accounting estimates and judgments include:

Retirement Plans and Postretirement Benefits

We have a number of defined benefit pension plans in the United States covering many of our employees. Benefit accruals under most of our defined benefit pension plan in the United States were frozen prior to January 2014.

We account for the consequences of our sponsorship of these plans using assumptions to calculate the related assets, liabilities and expenses recorded in our financial statements. Net actuarial gains and losses occur when actual experience differs from any of the assumptions used to value defined benefit plans or when assumptions change as they may each year. The primary factors contributing to actuarial gains and losses are changes in the discount rate used to value obligations as of the measurement date and the differences between expected and actual returns on pension plan assets. This accounting method results in the potential for volatile and difficult to forecast gains and losses.

We record amounts relating to these defined benefit plans based on various actuarial assumptions, including discount rates, assumed rates of return, compensation increases and life expectancy. We review our actuarial assumptions on an annual basis and make modifications to the assumptions based on current economic conditions and trends. We believe that the assumptions utilized in recording our obligations under our plans are reasonable based on our experience and on advice from our independent actuaries; however, differences in actual experience or changes in the assumptions may materially affect our financial condition or results of operations.

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The following table illustrates the estimated impact on hypothetical pension obligations and expenses that would have resulted from a 25 basis point reduction in two key assumptions for the year ended December 31, 2021 (in millions):

It is not possible to forecast or predict whether there will be actuarial gains and losses in future periods, and if required, the magnitude of any such adjustment. These gains and losses are driven by differences in actual experience or changes in the assumptions that are beyond our control, such as changes in interest rates and the actual return on pension plan assets.

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Non-GAAP Financial Measures

In evaluating our business, we utilize several non-GAAP financial measures. A non-GAAP financial measure is generally defined by the SEC as one that purports to measure historical or future financial performance, financial position or cash flows, but excludes or includes amounts that would not be so excluded or included under applicable GAAP guidance. In this report on Form 10-K, we disclose overall and segment earnings (loss) from operations before interest expense, net, non-operating pension and other post employment benefit costs, income tax (benefit), depreciation and amortization, other operating charges, net, and debt retirement costs as Adjusted EBITDA which is a non-GAAP financial measure. Adjusted EBITDA is not a substitute for the GAAP measure of net income or for any other GAAP measures of operating performance.

We have included Adjusted EBITDA on a consolidated and business segment basis in this report because we use it as important supplemental measures of our performance and believe that it is frequently used by securities analysts, investors and other interested persons in the evaluation of companies in our industry, some of which present Adjusted EBITDA when reporting their results. We use Adjusted EBITDA to evaluate our performance as compared to other companies in our industry that have different financing and capital structures and/or tax rates. It should be noted that companies calculate Adjusted EBITDA differently and, therefore, our Adjusted EBITDA measures may not be comparable to Adjusted EBITDA reported by other companies. Our Adjusted EBITDA measures have material limitations as performance measures because they exclude interest expense, income tax (benefit) expense and depreciation and amortization which are necessary to operate our business or which we otherwise incur or experience in connection with the operation of our business. In addition, we exclude other income and expense items which are outside of our core operations.

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The following table provides our Adjusted EBITDA reconciliation for the last three years:

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OUR OPERATING RESULTS

Pulp and Paperboard Segment

Our Pulp and Paperboard segment markets and produces bleached paperboard to quality-conscious printers and packaging converters, and offers services that include custom sheeting, slitting and cutting.

Segment sales, operating income and Adjusted EBITDA for the Pulp and Paperboard segment were as follows:

Sales volumes in our Pulp and Paperboard segment for the year ended December 31, 2021 compared to the year ended December 31, 2020 were flat. Sales prices for the year ended December 31, 2021 compared to the prior year increased significantly due to the impacts of announced price increases across the industry and changes in product mix. These price increases were driven by strong demand and the tightening of the supply of paperboard products. Offsetting the higher prices, the Pulp and Paperboard segment completed its planned major maintenance in 2021 which resulted in higher operating costs relative to the prior year.

