Graphic Packaging Holding Co (GPK) 2010 Q3 法說會逐字稿

Good morning. My name is April and I will be your conference operator today. At this time, I would like to welcome everyone to the Graphic Packaging Holding Company third quarter 2010 earnings conference call. (Operator Instructions). After the speaker's remarks, there will be a question and answer period. (Operator Instructions). Thank you.

I would now like to turn the call over to Mr. Brad Ankerholz, Vice President and Treasurer. Please go ahead, sir.

Thank you, April, and thank you, everyone on the line for joining our call this morning. Commenting on results this morning are David Scheible, the Company's President and CEO and Dan Blount, our Senior Vice President and Chief Financial Officer.

I would like to remind everyone that statements of our expectations in this call constitute forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995. Such statements, including but not limited to, statements relating to fiber and other raw material prices, consumer demand and pricing trends, capital expenditures, cash pension contributions and pension expense, depreciation and amortization, interest expense, debt reduction, cost reduction initiatives and achievement of previously announced operating and financial targets 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 present expectations.

These risks and uncertainties include, but are not limited, to the Company's substantial amount of debt, inflation of and volatility in raw material and energy costs, volatility in the credit and securities markets, cutbacks in consumer spending that could affect demand for the Company's products, continuing pressure for lower-cost products, and the Company's ability to implement its business strategies, including productivity initiatives and cost-reduction plans.

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 these and other risks is contained in the Company's periodic filings with the SEC.

David, I'll turn it over to you now.

Thanks, Brad. We're pleased with the third quarter results as we delivered another solid quarter of operating margins to cash generation. Our strategy of focus on our core business, growing through innovation and building the right execution culture continues to serve us well in a difficult economic environment.

Volume got off to a sluggish start in July, but we saw a healthy bounce-back in August and September in a number of very positive leading indicators that suggest volume trends should continue to improve. Throughout the entire quarter, we optimized production and managed our cost structure effectively, generating over $36 million in continuous improvement savings. This resulted in a strong adjusted EBITDA margin of 14.5% and over $73 million of operating cash flows.

We also strengthened our capital structure and lowered our cost of capital by refinancing a significant portion of our 9.5%, 2013 subordinated notes through the issuance of new, 7.875% senior notes due 2018. As we expected, pricing turned positive in the quarter and we cycled through our most difficult year-over-year comparisons on input costs. We should continue to benefit from higher prices and our input cost comparisons should ease over the next several quarters. We are therefore comfortable with our progress towards our 2010 operating financial goals and our, reiterating our net debt reduction target of $200 million by year-end.

Our mills had another very strong quarter with operating rates in the mid- to upper-90% range and no market-related downtime. We produced 33,000 more tons of board in Q3 2010 than last year after adjusting for the timing of scheduled maintenance-related downtime and our tons per day production increased nearly 7% over last year. We produced and sold more of our higher-margin CUK substrate than last year, which had a positive impact on our mix.

We are seeing strong demand in CUK as a result of substitution trends from SBS and strength in the Frozen Food segment and the Asia-Pacific beverage market as well. We continue to see relatively stable trends in overall Paperboard Packaging demand and backlog in both CUK and CRV is up from last year at around 4 to 5 weeks each.

The strong mill performance is being driven by our continuous improvement initiatives. We have increased grade-to-grade cycle times by almost three days and trimmed utilization by more than a full percentage point. Aggressive management inventories and successful substrate conversions enabled us to sell the additional production, keeping inventories at low levels and generating more cash.

In addition, our level of Paperboard integration is steadily rising and stands around 80%. By converting more of our internally produced board and substituting outside purchased boards for internally produced CUK and CRB, we are able to achieve better margins and lower inventory levels across the entire supply chain.

Earlier this year, we completed our Altivity integration efforts and made significant investments in our converting plants as part of that work. We're now focused on on-going operating and process improvement across the entire enterprise, but particularly in our mills. Better operating systems in the mills have led to improved visibility over input flows and operating costs. Higher trim utilization continues to reduce the number of odd lots and special size paper rolls we produce, thereby leading to a permanent reduction of inventory and working capital levels.

