Mercer International Inc (MERC) 2016 Q2 法說會逐字稿

Good morning, and welcome to Mercer International's second-quarter 2016 earnings conference call.

On the call today is David Gandossi, President and Chief Executive Officer of Mercer International, and David Ure, Senior Vice President, Finance, Chief Financial Officer, and Secretary.

I will now hand the call over to David Ure.

Good morning, everyone. Thanks for joining us. As we typically do, I'll begin by taking a few minutes to speak about the financial highlights of the quarter, and then I'll pass the call to David to discuss the markets, our operational performance, and our outlook into Q3.

Please note that in this morning's conference call we will make forward-looking statements. And according to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, I'd like to call your attention to the risks related to these statements, which are more fully described in our press release and in the Company's filings with the Securities and Exchange Commission.

In Q2, we achieved EBITDA of $34.7 million, compared to $45.3 million in Q1 2016. Our Q2 results were heavily influenced by a very ambitious annual maintenance shut at our Celgar mill and several unrelated operating interruptions also at Celgar, which prevented us from returning to full production for a further 10 days.

We had a total of 21 days of maintenance down time in Q2, 18 of which were at Celgar, compared to no maintenance downtime in Q1. Combined, the downtime associated with the maintenance shuts created a $21 million drag on EBITDA in Q2 when we factor in maintenance costs, lost production, and the negative impact on energy sales volumes.

On a positive note, pulp prices advanced higher relative to Q1, and we have achieved modest cost reductions in fiber, energy, freight, and SG&A.

We also benefited from the reversal of $7.2 million of previously accrued wastewater fees at our Rosenthal mill due to our meeting certain reduced effluent levels as a result of environmental capital improvements.

In terms of pulp revenue, the quarterly average RISI list price in Europe increased to $798 per tonne from $792 in Q1 2016. In addition, the quarterly average list price in China went up to $617 per tonne from $590 per tonne in Q1.

Our German mills ran very well. But as I mentioned, our overall production was negatively impacted by a longer-than-planned maintenance shut and slow return to full production at our Celgar mill.

The lower production volumes were also a major contributor to lower sales volumes, which were down approximately 63,000 tonnes, compared to the high volume sold in Q1 when we had no maintenance downtime.

We reported a net loss of $4.2 million for the quarter, or $0.07 per basic share, compared to net income of $8.8 million or $0.14 per basic share in Q1.

Our interest expense was down approximately $0.5 million compared to Q1, which reflects the benefit of our $23 million repurchase of our 2019 senior notes in Q1.

Income tax expense in the quarter was $7.9 million, of which approximately $3.4 million was current. We continue to have significant tax assets to shield cash taxes, but certain tax jurisdictions limit their use, which will continue to create a modest current tax expense going forward.

You will have noted that our effective tax rate looks unusually high this quarter, a result that sometimes occurs under US GAAP when an issuer is consolidating entities from several tax jurisdictions.

When consolidated earnings are low and companies with pretax income are combined with companies that have pretax losses, in certain circumstances, you end up with an unusual-looking effective tax rate.

Longer term, our typical accounting effective rate is about 30%.

Turning to cash flow, our cash balance decreased by about $17.2 million in Q2, compared to growth in cash during Q1 of nearly $31 million.

The principal contributors to the sequential change in cash flow in the quarter included the $23 million semiannual interest payment on our senior notes and a scheduled $5 million payment towards our Stendal interest rate swap.

Also contributing to the lower cash flow this quarter were lower EBITDA and our planned CapEx program, which saw our spending almost double to $13.9 million this quarter, relative to Q1.

As I mentioned, capital expenditures drew almost $14 million during the quarter, the majority of which was spent on high return projects at Celgar and Rosenthal. Two of the more notable high return projects currently under way include a railway log delivery system and a [line kiln] debottlenecking project, both at Rosenthal.

Also, we completed a lot of good smaller capital jobs during the Celgar shut, that we expect will help reduce some of the variability in production that we occasionally experience there.

We also spent about $400,000 on our ERP project. The project is progressing well and remains on target to be completed in late 2016.

And finally, our cash outflows in the quarter also included our quarterly $7.4 million dividend payment.

Our liquidity remains healthy. Our consolidated cash flow was approximately $120 million at June 30, 2016, and we had about $138 million of undrawn revolvers between our three mills. Combined, that puts our total liquidity at about $258 million.

Our $120 million of cash at the end of Q2 includes about $8 million of restricted cash. These are funds that are being set aside to act as collateral for our Stendal interest rate swap. The collateral amount is contractually calculated. And as the interest rate swap balance declines, so will the collateral amount, subject to certain minimum requirements.

This balance is down from $10 million at the end of Q1 and will continue to decline when our next scheduled settlement payment is made in October 2016.

As you know, the interest rate swap matures in October 2017.

On the trailing 12-month's basis, our net debt is about 2.5 times EBITDA, a level that gives us considerable financial flexibility as we consider future capital allocation decisions.

And finally, you will have seen from our press release yesterday, our Board has approved an $0.115 dividend for shareholders of record on September 26th, for which payment will be made October 4th.

