Graphic Packaging Holding Company Q3 2008 Earnings Call Transcript

| About: Graphic Packaging (GPK)

Graphic Packaging Holding Company (NYSE:GPK)

Q3 2008 Earnings Call

November 05, 2008 10:00 am ET

Executives

Scott Wenhold – VP and Treasurer

David Scheible – President and Chief Executive Officer

Dan Blount – Senior Vice President and Chief Financial Officer

Analysts

Joe Stivaletti - Goldman Sachs

Bruce Klein - Credit Suisse

[Sandy Burn] - KBC Financial

Bill Hoffman – UBS

[Beau Hunt] – Bank of America

Operator

Good morning. My name is Rachel and I will be your conference operator today. At this time, I would like to welcome everyone to the Graphic Packaging Corporation third quarter 2008 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. (Operator instructions) As a reminder ladies and gentlemen, this conference is being recorded today Wednesday, November 5, 2008. Thank you.

I would now like to introduce Scott Wenhold, Mr. Wenhold, you may begin your conference.

Scott Wenhold

Thank you, Rachel. Good morning everyone and welcome to Graphic Packaging Holding Company’s third quarter earnings call. With me this morning are David Scheible, the company’s President and CEO and Dan Blount, the Senior Vice President and CFO.

Before we get going I would like to remind everyone that statements of our expectations in this call constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Such statements including but not limited to statements relating to decline in commodity prices availability of the Company’s net operating loss and statements regarding our performance and our ability to recognize $90 million of annualized synergies by 2010 are based on currently available information and are subject to various risks and uncertainties that could cause actual results to differ materially from the Company's present expectations. These risks and uncertainties include, but are not limited to, the Company’s substantial amount of debt, inflation of and volatility in raw material and energy costs, volatility in the credit and securities markets, cut-backs and consumer spending that could affect demand the Company’s products, continuing pressure for lower cost products, the Company’s ability to implement its business strategies including productivity initiatives and cost reduction plans, currency movements and other risks of conducting business internationally, and the impact of regulatory and litigation matters including those that impact the Company’s ability to protect and use its intellectual property. Undue reliance should not be placed on such forward-looking statements as such statements speak only as of the date on which they are made and the Company undertakes no obligation to update such statements. Additional information regarding these and other risks is contained in the Company's periodic filings with the SEC.

With that, I will turn this mornings’ call over to David.

David Scheible

Thanks, Scott. Good morning everyone. Thank you for joining us today. Arguably, we are operating one of the more challenging economic environments in history. It seems that on a daily basis there is growing investor uncertainty as well as elevated market volatility with a growing global economy inside the credit market. However we believe we are taking the necessary steps to navigate this environment successfully and position Graphic Packaging for long term growth. This morning I am going to start by providing you with a brief overview of our quarterly results. And I am going to walk you through some of the recent steps that we have taken to ensure that we stay ahead of our cost inflation while continuing to explore growth opportunities. Next I will discuss the synergies we realized from the combination with Altivity continuous to prove the cost reduction we made during the quarter. Lastly, I will conclude with review of our key segments and their performance in relation to general industry trends. Following my comments Dan Blount, our CFO, will walk you through our financial results for the quarter in greater detail. Once we have concluded our remarks, we will open up the call and look forward to answering your any questions you may have.

Last night we reported a net loss of $0.04 per share. This compares to a net loss of $0.07 per share in the prior year quarter. The recent pull back in raw material prices did not occur in time to benefit third quarter result as we experienced significantly higher costs for energy, chemicals, fiber and freight. Higher pricing, continuous improvement, cost reductions and synergy achievement combined to offset some of the higher costs. I expect a decline in commodity prices to begin to benefit us in the fourth quarter.

Despite the slowing global economy our pro forma sales increased more than 3.3% as volumes remain strong. We shipped approximately 30,000 more tons of paperboard packaging and multi-wall bags this quarter when comparing to the prior year pro forma period. When coupled with higher pricing in all of our segments the top line grew at a solid pace.

As I have mentioned Dan will discuss the results in more detail shortly. Similar to our practice during the second quarter, we will include comparison to the 2007 third quarter result restated on a pro forma basis, assuming the acquisition of Altivity had occurred on January 1, 2007. This will give you a more apples-to-apples comparison between the periods. Although the nearly fifty percent pull back in crude oil prices from a $130.00 level to $70.00 and a similar decline in natural gas prices to below $7.00 per MMBtu is certainly welcome, cost for key raw materials such as energy, chemicals, fiber, and freight still negatively impacted our result by nearly $67 million during the third quarter.

