Packaging Corp of America (PKG) 2006 Q3 法說會逐字稿

Thank you for joining Packaging Corporation of America's third-quarter 2006 earnings conference call. Your host today will be Paul Stecko, Chairman and CEO. Upon conclusion of the narrative, there will be a Q&A session. I would now like to turn the conference over to Mr. Stecko. Sir, you may begin.

Good morning, and welcome to PCA's third-quarter earnings release conference call. I am Paul Stecko and with me on the call today is Bill Sweeney, who runs our corrugated Products Business, Mark Kowlzan, who runs our Containerboard mill system, Rick West, who is our CFO. They will be here to answer any questions for you also. Thanks for participating and after we complete the call, as usual, we'll take any questions that you might have. So let me get right to it.

Today, we're reporting third-quarter earnings of $44 million or $0.42 a share and that is compared to third-quarter 2005 earnings of 11 million or $0.10 a share.

This is a record quarter for earnings per share for us, excluding any special items, since we became a stand-alone company in April of '99. The only quarter with higher reported earnings was the fourth quarter of 2000 when we sold our woodlands to Southern Timber Venture. In that quarter, we reported $0.58 a share, but that included $0.35 -- excuse me, that included the woodlands sale, and without that woodlands sale, we would have been at $0.35.

This year, our third-quarter earnings were also up 35% over the second quarter of 2006 as a result of the full realization, a whole quarter's worth, of earlier price increases. Net sales for the third quarter were $575 million; that's up 12% compared to last year's third quarter of $512 million.

Net income for the first nine months of 2006 was $85 million or $0.81 per a share, and that compares to $51 million or $0.47 a share last year. The first nine months of 2005 last year does not include income of $0.06 from a dividend from -- does include, excuse me. The first nine months of 2005 does include income of $0.06 per share from an FTD dividend received in the second quarter.

Net sales for the first nine months of this year were $1.6 billion, and that compares to $1.5 billion in 2005.

The $0.32 per share improvement in earnings compared to last year's third quarter were driven by higher pricing and a richer product mix, which together improved earnings by about $0.41 per share. Partially offsetting this earnings improvement (technical difficulty)

Ladies and gentlemen, please stand by. Your conference will resume momentarily. Once again, ladies and gentlemen, please stand by. Your conference will resume momentarily.

Pardon me sir, you are reconnected.

I understand we are reconnected. I apologize for that. We had a problem. It's not AT&T; it's us. We had a fuse blow here, but we're back in operation. I'm told by the operator where we stopped and I'm going to pick it up from there.

And where we got disconnected is where I was about to say that our earnings improved by $0.32 per share compared to last year's third quarter. And this was driven by higher pricing and a richer product mix, which improved earnings by about $0.41 a share. Partially offsetting this earnings improvement were higher transportation costs of $0.04 a share, labor costs, which include incentive compensation of $0.04 a share and energy costs of $0.02 a share.

Looking at operations, our mills and box plants had an outstanding quarter. Our corrugated products shipments per work day equaled last year's record all-time third quarter. So our box plant cutup remained very strong.

Also, we were finally able to replenish our inventory somewhat, which then allowed us to capitalize a little more on a strong market for outside sales of containerboard, and we increased sales in this area. During the quarter, we increased our inventories from about 3.4 to 3.6 weeks of supply, and this was very important since October is a seasonally strong month with 22 box plant shipping days.

As a point of comparison, the Fiber Box Association reported yesterday that industry inventories at the end of September stood at 3.9 weeks of supply, and that matches the second-lowest September ending inventory in history. All of this was possible because our mills had their best quarter ever, running extremely well and setting an all-time production record of 621,000 tons. And that is up 20,000 tons compared to last year's third quarter. However, and I hate to say this, we're still not totally out of the woods inventory wise.

During the fourth quarter compared to the third, we have some additional mill maintenance work planned, which I'll discuss in a moment. And we must ensure that we get our inventories back to a level that will allow us to exit 2006 with enough inventory to cover our annual maintenance outages at Counce and Valdosta in the first quarter of 2007. And I think many of you recall with last year's unusually strong box cut up in December, we did not build adequate inventory at the end of the year to take both Counce and Valdosta down in the first quarter as we normally do. So we had to postpone our Valdosta shutdown in 2006 until the second quarter.

We would much rather complete these shutdowns in the first quarter when box demand is usually the weakest and energy consumption and cost is the highest with colder weather, the net effect of which is by doing it in the first quarter, we improve our profitability by doing it at a time when demand and cost are both favorable to a shutdown.

Speaking of costs, like most companies, we do continue to be impacted by our transportation costs, both rail and truck, which lowered our earnings by about $0.04 per share compared to the third quarter of 2005.