We see additional significant opportunities to improve efficiencies and reduce costs in the mills through water and energy conservation and upgrading our fiber systems. We are making focused capital investments to do just that.

Our core folding carton end markets were a tale of two stories in the quarter. July was soft, really across the entire space with sector-wide volumes reportedly down about 5% from PPC. Trends in August and September improved significantly, however, and our volume was up year-over-year during the last two months of the quarter.

In the latter part of the quarter, we also saw positive trends in the new [sample request] trial work and related structural design projects, which are typically very good indicators for future new product introductions. There was also an increase in promotional packaging work and brand-new machine orders, indicating that consumer product companies have started to spend on promotions and advertising to help stimulate demand in the marketplace and expect growth in 2011.

So we remain cautiously optimistic about volume trends but also recognize that high unemployment rate and changes in consumption trends -- the way consumers shop -- will continue to impact our markets.

Ready-to-eat cereal was once again one of our strongest categories, with growth in the mid-single percent range over the prior year. Frozen foods, which include pizza and pizza-related snacks, were also strong in the quarter, increasing in the low- to mid-single percent range as well. We also saw significant strengthening in the facial market as a result of share gains and inventory ahead of -- build ahead -- of the cold and flu season.

By comparison, our most challenging markets were refrigerated products due to higher commodity food costs coupled with consumers trading down from packaged refrigerated goods for lower-cost options that can be prepared at home.

Beer volumes across the industry remain down slightly in the third quarter. This is a modest improvement from earlier in the year trends, but beer consumption continues to be impacted by high unemployment rates. This is particularly acute in the manufacturing and the 21- to 34-year-old age groups. A recent report published by the Labor Department suggests middle-class households cut spending on alcoholic beverage by 20% from 2007 to 2009. This soft environment has driven industry consolidation and led major brewers to expand into other growing niches of the beer market such as home draft, craft-brews and emerging international markets.

Industry-wide shipments of carbonated soft drinks were down about 3.5% in the quarter, but take-home volume, a key sector for us, declined much less. Additionally, volume trends improved in September as a result of increased promotional activity around the Labor Day holiday.

Food and beverage inventory levels in the channel remain extremely lean and the entire industry has learned to operate with much less inventory. As a result, the velocity at which companies are turning their inventories is much higher and the entire supply chain is shortened.

For Graphic Packaging, the implementation of our SAP integrated system and better integration of our mills and converting facilities have helped drive improved domestic inventory turns to over 8 times.

Our Multi-Wall Bag and Specialty Packaging segments are more exposed to general manufacturing and housing environments. Prices were up as we looked to recover rising paper costs, but the volume improvement we experienced in the first half stalled. Strength in the pet food, chemicals and materials sectors was off-set by weakness in concrete ready-to-mix and roofing shingle wrap markets.

We further headwinds in this market as home construction continues to lag in this recovery and as a result, we have taken measures to consolidate volume into our most productive facilities and reduce our overall cost structures.

New product innovation in the third quarter was positive as we started developing commercialized value-added packaging for consumer-flexible and global beverage customers. Third quarter new product sales increased 27% year-over-year to over $70 million and puts us on track to exceed $250 million in new product sales for the year. Innovation remains a key growth area for Graphic and our customers depend on us to provide differentiated packaging to support their marketplace growth and cost reduction goals.

In our consumer business, the microwave platform generates strong growth by providing our customers superior consumer convenience. This quarter Reese Foods launched a range of family meals including chicken enchiladas using our patented Even Heating technology. We also supported the launch of a Walmart Great Value microwaveable pizza utilizing a susceptor-packaged carton.