That ends my overview of the financial results. I'll now turn the call over to David Gandossi to discuss market conditions, our operational performance, and strategic activities.

Thanks, Dave, and good morning, everyone. Our second-quarter operating results were heavily influenced by our annual maintenance downtime. As Dave mentioned, the overall EBITDA impact was roughly $21 million in direct costs and lost production relative to Q1.

Not surprisingly, our pulp sales were also down relative to what was a pretty strong Q1, however, steady demand did push pulp prices up slightly this quarter.

June NBSK producer inventories were at 28 days, down 2 days from the previous quarter end, which reflects, in our view, a pretty solid market, balance in the market as we continue to see steady NBSK demand in all markets.

The July NBSK list price in Europe is consistent with June, and the net price in China will likely settle a little bit lower.

Growth and global NBSK deliveries continues to be steady at 3.5% year to date, and China, in particular, remains solid at 6.7% growth when compared to the same six-month period of 2015.

Currently we expect steady demand in both the European and Chinese markets, but with some temporary weakness in spot pricing in China during this typically slow summer period.

Looking forward, we continue to believe that the global tissue market's growth will remain steady into the foreseeable future. We expect new tissue machines to continue to start up, especially in China, which will further strengthen demand for NBSK.

We also expect the supply/demand fundamentals to limit the impact of slower buying trends that often occur in Q3.

Regarding the much discussed incremental NBSK supply coming on later this year and in 2017, we believe that the timing of these mill starts is such that the additional capacity will not negatively impact the market until late 2017. Our view on this is that overall NBSK prices are near floor levels for some producers on the higher end of the cost curve. Should prices slide, we believe that high cost producers will be under significant financial pressure.

Moving to operations, as Dave mentioned, our Q2 production was reduced by our planned maintenance shuts and Celgar's delayed return to full production. Between the 18-day maintenance shut at Celgar and the smaller 3-day mini shut at Stendal and the slow startup, we reduced our production in the quarter by about 44,000 tonnes.

However, our German mills continue to run very well. In total, we produced approximately 338,000 tonnes of pulp this quarter, compared to approximately 378,000 tonnes in the first quarter of 2016, and approximately 359,000 tonnes in the second quarter of 2015.

I'm disappointed with Celgar's slow startup, particularly because the shut itself went quite well. We got a lot of really good work done and we saw some early indications of the results of that work in June, when we produced above plan levels.

I'm satisfied with the diligent approach we took with the required maintenance work and expect it to enhance the mill's operations going forward.

Consequently, despite Rosenthal's scheduled maintenance downtime in Q3, I expect our production levels to be at normal levels in the coming quarter.

As you would expect, our pulp sales volumes were down significantly in Q2 and totaled approximately 330,000 tonnes, compared to the exceptional 393,000 tonnes in Q1 and 371,000 tonnes in Q2 of 2015.

Celgar's production issues wound up pushing about 10,000 tonnes into the third quarter this year.

Turning to our energy sales, the mill sold approximately 190 gigawatt hours of electricity in the quarter, compared to 207 in Q1 and 197 gigawatt hours in Q2 of 2015.

Relative to the first quarter, our euro German fiber costs were down again, continuing what has been a pretty steady trend over the past few quarters. Overall, the German fiber market continues to be in balance. We continue to see sluggish demand for fiber from the board and pellet industries. So we expect German fiber prices in euro terms to trend slightly down through Q3.

In British Columbia, our Q2 fiber prices were up just slightly this quarter in Canadian dollar terms, relative to Q1. We're currently forecasting that Celgar's Canadian dollar fiber costs will remain essentially flat in Q3.

Our remaining 2016 annual maintenance shuts are scheduled as follows. In Q3, Rosenthal will have a 12-day shut and in Q4 Stendal will be also for 12 days.

With respect to our NAFTA claim, we don't have any new information for you, but we continue to expect a decision in the second half of 2016.

So to wrap up, I'm very pleased to confirm that our Board of Directors has again approved a quarterly cash dividend. We're pleased to be able to continue returning cash to our shareholders.

That's the conclusion of our prepared remarks, and I'll now turn the call back to the operator so we can open the call up for questions.

(Operator Instructions) Dan Jacome with Sidoti.

So looks like, I mean, what the market needs to see right now is you're saying Celgar is back to full capacity as of June?

Yes, June was a good month for the mill.

Okay. And then just couple high level questions here. Just remind us again on the wastewater fees. So you have discretionary CapEx projects and then you get paid back by the German government if you hit environmental benefits, I guess?

That's close, yes. So they're three-year cycles. And we accrue a wastewater fee on a monthly basis. And then we have a discussion with the authorities. And they have a program that says, if you can put some capital into the mill that reduces your effluent parameters, and you have to discuss with the authorities what those parameters are --

Right.

-- then you can use the capital spend as an offset to paying the wastewater fee at the end of the three-year period. So we've got a history of doing that. Rosenthal's period ended December 31 of 2015.

We did have a capital project in the preceding years that qualified and was agreed to with the authorities. So then you have to run the mill, have it audited so that the authorities can confirm that the parameters have been reduced. And then they send a letter confirming that your capital spend is an offset to the wastewater fee.