According to the U.S. Energy Information Administration, on highway diesel prices, per gallon, the third quarter averaged about $2.92 a gallon compared to $2.56 in the third quarter of 2005. So they are up [14]% and 14% in that period. If you go back to the third quarter of 2003, diesel prices are up 100%.

On a positive note, diesel prices dropped in September to $2.78 a gallon, and as of the latest weekly report for the week ending October 16th, the price was down to $2.50 a gallon. So hopefully we will continue moving in the right direction.

Looking at some other costs, labor was up about $0.04 a share, but about half of this increase was for incentive compensation, which moves with our level of earnings, which as you know quadrupled compared to last year's third quarter.

Energy costs were also up about $0.02 a share over last year, with purchased electricity and then fuel being the two largest components of this increase.

Moving on to revenue -- higher pricing and a richer product mix compared to last year's third quarter improved our earnings by $0.41 a share. We reported in our second-quarter earnings conference call that we completed the full pass-through of the April containerboard price increase to boxes by July 1. So this quarter, we were able to realize a full quarter's benefit of these previous price increases.

Our corrugated products volume per work day remained very strong, equaling last year's all-time record third quarter. In addition, with the three price increases, we had an opportunity to shed and in some cases lose some of our lowest-margin business, which was replaced with better business. This may have limited our volume growth somewhat but with our low inventories we think it was a very wise move as it improved our mix and our profitability.

Looking next at the balance sheet, we ended the quarter with $118 million of cash; that is up $24 million from the end of the second quarter. This increase in cash is after making a required $9 million paydown on our term loans, leaving our total debt at $687 million. Our total debt now includes term loans of $30 million, $109 million under our receivables securitization and $547 million in notes net of a $3 million unamortized note discount. Capital expenditures for the quarter were $15 million and $55 million for the first nine months of 2006. For the year, we would expect CapEx to come in at about $80 million.

If I had to sum up the third quarter, really I would say three things -- you know, record production, record shipments, record earnings and I would add we made good headway in strengthening our inventories and that is important as we enter the fourth quarter.

And speaking of the fourth quarter, as I mentioned earlier, we do have more mill maintenance downtown work scheduled compared to the third quarter, in which we had none. Our Filer City mill was down last week for its annual maintenance outage. And Valdosta will be down later in the quarter, probably for two days, for some modifications to the new head box that we installed in April of this year. These two shutdowns will reduce our production by about 12,000 tons in the fourth quarter.

Also, as I think many of you know, wood products demand has weakened, and some sawmills and plywood plants have either shut down or slowed back, which has limited the availability of residual chips. The situation is the most acute in the West and in Canada, but has also begun to affect our Counce, Tennessee linerboard mill. And as is normal, we must begin to build with inventories at Counce prior to winter, when inclement weather affects logging conditions and reduces fiber availability.

It's difficult to predict if and how tight this fiber situation could get. Obviously, it depends to some extent on how wood products demand fares going forward because wood products plants do produce a lot of residual chips for paper mills. And it also depends on how the weather behaves over the next three or four months.

The situation is a little more acute this year than normal because we have been running Counce and a couple of our other mills at more than 100% of capacity for the past few months. So at that run rate, it's very hard to build wood inventory to start with. As this situation continues to tighten, we will probably have to reduce production somewhat at Counce, as the wood situation would dictate.

We also expect a higher energy cost in the fourth quarter with the onset of colder weather. And as a result of some planned boiler and digester maintenance work at Counce, which reduces the amount of black liquor that we can burn when we are repairing this equipment. Overall, we expect energy costs to be about $0.03 a share higher in the fourth quarter than in the third.

Finally, corrugated products volume is expected to be seasonally lower in the fourth quarter compared to the third, primarily as a result of the normal business slowdown prior to and just after the Christmas holiday.

One plus, we think, is that with lower natural gas and gasoline prices, the consumer should hopefully have more money for holiday purchases, which in turn would help boost demand for things that are packed in corrugated containers. But, who knows?

Considering all of these items, we currently expect earnings in the fourth quarter to be about $0.35 a share. This forecast does assume another strong December for box volume, which has been the case the past two years. driven to some extent in our opinion by increasing Internet shopping, which generates additional corrugated packaging volume.

And we are a little optimistic about this December because of what I just said about falling natural gas and gasoline prices providing more disposable income to the consumer, and hopefully that translates into better box volume.

With that, we would be happy to entertain any questions, but I must remind you that some of the statements we've made on the call constituted forward-looking statements. These statements were based on current expectations of the Company and involve inherent risks and uncertainties, including those identified as risk factors in our annual report on Form 10-K on file with the SEC. Actual results could differ materially from those expressed in these forward-looking statements.