Our Strength Packaging platform is focused on substituting solid fiber solutions for other forms of packaging driven by customers looking to reduce supply chain costs. This was another successful quarter. Kraft is expanding their use of our patented Z-Flute technology with a brand-new launch of Oreo and Chips Ahoy Family Pack cartons. These packages are retail-ready, which eliminates the use of cord in the supply chain based on the strength of the primary folding carton. Nestle is our newest Z-Flute customer with the adoption of this technology for their Hot Cocoa Warehouse Club cartons.

Our Barrier platform is focused on delivering sustainability and consumer convenience. During the quarter, we achieved several successful commercial launches including our Fresh First foodservice offering. Fresh First packaging has been designed to meet performance and merchandising requirements of fresh foods in retail stores and restaurants.

Commercial launches include a pizza clamshell and pizza carton. The pizza clamshell is designed in the shape of a pizza wedge and provides a convenient food tray for on-the-go consumer. The package is designed with grease barrier properties and specially-positioned vent holes to release steam. The Fresh First packaging line continues to see commercial success as the paperboard solution resonates with consumers as a more environmentally-friendly package than the plastic alternatives it replaces.

Our beverage business saw a consistent level of activity of new products and new machine orders, both in the United States and globally. Our EZ-Pad product continues to grow in the US as a more sustainable replacement to corrugated trays in our soft drink accounts. A number of customers are evolving to Cap-It package as a PET multipack solution, including Coca-Cola, which ran a very successful market test within the convenience store chain.

I'm pleased with the international activity in South America, Caribbean and Asia for new machine orders and placements. We've experienced a significant rebound in these investments and it should bode well for long-term growth of paperwork packaging in these emerging markets.

Inflation, as expected input cost, increased substantially to $52 million on a year-over-year basis. With spot prices of OCC and wood as well, and other input costs like latex and resins and chemical bottoming out last year and then peaking this year, it made for a very challenging comparison year-over-year. However, on a sequential basis, quarter-on-quarter, input costs were relatively flat with the second quarter of 2010 and we would expect that same trend in Q4 of this year as well. Dan will discuss in more detail the individual components of our third quarter input costs inflation.

As expected, product pricing turned positive in the quarter as a result of higher contract pricing related on higher inflationary costs over the past several quarters. The majority of our business is contractual and the contracts include some form of backward-looking price adjustment mechanisms for change in raw material costs. As a result, our pricing typically lagged any change in raw material cost by anywhere from 6 to 12 months. This means positive pricing trends should continue over the next few quarters.

In the third quarter, the price of our CRB increased around $40 a ton from the prior year quarter, while the price of CUK was up around $30 a ton on a year-over-year basis. Given rising costs of inputs, we continue to raise paperboard prices. In CRB, we implemented a $40 per ton increase in August and recently announced another $40 per ton to take effect in early December.

In CUK, we implemented a $50 per ton increase in late August and recently announced another $40 per ton increase for late December. We did the exact same thing in Europe as well.

Our outlook for 2010 remains unchanged and we are on track to achieve our net debt reduction target of $200 million. We should continue to benefit from higher pricing over the next quarters as our contracts adjust for higher previous inflation levels. Moderation in fiber costs and relatively flat sequential costs in other raw materials should also begin to lessen the inflationary impact in the near-term quarters, so the differential between pricing input costs should begin to narrow in the fourth quarter, helping margins.

Our current view is that demand should remain relatively stable in our core Paperboard Packaging segments and weaken somewhat in our more cyclical Multi-Wall Bag and Specialty businesses. Tight inventories across both segments should keep supply and demand in balance and modest improvements in the economy will eventually lead to gradual improvements in volume.

I'll now turn it over to Dan for a more detailed view of the financials.

Thank you, David, and good morning, everyone. David provided the highlights of our third quarter financial performance. That included the continued delivery of solid operating margins and cash generation. I'll provide more specifics on our operational and segment performance.

As a reminder, when I refer to EBITDA and EBITDA margin in my discussion, I am referring to results adjusted to produce comparable financial reporting. The adjustments are detailed in the earnings release. For this quarter, the only adjustment related to the charge for the early extinguishment are modification of debt.