Some of these input cost like caustic soda, latex and fiber will continue to drive inflation as global supply in demand dynamics have yet to sort out in these commodities. As I said in last quarter’s call we are not relying on this broader commodity pull back to drive positive results. Instead we are taking proactive steps to manage our costs, improve our prices and provide innovative paperboard packaging globally to our customers

On July 9, we announced price increases and included a $40.00 per ton increase on our coated unbleached kraft paper as well as a $50.00 per ton increase for all our coated and uncoated recycled boards. All of these increases took effect on all shipments made during the third quarter. In addition to those increases on October 14, we announced a subsequent $40.00 per ton increase on all shipments of Pearl-Kote and Omni-Kote CUK, a $50.00 per ton for Aqua-Kote carrier board that will take effect in November 2008.

In addition to open market price increases, a number of our carton contracts will reset on January 1 and throughout 2009. These price increases will be based upon the inflationary impact we are experiencing in 2008. Last quarter I stated that we expected to have the ability to use price to offset more than 70% of our 2008 and 2009 projected input inflation by the end of 2009 and I still believe in that number.

Our integration team has been hard at work and after only two quarters it is a fully integrated company. Through September 30, we have achieved over $25 million annualized synergies through our announced goals of $90 million in synergies in 2010. Two areas of early focus by the integration team have the optimization of board sourcing and freight and transportation rationalization. For instance on the sourcing side, stand alone Altivity previously purchased roughly 50,000 tons per year of CUK boards and 43,000 tons of CRB boards from several competitors. After two quarters we have significantly reduced that outside supply by substituting with graphic produced boards and expect to continue to balance our production into 2009.

On the freight side, we are now ruling out the legacy graphic transportation management system at the Altivity locations, and we are actively consolidating our freight carriers. Today we have reduced total freight carriers by over 50% and eliminated nine warehouses and will continue to refine this even further going forward. A number of the actions we took during the quarter were also related to the ongoing realignment in consolidation of our operations.

On August 12 we announced plans to close several high cost folding carton facilities and transition business to our US operating locations as part of our strategy to streamline our cost structure. The company’s carton facilities in Greensburg, North Carolina, and Richmond, Virginia are expected to discontinue production towards the end of 2008 and the folding carton plant in Smyrna, Tennessee is expected to close during the first quarter of 2009.

Additionally we took steps to reorganize sales and operations in our specialty inks and encoding businesses to further drive the completion of reintegration goals by 2010. We closed our Handschy ink and coatings manufacturing operation in Indianapolis, Indiana at the end of August. And in October 1, we announced plans to streamline our label business United States by closing our label manufacturing facility in St. Charles, Illinois in early 2009.

As we indicated in our last earnings call, we announced the divesture of two CRB mills, one in Philadelphia, Pennsylvania and the other in Wabash, Indiana to an affiliate of Sun Capital Partners. That transaction received the approval of the US Department of Justice and officially closed on September 17. With the sale of these two mills, Graphic Packaging will manufacture approximately 850,000 tons of CRB in four mills and we estimate our average CRB cash cost per ton across our mill system is now the lowest in North America.

We are working very aggressively to successfully integrate assets, streamline our operating footprint and reduce our working capital requirements which will hopefully make us a more profitable company as we are able to reduce debt and sustain our competitive position. Although we are continuing to announce multiple plant closures as part of our ongoing optimization of manufacturing, this by no means should be interpreted as an ongoing contraction of our global footprint.

To the contrary this third quarter we announced the joint venture through our Japanese subsidiary, the Hung Hing Printing Group Ltd. to invest in the integrated paperboard packaging business in China. The market in China expected to grow substantially and our long term strategy includes participating as a leading supplier to existing customers and further developing a strong customer base in China. By establishing a joint venture with Hung Hing a well respected and successful company in China, we will have the ability to leverage their strong local presence and build a foundation together upon which to implement our mutual strategies.

Our challenge in what continues to be a difficult operating environment remains the realignment and optimization of our increased scope of operation in making our packaging business the lowest cost in the industry. We rely on our Six Sigma and Lean Sigma processes to continually drive down our cost. We had another successful quarter in managing down our cost across the entire enterprise.

Legacy Graphic Operations reduced operating cost by another $13.5 million bringing the year to date total to over $39 million, well on our track to achieve our target at $50 million by the end of the year. The Legacy Altivity operations are also delivering cost reductions mainly through the use of lean manufacturing principles which resulted in approximately $13 million of cost reduction on a year to date basis. Combined cost reduction year to date is $52 million and synergies add roughly $10 million more. So clearly we are making solid progress in this key measurable. In summary we are well situated to build on the success of our various cost reduction programs as we head into difficult economic environment for 2009.

We also announced a significant new expansion on our Kalamazoo Michigan mill and carton complex. We planned to spend approximately $27 million over the next few years to reduce the cost of manufacturing folding cartons in that facility. When completed we will consume over 240,000 tons of boards produced directly across the street in our CRB mill for products like cereal and other dry foods manufactured in that carton plant. Investments like these continue to reinforce GPK as the lowest cost producer in the industry and will significantly reduce the working capital necessary to run our business.

