Packaging Corp of America (PKG) 2017 Q2 法說會逐字稿

Thank you for joining Packaging Corporation of America's second quarter 2017 Earnings Results Conference Call. Your host today will be Mark Kowlzan, Chief Executive Officer of PCA. I will now turn the conference call over to Mr. Kowlzan, and please proceed when you are ready.

Good morning, and thank you for participating in Packaging Corporation of America's Second Quarter 2017 Earnings Release Conference Call. I'm Mark Kowlzan, Chairman and CEO of PCA, and again with me on the call today is Tom Hassfurther, Executive Vice President, who runs our packaging business; and Bob Mundy, our Chief Financial Officer. I'll begin the call with an overview of our second quarter results and then turn the call over to Tom and Bob, who'll provide more details. I'll then wrap things up, and we'll be glad to take any questions.

Yesterday, we reported second quarter 2017 net income of $143 million or $1.52 per share. Excluding special items, second quarter net income was $144 million or $1.52 per share, compared to the second quarter 2016 net income of $118 million or $1.25 per share. Second quarter net sales were $1.6 billion in 2017 and $1.4 billion in 2016. Total company EBITDA for the second quarter excluding special items was $328 million in 2017 and $290 million in 2016.

Excluding special items, the $0.27 per share increase in second quarter 2017 earnings compared to the second quarter of 2016 was driven primarily by higher prices and mix of $0.25, sales volume $0.09 and production volumes of $0.03 in our Packaging segment, lower annual maintenance outage costs of $0.05 and lower taxes $0.06 and a partial insurance recovery related to the DeRidder mill incident was $0.02. These items were partially offset by higher energy costs of $0.06; fiber $0.05; labor $0.03; and chemicals $0.01; higher freight $0.02, interest $0.02, and depreciation $0.02; and other expenses $0.01, and also lower Paper segment prices and mix $0.01.

Our results were $0.07 per share better than the second quarter guidance primarily due to higher Packaging segment salesprices and volume $0.03, a lower tax rate of $0.03 and a partial insurance recovery related to the DeRidder incident of $0.02. These were partially offset by higher recycled fiber prices of $0.01.

Looking at our Packaging business for the second quarter of 2017, EBITDA excluding special items of $303 million with sales of $1.3 billion resulted in a margin of 23.1% versus last year's EBITDA of $267 million and sales of $1.1 billion or 23.7% margin. The containerboard mills produced 947,000 tons in the second quarter driven by strong demand and the need to supply our growth in box shipments as well as the rapid integration of our new corrugated plants from the TimBar and Columbus Container acquisitions. We also successfully completed scheduled outages at our 3 largest containerboard mills. Although, higher recycled fiber prices of almost $19 million and higher energy prices of $5 million negatively impacted the mills compared to last year's second quarter, improved usage of recycled fiber and fuels helped mitigate some of that impact.

I will now turn it over to Tom, who'll provide more details on the containerboard sales and our corrugated business.

Thank you, Mark. Corrugated product shipments in total were up 10% with one less workday or 11.7% per workday compared to last year's second quarter. Our outside sales volume of containerboard was up almost 5,000 tons versus last year's second quarter, but down over 9,000 tons versus the first quarter of 2017. Overall, Packaging segment demand remained very strong with volumes contributing $0.12 per share above last year's second quarter and $0.07 above the first quarter of 2017. Even with excellent containerboard production from our mills, due to the continuing strong demand, we ended the quarter with containerboard inventories including the inventory needs of our 2 acquisitions, 25,000 tons below the second quarter of 2016 and over 14,000 tons below the first quarter of 2017. Domestic containerboard and corrugated products prices and mix together were $0.22 per share above the second quarter of 2016 and up $0.11 per share compared to the first quarter of 2017 as we continued to implement our announced price increases during the quarter. Export containerboard prices were $0.03 per share above the second quarter of 2016 and up $0.02 per share compared to the first quarter of 2017. I'll now turn it back to Mark.

Thanks, Tom. Looking at our Paper segment, EBITDA excluding special items in the second quarter was $43 million with sales of $254 million or a 17% margin compared to the second quarter 2016 EBITDA of $39 million and sales of $267 million or a 15% margin. We mentioned on last quarter's call that a key price index for all major uncoated freesheet grades dropped $20 per ton in February, and as expected our second quarter 2017 Paper segment prices and mix were lower compared to last year's second quarter as well as the first quarter of 2017. Seasonally, industry uncoated freesheet volumes in the first and second quarters are similar and ours were up slightly versus last year's second quarter as well as the first quarter of 2017. Our pressure-sensitive volumes were down slightly versus both periods. I'll now turn it over to Bob.