And you know Mark Kowlzan is a good mill guy, because he found where the fuse was blown and got us up and running back on this call again. He may have a career in telecommunications too. With that, let's open it up to questions.

(OPERATOR INSTRUCTIONS). George Staphos, Banc of America.

Paul, a quick question to start. When we look at actual box shipments versus the year-ago quarter, looking at the number that's reported, I was coming up with maybe a modest increase. I know per work day you were flat versus a record, but listening to your commentary sounded like maybe on an actual basis you were down a little bit for obvious reasons. Could you give us a little bit of color on that?

Yes, in 2005, there were two more work days, and so our box volume was a little higher on a total basis in 2005 because two more work days in the month. So it was a touch higher.

Fair enough. Now, you talked about transportation costs remaining high. There has been at least some evidence that trends there are becoming a little bit less acute or intense. Has that been your experience in recent weeks? There seems to be a little bit more availability of trucking and railcars. And in turn, do you think that might lessen your need to keep some buffer stock, which you have needed to run efficiently?

Well two things, I don't have a heck of a lot of buffer stock. I would like to get to a position where I had a heck of a lot of buffer stock, but I don't. But with regard to your question, September for the first time, we saw an improvement in transportation. Our costs were down a little over $1 a ton in transportation, which we relate to the fuel situation.

Secondly, we think in certain things -- in woodlands operations, where we had fuel surcharges that we were paying loggers, we've removed some of those because fuel costs have come down. So we're also being a little helped on inbound freight. But on outbound freight, we came down a little over $1 in September, and that may not seem like a whole heck of a lot on let's say our average costs close to $50, but the direction is important. This is the first drop we've had since Hector was a pup, as they say.

I remember maybe not last quarter but over the last few quarters, you saying, maybe about a year ago, that you're running with maybe about 10% more supply of inventory just to keep the mills running. is that an incorrect recollection or --?

No, what I said was we, over the last two or three years, felt that we had to get our inventory level up about 10% to maximize our profitability, because you have a trade-off between freight expense and inventory carrying costs. And as transportation went up and up, [add] through the balance even more that when you have to have an emergency shipment of paper to keep customers supplied or a box plant running, the cost is very high, and it's a lot less expensive. But we made a -- I'd say 10% is a modest adjustment. And so when I say not buffer stock, it's that 10%. And we're struggling to get at that number. That is one of the places we want to get to.

So, we should not expect to move that much even if transportation gets a little bit easier, from what you have said.

No, we're talking -- but let me tell you, 2, 3% extra inventory, that might only be 5000, 6000 tons for us. But on the cusp, that 5000, 6000 tons is very important.

Okay, two last questions and I'll turn it over. While you've called out some cost variances that were negative, overall, you performed at least in line maybe a little bit better than I expected on the cost side. Was it all in the operations or were there some other line items that helped you out? And also, with the CapEx coming down, what were the biggest factors there from the prior guidance? Thank you.

On the call, we had a terrific quarter cost wise. And the thing that -- energy prices were stable. No big changes in anything other than freight, but it was operational efficiency. We had our all-time record quarter in the mills in terms of production, and we had an all-time -- we matched our all-time record quarter per day in the box plants. So we ran extremely well, and as you know, we also continued to invest in the business with very good cost reduction projects, particularly in the mills. In the box plants, we invest for volume.

But you put that altogether, I would say other than transportation, you know we have the negative electricity prices are still going up, but most of it is related to -- when you have a problem particularly in a paper mill, they're very expensive problems. And it's kind of like in golf. It's kind of like having a real bad hole; it will screw up an entire round. And that's why paper mill, you've got to strive for production because the cost of mistakes are severe.

With regard to your second question, was -- CapEx. CapEx, I had given guidance that we would come in probably between $90 and $100 this year. We're not going to get there. We have had to -- not have to, but we have chosen to, to slow some things up. Because I don't want to take -- some of these projects require a little mill downtime before you do them, and if you're tight for paper, you're better off waiting maybe till the shutdown the next year to do them. And some you do, some you don't. But that has influenced to some extent our slowdown in capital spending. We've just got to balance when we do it with our current level of production and find an optimum place. And looking for that optimum place dictates a little slowdown in spending, because I don't have enough of that buffer stock, as you referred to.

Got you. Thanks, guys.

Chip Dillon, Citigroup.

Hey, one thing we noticed in the numbers, was again, it just seems to be happening over and over, was the divergence between containerboard consumption in the U.S. system and the box shipment numbers. Again, we're looking at about a percent increase in the weight of the average box. And yet you think the biggest growth area, Internet shopping, would actually reduce the average weight of boxes. I know there are other phenomena like the continued growth of the big wholesale stores, the Sam's, the Costco's. Do you have any thoughts on why these boxes continue to get heavier?