We are advancing our position and sustainability of our products as well. On August 29 we announced that we had achieved fiber sourcing certification from Sustainable Forestry Initiative by achieving SFI certification; Graphic Packaging joins a growing community of companies, landowners and socially environmental organizations who are committed to improving forest practices on a global scale. Achieving this certification is an important part of our continuous improvement initiatives and commitment to sustainability. We have strengthened our efforts to manage our business according to responsible environmental policy and we are well positioned to meet the increasing market demand for responsibly sourced raw materials and environmentally friendly products. Our customers can support their only environmental commitment by the products they purchase with confidence from Graphic Packaging.

Along these same lines, we are also proud to announce that Graphic Packaging has become a partner in the US Environmental Protection Agency Energy Star Program. We are pleased to be part of this partnership as every step towards a more efficient of use of energy adds improvement to our business.

Let us talk a little bit about segments. Graphic Packaging is focused on the food and beverage end use market segment with over 80% of our sales in this sector. Taking a moment to look at industry trends consumers, the customers of our customers saw a continuing rise in food prices during the third quarter. US Department of Labor reported 2008 year to date inflation averaged 6.2 % in the food and home category compared to 3.9% for the same period in 2007. Aggregate unit growth in major package food categories that we tracked using [Inaudible] data was approximately 1% higher in the third quarter of 2008 compared to the prior year period. However this growth rate has slowed dramatically as unit growth from these categories grew over 4% in third quarter 2007 compared to the prior year quarter. Unit volume for cereal and dry food grew 1.5% and 5.5% respectively while frozen pizza and prepared food unit volumes declined 6.7% and 1.7% in the quarter respectively.

The unit volume of all non food product categories that we tracked declined compared to the same period last year. The data suggests that consumers are reacting to economic conditions by changing both composition and quantity of their purchases. Consumers are a bit of a moving target right now as inflation continues to take root and is now further exacerbated by uncertainty in the job market driving a series of behaviors depending upon demographics from eating out less and cooking at more to moving some commodity purchases from branded to private label.

While overall higher food prices are dampening consumptions across the board, we actively and continuously track these and other consumer trends in our business to make sure we can quickly adjust our manufacturing and sales efforts accordingly. Our converted volume follows a very similar trend. We converted 1.4% more tons of paperboard in the third quarter, than in the same period last year and essentially the same tons year to date as 2007. However, we converted 5.1% more paperboard for food market in the third quarter than last year and 2% more this year than last year, year to date.

Most of this gain is in major food product customers such as General Mills, Kellogg’s, Kraft, Heinz, Sara Lee and Molson. The growth of these customers has been in cereal, dry food, frozen pizza and frozen fruit segments where the volume in paperboard converted was more, than the comparable periods in 2007. Our consumer packaging business has a number of new product commercialization both in North America and internationally during the third quarter. Within North America we worked at nationally decreed innovative product utilizing our microwave’s sleeve technology for the lean pocket calzone. Internationally we commercialized two new products in Spain including the innovative microwave cone shaped frozen pizza and sleeve for fish stick with CONGALSA. The CONGALSA project is our first successful microwave expansion into the fish category within Europe.

We also demonstrated continued success with our Z-flute program with two additional new items; one is American cereal with the 10 pound oatmeal package and the other Craft Canada Starbucks with a three pack coffee package. Products like Z-flute are focused squarely on the club store channel. Current trends suggest that if the economy worsens, this will be an incredibly important channel. These new products demonstrate that we are focused not only on products in traditional grocery channels but also maintain our position as consumer spending habits change. Finally, we have a number of new product launches and are awaiting a retail platform including a new customer for innovative heat transfer label in the first launch of our Snap 2C mobile data interactive packaging with Springer Mountain Farms.

On the beverage side of business, industry data indicates US take home volume in beer were up about 1.8% during the quarter, a positive change from last quarter when volumes were flat to slightly negative. Domestic brands continue to gain share from imports as a result of consumers moving to lower priced points in this sector. Total softdrink take home volume continues its downward trend. It was down almost 3.5% during the third quarter, with the expectation that it will continue to trend downward by mid single digit level during the fourth quarter. Although behind from our total beverage group, group was flat year on year on over all basis, our revenue was up 3% due in large part to our increased pricing initiatives, non-carbonated softdrinks products in a strong international market. Our growth strategy in beverage is to align ourselves with the major global customers and focus our efforts in key growth areas. During the third quarter of 2008 we continue to position ourselves as the preferred supplier for InBev worldwide. During the period we completed a 100% market supply for InBev in the UK for Stella Artois Boddingtons's and Beck brands. We also supply InBev Germany export markets in the US for Beck's six pack baskets. Finally we positioned ourselves in China with InBev [1709] with a marksman wrap machine placement.