Thanks, Mark. Looking at a few of the other earnings per share variances compared to last year and our guidance, our second quarter of 2017 recurring effective tax rate of 31.3% was almost 3.5% below last year's second quarter. This was primarily due to adoption of new accounting guidance related to employee share-based payments which took effect beginning in 2017. This key accounting change requires all excess tax benefits or deficiencies from share-based payment awards, including dividends paid on those awards, to be recognized in the income statement when the awards vest. Previously this was reported in the equity section of the balance sheet. While we anticipated some benefit in the second quarter, when almost all of our employee grants vest, the fact that our stock price rose almost 25% from the time we prepared our guidance together with unanticipated favorable tax law changes in a couple of states, the benefit came in $0.03 per share above our expectations. We expect our third and fourth quarter rates to be what you would normally see at a bit under 35%, but our full year rate for 2017 now looks to be just under 34%, which would be at least 1% below our 2016 full year rate.

Also, as mentioned when providing our second quarter 2017 guidance of $1.45 per share, this did not include any potential additional costs or anticipated recoveries related to the DeRidder mill insurance claim. Discussions are continuing with our insurance carrier, but of the estimated $0.07 per share that impacted our first quarter of 2017 recurring earnings, we were able to record a partial recovery of $0.02 per share during the second quarter. Our estimate of the total property damage and business interruption losses, including capital cost, remains in the range of $20 million to $25 million.

Moving on, cash provided by operations during the quarter was $221 million. Uses of cash included capital expenditures of $82 million, common stock dividends totaling $59 million and $2 million in term loan repayments. We ended the quarter with $321 million of cash on hand.

Finally, our planned annual maintenance outages for the balance of the year is unchanged from our previous guidance with an impact of ($0.11) per share in the third quarter and ($0.23) per share in the fourth quarter still totaling ($0.51) per share for the year. I'll now turn it back to Mark.

Thanks, Bob. Looking ahead to the third quarter, we expect to realize the vast majority of our previously announced Packaging segment price increases and we expect higher Packaging segment shipments resulting from strong demand. White paper sales volumes should be seasonally higher, although price and mix should move lower and scheduled outage costs for the Paper segment will be higher. We also anticipate continued price inflation in recycled fiber and certain chemicals, higher freight costs, and a higher tax rate. Considering these items, we expect third quarter earnings of $1.68 per share. This does not include any potential additional costs or anticipated recoveries that are related to the DeRidder mill insurance claim.

With that, we will 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. Statements were based on current estimates, expectations and projections of the company and involve inherent risks and uncertainties, including the direction of the economy. And those identified as risk factors in our annual report on Form 10-K on file with the SEC. The actual results could differ materially from those expressed in these forward-looking statements. With that [Christa], I'll open up the call for questions. Thank you.

(Operator Instructions) Your first question comes on the line of Chip Dillon from Vertical Research.

First question is on the really solid performance we're seeing in the Paper segment. You mentioned, of course, that prices had dropped both I think sequentially and year-over-year. And yet, you were able to show higher margins. I don't know if you could give us a little help of what is causing that? Is it all operationally? Or did you ship some production to a lower-cost machine?

It really has to do with the outage schedule as we'd outlined this year. We had planned our outage with the Wallula mill as an example in the third quarter, and I Falls will come in October. Traditionally, we use to to shut International Falls down in June and Wallula would have a second quarter outage also. So that's one big factor. And also -- we also, in terms of what would impact the EBITDA margins, we -- don't forget we took the Pulp business and eliminated that at the end of last year and so that was a very low margin contribution to that segment. So that's no longer in the equation. Those two factors are really the difference.

Okay, that's very helpful. And then if you could just let us know, I don't know if Tom has some idea what the organic volume improvement was? I know there's the 10%, the 11.7% per day. But if you excluded Columbus and TimBar and other M&A moves, what would those numbers have been? And while you're at it, if you could let us know how the volumes look so far this month?

This is Tom. I'm not going to break that out. I'll tell you why as I explained last time. It's very hard for us to break out the organic now, because we move business around to take advantage of the synergies of these acquisitions and to maximize the profit potential. So it's very hard for us to get a total grasp on what happens organically, but I'll just -- that's why we're reporting in total. But I will say that demand so far through 13 days of this month is running at about 14% increase, which is of course, very good.