Our data shows the opposite, Chip. We're making more 35 pound as opposed to 42 than we ever have. So when I look at our own mix, we're getting a touch lighter. So we're going against the industry trend. But I did see the data -- the box basis weights declined and then they bottomed out and they just sat there for a little while. Adn I think there's some variability around that number but I don't have a good explanation for the down tick, in terms of weight. If you said it's down another percent, I hadn't seen that number yet. But Bill, you want to weigh in on this?

I think you said it's up a little bit.

I mean, up a little bit. Excuse me. And it's counter to ours, which is down a little bit.

You know, I've brought this up to the Fiber Box Association. It's statistically correct, but it's hard to explain.

Got you. Do you analyze the in-transit data on a company level? There's obviously some assumptions you have to throw in there about what you think is going into non box usages and how much is being imported say in medium. But do you have a good view of that?

Yes, that's very, very important. When you're running with low inventories, you've got to know what's in the pipeline, and so we look at that every month, what our in-transit is. And you know you get in trouble around the Fourth of July when the railroads take extra vacation and you've got to plan for certain events because you're gong to load the pipeline up a little bit and that's good and bad. But I would say for the last three months, our in-transit numbers have been remarkably stable.

Okay. On a separate note, when you look at the cost situation, you mentioned the wood chip issue affecting counts. And yet a lot of the trade publishers talk about chip prices and wood costs being unusually high in the West. And I think that's one reason one of your competitors lowered guidance for earnings in the third quarter. Do you feel that this is becoming more of a national phenomenon or are you seeing the same thing say up in Wisconsin or down in Valdosta?

We have different situations; it's primarily, in our case, softwood. And that would be at Counce. Valdosta doesn't seem to be as affected as much. But I think the phenomenon is that when wood prices fell, I think some wood products producers are going to report -- I don't know this, but I suspect, if I believe what you analysts are reporting, that some of them are going to go into a negative profitability on wood products. And some of them are shutting down sawmills and plywood plants. More in the West -- maybe not more -- probably more in the West, but what exacerbates the situation in the West is that most of those mills out there don't have wood yards. They don't have the ability to take roundwood and make chips.

In the South, you've got a lot more flexibility because most of the mills have wood yards. So if your chip sources dry up, you can cut up to some extent more of your roundwood, and that's what we are doing at Counce. We have had some chip suppliers, that run sawmills, shut down. Those chips are gone. So what we're going to have to do at Counce is cut up more wood through our wood yard. Now there are limits to how much you can do.

The second thing you've got to get that roundwood, and what that usually means is you've got to go out a little further from your mill to bring it in. The wood doesn't cost anymore but the freight does. And when you pay, when you ship wood a little further distance, that increases your cost.

So I think the situation is, as I said on my call, more acute in the West because of those situations. But if sawmills throughout the country reduce production, that will limit sawmill chips. And I'm guessing at this number but it would not surprise me of 30, 35% of the average mill's supply is purchased chips. And that's a big percentage.

Got you. And last question, Paul. You have had a great run of free cash flow this year. Your payout rate is almost technically the same as your earnings, they're 100%. But you -- obviously, as you mentioned, the CapEx has been low and your net debt is going down. As you think about next year and sort of looking at the state of the industry and what might be out there, are you more favorable toward buying box plants, or buying back stock or raising the dividend?

I like all three of those, Chip. It's a question of how much money you have to spend. Is there a priority? It depends. If the best box plant investment of all time came our way, it would be hard to pass it up. On the other hand, we think our investors like dividend increases and share buyback and we have to balance these competing interests and it's dynamic in terms of -- it changes what you might do at any one time.

But I must say our objective is twofold, though. One, we want to get our earnings level obviously higher so that we are way above -- not way above -- but we're at least above our payout level. And if this market continues to perform like we hope it does, we will certainly have done that this year. If you take our guidance for the fourth quarter, earnings are north of $1 a share, so we have covered the $1 a share dividend. The objective is keep improvement of business, get the earnings per share up, and then that puts you in a high-class problem. You could do all of the above with regard to those three things to different extents. But make no mistake about this, our level of earnings will drive what we can do strategically with the money.

Mark Connelly, Credit Suisse.

Just two things. A little bigger picture. You've talked about the mill situation in the short run. But broadly speaking, your mills are pretty maxed out and the money you were going to spend was going to help on costs here and there. But is there money that you can spend strategically over the next 12 months to pull out maybe a little bit more than the usual capacity creep to get you some more volume without having to go out and buy something?

You're certainly right about our strategy. We invest in our mills for cost reduction as opposed to growing volume. And we invest in our box plants the opposite. And the investments that we make to reduce cost -- some of them do give you a little more creep potential, but not much.