So effectively, the accrual then gets reversed as the fee is forgiven by the authorities.

Okay.

So that letter was received in the second quarter. So we book it in the second quarter.

We had a similar program at Stendal. Their three-year period ends April this year, ended April of 2016. And we had a capital project for that. We're still in the process of confirming with the authorities that the project, met the objectives. Our view is it did. But it needs to be audited by the authorities. And we're expecting our pro forma would be a release in the fourth quarter of this year for that wastewater fee.

Okay. Got you. Appreciate the color. And then on the dividend, I guess it's encouraging. Your October payments lined up.

Have your thoughts on the dividend changed at all, given the 2Q production hiccups? I know things are back to normal. But it looks like they have, and I just wanted to confirm that.

Yes. No, there's no change in how we're thinking about that. We have always said that we expect that to be a sustainable dividend. There's ups and downs in this business and there's cycles. But we've designed that dividend to be sustainable. It's reviewed every quarter by the Board, along with our operating performance. So it's something that we address every period. But as I say, we don't see any reason to curtail that at this stage.

Okay. Got it. One more, and then I'll get in the queue. Hardwood capacity, I know it's getting harder and harder to get the data on the days inventory. But you guys have any thoughts what you're seeing?

On the hardwood side?

Yes, kind of on the days. Are they 28? 30? 40?

Well, we're at 28, and hardwood's up in the 40 range, which is not unusual, considering the distance that that pulp has to travel.

But, yes, hardwood's a little bit sloppy and will continue to be. I know there's been lots of capacity additions and will continue to be capacity additions on the hardwood side.

Having said that, the guys in South America are still making quite a bit of money. So I don't see any change to that capacity addition. I think it's really happening.

On the softwood side, as I've said, we're in good balance at 28 days. That's a tight market. China always slows a bit in the summer. It's not that they don't need the pulp. They just hold off, trying to [grind] the price a bit, but generally a stable market.

Europe's a very stable market. And the capacity additions this year and into early next year are not so significant, that I just don't see that equation changing.

It's sloppy on the southern softwood side, as IP brings their mill in and the beans come in. But it's not a direct competitor to ours. It's just it's in the market, the low end of the Asian demand chain. It's a factor and it impacts the psychology of the market a bit. But NBSK markets are tight, and I think they're going to continue to be tight well into next year.

Okay. Got you. Thanks a lot.

Bill Hoffman with RBC Capital Markets.

David, can you talk a little bit about you were mentioning with the softwood capacity coming on through next year, some of this higher cost capacity you think might come out of the market.

Can you just talk a little bit about where is that? Where do you see that capacity coming out?

Well, I hate to talk about competitors and things. But there's a couple of mills --

[Even] regions.

Couple of mills in France. There's more than a million tonnes in Canada, little bit in Finland. There's mills in Canada that are being held up just by where the dollar is today, the Canadian dollar. It's lots of really old capacity, lots of challenges in those mills. I'm sure the owners are struggling with the maintenance of business capital requirements that they have.

So it just is what it is. Our view is that the fourth quartile of NBSK is a very steep curve and there's two million to three million tonnes of capacity that would be on the bubble if we lose much more on price.

And do you have any thoughts on sort of what that price difference is to where we are today?

Well, as I said in my comments, Bill, it feels kind of flourish to me. Like I just, I can't see it dropping another $50 without some sort of reaction on the supply side. But I mean, that's just my view you know.

Okay. No, it's helpful. And the second question is just, just given sort of your financial structure right now and flexibility, leverage levels, et cetera, any thoughts strategically about [what] you want to go next, whether it be acquisitions, additional capacity expansions, if possible?

Yes. Well, right now we're really focused on getting Celgar up to the 490,000, 500,000 tonne range. I think that's a reasonable objective for us in the next year, year or so.

I don't really see NBSK capacity acquisitions that we could make that would make sense for our shareholders. I don't think anybody's going to sell an NBSK mill cheaply these days, looking at out medium and longer term, these are going to be valuable assets. And we certainly aren't in the market for junk. They're very expensive to run. And I'd rather see some of the old stuff shut down.

So we'll keep our eyes -- we're always sort of expanding our activities in our adjacent areas, logistics, harvesting, hardwood procurements, and we're open-minded about growth. But today's environment, this is not really something we should expect to happen in the near term for a variety of reasons.

Okay. Thank you. That was it.

Hamir Patel with CIBC Capital Markets.

David, could you give us a sense as to how substitutable NBSK is with SBSK? Because it seems like there's a lot of SBSK coming to market and it seems like it's getting priced quite aggressively in China.

Yes. The southern softwoods are good fiber for some of the lower end guys. And those guys typically don't buy NBSK really ever. They never need to pay the extra that it costs to get it. And when there's more SBK around, that's just it's better for them in a way.

But the customers that buy NBSK, European and Canadian, they buy it because they need it. And just because SBK prices are dropping, they typically don't switch. It's just the noise in the market and the price point in the market that they use to lever the price of NBSK down.

And we always take a really firm stand. You say, they're different grades, I don't care what's happening in SBK. It's not relevant directly. You can't use it, so. But that's just, like I say, it's a psychological factor in the market.