That's very helpful. The last one and then I'll turn it over. Mark, if you could talk a little bit about what you see as the potential for the fleet that's out there, both yours and others in the white paper world? Could be potential sources of new kraft linerboard capacity. And I say that, noting that demand so far this year is up 3%. You see virgin board prices outside of North America going up almost every 3 months and we've had two increases here in the last year and some of us think we could be close to running out in the next couple of years. So given that it is difficult to permit new mills, what are your thoughts about white paper mills being converted?

Well, it something that the industry has talked about. We talked about it the last few years. There are a handful of potentially good mills that could be converted primarily because of the wood basket they're in. And so you have to consider that as a primary factor in the conversion opportunity besides the amount of capital it takes to convert the asset. And so that capital required is a given and then the ability to fiber the mill with the right kind of fiber at the right prices is the other major factor. So there are a few mills that fit that criteria.

Your next question comes from the line of Mark Wilde from BMO Capital Markets.

Mark, is it possible to get an update on your plans for kind of de-bottlenecking down at DeRidder, where we stand and what the timeline looks like?

Yes, work is proceeding very well. I guess, a lot of the work that we had started on #1 machine is progressing very nicely and we're seeing what we expected to be on the incremental improvements with DeRidder. Also, the work that is planned that will give us the big incremental increase for next spring is still on track and that would be the press section rebuild in the new forming section work that we will be doing and so that will finish out the incremental activity that gets us the approximate 150,000 tons year-over-year. So -- but everything is looking very good and DeRidder is running very well. Extremely pleased.

That 150,000 tons would start to flow in the second half of next year?

Some of it's already flowing through work we did earlier in the year on the DeRidder #1 as an example and some of the work we did on DeRidder 3 is already flowing through. And then as we go forward, we will continue to make some of the improvements. Primarily it's a pressing, drying type enhancements that allow us to handle the available fiber we have. So we are seeing some of that benefit this year already.

Okay. Then Tom, I wondered if it's possible for you to talk just in general terms, about the pace of the current box side, how you see it rolling in versus kind of past hikes?

Are you talking about price hike? Is that what you're talking about?

Yes, the box price hike.

Yes. The pace is exactly as we said it would be. The -- as I said on the last call, the vast majority will roll in over 90 to over a 90-day period. So our results in the second quarter show some of that increase and we'll get all of that, we'll get the -- in a great majority of the remainder in the third quarter with a few laggers that trigger at the beginning in the year.

And should that, Tom -- should that net out to be more than the containerboard hike itself?

Well, yes. But keep in mind that, I mean, we may have a different set of circumstances than somebody else may have relative to all the contracts on all those sorts of things that go on. And in the number of accounts that we have in addition to the smaller accounts we have, which are negotiated each time a price movement changes.

Okay. And then my last question is, there is this supplemental corrugating medium hike out in the market. I think it's $30 on average. Will that have any effect on PCA?

Mark, we're such a small player in the external domestic medium market, we probably move less than 50,000 tons a year of medium out into the North American system. So we're such a small player, but the fact is yes, our price has gone up accordingly to what we see in the index.

Your next question comes from the line of George Staphos from Bank of America Merrill Lynch.

Thinking back on Mark and Chip's questions, can you talk at all to the extent, which priorities are maybe moving? Or which of the potential solutions to your vertical integration high-class problem are rising and which might be less of a priority and to the extent that maybe you can't talk per se to that? Can you talk about other projects, other initiatives that might be underway to improve returns? Either in the mills or the box plants we're beginning to see input cost start to rise again? Are there any things in that regard that might be helpful to your returns over the next couple of years?

Regarding the first question about capacity, we're not going to get into the details on that as we've been talking for the last few months publicly. We obviously have an array on our matrix of opportunity that we're studying and evaluating, and when we've made some decisions we're ready to announce obviously, we'll make that a public announcement. Regarding the opportunities within the mills right now, we obviously, across the entire legacy fleet, are working every day to enhance the efficiencies and opportunities. But keep in mind as we've always said that, that's more in-line with the [fleet] opportunity. And then, I'll jump to this, you talked about some of box plants, some of the other opportunities. And this is a capital spending question that somebody may be wondering. We've identified a number of opportunities in the box plant side of business with Tom and we are funding a number of these projects. We had called out that capital for the year would somewhere in that $325 million area. We now are moving that up to the $350 million for the year target and that's to take advantage of the identified opportunities that these are high-return, low-risk opportunities to enhance the margin and the mix of the volume on the box plant side.