However, our success was not limited to international opportunities. In the US we continue to extend our market share of the energy drink category which showed a growth of 3% year over year with major commercial rollout of [Monster and Ant] four packs as well as many new titles such as [1726], Steve's and brand extensions of our existing customers using a network of co-packers equipped with our Quickflex 2100 energy packaging machine. Additionally in an effort to better compete against plastic multi packs, we are in the process of marking testing new packaging systems for PET bottles in the Southeast. With a reduced paperboard quick print and high visibility in the shelf this multi-pack solution called [Cap It] is a great opportunity for growth and segments for paperboard was not previously a preferred source.

We experienced solid new consumer packaging product sales estimated $12 million for the quarter. These results were lead by our strength new pack new age beverage in microwave platform. Year to date our new product innovation sales is slightly more than $50 million.

Turning to our Multi-Wall Bags segment, we continue to take aggressive price actions to combat rising inflationary cost primarily driven by resin in this sector. The structure of our Multi Wall Bag contract allows to quickly pass through a high proportion of our inflationary cost, and as a result we have been able to offset approximately 85% of our year to date inflation in this segment.

Unfortunately with the global economic downtrend we are beginning to see Multi Wall Bag backlog consumers have elected to use up existing inventory and employ a wait and see approach to the economy. As a result, this could negatively impact our Multi Wall Bag backlog going forward. In light of the current economic environment, I am not sure that we can accurately predict all the forward demand, but our sales and backlogs for food and beverage base products continue to be strong. We believe our focus in this sectors is clearly the correct one.

Let me conclude by saying that despite what is clearly a very challenging market, our focus on the food and beverage industry has provided some insulation from the economic swings thus far. However, we remain diligent with our cost savings initiatives and are focused on installing a culture of continuous improvement throughout the organization to allow us to recognize ongoing growth and cost saving opportunities. We will continue with our price recovery to minimize the impact of input inflation and we will invest in new product activities to extend our margins. In a constricted credit market like the one we are seeing today, we will remain devoted to protecting our cash position and utilizing that cash only in areas we believe we will draw consistent long term growth or improve our near term cost structure.

Given the initiative we have in placed in the areas we have executed so far, we believe that we are well positioned to navigate through this environment beyond. Dan?

Dan Blount

Thanks, David. Good morning everyone. As David discussed in the third quarter Graphic Packaging made solid progress, as we grew revenues and delivered on integration synergies and cost reduction initiatives. These gains however, were more than offset by the challenging economic environment most significantly higher input cost inflation. In today’s national review first we will cover operational results in more detail and then we will turn to cash flow and liquidity. Before getting into the financials, a reminder, that in order to provide more of an apples-to-apples comparison, I will use adjusted pro forma financial results in my discussion. These results are the appropriate comparative ones to use as results here as if the merger was completed as of January 1, 2007; and include add backs for non recurring merger and integration charges.

In third quarter of 2008 add backs totaled $7.4 million and relate to one time charges which include severance related to synergy delivery. As an aid in understanding adjusted and pro forma reporting, reconciliation tables are provided as attachments to last night’s earnings release. To simplify today’s discussion, unless I specify otherwise, when I refer to net sales in EBITDA, I will be referring to the pro forma adjusted numbers.

Turning to third quarter results, first, we will discuss the drivers of the increase to net sales, then, we will bridge the change in EBITDA from the prior year period. Third quarter net sales is $1.166 billion or 3.3% higher than net sales from third quarter of 2007. Adjusting for the sale of the two CRB mills, real sales growth is approximately four percent. The $37 million sales improvement is primarily driven by higher pricing and improved volume mix. During the third quarter we realized total price improvement as $25.7 million as pricing improved in all business segments. Approximately $19 million of the increase is from higher pricing from negotiated and contractual inflationary cost past through. The remaining price contribution is the result of price increases and open market paperboard sales.

We expect pricing to continue to improve as contracts contained in inflationary price escalation clauses continue to reset. Year-to-date we have increase pricing roughly $80 million over the last year. Most of our contracts will escalate further in 2009. Volume growth and product mix improvements improve third quarter sales by $10 million. Benefited by product innovation and stable markets our food and beverage product lines deliver solid growth. We did experience weakness in our non-food packaging businesses which partially offset the gains. Our data suggests as we anticipated that consumers are reacting to the economic conditions by preparing more meals at home and cutting back non essential purchases. Staples like ready-to-eat cereals, cake mixes, breakfasts and dinners demonstrated strong sales. Soft drink sales were down 2% but beer sales were up reflecting more take-home consumption. Rounding out the change in third quarter sales is the reduction cost by the sale of the two CRB mills offset by the effect of foreign currency exchange gains. On a year-to-date basis net sales has improved 3.3% as well to a total of $3.423 billion primarily as a result of price increases and revenue growth from volume and mixed improvements.