But if you're a high-end tissue guy or you're making [decor] paper or thermal papers or high end fine printing papers, you can't use SBK. You use NBSK and you use eucalyptus and recycle or whatever else is in your firm. But you don't switch between NBSK and SBK unless you're a low end paper grade that's traditionally buying cheap pulp whenever you can get it.

Okay. Thanks. That's actually really insightful. Just touching on future growth. You referenced, I guess NBSK mill valuations for good assets will be quite high. Just curious to get your thoughts on the fluff pulp market. It seems is a potential that we may see one or two mills come up for sale as part of the IP/Weyerhaeuser transaction.

Just curious your thoughts about that grade and then also if you have any interest in any potential assets.

Well, fluff is oversupplied and is going to be for a while. I don't really expect those mills are going to come on the market at a value that's going to be attractive to us.

So I don't want to signal anything other than that. We're not going to buy expensive pulp mills today.

So, yes, remains to be seen, what happens. I mean, the nice thing about the fluff market is that at least the concentration is with big guys, like the big, big volumes coming out of the big guys. It's fairly consolidated. So that is a positive for them.

I've heard a rumor that that Sun's fluff expansion in Arkansas may have switched to dissolving. So that'll be a positive for them going forward, the fluff guys in general. But it is oversupplied right now.

Okay. That's interesting. I hadn't heard that dissolving thing. And just touching on your fiber costs, lots of discussions about potential antidumping kind of [railing] duties for Canadian sawmills next year.

If that were to take effect, curious what -- what do you expect the impact to be on fiber costs and BC if the sawmills are hit with duties?

Well, the nice thing for us is the sawmills in our region in Canada, they've got options in Asia. Obviously, what the average exposure to the US might be 15% to 20% or something like that. It's not nearly the risk factor that the guys back east would be going through.

So there's two things there. In terms of fiber availability for Celgar, I don't think much will change. I think the saw mills will keep doing what they do and the residual fiber will be available from that. And the harvesting will be continuing and we'll be continuing our roundwood program.

So I don't really expect any significant change to the fiber availability or the cost for Celgar as a result of this.

But I think it may impact pulp producers in eastern Canada. They're going to struggle with fiber availability if all those eastern sawmills are hit with the kind of duties that everybody's expecting.

So it sounds like it might actually be a positive if that leads to some capacity on the pulp side coming out. Okay. Thanks. Thanks, David. I'll turn it over.

Anthony Young with Macquarie.

Just a question on the outage. I mean, in your press release you guys say that your competitors capitalize this expense.

Would there be any thought, I mean, given some of the volatility around earnings and your stock price, that you guys might look to capitalize these expenses like in the future?

Yes, that's an accounting, Generally Accepted Accounting Principle question. And it's really the IFRS guys that are able to capitalize the maintenance costs and then amortize it through the depreciation line as a US public company and following US Generally Accepted Accounting Principles. We can't do that.

Okay. That makes sense. And then just with respect to where their ratings agencies are, I mean, your metrics, even with this one off quarter, the ratios and so forth look pretty good.

I mean, do you guys still think a upgrade is coming?

Well, they don't tell you these things. We're on upgrade watch, I think is the right term. Maybe we shouldn't expect that after the second quarter we just had.

But our metrics, as we've said before, our metrics are clearly above the levels that the credit rating agencies have us at. So we're a B1 under Moody's, as you know, and a B+ under S&P.

And if you put our metrics in through the filter, we're a couple notches above. But part of it's the momentum thing. I guess they have a whole lot of factors they look at.

So I think it's due, but I'm not all that hopeful it's going to happen in the next few months anyway, because of the quarter we just had.

Okay. And then just a last one. You gave the impact from an EBITDA perspective of the outage. But your energy sales still looked pretty attractive.

I mean, would those energy sales go back towards where we were in Q1 if not for the outage? Or how much of an impact was the outage on energy sales, basically?

Well, it's one third of Celgar's capacity was out during the quarter. Other German mills, which are the bigger contributors, they ran really well, so.

I guess I'd just add there, Anthony, at the moment the big exports in energy are coming from the two German mills. It's not directly proportional to the volume. So where you see a drop in energy exports or electricity exports, often it's coming when one of the German mills is taking their shut.

Okay. All right. That's helpful. Thanks, guys.

Andrew Kuske with Credit Suisse.

Could you maybe give us just some color and context on conversations with your customers, especially in the run up to Brexit and then post-Brexit and just what the sentiment's been like? Because some of the German economic data's been very sloppy.

Yes. So it's European customers you're thinking of?

Yes, exactly.

It's almost like it's a non-event in a lot of ways for our customers in Europe. I mean, the order books are solid. No questions about anybody curtailing their capacity or their orders. Everybody's making their orders early in the month and no big arguments on price.

So, I guess we don't really feel it in the market, to be honest. There's lots of discussions about what happened there. I think the general feeling in Europe is that the English made a mistake, a lot of people are voting with their emotions and some of the -- the absence of a real understanding of what they were doing is what really sort of came out in the days following, with all the questions to Google and things like that.

But I guess most people assume they'll sort it out, and Merkel's showing a patient hand, like not forcing them into doing anything too quickly.