Okay, Mark, thanks for that color. I guess, one thing I wanted to turn to is you would appear to be running relatively tight right now, heading into third quarter given your inventory position. Can you confirm that or correct that view? And if you are in fact running a little bit tighter perhaps than you would've expected to, aside from the obvious, what other things might you do to alleviate the production relative to the pulp situation you've got right now in your corrugated system, again a high-class problem?

Well, we are running right where we thought we would be. When we looked at the plan for 2017 and knowing what our shutdown schedule was looking like and what the box plant cut off demand was going to be modeled as, we're pretty much right where we thought the inventories would be. That being said, you are right. We have to run extremely well and yet historically, we proven that's what we do well. And -- so the pressure is on the folks on the mill side of the business to run extremely tight and that's what the plan is, but yes, we need every ton we can get out of our mills.

Okay. Two last ones and I'll turn it over. In terms of this quarter, even relative to the first quarter, it seemed like there is a little bit more pressure on you and I think other companies in the sectors results from input cost. Obviously, OCC is the headline pretty much every day, but also even from non-fiber based variable cost, what can you comment to in terms of what pressure or benefit you're seeing there and the outlook for the second half of the year? Are you seeing any kind of freight or logistics challenges like we had a few years ago that the also have to manage against either logistically or potentially through other margin improvement efforts?

Energy is a key factor. If you go back to a year ago, year-over-year, 2Q energy is up $0.06 and freight is up $0.02 year-over-year. And so those are the types of examples. And then you have called out chemicals, if you move into going from 2Q to 3Q, there's still some upward pressure on a little bit of the fiber with what we're seeing, but these are the type of a penny for this and a penny for that freight. But it's still in an upward trajectory just slightly from what it has been. So that's why we're calling it out. That's about where it is. But year-over-year, it's really the natural gas rise that we'd fully picked up throughout the system.

Your next question comes from the line of Phil Ng from Jefferies.

When you think about M&A going forward, would you consider buying some of these uncoated freesheet mills that you kind of called out that would fit that fiber basket as well as your current mill system on the white paper side? Do they have that fiber basket that could make it interesting? I'm not saying you're moving forward, I'm just curious about the parameters.

That's something I don't care to talk about. It's -- again that's -- any discussion around that is proprietary and confidential so it -- and then anything else is speculated.

Okay. Fair enough. I guess, pricing was pretty robust, more than offset cost for the most part in packaging. So I was a little surprised as margins were flattish, which was good regardless. Was there any mix dynamic in the quarter? And just given the shrink that you saw in box demand, did you have to buy more board in the open market?

Well, primarily, and Tom and Bob can weigh in on this too, but if you think about the lag that we've seen in the price increase, we saw the bleedoff all year long in 2016 for corrugated products. And then the price increase announcement last fall started to flow through so we saw the primary benefit moving into the first quarter and then this latest price increase was really a third quarter event and if you think about year-over-year there is still that pressure on the pricing in the total low-margin. We haven't picked up the full benefit. Bob, Tom, you want to weigh in?

I think you are right the recovery, the cost -- the cost paying from the run-up in recycle and these other things happens quicker than the price increase comes through. But as Tom said, the third quarter will get the vast majority of that and we would expect that to sort of flip in the third quarter.

Got you. That's helpful. And I don't know exports and just open market tons are not a big portion of your business, but just given the strength you're seeing you call of 14% box shipments in July. Are you starting to pull back on those open market tons and just repatriate some trades on those tons? Because the spread is pretty attractive, I would imagine.

I'll let Tom talk about this too but as we called out earlier in the year, we look at those tons and we move the tons to the best opportunity and so we are very, very cognizant of that. Tom, you want to add a little color to how we look at our export?

I will just say that in the export market, I mean, we're taking care of those long-term customers that we've had and that we value and especially since they buy the specialty grades that we produce. We will take care of those people, but we're not actively pursuing additional business in export.

It's still only a few hundred thousand tons a year of our total production.

Your next question comes from the line of Anthony Pettinari from Citi.

You've had TimBar for about 10 months and I think Columbus for about 8. Are your integration and synergy activities there basically completed? Are you supplying basically all the board for the box plant systems? Just wondering if you can give us a sense of what inning you are in for those integrations and if there's some incremental benefits that might flow through in the second half?

Tom, why don't you walk through that?

Our TimBar and Columbus acquisitions have gone very well. They're fully integrated. We're very pleased with the results. They continue to grow at what we consider the PCA growth rates, and we've been able to -- as I mentioned earlier, we've been able to move some business around, which has been very valuable to us in terms of some other synergy savings. We are very pleased with where that is.