So the answer to your question is, no, we don't have any investments planned in the next 12 months that will increase our volume a lot. We will get the peripheral benefit but most of these investments will continue to be to reduce cost because we think that's optimum. And so we are going to be tight and that puts a premium on good operations. That said, however, 2006 was a year where we had some big maintenance shutdowns.

We did a lot of work at Counce on the paper machine. We put a new head box in at Valdosta. We did a bunch of work on Filer. We're going to fine-tune that head box at Valdosta probably in December. That will help production a little bit. I would say in 2007, we're going to get a little bit of relief because I'm probably going to have a few more operating days because our shutdowns are not as extensive in 2007 as 2006. We'll get more tons that way. But bottom line is, there are not a lot more tons we can bang up.

So if we look on the board side, producers are not doing anything to raise prices, at least not right now. So that sort of suggests that you guys are pretty much approaching being maxed out, except for the cost side, of course.

Well, there is another element that we plan to improve our profitability on, and that is, again, one of our core strategic plans is decrease our vertical integration level. And where we are now is we make money in our box plants, we make money selling paper, but we are about 82, 83% vertically integrated. So on 17% of the paper that we sell on the outside, we make money on the paper but obviously don't have an opportunity to make it in the box plants. So continuing to grow our box plant volume helps our profitability. But again, make no mistake about it, the single biggest driver of profitability in this business is price. And that helps you more than anything else. And historically being over-obsessed with volume hasn't helped you.

Right, right. As you look at the market balance right now, Paul, is this market strong enough to accept a board price hike if there were one?

The only thing I want to say about that is it's the second lowest ending inventory ever, and ever is a long time. And that's about all I could say.

Thanks, Paul.

Mark Weintraub, Buckingham Research.

Thank you, Paul. Just a couple follow-up questions first -- on the cap spending side, do you expect to make up in '07 some of the -- for lack of better terminology -- under-spend in '06?

Absolutely, absolutely. We have got projects that are good and our normal level of CapEx is about $110 million. We hit that number like clock work. Last year, we spent more than that. We spent $120 -- excuse me, $130, and we did that to accelerate energy projects. And they are paying good dividends. I think as Chip Dillon pointed out on and earlier call, our costs were pretty good year over yar and one of the reasons is that energy work we did. And we have some other projects.

So I would think that next year, that number could be $120 million instead of $110. Because we want to do these projects. We have just got to find time to do them. I can't delay them forever, but this is a tough business. You want demand to remain strong but if it weakened for about a month, it would help me, but I ain't rooting for that.

The other follow-up I had was in terms of the capital allocation and thinking through buying box plants, increasing dividend, buying back stock. In the past, you talked about the various -- the thought process on the dividend. And one of the criteria is that when you're going to do a dividend increase, it would be significant. I believe that was -- (multiple speakers).

Yes, we're not going to raise a nickel. We think significant when we do it, a significant increase.

Okay, so you still have that mindset.

If we do it, we think a significant increase. Now what the definition of significant, it's not a couple of cents; let's put it that way, or a nickel. I said a nickel, so it's not a nickel.

Okay. And on the fiber situation, OCC actually seems to be coming off some in terms of the price. As you noted, the wood costs, at least in many baskets, going up. Do you have much ability to increase your OCC usage?

Yes, we do at some mills; some mills, we don't. Filer City, we could have loaded it up pretty good, but we've got good -- really good fiber costs at Filer City. So it's -- virgin fibers -- it's cheaper than OCC. We have no flexibility at Valdosta; we run 100% pine there, which makes one beautiful sheet because it's 100% pine.

And the good news at Valdosta is our wood costs are the best there in fiber. At Counce, we could put a little more in, not too much, and the same thing at Tomahawk. We can put a little more in but not too much.

Okay. Lastly, a number of your big competitors are going through significant restructurings. I'm curious at this point whether you're seeing any impact on the business landscape related to these restructurings?

None that I would say are noteworthy. We hear a thing here and a thing there, but nothing that would be at a level that we would consider changing anything we're doing.

Rich Schneider, UBS.

Just wondering in terms of the $0.03 impact you talked about for the fourth quarter in energy; I imagine that is all energy -- the usage rather than price. How much does your btu on usage go up in the fourth quarter versus the third? You can even do it on a percentage basis; just give us an idea on that?

Off the top -- it varies. The problem is, I don't have that number. It varies all over the map. It doesn't move a lot in Valdosta. It doesn't move a lot in Valdosta. It moves a lot in Counce, and obviously, the [Northern] mills. But a rough number -- and this will get you in the right ballpark -- about 10%. But it could be 4% at one mill and 18% at another. There's a wide dispersion. But average is about maybe 10.

And then the first quarter, does it stay pretty flat with the fourth quarter?