Now let us move on to EBITDA. The key issue for Q 3 as you heard was input cost inflation of $67 million. That more than offset the $40 million of improvement resulting from revenue growth and cost reduction. Overall third quarter EBITDA of a $131 million at 11.3% of sales is $27.5 million lower than the year ago quarter. Let us look at the details. Revenue growth which includes price and volume mix resulted in $30 million in EBITDA improvement. $26 million of the $30 million is from increased pricing. Cost reduction initiatives which include integration synergies and continuous improvement delivered $23 million of improvement during the quarter. $6 million of the $23 million is from integration synergies. Our post merger integration program is ahead of schedule and is currently at a forward annual benefit rate of $25 million. You will see significant synergy benefits coming through the 2009 results. And we are on track to achieve $90 million of benefits by early 2010.

Partly offsetting the cost improvement were the effects of the gulf storms particularly Hurricane Gustav. The storms caused power disruptions, supply disruptions and production issues that rose approximately $4 million of additional costs principally in our West Monroe Hill complex.

As I have said before, the key issue in the quarter is $67 million of inflation. Input cost inflation rose by approximately 8% compared to a year ago as cost for energy, fiber freight and coating chemicals increased dramatically. Looking at input cost today we see that costs for many inputs such as fuel, resin and recycled fiber have receded and may be less of an issue in later quarters. However, costs for other inputs such as caustic soda and wood chips remain high. While on the fourth quarter, we are expecting inflation impact to be somewhat less, it will still be a significant issue. To conclude the EBITDA change discussion, let me summarize. For the quarter, EBITDA improved by $30 million due to revenue growth and $23 million due to cost reduction. The gulf storms cost $4 million of additional cost and inflation was the key issue with a total impact of $67 million. The remaining EBITDA change is due to foreign currency exchange and the idling of our West Monroe paperboard machine number two.

On a year-to-date basis EBITDA had approximately $399 million; it is $9 million higher than the prior year. Benefits from revenue growth and cost reduction have more than offset $160 million of inflation. For the fourth quarter, we expect EBITDA to be in line with the prior year. I will end my discussion with comments about cash flow and the liquidity.

As you know, we tracked cash flow from the Altivity transaction date forward. Through the end of Q3 in line with our expectations $40 million dollars of cash before debt reduction was generated. To date we have completed our pension contribution payment that totaled $56 million and finished the interest payment on our public debt. We expect cash flow generation to accelerate in the fourth quarter and total debt reduction since the merger to be in the range of $110 to $130 million.

In terms of other cash projection guidance CapEx is expected to be in the $180 to $200 million range for the year. Year-to date we have spent $126 million on CapEx. Cash interest is expected to total $210 to $220 million year-to-date. Cash interest expense is $152 million. Now with the condition of the financial market, liquidity is of keen interest. As you know from past earnings calls, pro-active liquidity management is a top priority for us.

At September 30th we had strong liquidity availability of $320 million and we were comfortably in compliance with our secured leverage covenant. We reported a secured debt leverage ratio of 3.58 to 1 which is well within our required 5.25 times. In addition to normal liquidity management, we have taken additional pro-active steps to further strengthen our liquidity position. We made additional draws from our revolving credit facility and are now maintaining cash balances in excess of $160 million. None of our lenders had difficulty funding the draws, but we will maintain cash balances sufficient to fund foreseeable liquidity needs until the credit market uncertainty subsides.

We tighten the return criteria on our capital spending. We are focused mainly on the shorter duration quick payback projects. Since merger integration projects have attracted quick paybacks, they remain at top priority.

We are aggressively managing working capital and carefully controlling SG&A spending. Inventory reduction is a primary objective. In this regard, we have reconsidered restarting our idled West Monroe paper machine number two in January 2009. In the fourth quarter 2008, we will permanently shut down this machine. This will allow us significantly reduce inventory levels in 2009 and to better balance our paperboard supply-demand economics.

The machine’s annual production capacity is 100,000 tons and in 2008 we have produced both coated board and liner board on this asset. Paper machine number two is our highest cost CUK machine and shutting it down will allow us to reduce overhead spending and capital spending. Overall we have always operated with a strong liquidity position and these actions will result in further strengthening.

In conclusion, given the difficult economic environment, Graphic delivered a solid third quarter. We continue to realize increased pricing and to deliver substantial cost reduction. We made strong progress toward our integration goals and we are well on our way to the $90 million target by2010. And finally we took several pro-active steps to strengthen our liquidity position in these uncertain financial markets.

And with that operator, we will open the line for the question-and-answer session.

Question-and-Answer Session

Operator

(Operator instructions) your first question comes from the line of Joe Stivaletti – Goldman Sachs]. Your line is open.

Joe Stivaletti - Goldman Sachs

Hi, Good morning. I was just wondering if you could clarify on the comment you made about your expectation that you expect to offset roughly 70% of 08-09 cost inflation with higher selling prices. I think that is what you said. But what is that assuming in terms of [3234]

Scott Wenhold

Joe if you look at our inflationary rate for input inflation this year, we are going to end up I think $140 million or so and we put year-to-date our pricing as recovering roughly $80 and by the end of the year probably, we are doing about $25 million this quarter, we will probably see a similar or another $20 or so in fourth. So if you look at the problem, we are covered roughly 60% and so if you look at our input inflation that would be next year on a go forward basis. Based on the ways things look, we would expect another $50 to $60 million worth of additional pricing recovery in 2009. Traditionally for us, what we try to do is offset our labor benefits inflation with continuous improvement sort of focused in pricing driven to try and recover input inflation. That is sort of how we are tracking the business this year and expectations for next year as well.