So Europe's got its issues, but it's chugging along at the levels it's at and don't really see that Brexit changing that for the foreseeable future.

Okay. That's helpful color. And then just on the balance sheet, and I know this touches upon a few of the previous questions, how do you think about just the balance sheet positioning from a debt to equity mix on a longer term basis? How should we think about stabilized levels, especially if we're going to see, hopefully, an upgrade in whether it's a quarter or two, how do you think about access to debt markets? How should we think about just the balance sheet?

Yes. Well, for our balance sheet, I mean, we're quite comfortable and a solid balance sheet. But given what I've said about in our view of acquisitions of any capacity that might come available, being very disciplined and not prepared to buy high-cost capacity, we'll continue our debt reduction program and we'll continue to chomp away at the notes as and when we can in an appropriate way.

And longer term, I think that'll create a lot of value for shareholders as we transfer the enterprise value across from debt to equity and we, as you say, get re-rated and get a couple of closures, and we'll be doing fine. So we just stay the course.

Okay.

Yes.

That's very helpful. Thank you.

Andrew Shapiro with Lawndale Capital Management.

A few questions kind of closing the loop on these prior questions and answers you gave and your script.

What made Celgar's maintenance plan this last quarter more, as you guys said, ambitious, compared to prior maintenance shuts for Celgar?

It's a good question, Andy. Thank you for it. The mill achieved 500,000 tonnes in 2010, and then the average of the last three years it's been more in the 460,000 tonne range. And almost feels like we get hit by unexpected things. There was enough variability on what was happening that we realized we really got to do a deeper dive and figure out why that mill is struggling.

So we had a task force of combining some of our Canadian engineers and brought over some of our German team and did a deep dive and identified a number of these risky areas that are causing the mill these unplanned outages.

And in an ambitious way, we focused on getting a lot of that work done during this maintenance shut. And the work, as Dave said, was well planned. It was well executed, on budget.

But unfortunately, when we were in one of the big flash tanks, we found some metal corrosion that was significant enough that we had to do weld overlays on it. And that part of the project just took time. So we had to add six days to the outage to get that tank back up to standard.

And the guys did a good job of controlling costs and got additional work done during the outage extra days that they had, and they avoided overtime and didn't work Sundays and things like that.

When we brought the mill back up, it looked like it was going to be great, and then we had like a series of three completely unrelated upsets that were, just in our business it's just the nature of the beast.

One was we had a leak in a large vessel that it's a carbon steel vessel that's [plated] with tile and [thin set]. Imagine like six inches of tile on the inside to protect the steel, and there was leaks through the tile and it just revealed itself a few days after the shut.

This is a tank that's been in service since 1993. It gets inspected every year. It had been inspected this year. And there was just somewhere in the tiling there is a crack and the material, the liquid was flowing through and eating out at the carbon steel. And so we had to shut that system down to fix that.

And got the mill back up and running and then we lost like a big piece of piping, like an elbow on a pipe, a stock pipe that's going from one bleach tower to the next. So the whole flow of this thing comes through this pipe and goes up to the next tower. And this pipe elbow catastrophically failed. It's not related to -- no work was done on the shut again. All this stuff gets inspected. And it was we dropped 185 tonnes of pulp on the floor, took a few days to clean up, and we got the mill back up and running.

And then we lost power to the mill because of, believe it or not, an osprey had built a nest on a hydro pole somewhere way away from the mill, and shorted out the region that caused us to lose power to the water pumps to the mill.

So everything's up and running now. You did the ambitious maintenance from the programs you identified in the deep dive.

Do you feel now that Celgar will be operating back up at the 500 range?

Well, I got to be careful. We got a lot of the work done in this shut. We've got another big plan we've got to do next year. But we basically work through the list from the top down. So the most critical stuff is behind us. We've got another chunk of work to do next year, [but] the same magnitude.

But we fixed a lot of the latent issues that we're aware of. And June's performance is -- touching wood here. But the mill ran above budget for June, which is a very positive sign that the guys are moving in the right direction there. So maybe I'll --

So you think then after at least this deep dive and you have another one to do, but after this deep dive, the run rate should be above the 460 that the (inaudible) --

Yes, it should be -- yes, I think we should be making incremental improvement as we go forward here.

Okay.

Give us a year and a half, but they're getting better all the time.

All right. Let's move on to a few other questions, if I could. So you mentioned there's modern higher volume machine capacity build-outs. This has been a macro thing from Jimmy and then you at CEO.

The modern high-volume machine capacity build-outs in China, or, frankly, any developing country that requires an increased mix of softwood pulp to furnish that should soak up the incremental new NBSK capacity, which, compared to hardwood, there isn't as much being opened at all, but there is some new capacity in NBSK. But you mentioned that this macro demand would occur.

What impacts have you recently seen and, as importantly, expect to see, regarding the Chinese measures to accelerate the new modern capacity replacement from old, more greatly polluting capacity or just less productive capacity?

Yes. Well, it's been an ongoing trend for several years. And every year it seems the impact of the closures in China become more and more relevant in the sense that in the early years they were mills on a list that were very small and nobody really knew where they were or what they were, but you knew there were a lot of them. And then the next year be up the list more slightly larger mills, slightly more relevant, and then bigger and bigger.

