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SmurfitStone Container Corporation (NYSE:SSCC)

Q3 2008 Earnings Call

October 23, 2008 9:00 am ET

Executives

John Haudrich Senior Director, Investor Relations

Patrick J. Moore Chairman and Chief Executive Officer

Steven J. Klinger President and Chief Operating Officer

Charles A. Hinrichs Senior Vice President and Chief Financial Officer

Analysts

Richard Skidmore – Goldman Sachs

Sandy Barnes – KBS

Gail Glazerman – UBS

Joe Stivaletti – Goldman Sachs

Bruce Klein – Credit Suisse

George Staphos – Banc of America Securities

Claudia Hueston – JP Morgan

Mark Connelly – Credit Suisse

Mark Wilde – Deutsche Bank

Barry Haynes - Sage Asset Management

Chip Dillon – Independent Research

Mark Weintraub – Buckingham Research

Operator

John Haudrich

Welcome to Smurfit-Stone’s third quarter 2008 earnings conference call. Joining me today are Pat Moore, Chairman and CEO; Steve Klinger, President and COO; and Chuck Hinrichs, our Chief Financial Officer.

Presentation materials for this earnings call are also being simulcast from the company’s website at smurfit.com. Please review the safe harbor comments and disclosure for use of non-GAAP financial measures included in those materials. Unless otherwise noted, earnings relate to adjusted net income or loss, which excludes certain unusual items identified in the presentation appendix. Today we will review quarterly earnings, discuss operations including our strategic initiatives program, review financial matters, and share our business outlook. Following the prepared remarks, we will host a question and answer session. Please note, your questions must be submitted through the call-in number previously published and not through the webcast. Now I will turn the call over to Pat Moore.

Pat Moore

Before we begin our discussion about the third quarter, I think it’s important to address the recent decline in our stock prices. The unprecedented developments in the financial markets and a global slowdown are impacting stock prices across many sectors of our economy. We recognize Smurfit-Stone is under added pressure, given the sensitivity of our business to economic cycles and our higher-than-average financial leverage.

Our three-year transformation process has been essential to improve Smurfit-Stone’s long-term profitability. To achieve this, we have had to invest capital to scale our operations. Fortunately, we have nearly completed these investments and our productivity is improving. Yet today’s uncertain market requires flexibility. As a result, we are taking prudent measures to conserve cash, including deferral of certain capital investments, until such time that credit markets become more accessible. Despite these prudent actions, capital deferrals will not significantly impact our ability to successfully complete our transformation program in the first half of 2009.

Now let me turn to third quarter results. Today Smurfit-Stone reported net income of $62 million or $0.24 per share for the third quarter 2008. As previously announced, our results benefited $0.33 per share from the favorable resolution of Canadian income tax matters which Chuck will discuss in further detail.

As the chart on page 3 illustrates, our third quarter adjusted net loss was $0.08 per share which reflects earnings prior to unusual items, including this tax matter. As expected, Smurfit-Stone’s earnings improved from the second quarter. We reported an adjusted net loss of $0.08 in the third quarter. As illustrated in the chart, this represents an improvement from the $0.12 loss in the second quarter.

Higher selling prices and volumes more than offset continued cost inflation. When compared to last year, earnings were down from an $0.11 profit, reflecting absorption of significant year-over-year cost inflation and a lag in raising prices to offset these higher costs.

Our containerboard and corrugated box shipments increased from the second quarter. Roll stock inventories remain very low throughout the quarter. And we successfully implemented our previously announced containerboard and box price initiatives which began in July.

The unprecedented energy inflation experienced in the first half of this year carried over into the third quarter. As this inflation worked its way through the supply chain, chemical and freight costs also increased. Faced with the prospect of rapidly rising energy costs, we expanded our hedging program earlier this year. When energy prices dropped sharply in the latter half of the third quarter, we recognized a $0.04 loss related to our hedge positions.

Thankfully, our facilities were spared from the direct impact of numerous hurricanes. However, we did experience some supply chain disruptions; and extremely wet weather conditions negatively impacted wood fiber prices during the quarter.

After absorbing unprecedented price inflation earlier this year, our focus is on margin restoration as we completed the implementation of our July price initiative. We should further benefit from lower commodity prices and savings from our strategic initiatives program.

As our formal strategic initiative period ends, our transformation efforts continue. Our new world-class plants in Chicago and LA began operations in the third quarter. Also, we closed four box plants and reduced head count by 229 during the third quarter as we transitioned business from older, less efficient plants to lower-cost operations. Last week, we closed a high-cost paper machine at the Snowflake, Arizona, mill and announced our intent to close our Pontiac pulp mill at the end of October. We remain on track to achieve $525 million in cumulative savings in 2008 and complete our transformation plan on schedule in early 2009.