Joe Stivaletti - Goldman Sachs

Thanks. I guess I was trying to understand if you were in that number allowing or expecting a decent amount of decline in your input cost when you look at things like energy for 2009

David Scheible

We certainly think, I guess it really is a tough market forecast for input inflations you will know. As Dan said, certainly we have seen a reduction in things like OCC, and we clearly have seen a drop in energy prices, you know hedging for next year is certainly below our current rate. Some of the chemical prices have come down. What is really tough to figure out right now are things like caustic soda. We buy 35,000 tons a year of caustic soda and last year we paid $300.00 per ton, and this year $1100.00 per ton. So you know the supply-demand economics suggest that caustic soda will be back more in line in 2009. But right now, I am hesitant to predict that. So what I would tell you is that we would certainly expect a dampening of our inflation cost as we head into 2009. But I do not think I am good enough right now to give you a forecast on how that is going to roll through. What I would suggest however is that our contracts are based on board movement and embedded inflation, and so they will continue to run through and continue to accrue pricing into 2009.

Joe Stivaletti - Goldman Sachs

Thanks. The other question I had was you indicted Dan that the fourth quarter 08 EBITDA roughly would be in line with the prior year, I wondered if you had, if you could share with us the pro forma of 2007 fourth quarter, and also give us some indication of, you know what we see is market prices for the commodities and what not, but I did not know if you could describe the level of hedges, you know whether your hedge on gas or things for the fourth quarter is probably is below the current level.

Dan Blount

Yes, the pro forma of 2007 EBITDA is about $123-$124 million, it is between those two numbers. So that is currently our expectation. And just to let you know, there is a lot of caution in that expectation due to inability to predict what inflationary costs are going to do. So we have embedded in our inventory the higher cost that we have used to produce that product, and you know we turned about six times so that is about two months of that higher cost of flow through. So right now we are thinking that it should be around that $123 million for the fourth quarter.

And then in terms of hedging going forward, we have had 75% of our expected gas requirements for 2009. It is going to be higher in the first quarter; it is going to be in that $10.00 range and will taper down into $9.00 for the remainder of the year. So I think if you use about $9.00 or $9.50 mark for average for the year, that is currently what we are hedged at; and I just want to repeat that the 25% of our need is floating right now. And we will look for hedge opportunities with that 25%. As soon as we become more certain that we are going to actually use as much natural gas as we projected.

Operator

Your next question comes from Bruce Klein - Credit Suisse

Bruce Klein - Credit Suisse

What was the debt reduction. That was at 4Q thought for $110 to $130 million incremental debt reduction?

Dan Blount

That is right. And the way we are tracking our debt reduction is from the merger debts, merger date forward, so we are talking about March 10th forward; because as you know there was a lot of activity in terms of other types of merger related payments prior to that date. So that is from March 10th forward $110 to $130 million.

Bruce Klein - Credit Suisse

It is from March 10th, it is not from the third quarter?

Dan Blount

Third quarter would be approximately in the $90 million range in terms of cash generation, I mean the fourth quarter would be about the $90 million in cash generation.

Bruce Klein - Credit Suisse

So about $40 million or so in this quarter, the third quarter and an additional $90 million will give you a full year of roughly $130 million since March, is the way we are looking at it.

Dan Blount

You look at net debts, net debts is going to be about $3 billion.

Bruce Klein - Credit Suisse

I understand. And then cost inflation versus cost savings, I guess there are a lot of cost savings numbers I found floating around that maybe was not totally clear to me, you know I was the only one, but what you said cost inflation was I think you said $140 million right for 2008; and in terms of what we sort of realized in 2008 in terms of cost savings, could you help with that so we can square what maybe the negative variance was. I know you are recovering a lot in price which is a separate topic but is there cost saving that you are actually realizing between the three bucks because I think you said was all Legacy GPK and Altivity and the combined company. Am I thinking about that right or is there a different way you advisors are thinking about it?

David Scheible

I think that what we said was, year-to-date our combined continuous improvement about $52 million and we are getting about $15 a quarter or so, so that ends up being about $65 million or so for the year and you have to add to that what we believe is to be our total actual synergies that we will capture this year which is a roughly $10 million, so you sort of get your full year impact of cost reduction $75 million or something like that, in that range. In year-to-date, we have the $52 million plus the $6 million, so roughly $60 million, right, a little less than that maybe.

Dan Blount

Year-to-date $160 million of inflation cost of production. I think, right…

Bruce Klein - Credit Suisse

I was trying to compare cost savings you realized in 2008 versus cost inflation..