Yes, first quarter is actually worse than the first quarter because you have got two real cold months, January and February, versus only one real cold month in the fourth quarter.

The inventory that you need to build as you go into the maintenance shuts in the first quarter, how much more inventory do you need to have by the end of the fourth quarter if you are something at 3.6 days now?

You know, in an ideal world, we're not talking more than 10,000 tons but what the right number is -- I'm not talking -- I'm talking wood inventory now, okay?

Okay.

And that number is probably -- I'm looking at Mark -- 30,000 tons of wood -- probably another 30,000 tons. Because it takes 4 ton of wood to make a ton of paper; 4 ton of wood.

Great. When you talked about your fiber costs going up in the fourth quarter and you talked about Counce, it sounds like it's more of a wood availability issue than a price issue. Is that correct?

It's both. You can get more wood but you have got to increase the grain size. So that means you have got to go out a little further. You can buy the wood for the same price but you have got to ship it further. So I call that a wood cost item. Although it's all freight, it still increases your wood costs by going out. And that's what we're talking about. The delivered cost will be probably a little bit higher if sawmill chips really dry up. And I don't like the trend.

Again, what is really exacerbating the situation -- I think people lose sight of the fact -- Counce ran, I think, last month at 103.5% of capacity. We can't sustain that. It's like running 100 yard dash in 9.8 and then telling the guy he's got to run a half-mile. You can't do it. Because there's maintenance. You wear things out faster. You are going to have to slow down anyway. I'm just saying that the wood situation is even going to exacerbate that situation. You may have to shut down and do more work on your wood yard. That is going to limit your production.

When you run at these elevated operating rates, does that require you when you do take downtime and maintenance downtime to have the mills down for a longer period of time?

Well, not -- well, yes, because you're probably doing maintenance that you would not have had to do if you had been running hard. It's like getting 40,000 miles out of a set of tires or 30,000 miles out of a set of tires. Some things need to be done more often, and so it does require more maintenance downtime because you have got to change things out a little more often with wear.

How much maintenance downtime -- or maybe don't have that number yet -- are you anticipating in the first quarter?

In the first quarter -- no, we don't have that number. Typically, we take Counce and Valdosta down for a week, and I would say that's plus or minus two or three days. That's probably never more than minus two but it could be plus three; actually, it could be plus four. So it could be a five to 11 day thing per mill; seven is the average. This year, we were over that average at both mills, but this year, I think we will be probably a little under that average because we did so much work last year. But we have not come with that number -- we haven't planned those shutdowns yet. We are worried about running in the fourth quarter.

You usually give us some trends that you have experienced in the months starting in the quarter, like October. Could you go through what your box shipment and experience has been so far in October?

I would just characterize it as steady. I really haven't taken a hard look at that. It's nothing that's remarkable up or down.

Steady with, you mean, September?

Last year.

Oh, okay. Great. Thank you.

Richard Skidmore, Goldman Sachs.

Good morning, Paul. Just a couple of quick questions. First on the incentive costs, are those based on absolute level of profitability or is it an increase that drives the performance-based comp?

Both.

And so as you (multiple speakers)

Both. And in the case where -- and when profitability quadruples, that meets both requirements.

So as we look forward, assuming again sort of no pricing and steady markets, would expect that that incentive cost would go down a little bit?

I hope not. If our absolute level of -- I'm hoping that our absolute level of profitability continues to go up. And it's based on -- not a quarter, by the way. It's based on what we think we're going to do for the year versus last year. But we do accrue, according to accounting principles, for how much you contribute to getting to your target. And if you do better than you thought to get to your target, then you accrue more in that quarter. And if you do poorer to get to your target, you to less. And then as I said, if your level of earnings is up, usually your incentive compensation is up also. Last year, we only made $10 million in net income versus roughly 40. So obviously, it was a very low accrual last year, and it's a better accrual this year.

Okay. In terms of your customers, are there any customers that you have that have had long-term contracts or price protection such that as you move forward you'd actually see them start to pay a higher price? Or are all your customers paying the price increases?

The only things we talk about with regard to our customers is what we talk to our customers about. We view those relations as very intimate and we don't share them with anybody. But we did report that we had a full pass-through of a price increase. And that if you look at the numbers, $0.41 in mix and price, you can do the math, and you can see about where we came out. But our relations with our customers have been and will always be between us and them, and we don't share that information.

Last question, and you have talked about this over the last couple of quarters, and the industry data certainly points to the markets being extremely tight. What in your mind needs to happen in order for prices to move higher? Is it an inventory number? Is it a demand number? What in your mind would drive the next move up in price?

