Graphic Packaging Holding Co (GPK) 2005 Q2 法說會逐字稿

Good morning, my name is Brooke and I will be your conference facilitator today. At this time I would like to welcome everyone to the Graphic Packaging Corporation Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks, there will be a question and answer period. If you would like to ask a question during this time simply press "*" then the number "1" on your telephone keypad. If anyone needs assistance at any time during this conference please press "*" then "0" and an operator will assist you. As a reminder ladies and gentlemen, this conference is being recorded today, Thursday, August 4, 2005. Thank you. I would now like to introduce Mr. Scott Wenhold, Vice President and Treasurer. Mr. Wenhold, you may begin your conference.

Thank you Brooke and good morning everyone. Welcome to Graphic Packaging Corporation second quarter earnings call. Commenting on our results this morning are Steve Humphrey, the company’s President and CEO; and John Baldwin, Senior Vice President and CFO; David Scheible, our COO is also on hand to answer any questions at the end of the presentations this morning.

Statements of this company’s expectations including but not limited to the effect of inflation, the company’s ability to implement price increases and cost savings are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Such statements are based on currently available information and are subject to various risks and uncertainties that could cause actual results to differ materially from the company’s historical experience and its present expectations. Undue reliance should not be placed on such forward-looking statements as such statements speak only as of the date on which they are made and the company undertakes no obligation to update such statements. Additional information regarding risks facing the company is contained in the company’s periodical filings with the SEC. At this point I will turn this morning’s proceedings over to Steve Humphrey.

Good morning everyone. Yesterday the company announced its second quarter 2005 earnings, reporting a preliminary net loss of 10 cents a share. The second quarter was another challenging one as we continue to operate in a difficult inflationary environment. In total, higher costs for production inputs and services had an approximate $32 million negative impact on our second quarter bottom line. Fortunately, we did see some relief from higher costs in the second quarter as we began to realize greater level of contractual price increases with our customers. These price pass-throughs were preliminarily -- primarily related to price increases for paperboard that were announced in late 2004. As mentioned in the last call, as the year progresses we expect to continue to regain higher board and resin cost through additional price increases.

In addition, beginning with the third quarter inflation should not have as big a negative impact on year-over-year and quarterly comparisons, as the effects of higher costs first began to impact us dramatically in the third quarter of last year. We did have some positive developments in the quarter particularly in the non-beverage side of the business. In addition to improved pricing second quarter volumes in this sector were quite strong as shipments to our top three national accounts were all up versus prior year second quarter.

On the beverage side soft market demand for beer continued to impact our sales. When comparing to the second quarter of 2004 U.S. beer can shipments for the quarter were down approximately 1.7% as the domestic beer market continues to lose shares to wine and spirits. In response to this decline in demand, the major U.S. brewers have recently initiated promotional pricing activity in attempt to jump start sales. Despite a similar decrease in U.S. can soft drink shipments, our soft drink carton sales remained strong as volumes were up almost 6% over the prior year second quarter. The increase on our end can be attributed to share gains with several of our major customers.

As far as new product rollouts, the success -- the second quarter was a successful one. In beverage we developed a number of new packages to support our major customers. In the beer category, Anheuser-Busch rolled out a 16 ounce Budweiser in aluminum bottles using our four pack carton as well as 12 ounce cans and a 36 pound Graphic twin stack package. Miller Brewing has launched Brutal Fruit, a fruit enhanced beer into select test markets using a Graphic six pack carton. Internationally Kirin Brewery launched a new beer called Nodogoshi in April and this beer has already taken over the number two position in its category. And in Mexico, Jugos de Valle, one of Mexico’s largest fruit juice producer selected our patented Fridge vendor carton to help launch their line of ready to drink fruit juices. In non-beverage we had success with the launch of our Micro-Rite Susceptor pizza disc with two different customers in the Far East. Specifically Taiwan Rich food group and Dragon Island rolled out their products incorporating these discs during the quarter. And finally Kraft Foods continued to accelerate their implementation of our Z-Flute packaging with many of their club store offerings. The extra strength provided by this patented substrate allows individual product to be directly palletized and shipped without requiring additional protection of tertiary packaging like corrugated boxes.

We also continue to combat inflation through the execution of numerous continuous improvement projects and the continued investment in our manufacturing initiatives. During the quarter these programs achieved approximately $13 million in incremental cost reductions and increased productivity. On the production side our U.S. mills performed well and ran at full capacity over the entire quarter. No market related downtime was incurred and none is forecast at this time. Strong operational performance in process improvement initiatives enabled increased production volumes versus Q2 of 2004.