Despite $97 million of capital expenditures in the third quarter, our debt remained flat, we met all financial covenant requirements, and our liquidity improved from the second quarter. But, as you know, there’s much uncertainty about the future condition of the global economy given the turmoil in the financial markets. We are focused on maintaining the necessary financial flexibility in the event of a protracted downturn, and we are deferring capital expenditures where prudent.

As I said earlier, deferral of capital will not negatively impact our ability to achieve our transformation targets.

Both Steve and Chuck will expand on these topics, and I will not turn it over to Steve who will discuss operating activities.

Steve Klinger

As you can see on page 5, third quarter operating profits were $100 million, up from $74 million in the second quarter. Higher prices, volumes, and less maintenance downtime contributed $39 million to earnings on a sequential basis. These were partially offset by higher costs and other factors.

Our average domestic linerboard and U.S. box prices improved 4.2% and 1%, respectively, in the third quarter. Yet point-to-point increases are a better measure of progress when implementing price increases. In the first eight weeks following the pulp and paper index increasing in July, our U.S. box prices increased $33 per ton on a mix-adjusted basis. Upon the completion of the July price increase, near yearend we expect box prices will have improved by more than the original $55 per ton containerboard price hike. Our average pulp prices declined $22 a ton in the quarter and continue to drop in the fourth quarter.

The closure of the Pontiac mill, a high-cost, non-core asset, will eliminate our exposure to the volatile hardwood pulp market. Mill production increased 33,000 tons sequentially in the third quarter due to less maintenance downtime and one more production day. Our September roll stock inventories were again at record low levels. Our average per day U.S. box shipments increased 2.4% from the second quarter, but were down 1.2% compared to the prior year. Adjusting for plant closures and efforts to improve low margin accounts, our shipments were down 0.4% year-over-year, outperforming the market, which was down 3.4% per the FBA. This represents the fourth consecutive quarter our adjusted box shipments have outperformed industry trends.

Commodity costs, including energy, freight, chemicals, and fiber, were up $22 million from the second quarter. Supply chain disruptions due to multiple hurricanes in the third quarter impacted wood fiber and other input costs. Chuck will outline cost inflation in further detail. Overall, our operating and sales execution continues to improve.

Turning to our transformation activities on page 6, we have made continued progress this year executing our capital program and improving productivity. These efforts paved the way for several actions this past quarter which will have a meaningful impact on our cost structure going forward.

We have largely completed our container capital program as our new greenfield plants in Chicago and LA recently commenced operations. These are impressive facilities. They are significantly improving our position in the two largest packaging markets in our nation.

With most of our strategic capital spending behind us, we expect expenditures will decline significantly going forward. Likewise, as our transformation activities conclude, transition costs will decline. We shut four box plants in the third quarter for a total of 33 box plant closures over the past 3 years. Furthermore, we announced an additional four plant closures and remain on track to shut 40 box plants by the first half of 09.

As a result of these efforts, we reduced head count by 229 in the third quarter and 5,954 since 2005. Last week, we closed our higher cost paper machine at Snowflake and announced the closure of our Pontiac pulp mill. Including these moves, we have closed six mills since 2005.

Our transformation program is improving our cost structure to increase scale and productivity. As illustrated in the chart, mill and box plant scale has improved 20% and 10%, respectively, since 2005. Likewise, labor productivity is up 19%. As we conclude most of our transformation activities in early 2009, we expect continued productivity improvements as we benefit from our capital investments and fine-tune our operations.

Importantly, we will achieve continued cost savings without significant future capital expenditures. Driving profitable revenue growth continues to be a key component of our strategy. We successfully implemented the July price initiative, and I mentioned our adjusted box shipments outperform the industry over the past four quarters.

We are making solid progress in the last stage of our transformation program, and we remain on target to deliver $525 million cumulative savings in 2008.

Given the uncertainty about the U.S. economy, we are taking the prudent steps to conserve cash. While we focus on completing our transformation, we are carefully reviewing all remaining activities. As a result, capital expenditures will include maintenancelevel spending, committed capital, and projects providing an immediate cash return, such as expenditures necessary to complete closures in our threeyear initiative plan.

Going forward, our Snowflake machine and Pontiac mill closures will benefit both future profit and cash flow. Furthermore, we expect to reduce head count as we shut down additional box plants and the Pontiac mill. As a result of these and other efforts, we expect a meaningful reduction in cash expenditures over the next several quarters. I will now turn it over the Chuck, who will review financial matters.

Charles Hinrichs

I will start by reviewing the activities that drove our financial results on page 8. Our second quarter adjusted net loss was $0.12 per share. In the third quarter, results improved to a loss of $0.08 due to the following factors.