Historically, and I can only speak historically, supply and demand have driven prices. And a lot of things affect supply and demand. So if you just go down the list, obviously, if the industry cannot sustain these operating rates, for example, or somebody chooses to run at a higher or lower operating rate, that affects supply. And on demand side, the economy affects demand. What actually is the event that triggers something up or down? There's a lot of things and I'm not going to speculate on those on this call.

Edings Thibault, Morgan Stanley.

Thanks and good morning, Paul. Just a few follow-up questions at this point in the call. I wanted to ask you about your tax rate for the fourth quarter -- what you are assuming. It's kind of jumped around a little bit over the last couple of quarters. Do you have any guidance on that number?

Yes, tax is something that I turn over to the expert and he's sitting next to me, Rick West. So we're going to let him answer that question.

Yes, Edings, we expect the fourth quarter to be at about 37.7% for the effective tax rate compared to the 36.6% that we had in the third quarter. Really the difference in the third quarter, we had a couple of tax years that closed out and our contingency reserve was lowered in the third quarter and that was a third-quarter event. We don't expect the same thing in the fourth quarter and our tax rate will go back up to 37.7%.

Not detailed enough, Rick. Just kidding. Thank you for that.

That's why I don't answer tax questions.

That's an answer! Paul, I just want to make sure I'm following you when it comes to your fourth-quarter guidance. You said that you expected -- you had seen in September, your energy costs were down year-over-year. It doesn't seem as if that is prepared to change dramatically.

No, I didn't say that.

Then let me -- could you clarify that (multiple speakers)

Energy was up $0.02 year over year. I said our transportation costs came down in September, and that was energy-related in a way because diesel prices came down.

Are you expecting any benefit on the energy side in the fourth quarter?

No, our energy costs will go up $0.03 a share.

Year over year, okay.

Yes, in the third quarter, driven by two things. Colder weather, you consume more energy, a rough number 10%, although that can vary by mill. The second thing that we have going on is that we're doing some -- I was talking about running equipment hard. We are doing some repair work at Counce on the digestors and the recovery boilers. Normal maintenance, replacing things that need replaced. That means we will generate a little less black liquor that we can burn in the fourth quarter and that also adds to our energy cost. And so you take those two things together, higher consumption and burning a little less black liquor, that's about $0.03 a share.

I'm just wondering, as you start to extend your current energy price level -- maybe not -- when you think about year over year, do you anticipate a positive variance in the fourth quarter versus last year?

Probably about the same. Probably -- because don't forget what happened last year in the fourth quarter is gas prices went crazy, and we weren't affected by that. And fortunately for us, I think our gas consumption last fourth quarter got down to like 3%. So we weren't hurt too much by that.

And again, we don't burn -- if you take gas and oil together, you're looking at probably 20% of our fuel, so 80% of our fuel is coal and bark and that is pretty steady. I mean it's pretty steady -- not a lot of variability in its cost year over year.

Got it. Just wrapping up with a question on production. I think you had said the headbox downtime in the Filer City maintenance would cost you about 12,000 tons.

Yes, rough number.

Rough number. We have sort of talked about the potential for chip shortages. Is it fair to say that you're not really expecting in your guidance at any rate and certainly in that 12,000 ton production number a material [and] back from chips yet? It is just something you're highlighting as something to keep an eye on?

No, we don't think we're going to run at the same production rate in the fourth quarter as we did in the third. We can't sustain that. Our production rate will be lower in the fourth quarter.

Got it. That's clear enough. Thanks very much, Paul. Good luck.

Mark Wilde, Deutsche Bank.

Good morning, Paul. Just a couple of things. One, on the Valdosta outage in the fourth quarter, I assume you're not going to do any of the work then that you might do as part of the normal maintenance outage in the first quarter?

That's right.

Then the other thing I wondered about was just EBITDA margins. If we look at the third quarter, it's a good quarter. It looks like you're about 20%. If we go back and look at like 2000 and 2001, my numbers have just about 29% in 2000 and about 22% in '01, but we've got higher containerboard prices here in the third quarter than we had in either of those years.

Can you just help us understand what kind of the key issues are for the lower margins and whether you think we can get back to a 28 or 29% rate? And maybe as one other piece of that, do you think the variance is more in the mills or in the box business?

Well that's a pretty simple question to answer. I can answer it in one word, but before I do that, I'll give you the right EBITDA margin. It's 23.5%. Was our EBITDA margin this quarter, not 20%. So, that's the right number. But the one word answer to your question is inflation. Some costs are up a lot.

Energy costs and transportation are the two biggest costs that are up. Medical cost is up a lot. And when you go -- labor costs are up for various things. And when you go back to those years and you even go back as far as five, you've got to adjust for inflation.