Beverage converting performance was strong during the quarter particularly at our Perry, Georgia, and Cincinnati, Ohio, facilities. The start up of our new 67 inch Gravure Press in West Monroe, Louisiana is slightly behind the original time line. The causes for this delay has been identified in our currently being addressed by Graphic and the vendor. The press however has shown continued improvement in output and is expected to reach full potential during 2005. The improving efficiency in West Monroe combined with the operating of our –operation of our expanded Fort Smith, Arkansas facility will allow us as previously announced to close the Clinton, Mississippi, converting plant. The Clinton facility is expected to halt production later this month. In non-beverage we saw excellent converting performance across all our plants including the very good startup of the new Fort Smith, Arkansas facility.

In summary, the story continues to be inflation although our sales contracts often limit timing and ability of raising prices we have begun to see price increases related to Q4 2004 published board increases. In addition we expect to attain additional price increases in the second half of the year. We also continue to push longer term top line growth by prioritizing product innovation and providing customers with new packaging solutions.

Finally, both the dedication to continuous improvement and the investment in our manufacturing initiatives will continue to drive cost savings and productivity improvements over the remainder of the year and into 2006. And with that I will turn it over John Baldwin for a review of the financials.

Thanks, Steve and good morning everyone. As Steve has said we did release our earnings for the second quarter last night and reported a preliminary net loss of $19.6 million or 10 cents per share. This compares to a restated net loss of $4.6 million or 2 cents per share for the second quarter of 2004. As we discussed in last night’s earnings release the company has restated its first quarter 2005 and prior three years of financial statements. The restatement arose from the difference in the treatment of goodwill between book and tax accounting. As dictated by accounting rules which changed in 2002 the company no longer deducts goodwill for book purposes but continues to amortize goodwill for tax purposes. This difference in treatment gave rise to additional income tax expense that had not previously been booked. The non-cash increase in income tax expense and net loss is $19.1 million, $12.8 million and $37.8 million for the full years 2004, 2003, and 2002 respectively, and $4.9 million in the first quarter 2005.

Second quarter 2005 net sales were $623 million which was up $16.7 million or 2.8% as compared to net sales of $606.3 million in the 2004 second quarter. The increase in net sales versus the prior year second quarter was driven by several factors including an approximate 12.9% increase in non-beverage carton sales to North American markets. Sales increase there was driven by both stronger volumes and price increases that were implemented during the quarter. The increased pricing is a result of published paperboard price increases that occurred late in 2004. And as we have mentioned in prior calls there is typically a 90 to a 180 day lag between published board movement and contractual price increases that take effect with our customers.

Secondly, foreign and currency exchange rates also made a positive contribution of $4.5 million to second quarter sales. The company‘s total international sales during the quarter were $108.7 million or approximately 17.5% of our total sales. Partially offsetting these positive factors was a slight decrease in North American beverage carton sales. The decrease was primarily the result of both lower pricing and lower volumes for beer cartons as Steve had mentioned. The news was a bit better on the soft drink side as carton sales for this market were up over the second quarter of 2004 to slight an approximate decrease of 1.5% in total US soft drink can shipments.

Income from operations for the 2005 second quarter was $23.6 million down from 2004 second quarter income from operations of $36.7 million. I will take you through the major drivers of the year-over-year second quarter decline in just a moment. Net interest expense was $38.9 million for the second quarter 2005 as compared to net interest expense of $36 million for the second quarter 2004. The increase was a result of the higher interest rate environment. Income tax expense of $4.8 million in the quarter compared to a restated second quarter 2004 income tax expense of $5.7 million. EBITDA for the 2005 second quarter was $77.8 million or 12.5% of sales as compared to EBITDA of $93.4 million or 15.4% of sales in the 2004 second quarter. Credit agreement EBITDA for the second quarter was $91.8 million as compared to $104.9 million in the 2004 second quarter. Unlike straight EBITDA add-backs for Credit Agreement EBITDA include pension, post-retirement and post-employment benefits, as well as merger-related expenses and unusual write-downs.

Capital expenditures for the 2005 second quarter were $21.5 million. Approximately $3.5 million of that amount was related to our food and consumer products sheet-fed manufacturing initiative which now brings total expenditures on this project to approximately $23 million of the total $26 million we expect to spend there. As Steve emphasized earlier, cost inflation had a substantial negative impact on income from operations this quarter. The most significant increase related to chemicals, coatings and resins. Costs for these inputs increased approximately $10.3 million when compared to last year second quarter. The price for fiber, board and corrugated materials was also substantially higher than the prior year second quarter, resulting in increased costs there of approximately $6.9 million.

Energy, primarily natural gas and purchased electricity, was also up approximately $5.9 million over the second quarter 2004. Labor and benefits costs were approximately $5.7 million higher than the prior year second quarter and the Company has also been negatively impacted by higher pricing for freight. As mentioned in our prior calls the increased costs are two fold, higher fuel surcharges as well as overall lane-rate increases resulting in an approximate $1.8 million increase over last year second quarter. Partially offsetting the impact of inflation was an approximate $13.3 million reduction in operating costs as a result of ongoing continuous improvement projects as well as the investment we’ve made in our manufacturing initiatives.