David Scheible

And so that is the cost reduction and cost inflation; as Dan said year-to-date is roughly $160 million and that includes all inflation, so that includes not just import inflation but labor inflation as well.

Bruce Klein - Credit Suisse

So it was a good mismatch for at least 2008. I mean loss inflation far exceeded like $80 million or something.

David Scheible

If you are looking at pure cost, right. That is why you really have to look at the price and cost relationship rate. The price cost reduction in relation to the inflation cost and pricing got at $82 million year-to-date….

Dan Blount

So Bruce just to summarize, if we got an inflation of $160 million, and cost reduction is around $91 million year-to-date… that is what it says here.

David Scheible

No. It is about $52 million plus about $7 million, is about $65 million of combined and $82 million of pricing. And that is the way it works out year-to-date.

Bruce Klein - Credit Suisse

And remind us how much OCC you buy in a year.

David Scheible

We make about 850,000 tons of CRB, so if you combine OCC mixed paper and all that it is going to be roughly 850,000 tons of OCC and waste paper annually.

Bruce Klein - Credit Suisse

Right

David Scheible

Annually, and that takes out the two mills that we sold. So that is a run rate sort of number, okay?

Bruce Klein - Credit Suisse

Okay. I got it. And then the contracts that are, I guess when we think about the percent of your business that is up, in 2009, remind us, you know, a lot of the contracts that used to be medium term in length and now they are a lot shorter in my understanding, so how much of your business I guess is up in 2009. How do we think about that?

David Scheible

I have not really looked at that, we had a pretty heavy activity year for contracts in light of the merger, so it is going to be a much lower kind of percentage that what we saw in 2008. I will have to get back to you because I do not have at my fingertips what is the total numbers. I will tell you that from a business standpoint, we do not have mill beverage contracts for example or they will be up at all in 2009. Most of our major national account businesses in consumer products have been renegotiated and extended because of the merger because some of those would have expired by virtue of that. So it was going to be a pretty low year for contract renegotiations.

Bruce Klein - Credit Suisse

In terms of the contracts in the past, are they working sort of better than you thought, or worse than you thought?

David Scheible

I like these contracts better than the ones that they replaced, because if you remember, the ones that they replace were either get back contracts or no escalators and of course today, all of our contracts have some form of reset or escalator clause. So they are working much better and that is why we have $82 million worth of price recovery. If this quarter, we get, pricing improvement this quarter was 2.3% across our businesses, I know you can remember back in the days we were giving 1% average on back. So if you sort of think about the delta in our business, I realize some was driven by the inflationary impact, but in the past regardless of the input inflation was, we would have been eating all that so clearly I like this trajectory better.

Bruce Klein - Credit Suisse

Last question, are there any Legacy contracts that had those not as favorable positions or recover? Are there any left in '09 or they are gone?

David Scheible

We took care of those actually earlier this year, I think the last was in March or April this year, something like that.

Operator

Your next question comes from [Sandy Burns] [44.48] - KBC Financial

[Sandy Burn] - KBC Financial

Just in looking at the segment information if you take the paperboard packaging segment revenues divided by tons sold, as an approximation for average realization, it looks like it is actually down both sequentially and year-over-year. And you have talked about the positive impact of pricing on your results, can you may be give a little color on what may be driving that as a product mix, you know the mix between the mill and converting businesses, maybe other issues at play there as well?

David Scheible

Well, our mixed clearly, as I mentioned our mix has clearly been changing because we have been integrating more internally. We buy outside roughly 150,000 tons of other boards that we do not manufacture and some of those businesses are honestly they are SBS based so it is a higher average board price and we have systematically exited that. So you do year-on-year comparison in the middle of a merger for that kind of thing is probably not a very good metric relative to overall. Now what I will tell you is that our growth in our core businesses, so our integrated board business was up 7%, so if we look at the business for us in food or that integrated portion that we want to do, that business is up significantly. But you have to net that against past businesses that we have exited, either here or global. Our mix include a fair amount of business that we do in Europe and outside and a number of those export forward markets, in light of the inflation of the impact of the businesses we have exited. So too much mix probably do that math.

[Sandy Burn] - KBC Financial

Okay. Thank you. I just have a question, in terms of starting to think about 2009 any range you can give us on what CapEx might look like as well the Pension contribution especially given what is happening in the financial markets.

David Scheible

Yes, if you look at the CapEx, we expect it to be about the same level as 2008 and that is $200 million range. And in terms of pension contributions, we have looking at that and there are a couple of sides to that formula, but in any event we are thinking about somewhere around $60 million in terms of contributions, which is approximately a little bit higher than what we made this year, but it is in the same range.

[Sandy Burn] - KBC Financial

Okay great. Last question; you have talked a little bit about the merger synergies and how it is progressing, I was wondering just maybe if with a little more detail we can talk about any positive and negative surprises you have found since you have really been able to go into the Altivity operations and what is your findings there in terms of what you may be able to do. And just given the slow down in the economy and likely in volume, does that impact you that the timing or magnitude of some of the benefits that you had expect to see at least in the short term.