Higher selling prices boost earnings $0.04 per share as we implemented our July price initiative. Earnings benefited $0.01 from higher box and containerboard shipments. Timing factors, including 27,000 tons of less mill maintenance downtime, lower related maintenance costs, one additional mill production day, and lower energy usage contributed $0.07 per share.

Cost inflation impacted results $0.05. While recycled fiber prices trended down due to lower export demand, the hurricanes drove higher wood fiber and other input costs. As a result, net fiber cost increased in the third quarter. While higher energy prices decreased recently, average prices were still higher in the third quarter. Freight and chemical prices increased as energy inflation from earlier this year worked its way through the supply chain. As Pat mentioned, our energy hedge marktomarket loss impacted results $0.04 per share. Finally, earnings benefited $0.01 from other items.

Turning to other financial matters on page 9, as previously reported, certain Canadian tax matters related to our 2000 acquisition of St. Laurent paperboard were resolved in our favor. As a result, reduced the previously established reserve and increased our benefit from income taxes by $84 million or $0.33 per share in the third quarter. This is a noncash event.

As Pat mentioned, we hedge our exposure to natural gas, fuel oil, and diesel in order to decrease price volatility for these commodities. Each quarter, we value our energy hedge book against market prices and the forward curve at quarterend. As forward prices for natural gas, fuel oil, and diesel declined during the quarter, our marktomarket loss on ineffective hedges was $18 million or $0.04 per share on September 30. Most of our energy hedge contracts expire in the fourth quarter 2008 and first quarter 2009. Currently, we have hedged 72% of our natural gas usage in the fourth quarter. This drops to 46% in the first quarter of 2009 and is lower for future periods.

Our capital expenditures totaled $97 million in the third quarter. Debt remained unchanged at $3.57 billion despite $47 million of debt assumed related to the Calpine acquisition in the third quarter. Adjusting for Calpine, our free cash flow was positive in third quarter 2008. Our offbalance sheet debt was $391 million at the end of the quarter.

We reported liquidity of $178 million on September 30, and increase of $35 million from the second quarter. This improvement reflects higher earnings, various timing factors affecting cash flow, and efforts to conserve cash during challenging economic conditions. We remain in compliance with all financial covenants outlined in our bank agreements.

At the end of September, our actual EBITDA exceeded the minimum requirements by $78 million. Based on current market conditions, we presently expect to remain in compliance through next year. Now I will turn it back to Pat for our business outlook and concluding remarks.

Patrick Moore

In summary, SmurfitStone's third quarter results reflect a benefit of higher selling prices and improved containerboard and box volume despite continued cost inflation. We remain focused on restoring our profit margins as we implement our July price initiatives following unprecedented cost inflation earlier this year. Furthermore, our transformation program remains on track. And we should generate continued benefits through 2009.

Looking to the fourth quarter, we expect higher average selling prices as we complete the majority of the July price initiative. Our earnings should further benefit from moderating commodity costs. We have seen a sharp decrease in OCC prices in recent weeks, and both energy and freight prices are down.

While the U.S. packaging demand reflects the global slowdown, we continue to drive sales excellence. Through our investment in people and processes, we anticipate our box shipment trends will continue to outpace market trends. Finally, we expect seasonally higher energy usage. While there is a lot of economic uncertainty, we currently expect earnings will improve sequentially in the fourth quarter.

Clearly, we face many challenges including turmoil in the financial markets and a slowing U.S. economy and are confident that we are taking the prudent steps to weather a challenging market and actions to drive longterm profitability at SmurfitStone. Thank you for your interest in our company, and I will now turn the call back to John.

John Haudrich

That concludes our prepared remarks. We have set some time aside for questions. Before we get started, let me remind you. Legal considerations require that we refrain from commenting on questions regarding future downtime and our pricing strategy. We are ready to take the first question. Please limit your comments to one initial and one followup question, if needed. Thank you.

QuestionandAnswer Session

Operator

(Operator Instructions) Your first question is from Richard Skidmore Goldman Sachs.

Richard Skidmore Goldman Sachs

Chuck, can you just a little bit more about some of the cash conservation things that you're doing. And over the next quarter or two what big cash items you have, i.e., CapEx and any interest expense payments, hedging contributions, etc.?

Charles Hinrichs

We have been working on this for some time now, so we've been managing our working capital very aggressively; and, as both Pat and Steve alluded to, we're trimming the capital spending to the levels required to complete the projects necessary to enable completion of the transformation plan. As far as future lumpy cash flow payments in the fourth quarter or first quarter and into next year, it's not that much different. It's also difficult to predict those swings in working capital at the end of the quarter. Generally, there's not that much fluctuation.

Patrick Moore

I was talking about for competitive purposes we are not going to outline the details of the plans I think as both Steve and I alluded to. We believe that we are taking very meaningful and prudent actions within the company today to conserve cash. We recognize the environment in which we're operating, but we don't feel that providing significant details on exactly what the plan is would be in our best competitive interest.