And it's the air pollution and the water pollution parameters that they're focused on. And they're getting just increasingly tougher and tougher on those guys.

And the impact of that has been to create more demand from the bigger, more modern machines to fill in what's being taken out by the old China equipment.

It's, as I say, it's been going on for quite a number of years now. It's not a dramatic change to expect from this point going forward. But it's just a continuation of a theme.

One of the things we don't talk about a lot, but we should, is that there's also this pretty significant decline in the recycled fiber availability because the change of the profile of the end use of long fibrous pulps -- if you go back 10 years, so much of this long fiber was going into printing and writing grades that can be captured in the recycling chain, whereas, that shift has gone from 65% printing and writing 10 years ago to 30% printing and writing, or thereabouts, and much heavier to tissue and to core papers and other specialty papers that you can't recapture in the recycle chain.

So that the reduction in recycled fiber is one of the drivers of demand for the hardwood guys. They're filling in that space with virgin fiber. But a lot of the paper grades do still need some level of tensile in them. And that's where you get this [creep] demand for virgin long fiber coming in through the reduction and the recycle basket.

So it's not just new paper mills being built, but it's also a shift in the [furnish] globally that's part of this whole theme.

Okay. You guys discussed the currency effects during this quarter. But Brexit happened at the very end of the June quarter. And the US dollar, relative to other currencies greatly increased.

So presumably, the Brexit effect didn't have a huge effect on the second quarter results. Overall, I mean, we're now at the end of July, so one third of the quarter's already done and currencies have not gone back to the pre-Brexit level.

So just overall, what are the pluses and minuses here that you think the effects to the current Q3 as well as through the end of the year that might occur from, I guess a relatively stronger dollar?

Yes. Well, I mean, the moves have been much lower than previous periods. The Canadian dollar's just slightly stronger on the quarter, been fairly steady. The euro is 1.13 for quite sometime, dropped down to 1.10. Back up to 1.11 today.

I don't think these are really big drivers. And I don't think consensus views are that they're going to be some big moves.

Okay. I'll move on. Two more questions here. Following up on prior questioner's inquiry about the credit rating upgrade and timing and possibilities.

With no rating upgrade, maybe likely at least in the current quarter, until there's at least a more favorable trend for you and maybe some incremental debt pay down, are there any additional open market repurchases opportunities? Does the call premium drop each quarter or just annually, whereby it may make some sense to potentially take out some more of those 2019 or other notes?

The call premium kicks in December 1 this year on the 2019 series. Until that date, it's just open market pricing that's available to us. And we always reserve the right to pick away at our bonds as and when we feel it's appropriate. So I probably shouldn't say much more than that.

Okay.

But, yes.

Well, then we'll watch for it. And last, what are your plans for investment presentations, (inaudible) road shows, et cetera, in the coming quarter, five months? Or I mean for the rest of the year.

Go ahead, Dave.

Yes. So we'll be attending the -- it'll be pretty quiet in August for us. But we'll be attending the Credit Suisse Fixed Income Conference in the third week of September. And then we will have a little bit of marketing to do on the east coast with one of the banks, probably mid-November. And then in early December, we'll be attending the BofA Industrials Conference.

Very good. Thank you.

(Operator Instructions) Sean Steuart with TD Securities.

Thanks for all the detail. Couple of questions. David, just wondering if you can go into a bit more detail on fiber cost in Germany. You mentioned the Q2 release, and that's been a recurring trend in recent quarters.

Just go into a little bit more detail, I guess on less competition from pellet manufacturers and the board industry, what factors are there, and your outlook for further cost relief on that front going forward?

Yes. Just there was a time several years ago where the demand for fiber in Germany kind of got ahead of itself. And we had a cold winter, you had all these new pellet mills being built, your particle board mills built, and aggressive expansion of sawmilling. And we built our two mills. And it just got tight and it was really sort of like a new market.

Our response to that was to think very differently about how we procure fiber in Europe. And so we became quite aggressive strategically, and in particular with imports.

So we've been investing, as you know, in logistics, increasing the efficiency of our rail capabilities, our port capabilities, and have been bringing a lot of wood into Germany.

Meanwhile, there's been about four of these large particle board mills have shut down and moved east. The pellet business has been in tatters for several years - a combination of weather, excess capacity, guys bringing pellets in from other regions.

And the sawmills are doing quite well right now. They've got a nice stable market in Europe. So they're running hard and making money.

So it's just generally, it's just an easier market for us. And we just continue to bring more and more wood into the domestic market, which just sort of has the effect of sequentially pushing prices down.

And it comes in small steps. Guys that are used to getting a certain price for wood all of a sudden -- like the sawmills have to -- they have to relieve themselves of the sawmill chips. But the wood on the stump, if a guy's used to getting a higher price and he doesn't like the price, he stops harvesting for a little while. And then he realizes, well, things aren't going to get any better. Maybe they're going to get a little worse. So then he starts up again at a notch below.