Also lower depreciation and amortization of approximately $2.5 million contributed to offset those increased cost. Specifically our depreciation and amortization for the quarter was $54.2 million compared to $56.7 million reported in the second quarter of 2004. The decrease is primarily a result of lower amortization of merger related intangibles such as non-compete agreements and this lower amortization is reflected in the Other Expense line on the income statement. SG&A was $53.2 million during the second quarter compared to $49.2 million in the prior year's second quarter, a significant part of this increase was attributable to the higher labor and benefits which was included in the inflation numbers I mentioned earlier.

Let me wrap up with a few comments regarding the balance sheet and our cash flow. At the end of the quarter we had $7.1 million in cash and equivalents and approximately $275.3 million available under our revolving credit facility. Our total revolver commitment is for $325 million and as of June 30 we had $35.8 million in cash borrowings and $13.9 million in outstanding letters of credit which reduced our availability from the revolver. Total debt at the end of the second quarter was approximately $2.059 billion representing a decrease of approximately $39.8 million during the quarter and a decrease of approximately $88.2 million when compared to second quarter of 2004. With that Brooke, we’ll open the line now for the question-and-answer session.

At this time I'd like to remind everyone, if you would like to ask a question, please press star, then the number 1 on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Your first question comes from Bill Hoffmann with UBS.

Hi all. Good morning.

Hi good morning.

Steve it seems you are doing a pretty good job of blocking and tackling here at least through the second quarter and I guess one of the things you mentioned going into the second half of the year is that, is the potential to actually get some further price improvements and the fact that maybe inflation is waning a bit. Can you just give us a little bit more color on what -- where you are on the pricing front as far as talking with customers and what kind of feedback you are getting?

Well, as we have said previously, we are going to collect all the money that is due us under our existing contracts and, while we don’t discuss the actual numbers, the third quarter will have about the same magnitude of new price input as we experienced in the second quarter which will be substantially all the pricing that we are hoping to collect absent new board and resin price increase announcement. I think the reference to inflation was really as we look at year-over-year comparisons, it will be less dramatic in the future because inflation really started to hit us hard in the third quarter of last year. We are continuing to see net new inflation in certain important cost inputs, some in freight rates, some in gas, some in purchased electricity, and still some additional pressure on coatings and chemicals. We are working through our projections and our inputs for 2006 and beyond as we speak so there is still a little bit of cloudiness in the crystal ball but we are expecting additional net inflation to hit us next year, new inflation.

What is the dollar amount of the pricing per ton that you expect to get to fully implement on this round as previously announced?

We have declined to speak to that with the exception of containerboard where there is a lot of transparency in market pricing, but we have characterized it carefully and consistently as meaningful, but in no way, shape or form does it recover substantially the impacts of inflation. And that’s about as much commentary as I can give you Bill.

Okay, and then just a final question, you talked about that non-beverage growth is being really strong, could you just remind us on what percentage is non-beverage at this point, of the coated board sales?

Well, David Scheible,

Yes, it’s the consumer -- well that part of our consumer sort of end is about 60% of our business and that business was strong primarily because the customers had good quarters. If you look at -- you know, if you sort of look at our primary customers in that space like Kraft, and General Mills, and Kellogg’s, they all had good volume growth in their business, we did have price recovery in that sector, and that led overall to I think as Steve about 13% volume year-on-year.

The good news as I view it is that the growth in the non-beverage consumer products has been strong in the integrated carton business or actually roll stock sales that go to other converters is down year-over-year, so you know our stated strategy of becoming increasingly integrated continues to work.

Great, so can we know the paperboard packaging sales number here, you are saying 60% is the consumer non-beverage?

It works better when you look at tons than dollars because there are some differences in dollar per ton.

Right, that’s fine.

Okay, great. Alright

Yes, thank you.

Your next question comes from Joe Stivaletti with Goldman Sachs.

Yeah, hi. Just to clarify when you talk about the price pass-throughs that benefited you in the second quarter and you hope to benefit you more in the third, that is more for your non-beverage tonnage?

Yes.

Right and so on the beverage side obviously, you know, I know you have talked about how you entered into a number of long-term contracts and some of those or a number of those don’t really provide the kind of pass-throughs that some of the non-beverage customers do if I am correct?

You are correct.

And when is it that, that you will be able to start having discussions or when are those contracts -- when do some of them start coming up for renewal so that you can maybe start to try to recover some of that on that other side of the business?

The discussions started a year ago when we first saw the first signs of significant inflation. By and large the contracts are renewable or discussable in the '07 and '08 timeframe. I would remind you that part of the quid pro quo in getting into those long-term agreements was knowing we’d have the volume which then justified the investments we made in the beverage converting world which are now producing very significant and sustainable cost reduction. But fair to say we have got conversations with all the major customers and really are looking for at some point in the foreseeable future getting some form of sharing of inflationary risk back in that segment.