Operator

Your next question comes from Sandy Barnes - KBS.

Sandy Barnes - KBS

In terms of the transformation program, you mentioned how you were on target with the costs saved. I imagine the 525 is more of a run rate number at this point in time. I was wondering if you can quantify how much on an actual basis you expect that would benefit your results in 2009?

Patrick Moore

From an additional amount? I don't think I understand your question.

Sandy Barnes - KBS

Is the full 525 based into your results through the end of this year? Or is that more of a run rate basis where on an actual basis you achieve less than that in your income statement and, thus, you will have some of those savings hitting your P&L next year?

Patrick Moore

Most of that is baked into our 2008 results. Outside of the 525 as we talked about, we got a number of continuing process improvement activities going on in the company, which we haven't specifically put dollar amounts on. But the 525 would be reflective for our full year results in 2008.

Sandy Barnes – KBS

Just related to transformation program, as you are ramping up the LA and Chicago box plants, any positives or negatives you are seeing in terms of ramping up those plants? Just also, given the uncertain economic environment out there, does the fact that lowerthanexpected volumes based on the economy hurt your ability, at least in the short term, to achieve some of the benefits and savings in those plants?

Patrick Moore

Let me ask Steve to address that, he's just recently visited both of those plants.

Steven Klinger

Both of the plants started up exceptionally well. Our corrugators are running at the machine speeds that we expected to be at this point. There were two plant closures associated with each of these openings, so the business, from our standpoint, was really to consolidate those two operations business into the one individual plant and then give us the capability to grow from there in terms of full utilization. We're on target with what we had established within our pro forma in terms of machine speeds and costs and our ability to close the four other facilities.

Operator

Your next question comes from Gail Glazerman UBS.

Gail Glazerman UBS

Could you give a little color on what you have been seeing in terms of demands maybe over the last few weeks, maybe starting from the middle of September going into October?

Patrick Moore

It's a bit difficult to be specific given all the uncertainty in the marketplace. The [reesee] outlook has changed several times this year, and you probably saw was recently revised to around a 2% yearoveryear decline for the next several quarters.

We also saw the September FBA box shipments which are reportedly down 11%. Our shipments were down by less than half of what the FBA reported. We do expect, I would say, demand to be down seasonally over the next several months. It's a uncertain environment today. We have certain customers that are experiencing growth and others that are struggling a bit. I would say that the underlying business is probably down somewhere close to the numbers that we saw in our September results as opposed to what we were seeing coming out of any kind of reported numbers.

Steven Klinger

The only thing I would add there is we came out of September 4.5% to 5% in September negative and we see that about the same for October.

Gail Glazerman UBS

Just following up on that, can you touch on the export markets as well and what you're seeing there?

Steven Klinger

Talking about the export market, what I would say is from a total market standpoint, most of the containerboard is going really into South America. We saw Laredo prices increase during the third quarter. The whole Latin American area is really our biggest export market. We're keeping a close eye on that, but really we're seeing similar demand that we have always seen out of there since a lot of it is producerelated and then other products. Really Europe and the Middle East is a bit slower. We're not as exposed to that market as we are to really South America, Latin America, however you want to consider that from Central American standpoint.

Gail Glazerman UBS

One last question. Shifting gears. Can you talk a little about the transition costs that we should expect or expect to go away over the next couple of quarters?

Steven Klinger

The transition costs, we still have some additional plant closures that will be coming up into the first half of 2009. As we wrap all that up, plus our op ex program, our operational excellence program, for manufacturing in our box plants, is really starting to take hold and will be completed in terms of roll out by the end of the year.

I would expect in the second half of 2009 that a lot of those costs will be going away. We've actually started to see a reduction in those costs in the third quarter, and we expect additional reduction in the fourth quarter. As you know, they're mostly related to closing of plant or putting in corrugators and a lot of those things are behind us. But we still have a bit more to do in the first half of 2009.

Operator

Your next question comes from Joe Stivaletti Goldman Sachs.

Joe Stivaletti Goldman Sachs

Addressing your liquidity and that your big focus, I wonder if you could talk a little bit about the options you're looking at in timing for any kind of progress on that. Also, does it involve just trying to work on your revolver or would it encompass your entire bank credit agreement?

Patrick Moore

It was tough to hear you, but I think you were asking about liquidity and then just the plans for the refinancing. We were prepared to launch our comprehensive refinancing in the third quarter, and the turmoil in the financial sector and obviously the closing of the credit market stopped that plan. We still have 12 months to complete our revolving credit facility refinancing. That has a November 2009 maturity on it. We will take a look at the credit markets over that period of time and make decisions as to how we want to approach that from a refinancing standpoint.