And then you sort of just have to keep grinding it down, grinding it down. But we've got enough optionality now that when guys say they want more for their wood, we just say, no thanks, and go somewhere else.

And I don't know if that helps, but --

No, it does. What sort of order of magnitude year-over-year fiber cost declines did you see from your German mills right now?

Well, wood and a tonne of pulp at Stendal has gone from the 300 ranges down into the 270 range now. Rosenthal's down in the 240, 250 range per tonne of pulp, so.

That helps. Apologies if you went through this already. But do you guys have the volume by mill this quarter? I get a sense, given the downtime at Celgar. But do you have those details mill by mill?

Do you want to do that, Dave?

I can quickly run through them for you, Sean. So production at our Rosenthal mill in Q2 is 92,000 tonnes. Stendal was 165.5 thousand tonnes. And Celgar was 80.8 thousand.

Great. Okay. Thanks, guys. That's all I had.

DeForest Hinman with Walthausen and Company.

I'm going to go back and ask more of capital management questions. When you make the comments that you look at deals, everything's too expensive, we're not going to be able to do big debt refinancing transaction in the near term, looks like maybe the call premium's a little too high, unless they [tick] away at the debt in the open market. But your stock, when you add back the grants, it's probably trading below book value. You have very high free cash flow yield.

When is a good time to buy your own stock? And if so, what is an appropriate leverage ratio for the Company?

Yes, good questions. Well, on the leverage ratio, down at what are we, 2.2 times net debt? Yes, that's, frankly, that's comfortable. It'd be totally fine to be above that.

On the stock buyback question, we've done a little bit of it about a year ago, and I guess it's not something all of our shareholders like us doing. Some of our shareholders really want us to do it. It's just one of the ways to return cash to shareholders. At the moment we're focusing on dividend and debt reduction.

But as we watch the stock, I mean, it does start to get quite appealing if you imagine it trending much lower than where it is today.

So I just kind of leave it at that. We could debate it for hours, actually, and we have.

Okay. I mean, it's good to hear your thoughts, because the stock has moved around a lot over a long period of time. I imagine the team is fairly vested. You guys have some pretty decent ownership, especially Jimmy Lee.

The dividend yield is obviously attractive, but if the market isn't going to -- a market that's seeking yield hasn't really led to meaningful appreciation in your share price. And it makes you wonder if a buyback would be more appropriate. So I'll just leave my comment at that.

And one other question. Can you just give us an update on the rail initiative in Germany that you touched on briefly, from a CapEx perspective? How far along are we on that project? And how meaningful can that be in terms of lowering fiber costs?

Yes. So the program is -- let me start at the beginning. So we run around 300 rail cars for roundwood in Germany and we lease these cars in the market. And we've designed and are having built a new format of rail cars that can carry about 65% more wood for the same length of [block] train.

And so the further east you go from us in Europe, the cheaper the wood is. And then it's just a question of the cost of the wood plus the cost of transportation to get it into the domestic market.

So you can imagine with trains that are that much more efficient, we can go that much further, get that much cheaper wood, and continue our strategy of bringing imports into the market to continue to push the price down.

Where we are in the program is, so we've ordered 200 cars. About half of those have been built and are being brought into service and to produce. By the end of the year, we'll be completely full with the 200. And then we've got another 50 to order, which we'll do in the near term, which will be received within about nine months.

So by the end of the year, we'll be about, I guess 70% or 80% of the way along on the conversion from the old cars to the new cars.

The lease cost for the new cars is very similar to the old, actually. So it gives us a real leg up in terms of our ability to import wood from places further away.

And how meaningfully does the cost of fiber drop? Are you willing to say anything in terms -- because you have to be negotiating with some of these guys, prepping them in terms of, hey, we're looking at however many board feed or loads of wood. I mean, what are the numbers we're looking at in terms of savings?

Well, you've seen our fiber costs coming steadily down over the course of the last couple years. And I'm just signaling that that's going to be a -- we're defending that, and pushing it hard wherever we can.

I mean, I don't want to signal huge swings in fiber cost. But I think the trend is down and will continue to be for the foreseeable future.

And just so I understand. Is that only a benefit to Rosenthal or is that a benefit to Stendal as well?

Yes. No, both. Yes, Stendal consumes a lot of roundwood. So both mills benefit.

Okay. Thank you.

[Sean Suller] with Redwood.

Congrats on a good quarter, in light of what happened with Celgar. Wanted to, I guess touch on the balance sheet, which I think a few other people have touched on. Is there a target leverage ratio that you guys think is appropriate for the Company, kind of on a through-cycle number?

Yes. I think we're already through that threshold. I think the leverage is quite comfortable today. What else can I say? I mean, we're going to continue to push free cash flow in that direction, continue the dividend. And, as you know, we think about share buybacks, and we'll have to continue to think about that as we see the performance of our stock going forward.

But, Sean, I don't want to say that we have a target of how much lower our leverage is going to be. We'll knock away at it as and when we can. And it just makes us better and stronger as we do that. But I'm not uncomfortable with where it is at all right now anyway.

Understood. And then, I guess this is more of a holistic question. The dividend yield, which you guys, from the last couple years and, at least we think over the next few quarters and next few years, should generate a lot of cash in excess of EBITDA minus interest and taxes and the dividend.