Yeah, well that sounds good. Just the other thing I was wondering about is if you could talk about in looking back at when you, when the merger was completed you talked about one of the opportunities being cross-selling you know putting coated board into consumer products customers putting may be taking some of Graphic’s products into international markets. And I wondered sort of how you would characterize the progress you made there.

I think all aspects of the merger are more mature and have happened more quickly than we would have allowed ourselves to -- to anticipate. We flew by the synergy numbers. A couple of very specific examples as referenced in the call. You will see a significant introduction from Kraft of various brands and club store packages utilizing the Z-flute and Composipac functions that come from both legacy companies. The fact of the matter and we were petty candid when it was it was just Riverwood, Z-flute’s a great invention, but we didn’t have the face to the customer or channel to market because most of the opportunity is in dry package food. And our sales have gone up significantly; we’ll basically double this year of what we did last year and importantly the acceleration is very stout. The references to microwave in the Far East and in Europe that we’ve made previously really comes through access to customers that is created by the legacy Riverwood infrastructure. And we meet every month as a management group in our new product development and innovation session, we just had our most recent one yesterday, and we had a pretty encouraging report from our folks over in Europe relative to exploiting microwave technology. As we acknowledged all along, it takes a while to get in front of the customers go through all of the product trialing and kind of the pre commercialization activity but that stuff is come along nicely, so I am really quite pleased and the good news is we keep identifying additional opportunities to kind of cross sell or take advantage of legacy capabilities.

I think also what gets lost in there, too, is that while we had solid growth in the consumer products side of the equation, what's massed in there is also the exit of business that really is not great business for us and we continue to walk away from or jettison business that doesn’t make sense for us. So, on top of the strength in that, there’s also $7 million to $8 million worth of business in that quarter that we just- - I guess- - what I would consider- - we sort of margin mix improved, so that is also a result of the merger having better access to coded board and ability to integrate that and get rid of business that is the externally purchased that just doesn't seem to have the same sort of contribution, so that part of the equation has been very solid.

Alright well that sounds good. Thanks a lot.

OK thank you.

Your next question comes from Bruce Klein with CSFB.

Hi, good morning.

Yeah good morning.

I was just wondering, not to be a dead horse in this contract stuff, but I guess I think it sounded like a one or two quarter lag. I know there was some SBS movement I guess in the spring of higher prices and I don’t think the recycled box board price really moved very much. But is the benefit that you’re sort of seeing in 3Q related to maybe some success in bleached in terms of the board up in the first half or is it left over from the fourth quarter?

It;s all hang over from '04 Bruce.

Oh, OK.

In all three of those grades, though. In SUS, CRB, NSBF’s hangover -- overhang. But really not much, as Steve said, not really new board increases.

Okay, if some of these new board increases do take in the summer or the fall that will, I assume, transfer in similar timeframe.

No, going back to Joe Stivaletti's question, we have had some discussions with customers that if new increases come along that it might be good for them to acknowledge and pay for as they incur rather than as a traditionally - - a 90 to 180 day lag that were part of being a bank.

And the beverage contracts that are up I quite catch - - I am not sure I understood what you are saying I think you tried to achieve some pass-through on that earlier, it didn’t happen, but the timing of the '07 or '08 is more a function - - these were what 3-4 year contracts or something?

Yes, that’s correct and our customers fully understand the challenges that the industry is facing and they have heard, I think, at least from us, that we need to get some sharing of inflationary risk incorporated into future agreements.

Okay. And on the debt side, I know a while ago the business changed, it got more difficult with these pass-throughs, but I guess on the debt side it sounds like it will be more of a flattish year versus what had hoped to be some decline in '05. Is that a fair characterization I know you’re up year-to-date I think 35 million bucks in terms of net debt?

I’ll let John Baldwin comment.

It should be a mirror image to what we had last year which is that debt increases through the first part of the year and then most of our debt reduction comes in the fourth here; that’s why I pointed out that our debt is down by about $88 million from this time last year because I think that’s the more important comparison.

Okay, so you expect it to come down but net-net for the year, I suspect it’s not going to change a lot versus when you look at or 4Q '04?

It should go down from where it is, yes, I mean we finished last year at net debt of 2017, and we're now a debt of 2059, so we expect it to come down, primarily in the fourth quarter.

We had previously discussed a net reduction -- net debt reduction range for the year of something around a $100 million?

Right.

And with the increased inflation I think that number is going to be less than that, it might be in the 70ish kind of range, but still a meaningful reduction in net debt for the year and, as John said, the way our business calendarizes, most of it will come yet again in the fourth quarter.

Okay. And then lastly, the Credit Agreement EBITDA I think is about $14 million versus the reported. Since it’s not an insignificant number, I wonder if you had a breakdown of the pension versus merger versus write-down for us?