In the meantime, as we said, we are conserving cash to weather these uncertain market conditions. We are cutting back dramatically on capital, as Steve alluded to. We're continuing to pursue the transformation program and cost savings associated with that. As Chuck alluded to, we're aggressively managing working capital. We are taking very prudent steps in our mind to alleviate any liquidity concerns over the period of time that we have. I do want to remind everyone that is a November 2009 revolver maturity.

Joe Stivaletti Goldman Sachs

Given though that you talked about wanting to do a comprehensive refinancing, but obviously the markets have changed dramatically. Are you considering something that's far less comprehensive, maybe just for example a brief extension of the revolver or revision of covenants or that kind of thing or are you waiting for a window to possibly do a more comprehensive refinancing?

Patrick Moore

If the window opened, we would certainly look at and continue to assess whether or not to do a full refinancing. In the meantime, we will look at all alternatives that might be available during that period. Certainly our preference would be, if possible, and the credit markets are accessible to look at the opportunity to do something more comprehensive.

Joe Stivaletti Goldman Sachs

Finally, one quick thing. Do you have an 09 CapEx budget? I know you said it would be coming down a fair amount.

Patrick Moore

We have not yet presented our budget numbers to the board, so we are not prepared to publicly give guidance on that today.

Operator

Your next question comes from Bruce Klein Credit Suisse.

Bruce Klein Credit Suisse

Is asset sales, is that something that at this point you would consider or on the table or is that not something?

Patrick Moore

I would tell you that everything is under consideration. We have got a number of opportunities from an asset sale standpoint relative to box plants closures. So far this year we've generated about $8 million from the sale of closed plants. We are aggressively marketing today closed facilities to quickly convert them to cash. I will tell you that we never take those options off the table. With the opening of the new plants in LA and Chicago, we have some opportunities from a standpoint of real estate sales there as well. Asset sales are on the table, and we're continuing to aggressively pursue them in the interim period.

Bruce Klein Credit Suisse

Maybe, Chuck could help us with the secured debt EBITDA test. Can you just tell us what's included in the enumerator and denominator and possibly tell us what the actual numbers were to get to the leverage ratio that would be below three times for the third quarter?

Charles Hinrichs

The numerator would be pretty straightforward, all the senior secured debt which would clearly be the credit agreement debt. We include the AR securitization and then any other smaller pieces of secured debt. The denominator being the last four quarters of EBITDA. Those definitions vary slightly from the externally reported EBITDA. You might not always get it. We continue to report what that excess, what the cushion, the headroom is on those covenants, and we gave that number in our presentation.

Operator

Your next question comes from George Staphos Banc of America Securities.

George Staphos Banc of America Securities

I was wondering perhaps if we can't get to the reduction in spending that you will see in the next quarter or two or reasons that you have already discussed. Maybe out a year, year plus, what aggregate reduction in cash expenditures might we be able to see and, therefore, improvement in base operating cash flow otherwise. So aggregate CapEx, aggregate integration spending if that helps given the forum. What kind of reduction in spending could we see in a year plus out?

Patrick Moore

I guess I would refer back to comment that we made previously and hopefully that will be helpful in the analysis. When we look at what we consider to be maintenance spend and what we consider to be environmental spend etc., I think we've guided in the past that those numbers are somewhere around $250 million a year. Clearly if the situation warrants, we can move towards levels like that. Other than giving that general guidance today, we are continuing to vet this through our organization. We have not presented any budget to the board. Those are the kind of maintenance and capital levels that we've referred to in the past.

George Staphos Banc of America Securities

Could those numbers actually decline just given the fact that you have become a more productive organization? You have taken out some of your highercost facilities. Presumably you've become more environmentally in compliance. Could that be a shift to a lower number on a new normal basis?

Patrick Moore

Let me ask Steve to maybe provide a little color. Hopefully, that will help.

Steven Klinger

I think what we've got into before was the $250 million plus or minus $25 million when you review the asset base that we're going to have on a goforward basis. Now the mix of where we will be investing will change, which I think is at the base of your question.

Our container business at the end of this transformation will be in a much different condition. Remember, in past periods, I think we underspent on our container business; and we're going to have to spend some money in our mill business and our reclamation business. When our team evaluated all of our businesses and really looked at it from a specific asset standpoint with the rationalized assets from all the closures that we were expecting to be able to do, both on the box and the mill side, and then the growth prospects and our reclamation business, I think that is where the $250 million plus or minus $25 million came from.

It was not a fromto, it was more a build up from the base of what assets we were going to have.

George Staphos Banc of America Securities

Free cash flow, you would expect to be positive in the fourth quarter presumably given the third quarter performance in the other items you mentioned from an operating standpoint in 4Q?