Would you consider raising that dividend? That's the first part of the question.

And then the second part of the question is, I think you talked about capital allocation. How do you think about the yield that you would get on the bonds in open market purchase if you were to do that, relative to the dividend, current dividend yield on the stock? I think the dividend yield on the stock is higher than the bond yield, which is probably a commentary on the market. But I'm curious how you think about the two of them. So two-part question.

Yes.

One long one.

Yes. And I don't know how to answer part two, to be honest. But part one is, I think the Board looks at the dividend level every quarter and we do in management as well. And given where the stock is, it's enhancing the yield, and so there's not a lot of pressure to raise it. And it doesn't seem to really be helping the stock anyway. It's quite disappointing, actually, how really the stock is performing, considering our balance sheet and our returning cash to shareholders.

So I don't think we should signal it's going to be increased in the near term. Board obviously has a right to make a decision every quarter. But I think we're going to be steady on it.

And in terms of bond yields versus dividend yields on the stock, to an investor like you versus how a company thinks about these things, it's a slightly different equation for us. And it just gets us into this whole debate of what is the right way to return cash to shareholders?

And you know from discussions with me, one of the factors is the size of our float, the liquidity in the stock, the optionality of being liquid under various points in the cycle and being just steady, prudent managers of the balance sheet to weather any of the volatility issues that the world may throw at us at any given time. So we just want to be as safe as we can, but not be too cautious either. So just it's a balancing act and we look at it every quarter.

Understood. Yes, I guess, obviously, the commentary is it's if you're comfortable with your leverage, the current amount of leverage and you could -- by buying stock, you're actually buying a cheaper instrument that has upside, versus the bonds, which I think yield around mid-5% right now, it seems to be a better use of capital.

So I guess I would reiterate the Walthausen individual's comments. But thanks a lot, guys, and congrats on the quarter.

Thanks, Sean.

Howard Bryerman with PENN Capital.

David, I just have a mundane kind of straightforward accounting question. It's directed at the wastewater fee accrual. I think you said on the call that you reversed the accrual this quarter to the tune of $8 million and there's most likely more to come at the end of the year based on these capital project spends that once approved, allow you to reverse it.

I guess what I'm a little confused about is, it seems like it's -- why make the accrual to begin with? It seems like you know what needs to be spent from a capital perspective in order to get the necessary approvals and, therefore, reverse the accrual. It seems to like make earnings very choppy when you're reversing $8 million to whatever million dollars a quarter.

It seems like, and I'm quite familiar with GAAP. It seems almost like it would be better just to book it on a cash basis if and when you ever have to pay the fee.

And then the last part of it is, I assume it has no cash impact. But are these fees being -- does it have a cash impact?

Yes, so couple of comments. Doesn't really have a cash impact. So we have a three-year cycle. And the German authorities say, if you can bring a capital project to us that allows you to lower your permit levels in whatever the negotiated parameters are, then bring it on.

So at the beginning of a three-year period, we're working on thinking about trying to develop a concept that we think will fly. And we may go to the authorities with one and it doesn't fly, go with another, doesn't fly, go again with some other concept, and they start getting interested. So then we have to work our way through it. So that takes a year or more.

And then we have to engineer the capital project itself. Then we have to build it. And then we have to run it and measure and achieve what we said we were going to achieve.

And so in that degree of uncertainty, under US GAAP, we're not allowed to assume that we are going to be successful. Although we've got a history of being successful and we have a high level of confidence as managers that we can do what we say we're going to do and we have strong engineering and all these other capabilities, it doesn't meet the test that our auditors would require to not book that accrual.

The test for us to release is when the authorities have been into the mill, audited the parameters, reviewed all of the invoices, and then made sure we spent the money on the things we said we were going to spend it on, and totally got their heads around the whole thing. And then they make a decision and they sign off and they send us a letter saying, you're good. That's the point where the uncertainty diminishes enough that we can reverse the accrual.

So I agree with your comment that it is choppy on earnings. We don't believe there's any other way to treat this from an accounting perspective.

Okay. So just how much should we expect through the balance of the year in reversals of this accrual?

Well, the Stendal program is just a little over 12 million euros. And it's not as advanced as Rosenthal. But as long as everything goes according to plan and it's successful, we'd expect that to be released in the fourth quarter.

Okay. Great. And then just kind of as a general comment, as a credit guy, even though we do invest up and down your balance sheet, never ceases to amaze me how management gets pushed on a short-term basis to buy back stock or pay out dividends.

I think it's extremely prudent in your industry to keep your leverage as low as you do, to keep your liquidity as high as you do, and to be extremely well prepared for the cycle ups and downs in the paper industry, in particular. So kudos to you. And your stock should reflect that as opposed to flushing out all your liquidity and then having a problem when you're in downturn. So thanks, David.

Thank you, Howard.

There are no further questions at this time. I turn the call back over to David Gandossi.

Okay. Well, thanks, everyone. That was a long call this morning, lots of detail. I hope I didn't overdo it there for you. But appreciate all your questions and your interest and look forward to speaking go you again next quarter. Bye for now.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.