No not specifically, but it, as has been in the past, almost all pension and post related benefits that are in that number.

Okay. And the last one is just I think the revenue per ton I was getting on the paperboard side was down a little bit sequentially 2Q versus 1Q and I have to think that’s mix because of the contract pass-throughs but is that the case or have you guys studied that -- looked at that way or?

Yeah, quarter-on-quarter?

Yeah, 2Q versus 1Q.

I think, yeah, I think what you have seen is a little bit of shift in that coated tons were up and containerboard tons were down, so the quality of those ton shifted is what you’ve seen. And that's really our plan, right, to -- I think we released that containerboard tons, while containerboard volumes or revenue was the same, we sold significantly less containerboard tons, almost no linerboard at all in second quarter, and so what you see is coated tons going up.

I am just looking through the detail and the actual is affected principally buy revenue changes in Europe, where it has been a fairly dramatic reduction in beverage carton demand and then they have a higher -- beverage cartons have a higher sales per ton in Europe than other areas so…

That would be most of the mix issue.

Right.

Okay, I will pass it on. Thanks guys.

Okay.

Your next question comes from Jeff Harlib with Lehman Brothers.

Hi, good morning.

Yeah good morning.

Just maybe you can talk a little bit about it looks like you had a year-over-year pick-up in tons sold in paper packaging in 2Q. Can you talk about how things are looking in your key markets into the third quarter in consumer soft drinks and beer and how you are positioned to meet your consumer needs?

Yeah, I’m going to turn it over to Dave Scheible on that one.

Well you know, what I would say is that the consumer products business continues to be strong as we look out forward, order backlog is solid in that and you know this starts our back to school time of the year, so cereal and dry foods, frozen pizzas, those kinds of things continue to strengthen. The beer market and the soft drink market, it looks to be very much more of the same; our customers themselves are struggling with the ‘how do you prop up volume in take home cans, that’s our primary business sector. What you saw underlying this quarter was for the first time in soft drink, for example, the diet business did not show the strength to cover the traditional decline in sort of the full sugar colas and take-home. What we would say is that rate of decline seems to have stabilized but our customers are working on promotions, you saw probably with the 4th of July holiday, more aggressive pricing out the soft drink guys to try and improve volume in that mix, so- - . so, what we would we say is we expect the third quarter to be traditionally -- to fall inline with our traditional seasonality in that business. The one that I think that we struggled a little bit to understand is what's going on in Europe. Europe is a difficult market right now on lots of fronts, both cost, price and volume and while it's not a big business for us, certainly the impact on our P&L is something we are continuing to comprehensively look at and understand what's the best strategy forward in Europe.

Okay. And just moving on to what you commented on with the press that it was taking a little longer than expected to come online. Does that impact your -- meeting your customers’ requirements? And also what does that mean for your anticipated cost reductions under your beverage cost initiative?

What I would say is that we’re not having any problems whatsoever meeting customer demands in fact if you look -- our service rates for customers this quarter-on-quarter is significantly better than last year, yet our inventory is down. So, I would tell you that the press is not an impact on service. As Steve mentioned we'd like it to run better than it is, but an overall impact on cost is diminimus in the overall P&L. And we’re talking -- we’re talking rates of throughput in 5% sort of less than what we would expect. So, not a significant issue, one we have to fix it because it's a new press but certainly relative to our overall, you know, our overall returns is diminimus.

Okay and just to clarify, Steve, on the beverage contracts which expire in '07-'08 you're not saying you may look at that before those contracts mature, are you?

Well, we've asked the customers to consider it, they have…

Right.

They haven’t been particularly responsive, but there is a lot of dialogues so that they understand the severity of the problem and at least get ourselves well-positioned for when these things are up for renegotiations.

Okay and the continuous improvement of cost savings, it looks like the year-over-year change was higher in Q2, do you have a kind of target and where you stand on those initiatives as a target?

Well, I think we mentioned in the commentary and in the press release that it's combination of capital projects as well as continuous improvement. We've disclosed or discussed previously that our cost reduction from continuous improvement and use of Six Sigma runs in the $25-30 million a year range and we are comfortably at or slightly ahead of that rate year-to-date. We've been very specific about the paybacks that we're expecting from our beverage manufacturing strategy, something in the high $30 million a year range and from our sheet-fed strategy in the consumer products, something in the order of $16 million a year when it's fully implemented. Now the good news is that the beverage strategy is substantially implemented and we're seeing the savings that we expected and the sheet-fed strategy is really just starting to kick in now because the new Fort Smith plant, which is the kind of the key linchpin in all of this, is just in its early stages of operation. But it is going well enough that we are going go ahead and close the Clinton, Mississippi carton plant at the end of this month and we have previously disclosed that the savings associated with that are something in the order of 4.5 to 5 million a year, largely fixed cost reduction. So, you know, we‘ve got a lot of moving pieces but the answer is we continue to look for additional opportunities to take cost out given the kind of the relentless impacts of increasing inflation, we just have to match the cost side of the company or the cost reduction side with the new cost increase side so, more of the same for us.