Overall, operating income and Adjusted EBITDA for the year ended December 31, 2021 compared to the prior year was essentially flat with higher sales prices in 2021 offset by inflation specifically related to chemicals, freight and energy and our major maintenance outages at both of our facilities which did not occur in in the prior year.

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Consumer Products Segment

Our Consumer Products segment sells and manufactures a complete line of at-home tissue products and previously sold minor amounts of AFH products prior to the closure of our Neenah, Wisconsin facility in July 2021. Our integrated manufacturing and converting operations and geographic footprint enable us to deliver a broad range of cost-competitive products with brand equivalent quality to our customers.

Segment sales, operating income and Adjusted EBITDA for the Consumer Products segment were as follows:

n.m - not meaningful

1 Excludes contract manufacturing cases of 157, 314 and 807 for the years ended December 31, 2021, 2020 and 2019.

Sales volumes decreased in our Consumer Products segment for the year ended December 31, 2021 compared to the prior year as consumer demand slowed due to the lessening impact of COVID-19. Sales prices changed in our Consumer Products segment for the year ended December 31, 2021 compared to the prior year due primarily to changes in product mix. We saw an increase in our non-retail business related to increases in parent rolls sales offset by reductions in our away from home business due to the announced closure of our Neenah, Wisconsin facility during 2021. Sales prices in this category decreased in the period due to a higher percentage of parent rolls sales which are generally sold at a lower price.

Overall, decrease in operating income and Adjusted EBITDA for the year ended December 31, 2021 compared to the prior year was driven by higher input costs, primarily pulp, reduced operations to balance supply and demand and lower sales volumes due to lessening impacts of COVID-19.

Corporate expenses

Corporate expenses were $60.1 million in 2021 as compared to $63.0 million in 2020. The reduction between years is

primarily related to the lower incentive compensation due to lower financial results. Corporate expenses primarily

consist of corporate overhead such as wages and benefits, professional fees, insurance and other expenses for corporate

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functions including certain executive officers, public company costs, information technology, financial services,

environmental and safety, legal, supply management, human resources and other corporate functions not directly associated with the business operations.

Other operating charges

See Note 9 "Other Operating Charges, net" of the Notes to the Consolidated Financial Statements included in Item 8 of this report for additional information.

Interest expense, net

Interest expense for the year ended December 31, 2021 compared to December 31, 2020 was $10.1 million lower due to lower debt outstanding. See Note 10 "Non-operating income (expense)" of the Notes to the Consolidated Financial Statements included in Item 8 of this report for additional information.

Potential impairments

We review from time to time possible dispositions or reorganization of various assets in light of current and anticipated

economic and industry conditions, our strategic plan and other relevant factors. Because a determination to

dispose or reorganize particular assets may require management to make assumptions regarding the transaction structure of the disposition or reorganization and to estimate the net sales proceeds, which may be less than previous estimates of undiscounted future net cash flows, we may be required to record impairment charges in connection with decisions to dispose of assets.

LIQUIDITY AND CAPITAL RESOURCES

Overview

Our principal sources of liquidity are existing cash, cash generated by our operations and our ability to borrow under such credit facilities as we may have in effect from time to time. At times, we may also issue equity, debt or hybrid securities or engage in other capital market transactions. Due to the competitive and cyclical nature of the markets in which we operate, there is uncertainty regarding the amount of cash flows we will generate during the next twelve months. However, we believe that our cash flows from operations, our cash on hand and our borrowing capacity under our credit agreements will be adequate to fund debt service requirements and provide cash to support our ongoing operations, capital expenditures and working capital needs for the next twelve months.