Starting with revenues, net sales improved over the prior, previous quarter and were about 1% lower than the prior year. The slight year-over-year decline was driven by lower demand in July where volumes dropped 6%. Demand rebounded above prior year levels in August and September and we ended the quarter with a sales volume drop of only 1.3%. Additionally, we have gotten off to a positive start in the fourth quarter as October volume ran above the prior year.

The most positive news in the quarter was that we completed our cycling-through of our downward price adjustments related to 2009 deflation. Q3 prices increased 1.3% over the prior year and we expect this favorable pricing trend to continue into Q4 and into next year.

To conclude the review of third quarter sales, here is a breakdown of the $11 million, 1%, year-over-year decline. $14 million improvement in price from contractual inflation recovery and realized open-market board increases. $13 million impact from the volume decline resulting from the July demand drop-off. $12 million of negative sales mix due to demand shift to lower-priced products.

Now, turning to EBITDA, solid margins continued to be delivered. Q3 EBITDA margins improved to 14.5% from 14% in the second quarter as a result of improved pricing and continued cost reduction. Most of this improvement was in our Paperboard Packaging segment, where margins improved to 17.1%.

Total Q3 EBITDA at $151.3 million was $6.2 million better than second quarter and $3.8 million lower than the prior year. In a quarterly comparison to the prior year, we saw price improve by $14 million and $36 million of net cost reduction. Offsetting these improvements was a large quarterly year-over-year increase in inflation of $52 million. The year-over-year increase is large because we benefited by $40 million of commodity input deflation in third quarter of 2009.

Since that time, input costs have returned to more historical levels. As we shifted from a deflationary environment in Q3 2009, to a more normalized inflationary environment thereafter, I do not think the year-over-year inflation comparison is all that relevant comparing quarter on quarter.

What is relevant, however, is that on a sequential basis there was no net inflation from the second quarter and we not expect to input cost to rise above current levels in the fourth quarter. In fact, due to the rapid recovery of commodity input pricing in Q4 2009, we expect fourth quarter 2010 year-over-year inflation to be significantly less than the amount seen this quarter.

Turning back to performance improvements, you saw that we delivered another strong quarter of cost reduction at $36 million, bringing the year-to-date total to over $109 million. Our mills delivered particularly strong results via higher yield, energy conservation and overhead reduction. Mill production hit record levels as yields improved by nearly 0.5% and energy usage per ton declined by over 5%.

In our converting operations, we reduced waste by approximately 3%, improved labor efficiency by almost 10% and continued to optimize our warehouse footprint. We continue to have a healthy list of continuous improvement projects in the pipeline that will allow us to achieve cost reduction benefits well into the future.

And to summarize our current view of Q4 2010 results, we see inflation over the prior year at about 1/2 the rate seen this quarter. We see pricing continuing to improve at the rate experienced this quarter and we see continued cost reduction at the quarterly rate we have delivered all year.

Now let's turn to CapEx, debt and liquidity. Starting with CapEx, expenditures were $34 million in the quarter. We expect next quarter to be about $54 million, so our full-year, 2010 estimate for CapEx is in the $130 million range.

With regard to debt levels, we continue to strengthen our capital structure and our net leverage ratio improved to 4.5 times. As David described, we had strong cash generation in the quarter and focused a portion of our cash toward paying down the higher-cost bonds. As a result of on-going debt reduction, interest expense was lower by $9.3 million in the quarter and $24 million year-to-date as compared to 2009. This trend should continue as we expect debt levels will continue to decline and we have proactively refinanced higher cost debt, the most recent financing being the $250 million 7.875% bond due in 2018.

On a year-to-date basis, either through refinancing or through cash prepayments, we have addressed $352 million of the original $425 million of 2013 bonds. We plan to use cash generated from operations to fully retire the remaining $73 million.