Okay, that's helpful. And then Tom, I think this might be a difficult question to answer, but is it possible to estimate what percentage of your box volumes maybe move through e-commerce or have exposure to e-commerce? And then also in the past you've talked about manufacturing, reshoring, being a potential driver of demand. I guess, Foxconn had a big announcement about a big Midwestern plant. How much has manufacturing and industrial manufacturing renaissance been a driver for the very strong growth you've seen this year?

Anthony, let me talk about e-commerce first because that gets a lot of attention and I think a lot of people want to say that the increase in demand in boxes is generally driven by e-commerce. It certainly is a driver, but I don't think it's the only driver at all because as you just mentioned, some of the reshoring of manufacturing or what I would really consider at this point it's been more of a retention of manufacturing base which we've seen growth in some areas, bleedoff in others, things like that. We are not seeing the bleedoff that we've seen in the past. They're staying here and I think that's very helpful to the base of the business, and then things like e-commerce are a growth engine on top of that. And then as you mentioned, this Foxconn announcement that's coming out, which is a major facility moving into Wisconsin. At least that's the indication at this point of time. In addition, Samsung has announced a big facility that's coming to the United States. So I think the future is very bright in terms of box demand.

Your next question comes from the line of Debbie Jones from Deutsche Bank.

Going off of what Anthony just said on demand trends, is there anything from a like a regional perspective that you're noticing that is surprising to you? And then you do you have any color on how trends have been through July?

Tom, why don't you go...

Debbie, I would say, on demand trend the only thing that really, I mean -- we're seeing right now is, we're seeing the recovery of the West Coast Ag market. So the West Coast is definitely up for us. The remainder of the country is pretty steady in terms of demand and demand growth.

Okay. And anything on July?

Well, in July, we are having as I said we're up, we're trending up 14% right now and that demand is pretty well evenly distributed across the country.

Okay. And then in paper, typically your mix and volume improve seasonally. Can you just talk about your confidence level on that and just remind us, what exactly is driving that?

Well, third quarter is always the higher volume quarter and traditionally a richer mix quarter. But that being said, prices are down for the year as the indexes indicated earlier in the year and so volume back to schools is always a big time in the third quarter, that all the school system nationwide restock and so that's what pushes volume on cut side. So in that regard, that's truly what drives the third quarter.

Okay. Just one quick one, this might be pretty simple, but you have experienced higher freight costs, which I think is understandable. But is there anything in that, that is related to availability or having issues getting freight?

The availability isn't our concern right now. Just the general increases in cost for the year. So it's not like it was 4, 5 years ago with driver and tractor-trailer shortages.

Your next question comes from the line of Mark Weintraub from Buckingham Research.

The 14% and I realize it's only a few weeks, but that seems like a pickup even from the 10% to 12% that we had in the prior quarter. Is that -- are there some additional acquisitions that kind of are feeding into that number? Or is that indicative at least that your business is actually even picked up from the forward things that we were seeing?

That's just our business in general picking up in a higher trajectory. We are very pleased with where we are.

And as you have been growing quite fast, has your customer base shifted at all? What I mean by that is, are you selling even more to local accounts for instance versus national? Or the other way round? Or any changes as you are going through this relatively fast growth?

No. Nationwide, if you looking at our box plant footprint, we are seeing robust activity nationwide, and we are taking advantage of the TimBar and Columbus acquisitions and integrating the regional activities. But again, that's the good news that we are not seeing in any one area. It's across the board and don't forget we've got an extremely large customer base with 18,000 plus customers nationwide. And so it's a very well spread out nationwide activity. Tom, you want to put more color on this?

No, I have nothing else to add.

Your next question comes from the line of Chris Manuel from Wells Fargo.

Just a couple of follow-ups. One along the lines of previous questions. You said 14% versus up 10%, did you start to see an acceleration as the quarter went on or was that sort of all incremental in June or July? I'm sorry. And can you remind us what your comps kind of look like the next couple? Are they still relatively simple or can we kind of annualize this rate until this is all through?

Chris, I'd say that the -- as Mark just mentioned, I mean, the demand has been essentially a pick up across the board. We usually have a pretty robust third quarter anyway. Looking forward though is the 14% number, if you look into the third quarter,I think we are going to have some little tighter comps because TimBar Corporation came on in September. So when you get to the September number in the month in that quarter, and you start to make those comparisons, I mean, this number comes down because you now got TimBar in both years of comparison. So we'll break some of that out for you and give you a little color on that in the next quarter.