Our principal uses of liquidity are paying the costs and expenses associated with our operations, servicing outstanding indebtedness and making capital expenditures. We may also from time to time prepay or repurchase outstanding indebtedness or shares or acquire assets or businesses that are complementary to our operations. Any such repurchases may be commenced, suspended, discontinued or resumed, and the method or methods of effecting any such repurchases may be changed at any time or from time to time without prior notice.

Operating Activities

During 2021, we generated $96.4 million of cash from operations, as compared to $247.0 million in 2020. This decrease was driven by decreases in our net income and changes in working capital due to decreased demand in our consumer products division which resulted in higher inventories. Accounts receivable and accounts payable agings have remained relatively consistent with balances as of December 31, 2020.

Investing Activities

During 2021 we used $25.1 million in cash for investing activities attributable to $38.4 million of capital expenditures partially offset by $13.3 million of proceeds from divested assets, as compared to $39.6 million for capital expenditures during 2020. Capital expenditures were primarily related to maintenance projects. Included in accounts payable and accrued liabilities was $11.0 million related to capital expenditures that had not yet been paid at December 31, 2021.

In 2022, we expect cash paid for capital expenditures to be approximately $60 million to $70 million.

Financing Activities

Net cash flows used in financing activities were $82.0 million for 2021 as compared to $192.9 million for 2020. The change was driven by lower debt repayments for the year ended December 31, 2021 as compared to the prior year.

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Commitments

As of December 31, 2021, we have purchase commitments of $108.7 million million related to contracts for the purchase of chemicals, pulp and contracts with natural gas and electricity providers that are legally binding on us and specify fixed or minimum quantities. Additionally, we have $16.4 million in purchase commitments associated with capital expenditures.

Credit Agreements

We must make mandatory prepayments of principal under the Term Loan Credit Agreement upon the occurrence of certain specified events, including based upon a percentage of annual Excess Cash Flow we generate which can fluctuate depending on our Senior Secured Leverage Ratio (as those terms are defined in the Term Loan Credit Agreement). For instance, if our Senior Secured Leverage Ratio on the last day of a fiscal year is below 1.50x, we are not subject to an Excess Cash Flow mandatory prepayment. There is uncertainty in the amount of Excess Cash Flow that we may generate during the current fiscal year, therefore, we are unable to estimate the mandatory prepayment under the Term Loan Credit Agreement that could be required at the time such payment is due in 2022. During the year ended December 31, 2021, we prepaid $79 million of principal under the Term Loan Credit Agreement. Amounts repaid or prepaid cannot be reborrowed. However, we may add one or more incremental term loan facilities to the Term Loan Credit Agreement, subject to obtaining commitments from any participating lenders and certain other conditions, so long as our first lien secured leverage ratio does not exceed 2.00x to 1.00x. At December 31, 2021, our first lien secured leverage ratio was 0.24x.

The ABL Credit Agreement includes a $250 million revolving loan commitment, subject to borrowing base limitations. Borrowings under the ABL Credit Agreement are subject to mandatory prepayment in certain circumstances. We may also increase commitments under the ABL Credit Agreement in an aggregate principal amount of up to $100 million, subject to obtaining commitments from any participating lenders and certain other conditions.

Both credit agreements contain certain customary representations, warranties, and affirmative and negative covenants. The ABL Credit Agreement also contains a financial covenant, which requires us to maintain a consolidated fixed charge coverage ratio of not less than 1.10x to 1.00x, provided that the financial covenant under the ABL Credit Agreement is only applicable when availability falls below $25 million.

At December 31, 2021, we were in compliance with the Credit Agreements, and based on our current financial projections, we expect to remain in compliance. However, if our financial position, results of operations or market conditions deteriorate, we may not be able to remain in compliance. There can be no assurance that we will be able to remain in compliance with our Credit Agreements. If we are unable to do so, it would be necessary to seek an amendment from our lenders, which, if obtained, could require payment of additional fees, increased interest rates or other conditions or restrictions. See Note 8, "Debt" to the Notes to Consolidated Financial Statements included in this report for additional discussion of our Credit Agreements.

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