Looking forward to the end of 2011, we expect our net leverage ratio to be in the range of 3.7 times. This continued focus on debt reduction, along with the corresponding improvement in our credit ratings, will put us in a strong position to address our senior secured bank debt which matures in 2013 and 2014.

Leverage at the end of the second quarter remains strong at about $534 million. We had no borrowings under our $400 million revolver and $166 million of cash. We are also well within compliance of our senior secured leverage ratio covenant under our credit agreement at 2.95 times versus the maximum allowable ratio of 4.75 times.

And now I will conclude by summarizing 2010 full year guidance. In the fourth quarter we expect to continue to realize price improvements and expect stable volumes. Additionally, net input costs are expected to be consistent sequentially and at roughly half the year-over-year impact we experienced in Q3 of this year.

As such, we are reiterating the financial targets we laid out during our last conference call. These include capital expenditures in the $130 million range; cash pension contributions of $45 million to $60 million, of which approximately $36 million has been contributed through September; pension expense of about $32 million; depreciation and amortization in the $310 million range; interest expense of $175 million to $180 million; and net debt reduction in the $200 million range with a resulting net leverage ratio of around 4.3 times.

And with that, I will turn the call over to the operator for questions.

(Operator Instructions). Your first question comes from Ian Zaffino.

Hey, guys, it's Brian Bitner in for Ian. Good quarter.

Thanks, Brian.

You know you talked a lot about the trends, how they got better throughout the quarter and it seems as though you could have volumes up in the fourth quarter so with that, you know, a more favorable raw material comparable, higher pricing, I mean, do you think you can have a year-over-year EBITDA number in the fourth quarter? Is it possible?

Can you specify what you mean, Brian?

You know, EBITDA in fourth quarter 2010 higher than the fourth quarter 2009. It seems as though that the dynamics you laid out that that could take place.

Yes, all the trends point in that direction. You remember from 2009, we had some volume challenges because of the economy at that time, as well, so it all points in that direction.

And can you tell us how much volumes were up in October?

Well, let's see, only in October, yes, what I would say is the October trend was pretty consistent to what we saw in August and September, you know, they're up --

It's about 1.5% to 2%.

Yes, 1.5% to 2%.

Was the range.

Which for us, of course, for us in a food and beverage business, that's not insignificant, right?

One of the keys is where is it up and if you look where it's up, it's in some of the areas that we had discussed that were down in the prior -- in this quarter of Q3.

So beer is up.

No, no, not the beer so much. The frozen foods were --

Frozen foods, although beer has got a better trend today than it did last year, for sure. There's no question about that. But what I would say is the Paperboard sector overall, trends are positive. I haven't really seen a lot of improvement in the Multi-Wall Bag sector. It's just too dependent on industrial recovery, primarily for home construction stuff -- shingle wrap, concrete -- I just, that just doesn't look like that's going to get strong in the fourth quarter.

Okay, okay. Thanks a lot for that and then the last question would be, as far as your utilization rates of your board mills, where are those at these days?

We're busy in our board mills. As I said, we have, I think I said 4 to 5 weeks across the board. We have certainly 4 to 5 weeks in CRB. Our backlog in our SUS mill is every bit to 3 to 4 weeks, sort of, our SUS mills are 3 to 4 weeks. So manageable backlogs but we're busy and we have, we have no additional down -- we have no additional downtime scheduled for the rest of the year, so if volume holds, we should be able to make the board with no problem.

Wonderful. Thanks for taking my questions.

Sure.

Your next question comes from Philip Ng from Jefferies.

Hi, morning guys.

Good morning.

Just a quick question on the inflation front. I think you guys mentioned that you expect inflation to be flat sequentially from 3Q to 4Q, but OTC prices have obviously edged higher so I just want to get your thoughts on that.

Philip, one of the things you have to look at is that we're on FIFO accounting, so the OCC that we're selling in the fourth quarter, we actually purchased in the second quarter.

Third quarter.

Okay.