Okay, that's helpful. Just two last questions. First was when we think about the 150,000 tons that you've got kind of de-bottlenecking and work for, that across your roughly 3.8 million rated tons is about 4%. Could you just maybe estimate for us, you mentioned you had some of it already at D1 and D3, was some improvements there but do you feel you've got quarter of that, half of that? How much of that do you think you have already kind of flowing through versus yet to come?

Just using the number, we probably get 50,000 tons of pick up this year all those projects on both machines and then we'll get the balance of 100,000 next year.

Okay, that's very helpful. That's helpful. Last question I had was with recycled mix, if memory serves, and correct me if I'm wrong, you use kind of 10% to 15% OCC into your part of your basket today, even though most of your paper comes out as kraft. With some of the changes of Chinese wastepaper exporting and such, do you have an opportunity being that the rest of your mix as you put that in there is pulp, do you have an opportunity to maybe use some more wastepaper versus OCC? How do you think about that mix or what it might do? Would it degrade the quality of what you'd have coming out? How would you think about that as an opportunity?

You just summarized it well. You got to be very careful about what you're putting into the furnace in regards to what the impact of the quality is going to be. And so I don't even want to speculate about that, that kind of opportunity or what that means.

Your next question comes from the line of Adam Josephson from KeyBanc.

Mark, just one question back to packaging margins for a second. I know you talked about all the other OCC, energy, freight, chemical inflation that you've experienced. Were you expecting going in the quarter your margins to be flat or down? Or did you actually expect margin expansion knowing what you knew going into the quarter?

We are right where we expected to be, because of what I told you about the leak, leak off last year we had to overcome in the pricing alone, pitted against the fiber OCC cost inflation in chemical and energy. So we're right exactly where we thought we would be.

Okay. And Tom, you talked about demand and the e-commerce impact and how much play that's getting. If you don't think is e-commerce is driving most or all the growth, what do you think is driving up OCC to the extent that it's gone up? Do you think it's half China, half e-commerce? What exactly -- what do you think is going on? And do you see any end in sight to this highly unusual OCC run we've seen?

Well, let me first comment. I didn't say that e-commerce is not a growth engine. It is a growth engine, it's clearly a growth engine. Because if you just make the comparisons about deliveries to home, with even, let's say apparel as an example. Apparel did not go in boxes when it went to big box stores but it does end up in a box when it comes to your home. So that alone is a pickup for us. And e-commerce is a lot bigger just an Amazon as an example. E-commerce, everybody has got e-commerce sites. Everybody -- every day they are opening up new sites, everybody is trying to cut in to what Amazon is doing to them, et cetera. So it's a huge moving target and it's very hard to get your arms around that completely. Now that said, moving to OCC, e-commerce clearly has an impact in OCC collection as well because the big box stores used to collect all of the corrugated used to mail it and send it, ended up back at the mills. Today, you've got a lot of these boxes showing up at apartment buildings, condos, homes where the municipalities may not have collection and consequently it ends up in a landfill. So there has been a little bit of a curtailment in terms of the ability to collect and -- but we saw this trend in OCC coming way back in '05, '06 timeframe before the great recession hit. If you go back, if you looked at collection rates and the demand because all of the additional mill capacity that came on over the last few decades, it's all been 100% recycled. So at some point, there is going to be push comes to shove in terms of supply versus demand. And we are at that point right now where OCC is in very tight supply and consequently the prices remain high. And even when a few months ago when China curtailed some of their purchases and everybody thought OCC would retreat back to levels that had taken place in the previous 6 months. It didn't do that at all. It came down little bit and then as soon as China reentered the market, it went right back up. So we think it's clearly going to be an issue.

So you think essentially we're in kind of a new paradigm for OCC now?

I do. Yes, I do. I think that as those people that know that business well know that we collect up to 90% at this particular point in time, that last 10% is very expensive to get. So OCC has to have pricing significantly higher in order for people to have an interest in getting into really what an essence is sorting trash and trying to recover the paper from that.

So just last question on that. So you don't think there'll be a huge push like right now among recycling companies now there is to try to collect more of the stuff.

I think they're trying to collect all they can.

Yes, we're at an inflection point of the opportunity, as Tom said, it's a diminishing return at this point.

It's just expensive to get. But it's very expensive to collect beyond where we are right now.

Your next question comes from the line of James Armstrong from Armstrong Investments.

In the quarter, could you remind us, what was your mix of virgin versus OCC? And do you think you have any room to reduce your OCC usage further? Or are you pretty much maxed out on virgin?