Steven Klinger

We have given guidance to improved results. But, as I mentioned, the changes in working capital are difficult to predict. That will probably be the driver as to whether we end up with our debt down. From an operating basis, our free cash flow should be positive.

Operator

Your next question comes from Claudia Hueston JP Morgan.

Claudia Hueston JP Morgan

I was hoping you could provide just a little bit more color on fiber costs. Maybe share your thoughts on where OCC might go from here. And then you didn't comment too much on wood costs, which have been a hot topic from some other companies. Maybe just some color on what you're seeing in terms of your wood fiber costs.

Patrick Moore

As we said in the prepared remarks, wood fiber costs have been up this year. Couple of reasons, really driving that. As we alluded to in the prepared comments, certainly the hurricane activities during the course of the third quarter had a very significant impact on wood costs. Really, more importantly, the transportation of wood out of the forests and to the mills. We would expect that wood costs will continue to remain under pressure. It's also contributed by the housing slumps.

You are just not seeing much in the way of activities coming out of chip facilities and other form of residual products. I think we're going to continue to see wood costs under pressure nearterm. From an OCC standpoint, as I said in my prepared remarks, we're seeing fairly dramatic decreases in OCC during the fourth quarter. Our expectations nearterm would be to see those continue certainly into the fourth quarter, and probably into the first as well. Any color on that, Steve?

Steven Klinger

The only thing I would add would be on OCC is, in particular, Chinese producers have significantly reduced their operating rates, postponed new mill capacity; as a result, we're seeing not as good pricing into the export markets which then is backing up into the domestic market.

I would hate to speculate on exactly how low that could go, certainly the generation has been pretty consistent. It hasn't been up like we would expect at this time of year. But it's been consistent enough where there's a lot of OCC and DLK available. We're reacting to that in terms of increasing the amount of OCC just a couple points is the flexibility we have. But we're maximizing that in our mill system as well as focused on that.

Claudia Hueston JP Morgan

Do you have any maintenance scheduled for the fourth quarter?

Steven Klinger

Our maintenance will be slightly higher than what it was in terms of the amount of days and the tonnage that we take out. Just marginally higher.

Operator

Your next question comes from Mark Connelly Credit Suisse.

Mark Connelly Credit Suisse

Couple of big picture questions. When we look back to your restructuring program, the decision was to focus most of the attention of the box plants, more of the attention. As energy prices went up, that third looked like it might not have been such a good idea. Now they're coming back down, it looks better. I am curious how you feel about box plant, your mill positioning costwise.

Secondly, as we think about your focus on the box plants, one of the things you said, Pat, at the beginning of this process was that there was business you simply weren't able to feed on because you were priced out of it. How differently do you see your position now with this program coming to fruition?

Patrick Moore

Let me try the second half of that and then I will ask Steve to comment on the mills and our cost position there. We certainly have not neglected the mills during this process, but realize that it was more significant to invest in our corrugated plants.

Part of the commitment that we made back in 2005 was certainly to find ways to grow the business as well. You will recall when we announced the transformation plan we did have some level of savings associated with growing the business, which we had really not done a very good job of over the last number of years. As we got into the restructuring, it was probably the need to be more aggressive than we had originally thought relative to our ability to compete and our ability to profitably run business in the number of our plants. That number was larger than we thought, and what you've seen over the first couple of years of the transformation is our exiting from business that we just never thought we could make any money at and the closure of those unprofitable plants.

We committed to 30 originally and our number will be closer to 40. Again, we have even a more significant transformation than what we had originally thought. Certainly we feel our ability to compete and to complete profitably for business today is much greater than it was when we started this process. We have invested in significant talent improvement in the company and process improvement in the company and resources around some of our specialty businesses. Our ability to compete in the market today is just far greater than it was at that point in time and we can do so profitably. That's how we're approaching the business today. It took us longer to get there than I would have expected in 2005, but we frankly had a more serious restructuring than even I had anticipated during that time period. I will ask Steve to maybe comment on our mills.

Steven Klinger

When we started the process in 2005 and you look at the industry data, our liner and white top were third quartile and in the upper of the third quartile in terms of average cost. Our medium was just slightly above average. Today, we have got a second quartile medium organization in terms of total cost and our liner and white top are now at average cost.

That step change really came in two ways. One is we talked about this many times that we invested in high return projects which have been labor reductions, energy, and different cost in fiber, cost reduction activities. I think that money has been well spent by the leadership in our mill system.

Then we also, remember we closed six mills and as we closed those mills for instance, two of the facilities, we closed the two medium facilities and then opened up the machine in Seminole, that's in Florida for those who don't know what Seminole is, we've really focused our efforts through the LP model and understanding our cost structure and investing from prudent investments that would lower our costs but also from a scale standpoint put us in a better position.