And in order to get back to the kind of numbers -- although 23.5% is not that far from 29%, but we were in the low 30's in '94, '95 on EBITDA margins. But if you're talking -- and let's talk about getting back to those kinds of margins, you have to look at the price and adjust it for inflation. So when you say the prices are higher or lower, you have failed to adjust those for inflation. And if you just do a simple model of adjusting those prices for what the normal level of inflation is, these profitability numbers get very, very high, and they will approach those levels.

So the bottom line is, price, price, price, that's what it takes because that's how you offset inflation. Obviously, if you are in an industry that's growing 8% a year, you can offset inflation some with productivity, but this industry hasn't grown at that rate. So it's inflation is the reason that those margins are not bad. But we're getting -- I'm going to say pretty close -- 23.5% versus the number you quoted for 2000, which I assume is right.

Well, what about just looking at the two sides of the business, because you don't buy a lot of purchased energy or at least the stuff that really moves. Can you give us any sense of whether you think the difference is more in the converting business or more at the mills?

Well it's more in the mills because you look at the converting -- the a single biggest cost in converting is in paper. And so you capture that in the mills anyway. And the mills use a lot more energy than the box plants do. 90% of our energy is consumed in our mills and 10% is consumed in our box plants. And so energy is a 9 to 1, hurting the mills over the box plants.

The box plants single biggest cost by a wide margin is labor. It's much more labor-intensive than a mill. And so they are hurt by medical; those costs go up more than the mill because they have got a lot more employees in the mill. And the box plants are also hurt by freight costs because the box plants are actually more freight intensive than the mills because what they ship doesn't weigh as much as the thing. So they need many more trucks pulled than the mill and they don't have the luxury of rail. So the answer -- it's a long-winded answer but I think it's a good question to give you some detail. The answer is the mills, but the box plants are affected because of labor and freight.

Okay, I guess that's getting at what I wondered, because it seems to me prices on boxes have moved, but they really haven't moved up enough to capture the natural gas used in the corrugator or the freight costs.

Absolutely. I think the way we look at our business and the way Bill Sweeney runs his box business is that he needs pricing to do exactly what you said. And that is not only pass through the price of paper increase but to also capture the yield difference because let's say you're running at a -- pick a number -- 90%, 92% yield, you have got to use -- you need a little extra paper to make a box, so you've got to capture that. And then you've got to capture normal inflation. And as I have said I think more than once, I think the history of pass-throughs have been -- in the first price increase, you may only capture board costs. But as progressive price increases go through and the market gets tighter, it is incumbent on the box plants to capture some of that. And that has certainly always been our objective.

Okay. The last question I had is just on this board and box weight that Chip Dillon brought up. I've been hearing a little bit about the [Seika] machine over in Spain that just came out, making some real light-weight board, like 13 and 15 pounds. Is that a trend you think we could see here in the U.S. over time, Paul?

No, I don't think so. To me, that's not something -- it's a different business in Europe than it is in the U.S. Because fiber is so expensive in Europe, what they tend to do is make a box with many layers that are -- each layer itself not that strong. So you might have three layers there to do the same job as a one layer box does here.

And the other reason for that is that is primarily a test liner market, so they use recycled paper. And I think that mill you're talking about is a recycled mill. So to strengthen that stuff is not too good, and as a result, you've got to design around that and make the boxes a little different. So that fits the European market much, much better than it fits the market here and the types of equipment that our manufacturers have to convert boxes and fill them and that. So no, that is not something that I think is too relative to this market.

Any other calls?

We have one final question from Andrew [Feinman] from Iridian.

You, with your guidance for the fourth quarter are going to generate around $200 million of free cash this year after you spend $80 million, or --. And the dividend is about $100 so that leaves $100 left. And my assumption, which you don't have to validate or disvalidate is that you're not going to just leave that money laying around. So if you don't get the world's best box plant to buy, then you're going to use it in the way that creates shareholder value. So the question is, do you get more bang for your buck right now from paying down debt or from buying back stock?

Well I'm not going to validate that list of numbers you just went through, because I didn't follow them all. But I think I can answer your question. We don't think we get a very big bang for our buck paying down debt. We think our debt is as low as it needs to go. You can argue that we ought to have more debt, but we like where we are. And so any excess cash that we have we look at three places to do it, as you said.

Box plant acquisitions, dividend increase or share buyback. That is the three places we look. And as I said earlier on a call, that depends on the circumstance at the time, but what I can safely say is debt paydown is not on our priority list.

Thank you.

Thanks, Andy. That's going to conclude the call. I want to thank you for tuning in. I hope I did not inconvenience you too much when we lost the connection. We will build in a redundant system next the next time so this doesn't happen again. But hey, it could have been worse. It could've been a recovery boiler going down. So with that, say good bye and talk to you next quarter.

Ladies and gentlemen, thank you for participating in today's conference. This concludes our call. You may all disconnect, and have a wonderful day.