We're not giving you this the exact number. We're somewhere around 20% total usage of OCC. We can move that up and down a few percent but don't forget, running the mills full and with the demand we have, it's probably, if you look at the math, in our best interest to use what we need to use for OCC and DLK to fill out that demand we have for containerboards. So it's somewhere around 20%, and we did obviously take advantage of our system this year in fact, and really stretched out our kraft capabilities in the mills. So 20% is a good number.

Okay. That works. Switching gears and coming back to capacity. If you or another producer decided to convert a white paper mill, how long do you think it would take to complete that conversion? And can you compare that to what you believe, how long it would take for a greenfield operation?

Well, let me start with a greenfield operation. Nobody has permitted a greenfield mill in decades, and so the likelihood of somebody trying to go through the permitting process and the site locations, that's probably a low probability. On the other hand, if somebody was just starting to think about converting a facility, you're probably talking about a couple of years. By the time you would do your pre-engineering and your detailed engineering and order equipment, vertical pieces of equipment for paper machine conversion, pulp mill requirements. A lot of this equipment now is up to 14 to 16 months delivery. Just on the delivery phase of this. So it takes quite a while to do your engineering and scope the project out. So you're talking about couple of years in many cases to do a good project.

James, I'll also like to add that more important than even the mill or the potential fiber base, you better have a place to sell your output. So if you don't the open market is so small today that it would be virtually impossible for somebody who doesn't have the integrated cut-out to go in and convert mill and then try to find a home for those tons.

To what Tom's saying is if you think about just in the past year with the acquisitions of the independent box plants that the industry has been announcing, we've probably taken the independent activity down from probably 9% or 10% down to 5% or less of the open market containerboard purchasing.

Your next question come from the line of Scott Gaffner from Barclays.

Just a follow-up question on inventory. You seem to be relatively tight on inventory now and I think normally you would build some inventory this time of the year in anticipation of a strong 4Q print or 4Q demand, or 4Q has been stronger recently than it has been in the past. How are you thinking about the inventory positions sort of as you move through 3Q into 4Q?

Well, it's a high-class problem right now. We got used to running well and just keep running well. The point you're making the fourth quarter is no longer that seasonal downturn that the industry used to see but that's been going on for that part of a decade now that 3Q is always your highest volume quarter and a better, richer mix, but 4Q because of the holiday activity and that is actually requiring us to run just as hard so the good news is, we got to run hard and tight, we need the tons, so the plan right now is to get ourselves back in balance and keep running well to supply what the box plants need.

No absolutely -- we have a range of our inventory tons and we know where we come out of the annual shutdowns, we are moving there. But also the key is with box plant demand, it's I use that term as a high-class problem to have.

Sure. And may be a follow on to that for Bob. How should we think about working capital associated with inventory? Because you got tight inventory situation but you have the price increases coming through the system. How should we think about inventory as a source or use of cash for the year?

I think to Mark's point, producing to meet the box demand and keeping those in sync, we don't see a lot of movement up or down with inventories. So you wouldn't get one or the other.

Last one for me, just on input cost. We talked about a lot of inflationary pressures. But what about virgin pricing trends? Are you seeing anything there as far as deflationary trends on virgin fiber pricing?

Year-over-year, that's been a bright spot. If you look nationwide across our legacy systems, we've seen from 2016 timeframe into this year, we've seen some price decreases. It's primarily related to weather events; rain, winter activity. And so we have one mill location in the south that had a little bit more rain in the spring and we saw some uptick in the virgin wood cost at the particular location for a few months, but in general, across the board, year-over-year, what's helped us mitigate the OCC, DLK price impact has been that we've been able to buy at a better pricing year-over-year on virgin. So that's been a positive so far. But again that can change in a heartbeat with hurricanes, tropical storms and winter weather. So far it's been positive.

Your next question comes from the line of Brian Maguire from Goldman Sachs.

A lot of discussion today about the recent demand trends, which obviously are strong and your commentary around the go forward seems really constructive there. And your commentary around OCC maybe being in a new paradigm also seems to make it clear that the world is going to probably need some more virgin capacity at some point. Was wondering if you could follow up on James's question and your response there and provide some color on what you think that the capital cost might be on a conversion like you were talking about? And would you comment on whether you think the current margins in the industry are attractive enough to justify that kind of an investment acknowledging that it would be a little bit of risky because it will take a couple of years to come online? And the world has been an uncertain place?