In the third quarter, that's correct. And so since we've got about a 2 to 3 month lag, we have to build that into our projections of financial results.

Okay, so you're going to start seeing some of the uptick from an inflation standpoint, I guess 1Q next year, right?

That would be more likely, although, honestly as you well know, OCC spiked, but it's kind of flattened and if anything, some of the forwards right now because the demand from China has dropped off precipitously, OCC has been pretty flat. And we don't -- our primary OCC exposure is in the Midwest, which as you know, tends to be a little bit less variable than what we see on the Coasts, right? So it's very -- it can be company specific in that process. Our only exposure on the West Coast is really our Santa Clara mill, much smaller -- of course, a much smaller footprint than our Midwestern exposure in Battle Creek, Kalamazoo and Middletown.

Okay, that's helpful. And then from a price-cost standpoint, you guys are obviously still cycling through higher inflation and pricings are in flow-through, so when should I expect to see a positive price cost spread?

Well, you started to see a solid, really -- on a sequential basis -- we started to see it this quarter, right? Margins, if you think about our margins, we've been able to maintain -- let's just say roughly 14.5% margin despite the fact that in year-on-year -- despite last year -- we had probably the lowest cost quarter in the history relative to those, in the recent history of those input costs and yet those input costs have flowed through and we've still been able to keep our margins up. So through performance and pricing, I would say, I would say I feel good, optimistic if you will, about maintaining or slightly expanding margins as I go forward.

Okay and I just wanted to get your thoughts on the most recent price increases. If I read the trade publications correctly, I don't think many of your competitors have followed suit. Just want to get your thoughts on the most recent increase.

I can't respond to what they should or should not, or will or will not do. I mean, what I would tell you is based on our input costs and based on the forwards and the demand, it made sense for Graphic Packaging to raise our paperboard price. What happens is beyond my control for sure.

All right. Thanks, guys.

(Operator Instructions). Your next question comes from Mark Kaufman.

Good morning, guys.

Good morning.

I've got a quick, well, couple of quick questions. I was wondering if the Kellogg cereal recall that they had. You think it had any impact in the quarter? Also, what your outlook is on natural gas costs for the fourth quarter and if you have any insight into early next year? And just one where I imagine is more philosophical costs, if indeed we did see a pickup in your end markets? The plants are running full-out, well, not quite full-out. Are you ready to meet that demand?

Well, let's start, first of all, the Kellogg's recall is probably a bigger, a bigger question for Dave MacKay at Kellogg's, which he's handled it deftly through his own conference calls. As you can well -- I think what he would tell you is that the demand for cereal was covered by other competitors. I think that's what I read for his thing in -- so for Graphic, it had really no net impact, for the most part, on cereal [since] for us, since we just make cartons. And cereal has been a pretty consistent performer throughout this economic environment and it was up again this quarter for Graphic, as I said in my prepared notes, so I don't foresee that as an issue.

Relative to capacity, I mean, as we've talked before, we have lots of converting capacity to be able to meet rising demand. That would be a high-class problem to have to deal with so we'd be pleased to be able to deal with that. In the meantime, what we're trying to do is make sure that we don't have excess capacity at a time when demand is moving sideways in the process. So I'm -- we're all set up and ready to go when the volume kicks back up.

In terms of natural gas, we follow a practice of when we like the price, we hedge-forward in natural gas and currently we're hedged -- we've hedged about 42% of our need and our expected need in 2011. So as we look forward at the hedge prices, we're about $0.60 to $0.75 better than the prior year at this point and we use about 12,000 MMBtu's -- 12 million MMBtu's -- per year. So as we look forward, we think natural gas, based on these hedges and the positions we've put in, it should be favorable over 2010.

Thanks very much, guys. Good luck in the quarter.

Thank you.

April, is there anybody else on the line?

There are no audio questions at this time.

Well, thanks everybody for attending the call and we'll talk to you next quarter.

This does conclude today's conference. You may now disconnect.