Okay, so that 13 million amount you highlighted in Q2 that’s continuous improvement and your specific initiatives combined?

That is correct.

Okay. Alright and last question CapEx for this year, you are still looking about 125 million?

It will probably be less than that. There are some areas where we have just decided that we will tighten our belt or push some projects off for a while that we would otherwise intend to do. We are not prepared to give new guidance but it would be less than what we previously allowed.

Okay. And ’06, I guess it is early for that but a rough one?

As I said, in the opening question, this is the time of the year when we are working on our long range plan and the preliminary development of the '06 budget. So we are a little ahead of ourselves in terms of pulling all that together but, I think the indication that we have given is that we think that there is a role for capital to help us drive cost out of the company so, we will be spending something for sure.

Thank you.

Okay.

Your next question comes from Christopher Miller, with J.P. Morgan.

Good morning just a couple of quick follow up questions. With the decline in the containerboard volume, obviously that is part of the strategic tact that you are taking going forward, but this sort of decline in the 16%, is that the right way to think about it going forward on kind of a year-over-year basis or is there a way to kind of discern what was kind of the business you have intentionally exited versus what was just soft industry volumes?

Well, that’s a great question. We have three grades in containerboard: corrugated medium, which is something in the order of 130,000 tons on a machine that is dedicated to make that product and is part of our go-forward calculus. We also have a bag kraft machine that produces something in the 30,000-35,000 ton range, and that’s all that machine makes and it is part of our go-forward calculus. We pretty well -- we have ceased production on brown linerboard, but we still have a coated linerboard post print product that we find attractive and until we can find other coated business that would be marginally or incrementally better we are going to continue to make and sell that. It has been a good grade, we call it kraft coat. And that’s something that's in the kind of 20,000-25,000 ton range. So that’s the piece that you can expect through time will be kind of on the bubble, but we are out of the containerboard stuff we want to be out of, finally.

Okay. And then just turning back to the balance sheet and the debt reduction and maybe a longer-term view in terms of how you look at it, obviously made good progress last year paying down north of a 100 million. You are going to come up sounds like a little bit short of that this year. Is that 100 million is that a pace of debt paydown that you are comfortable with as you look out to '06, '07 and beyond on an annual basis? Do you see a need to try and accelerate that over time and, if so, how do you kind of think about that with this business particularly with you know the rising inflationary costs?

Well I think that everyone and management on the board would hope it would be a bigger number. Okay. On the other hand, when you work through the kind of the timeframe and calculus on de-leveraging the balance sheet, something in the order of a $100 million a year is pretty meaningful and probably ought to be kind of our nominal planning target in today’s business environment. And I don’t know if the question is kind of rooting around would we consider other strategic actions to kind of top off debt reduction. We have been very open over the years that we have some non-strategic assets including a white line chip mill in Sweden that we’re always open to consider monetizing if we can see a fair return, but I don’t think there is any situation that we are anticipating where we’d be forced into taking those kind of actions.

Okay, wasn’t trying to be that subtle with my question, but I appreciate the information. Thanks so much.

Your next question comes from David Frey with Stanfield Capital.

Hi David Frey at Stanfield. Thanks for taking my question.

Sure.

You had indicated I guess on the last call obviously is you implemented the price increases and got what you deserve. It would be meaningful it looks like just as that blends through your business, your cost per ton -- I mean your revenue per ton is up $10 to $12 - - cost per ton’s up something like 58 and it sounds like you are expecting maybe another 10 or 12, but costs will continue to at least remain at this plateau if not I guess you said increase into '06. It means like you still have some considerable headwinds over the next couple of quarters and into '06 as far as recapturing some of that. I guess I am trying to -- it seems disappointing versus what you were indicating last quarter.

Well, I don’t know how to calibrate or reference “disappointing” because I think we’ve been very clear that we would never in today’s business environment with our existing contracts recover substantially inflation. I think the one piece of your calculus that we’ve already spoken to is there is mix in the revenue and cost per ton and that’s kind of off the radar screen, but there is some component of that. But I do take the point that we have a deficit that has to be offset with additional cost reduction and that’s really what we can control, I mean the things that we have the most direct control over is product mix, innovation and cost reduction and that’s where our focus and energy is largely directed.

As far as the specific cost savings that you identified at the time of the merger are those basically done and now you are doing the normal everyday blocking and tackling cost reduction?