What we have said all along is we have taken out basically four mills and we're producing, from a containerboard standpoint, we've invested in taking out four mills and we're producing the same amount volume that we produced in the beginning.

Mark Connelly Credit Suisse

I think people forget how much you've done on the mill side sometimes. Can you just tell us, Steve, when all this is said and done, what your integration level between box plants and mills will be?

Steven Klinger

When it's all said and done, I mean right now it's 75% something like that. It will be plus or minus that figure. Obviously, we can produce all the products that our box system uses. As we increase our position through segmentation through all the ways that we're growing our business, obviously we will be able to produce more products into that channel.

Operator

Your next question comes from Mark Wilde Deutsche Bank.

Mark Wilde Deutsche Bank

It sounds like you've been picking up some big box contracts recently. Should we expect that your volumes, relative to the industry volumes, that delta should get a little bigger over the next few quarters?

Steven Klinger

I was really excited to read your note this morning because, to be honest with you, because there was business in there that I didn't know I had won yet. So I was excited.

What I would say is that overall what we've done is over the past couple of years, as we've invested in operational excellence, as we have started to focus on certain segments of the business, we started to provide some real value to our customers in terms of differentiation against our competitors.

From my standpoint, I have always believed that companies that have a successful manufacturing strategy, have a successful understanding of what customer needs are, and then can work towards that can grow their business and be price disciplined at the same time. That's a key component of our strategy.

We put in over the past several years some fairly heavy analytical capability to fully understand the profitability at the box plant level of business that we are pursuing and accepting. Over the past four quarters or five quarters in particular, we have exited a lot of business because, as Pat said, that business could not be profitable for us in any way shape or form. We exited that business and we talked about that and been very public about that.

As we have resurrected our container business, put in all the disciplines that we need to fully understand the business, I think it is a vote of confidence from our customers that that is why we're growing our business.

Whenever you talk to anybody about why they lost a piece of business, they never say I lost a piece of business because it was off quality or delivery or my capabilities versus my competitors, they always say that guy took it on price. That's not always the case has been my experience. I would say we're providing a different level of value to customers, and what I would expect is that we modestly continue to do better than some of our competitors.

Mark Wilde Deutsche Bank

I would like to switch for a second and ask a couple questions related to China. First of all, I think you sell some board or OCC over there. At one point I think you had a couple of box joint ventures. Is what you're seeing in China over the last two or three months, is it consistent with a 9% GDP growth rate?

Patrick Moore

I would say that we would probably view the growth rates in China below that today. It's hard to speculate on how those numbers get reported. Certainly from what's going on with some of the major producers over there, some of their recent announcements. Certainly activity that we see in other commodities over there would suggest that we may be seeing levels below that. Again, it's hard to contradict what's reported there. I would say levels of activity there would suggest that it may be below high singledigit growth rates right now.

Mark Wilde Deutsche Bank

One other question. Don't seem to have been real active in containerboard exports from I can tell over the last couple of quarters and I just wonder with OCC costs dropping so much and then ocean freight rates dropping, why wouldn't we expect to see the Chinese mills with these low operating rates cranking up their exports over the next couple of quarters?

Patrick Moore

All the analytics that we have run continue to suggest that some board from time to time show up on the West Coast, but that's more dipping their toe into the water than anything else. We have not seen any significant change in our position on that.

Mark Wilde Deutsche Bank

I was not thinking in terms of North America, but maybe just going to other markets more aggressively.

Patrick Moore

Today we have not seen that.

Operator

Your next question comes from Barry Haynes – Sage Asset Management.

Barry Haynes – Sage Asset Management

I just had a question on the natural gas issues you talked about the amount that you had hedged in the Q4 and Q1. Could you talk about the prices you got those hedges on?

Charles Hinrichs

The prices hedged for the fourth quarter are at a price that is above the market and in the first quarter they align much more closely to market price. Again, given the marktomarket charge we took in the fourth quarter, we have essentially neutralized the ineffective part of those hedges to the current market price at the end of the quarter.

Operator

Your next question comes from Chip Dillon Independent Research.

Chip Dillon Independent Research

Question regarding the situation with the EBITDA. You said, Chuck, that you were about $78 million above the minimum of the covenants. Is that a last 12 months number, that wasn't just for the quarter, is that correct?

Charles Hinrichs

It's a rolling four quarter. When we calculated it at the end of the third quarter, the third quarter 2007 number of $217 million drops off and then the third quarter 2008 rolls on at $129 million.

Chip Dillon Independent Research

So you think the fourth quarter sort of gives you some tailwind when that gets calculated in three months. What about if we look at the CapEx number, you mentioned $250 million as the number for next year. Is that something that could, I know this was asked before, but have you noticed your suppliers possibly cutting their prices? Is their business drying up to a point where you might be able to squeeze more and maybe you would readjust downward what you see maintenance to be?