That's a very speculative question because depending on what quartile you wish to achieve a conversion ultimately end up and also, as Tom said, assuming you have a home for these tons and where those tons are going, you have to run the math, but taking an older bleached mill, white mill into a containerboard conversion can get extremely expensive in terms of hundreds of millions of dollars of conversion. If you wish to do it and place yourself in a cost competitive position. But again, it's not just the capital, it's the sales side on the margin to make the math work. But it's a timing issue in terms of a couple of years from inception. The amount of capital to do it properly. I think if you go back and look at what's been done up in the Canada, the latest conversion we know what they spent. And again, the time it took. And then, but the biggest thing and Tom mentioned and that is truly the biggest factor. Where you're going to go to sell this stuff?

Okay, appreciate that. I was curious the comment you made about better usage of recycled fiber is been a little bit of a benefit. Is there much you can do on the operating side kind of adjust, and I don't imagine there's huge benefit, but maybe switching from OCC to sort of paper or DLK on any other kinds of recycled fiber? Anymore color on that comment?

No, we are in balance right now for quality and where we need to be presenting the right kind of containerboard to our system. The amount of DLK, the amount of OCC we are using, but we wouldn't consider mixed weight.

Your next question comes from the line of Steve Chercover from D.A. Davidson.

I just wanted to verify a couple of volume figures if you would. I think you said offshore sales are 200,000 tons?

No, we probably used 300,000 as a number.

300,000 okay, thanks. Recycled medium was 50,000 tons a year?

No recycled -- medium sales?

No medium sales to domestic customer.

Domestic customers, somewhere in that 40,000 to 50,000 tons of domestic activity a year. That's just a range.

Got to get a hearing aid. And then -- and finally, could you tell us what your total open market purchases are?

We're not going to quantify that, we've always been an open market buyer of containerboard primarily in the specialty grades and so we continue to do that as we need to and as the opportunities present themselves.

Okay, would it be fair to say that's part of your secret sauce to generate margins that exceed those of your counterparts?

No.

Your next question comes from the line of Gail Glazerman from Roe Equity Research.

Just going back to your options as you look at potential incremental board supply. Understandably a lot of the focus has been on virgin, but could you envision a scenario where you might look to -- add some recycled capacity just given how low your relative share is?

That would be a low probability in the matrix that I mentioned of our opportunities. That's in the low opportunity, low probability part of the matrix.

Alright. And then just in terms of the converting strategy moving forward. As you look to the independent share shrinking, as you said possibly down to 5% already, obviously, the opportunity to continue your strategy of acquiring independents is going to get tougher. Is the math, can you just -- how are you thinking about given where the recent valuation has been relative to perhaps doing some more organic work in the system to the extent that you're talking about putting some money into the converting system in your CapEx plans?

Regarding acquisitions, the box plants we continue to evaluate and take advantage of opportunities that presented a good rich mix of business. And that's probably what (inaudible).

Is the balance shifting at all compared to when it's been the past when the available opportunities have obviously contracted so much for the several years?

Yes, Tom a go ahead and put some color on that.

Yes, they are shifting a little, there is no question about that. I mean, as Mark mentioned earlier, I mean, we've got additional CapEx spending going on in box plants not only for growth purposes but also to be more cost effective. That's something we've always done. So we're probably ramped that up a little bit more. And yes, there's no question that the acquisition opportunities are going to be a little bit fewer and more selective. But that's not to say they don't exist and that's certainly not to say we won't do them if they fit our criteria.

Just one last quick one. OCC, just your near-term outlook, obviously the print was up in July. Is your guidance expecting that goes up further in August? Just kind of what you're expecting in the third quarter?

Yes, yes, yes. We do expect third quarter prices to be above the average you saw in the second quarter.

Your final question comes from the line of George Staphos from Bank of America Merrill Lynch.

Very quickly, to the extent that you can comment. Bob or Mark, can you remind us what kind of returns you typically seek to get with your capital spending? Said differently, if we hold the fiber cost constant and pricing constant, what sort of organic EBIT on EBITDA improvement do you think you can get within the Packaging segment over the next call it 2 years from the projects that you're contemplating?

I don't want to get into that analysis and the range of in terms of our targets when we are evaluating capital spending, there is a range of opportunity and it depends on the amount of capital and the complexity of the project looking at the ultimate returns that it presents. So we don't have one metric. That's the target that has to be hit on in evaluation. So it's a lot of factors go into capital spending decision.

Would you say the returns are as good as they've been in the past? If you can't put a number on it?

Absolutely. With that, operator, I believe that concludes the questions. Thank you for joining us today. Look forward to talking with you in October on the call.

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