Exactly, we stopped giving guidance on synergies at the $80 plus million range. Our stated target was $51.6 million over three years and -- well we did acknowledge that there would be some follow-on contribution in the sheet-fed strategy that we're using or implementing is part of the continued rationalization of the company's manufacturing network and there may be some additional opportunities and whether we call them ongoing cost reduction or synergies is less important than the fact that we identified incremental ways to lower the cost of running the company.

Right, but as far as the initial ones you identified at the merger, those are done and in the numbers kind of on a run rate at this point?

That's correct.

Okay and then lastly I guess you had natural gas hedges that roll off, by the end of the year. Do you have a sense of how much your gas costs in the fourth quarter will be over last quarter and what you see going into '06 on that?

I can’t give you the exact dollars, but we are hedged through the end of the year. We're in a significant review as we speak relative to what kind of positions we’ll take for ‘06 and when to place them. I think the consensus view of all of our outside advisors/experts is that our effective gas costs for next year will be higher than it has been this year. But we haven’t made those hedges, so we can’t really speak to anything with certainty. I think we said that inflation for energy and related inputs was up in 5.9 million range, and so I think that's about as much guidance as we can give you.

And just to clarify, you indicated earlier on the call you expected some of these inflationary pressures to increase going into '06?

We are early on in our modeling for ’06 but our first, excuse me, our first pass at that we think that there is exposure for increased inflation in natural gas, purchased electricity, some in transportation and some in coatings and chemicals. Now clearly, we've got goals to mitigate that through how we negotiate and how we contract. We also have a lot of programs to reduce usage of those inputs. So that on a net basis we can minimize the impact. But just on an input cost basis, we are expecting at this point '06 cost inputs to be higher than what we think the '05 actuals will turn out to be.

And most of your contractual business has like negative 1% to 2% price decline, so do you think you will be able to make up that difference to further cost reductions or are you kind of looking at a lower '06 EBITDA number now?

Well, it's a little soon to handicap the race but clearly our intent is to match the inflation with cost reduction.

But you'd still have the negative price erosion though?

Yeah, we clearly have that although I don’t think we have experienced sort of a 2% price reduction range. But you’re right, we’ve been in sort of a 0.5% to 1% price reduction in those contracts and that’s really what we put in our calculus on a go-forward basis. Now we do have some work going on to help reduce the amount of units that we are purchasing, for example, latex and coatings. We have the flexibility to change those processes and since we're more of an integrated company now, it makes it much easier to integrate those processes into our manufacturing of cartons, where we are substituting hardwood for pine because -- I am sorry, pine for hardwood because the cost differentials are different. So when we talk about per unit costs certainly natural gas and those types of things and hardwood itself on a unit basis will go up, but we do have some programs to eliminate the amount of those higher cost alternatives that we need to make our finished cartons.

Great, thank you very much for taking my questions.

Sure thank you.

Your next question cones from Jeff Bencik with Jeffries and Company.

Okay, thank you. In terms of renegotiating the contracts, have you been able to renegotiate any of them? And do you expect to be able to renegotiate any of them before they expire in ’07, ’08?

We have not for the most part renegotiated early those contracts. Those that have expired, and some have, we are -- we certainly are either maintaining or adding to those contracts, cost recovery, pass-through for future inflationary impacts in our business. But as Steve said, our primary contracts, certainly in the beverage business, expire in the ’07 and ’08 time and so we will probably not start negotiating those contracts until sometime next year.

Okay. And then when you renegotiate those contracts, are you going to try and limit the term of them to a shorter term than previous? And/or you spoke about sharing inflation risk?

I guess Jeff what I would say on that is what I would prefer to do -- we want to be able to have the runway in front of us to be able to make the kind of investments we need to make in our facilities either -- reducing higher cost facilities or higher cost presses and to do that, you need to have little bit of understanding of what your volume will be on a go forward basis. So, I think our strategy going in and, as Steve has said and we have talked to our customers, is to get ourselves in a situation where these inflationary impacts hit our business, our customers help share those costs as opposed to getting into a number of short term contracts where you are churning negotiation on an annualized basis that just doesn’t seem to fit a legitimate business model in this environment.

Okay. And understandably what's the inflation -- the variability in the raw material that may be a better way to go to but that’s a little bit different from your previous strategy I guess, in that you wanted price certainty and the ability to cut costs and therefore have a sort of a limitless potential for improving earnings. If you share the inflation risk, presumably, that would also sort of lock you into a maximum type of potential earnings? Is that a fair way to read that?

Well, it’s not the way that I would look at it. I think that the business model in the non- in the beverage sector, if you will, worked just fine with nominal inflation. Okay, and then when inflation took-off the model gets stressed. So I think what’s the right outcome is our customers in beverage have very large volumes that requires very specialized equipment and they really want companies like ourselves to be motivated to continue investing in new technology, I mean we just spent $75 million to recapitalize our converting system to put in the newest, widest, fastest most efficient presses, dye cutters and gluers in the world and that only works if the business continues to be attractive. And as Dave said, part of it is knowing you’re going to have the business and have it for a certain period of time gives you the base to make those kinds of capital decisions. But you can't make those decisions if the attractiveness of the business continues to erode. So, getting some sharing of future inflation risk, I think is equitable for both us and for our customers.