Charles Hinrichs

The number we had was not for the full year 2009, that was kind of this steady stay or run rate following the completion of our programs, particularly in the first half. I am not sure that we've seen that much real change in the positioning of our suppliers. Clearly we're using the leverage we have buying the equipment with them to get the very best terms. I am not sure there's been any recent change.

Chip Dillon Independent Research

Last question. In the past several years, Chuck, especially you've encouraged us to build in, I am going to probably not exactly give the rate, but $0.07, $0.08 a share of incremental expense, certainly not all cash as we go from fourth to first because of the way you flow the employee benefit programs through. Also you have a little bit of an energy usage increase.

Is there any reason in a should change this year as we look at the first quarter?

Charles Hinrichs

I think that's probably still a reasonable amount to use.

Chip Dillon Independent Research

Lastly, the Pontiac mill which you are shutting down. Could you tell us was that either cash flow or earnings created in the first half of 08? And what is the cash impact of shutting down both Pontiac and Snowflake? How much cash are you going to take?

Patrick Moore

Pontiac was marginally profitable during the first half of the year. Given current pulp prices, it would have had a negative impact on cash flow from the balance of this year and into 2009. That's what really drove that decision. It's a hardwood pulp mill, and we have no other exposure other than Pontiac and we thought that was the prudent thing to do. As we said, that closure will be cash flow positive in the fourth quarter.

Chip Dillon Independent Research

And what's the cash cost of those two shut downs?

Steven Klinger

The cash cost for Pontiac would be in total about $19 million to be paid out over the next four to five quarters. In the fourth quarter, it will benefit cash flow, particularly as we liquidate working capital out of the mill.

Operator

Your last question comes from Mark Weintraub Buckingham Research.

Mark Weintraub Buckingham Research

First I wanted to clarify on the box pricing, if I understand correctly, you expect to get more than the full $55 passed through? If I believe by my math that would suggest that you have at least another $50 per ton to achieve. Is it fair to say that by the first quarter if you're selling roughly 1, 1.2 million tons, that should be $50 or $60 million of improved cash from the box price increase being passed through. Is that a fair analysis?

Steven Klinger

We project our improvement in average box prices will exceed the $55 per ton. That's consistent with what we said going into the July price initiative. What you see from a percentage basis on the statistics includes the Canadian exchange rate change, which had a significant impact on what we reported the overall box prices over this past quarter and it also includes mix adjustment. As we said during the quarter, we had $33 of increase from a pointtopoint standpoint. I don't think you can do the math the way you're doing it. From our standpoint, we will be getting by the first quarter, we will have realized, we got some national account business that moves January 1 that will impact January and then we will be above the $55.

Mark Weintraub Buckingham Research

Even though the exchange rate and the mix adjustments, etc., money the equation, is it fair for you to give us, if it were, and I realize you're saying it's not necessarily $55, it can be more than $55. But if it were just $55, how much higher would your average box prices be in the first quarter than in the third quarter?

Patrick Moore

I don't know that we have that number. Can we do that offline?

Mark Weintraub Buckingham Research

I guess to followup and relatedly, how concerned are you that in your push on the sales excellence program that in a negative demand environment, highly negative demand environment, that competitors might respond by price cutting. How do you think through that issue?

Steven Klinger

Obviously I can't control and our sales organization can't control how our competitors respond. What we have been doing as I said earlier is that from a segmentation standpoint in specific segments, we've been building capabilities that we believe exceed some of the capabilities of some of our competitors in certain markets and in certain areas.

Obviously we have also put in a manufacturing program that gives us a better chance to deliver product on time, at the specified quality, and exceed that quality. As we said, we're not pursuing a volumebased strategy. We clearly understand that price realization is our top priority. A successful sales organization can improve both price and modestly exceed industry sales trends.

We have implemented five price increases over the past three years. I think in total the amount of new method that you're seeing is in a modest amount. This is customers who want us to serve them in a specific segment that we have targeted and, I want to add one more thing, for our organization, we exited business that we saw was unprofitable in our current structure or future structure. And we've done that in a pretty disciplined way over the last couple of years.

Patrick Moore

I think that last point is very important. As Steve said, it's not a volume strategy. If you go back and you look at our shipments over the last three years, our shipment level today is significantly below levels that we were running at three years ago. Now we do expect through all of the processes that Steve alluded to that we will rebuild into our facilities. We are not pursuing a volume strategy in the market today.

John Haudrich

That concludes SmurfitStone's third quarter earnings call. Thank you for your interest in SmurfitStone and have a good day.

Operator

Thank you, you may now disconnect.

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Source: SmurfitStone Container Corporation Q3 2008 Earnings Call Transcript
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