No, understood. I’m just - - in terms of if and when raw material inflation turns it's head the other way, under the current system you are poised to benefit from that more significantly, presumably your customers if they are willing to take on inflation risk on the upside, are going to want protection on the downside when it goes down and to...

We are not traders, okay. If the cost goes down and you’ve got to share some of that with the customer, so be it. I mean that’s sleeves out of our vest in a sense. You’re not incurring it so, what's the basis to charge it. On the other hand if costs continue to go up and you’re not getting anything, that has only one effect on your financials and that’s to reduce them. So, I think, we -- you know, the beverage business used to operate just like the non-beverage consumer packaging business with some sharing of inflationary risk and I think that it’s wholly logical and given what we’ve experienced in the last year or so, to see something move back towards that, and I think that’s a good move.

Okay, and if I can just talk about some details on the income statement, in terms of your SG&A expenses going forward they increased this quarter sequentially fairly significantly, is that sort of a good run rate going forward for the rest of the year now?

Yes, for the rest of the year that’s a good run rate.

Okay, and then also same type of question on the expected tax that you have paid there?

Well, let me just quibble with the word paid. We only paid less then $5 million of taxes. However, the amount that we book should be of that rate for the foreseeable future.

Okay.

About $5 million a quarter in deferred taxes.

Alright, that's all I have. Thank you.

Alrighty.

Again I would like to remind everyone if you would like to ask a question please press "*" then the number "1" on your telephone keypad. Your next question comes from Bruce Klein with CSFB.

Actually, it was answered. Thank you.

Your next question comes from Timothy Burns with Cranial Capital

Good morning gentlemen.

Yeah, I think you also get the distinction of this will have to be our last question.

Oh Do I get any like a new six pack of you know aluminum bottle Bud?

There you go.

If you buy it.

At a company discount.

There you go, you're just like the car guys, we’re gonna….

Am I now an employee of Graphic Packaging so I can buy it cheaper?

Yeah, what's up?

I wanted to get back to this point of kind of more tolling or sharing of raw material costs because in the beverage can area in particular the world was coming to an end when it turned out that some of the large buyers, some of your customers were going to begin buying metal for the can converters and it has actually worked out to be the best thing that could have ever happened because it focused the can makers on converting innovation and value add and you don’t have to worry anymore. Well, they still worry but they don’t have to worry as much about the whole commodity gain. So I think that's point one. Point two is whether you want to do it or not, the big soft drink and consumer product companies are going to go this way. It's no secret that the profitability in PET containers is virtually all resin trading and Coke and Pepsi are very smart to this and they are going to ferret it out and kill it. So you are back to being an innovative, cost effective converter, which I think you guys can be. So, I don’t think it's that big of a dramatic situation and it’s probably one that should be embraced more aggressively by you and the rest of the industry. But, I do have a question for Dave Scheible. The technology that you are funneling internationally and cross selling domestically. It's been a long time coming -- thank God it’s coming finally. I mean, is there a number that you guys look at long term for technology laden products. Steve, you pointed out that it was one of your controllable innovations.

Right. Tim I think what I would say is, we do measure it, and we run our business internally on what we call innovation platforms, we have four of them, and that is a longer discussion you and I can have at some point but we do have internal targets this year we will see incrementally probably around $40 million of new products that we did not manufacture, did not make last year, a combination of Z-flute, a combination of microwave products, a combination of different applications on a global basis and of course that target increases every year with direction from Steve and the Board and others as well and the amount of resources that we have dedicated to that are pretty significant. And what we have been able to leverage, as Steve said, is some of the technology combination between Riverwood and Graphic Packaging into customer access that we didn’t have before and so that has in fact improved and accelerated the slope of commercialization and adoption of new products and innovation. It’s a platform of our process and had it not been for the inflation that we’ve see in our business, I think you would have seen a much larger impact on that, but it is a, it is absolutely a strong focus for the corporation. And one that we’re quite frankly pretty good at it.

Well that’s -- I think that’s still the key, I mean, getting your cost, you can take your costs down forever, but if you are not at some point being treated as a value driving supplier then the end game’s kind of mute. And I think you’re right on your comments on back-to-school. We’ve been studying some of the new product offerings like these nutrition bars and what have you, and I mean pizzas, they’re just going crazy. So if I can get a discount on a case of that stuff, I’d really appreciate it.

Okay. Well thanks Tim. Thanks to all for joining us and with that operator I think we will call it a halt…. bring the call to a close.

Thank you, This concludes today’s Graphic Packaging Corporation second quarter earnings conference call. You may now disconnect.