David Scheible

What I would say is that if you look at the acceleration of our synergies versus what we thought when we did the original; we are certainly ahead of schedule, and that is really attributed mostly by virtue of the fact that as we looked at the combined companies we actually saw better damages than we thought. So a number of the Altivity plans are doing really well, and we are able to sort of use that lower cost structure. What I would tell you on a forward basis is that we are not walking off from any of the integration numbers we have seen at all. I would like very much the trajectory in that business. You have got to remember 80% of our businesses on a combined basis are in food and beverage, right. And so what I would say those businesses are not recession proof. I do not think there is a business that is recession proof. But certainly we have seen better insulation in that because we are basically with the staples in, so we are in cereals, in breakfast bars, and beer. And so what we are seeing are continuous strong demands and our backlog and our sales are solid as we move into the fourth quarter in those sectors. The softest we have seen in our volumes has really been what we consider as our non-core business or to some extent businesses that we have exited. We have shut down our label business in St. Charles, we have certainly seen a volume decline in that business, but that was not a core business for us to begin with. So in the businesses that we are counting on to produce volume in sales next year, at least right now we feel good about that focus in food and beverage.

Operator

Your next question comes from Bill Hoffman - UBS

Bill Hoffman – UBS

Good morning. I was wondering if you talked a little bit, you went through pretty quickly about the folding carton operation that you have shut, and or rationalize etc, if you could just help give us some color on where you are from an integration standpoint, like how the business is operating at this point.

David Scheible

The plant closures are slightly ahead of schedule; for example on our original list, the Smyrna, Tennessee was not part of the list but as we looked at the integration activity, what we found was we were getting much better productivity in some of the plants, both Legacy Graphic and Legacy Altivity which, you know Bill in this environment made the most sense to say you know what, keeping a marginal plant or a higher cost plant open just made no sense. We had no real belief that volume was necessarily tick off or increase significantly so we sort of accelerated that. We are doing the same thing across a number of other facilities. We are continuing to evaluate a number of these facilities. I did a number on the investment of the Kalamazoo so $27 million in Kalamazoo investment is not going to expand that plant materially. 240,000 tons I think I said of paperboard is coming right from the mill. With that acceleration and once those presses gets installed there it is quite possible that we will end up running that more effectively than we planned; and if so what will happen then is higher cost facilities, running products that we can make there will come out of the mix. We have a view of what those facilities might be today, but honestly it could change in the light of what that productivity has increased.

The integration teams are ahead of schedule and what that means is we are getting all these products transitioned at a much faster rate and so we are getting more efficiency in the actual printing and cutting these cartons, which means that we need to balance our converting capacity. If we do not need the plant or the capacity Bill, we are just taking it out of service.

Bill Hoffman – UBS

Right. And have you quantified your target integration level and have the business operate that way?

David Scheible

You mean from integration like from a board capacity standpoint?

Bill Hoffman – UBS

Yes.

David Scheible

Well, we do not use a specific target for how many tons we are going to sell internally versus externally. What we simply do is we balance the book of converted business that we want. We certainly want to be in cereal, we want to be in pizza, we want to be in dry foods and so what we do is we lay that entire business out of cross those presses and then we blow that back to our board mill. And so for the grades and the cuts that makes sense in our board mill, then we will make those things internally.

To the extent that we have products that we need to buy that really do not fit our internal structure, we will continue to buy on the outside. And that is across a number of grades. Today, in realigning, as I have said earlier we have integrated 45,000 tons of boards that Altivity bought on the outside before. But that does not mean that we do not continue to buy, it is just that what we buy is not a good mix for our mill system. And that is the way I will balance it, so our integration level is not the target, I think our integration level has probably run 80% or 85%, but I do not use that as my target, what we target is what board makes sense for us to convert at the lowest cost within our facilities and then we buy the rest of it. And then I guess the final comment on this, if it makes no sense at all, in other words, if we do not have the right to compete in that space and there are some spaces we do not, whether it is converting our board, then we will just exit that space. And we have; as I mentioned earlier, our Richmond facility closing, that business was very much dedicated to tobacco. But we did not really have a good solid position in converting or in board in that business so essentially we exited that business. So when you start doing some comparators relative to average EBITDA per ton it is a bad comparative because it looks high on the outside but in reality the contribution was pretty low. So it is a non-integrated play we cannot make money doing it, and we sort of exit the business; and that is how we are managing the mix for both board and carton.

Bill Hoffman – UBS

Thank you, that is helpful. The second question is this price increase initiatives and what kind of response you are getting from the market. Given the time of the year one when obviously you will get some seasonal demand, obviously less so in consumer beverage, the demand is softening here and we are also seeing a pullback in most of the cost whether they be freight, chemicals, energy, etc. what kind of pushback are you getting on the pricing initiatives?

David Scheible

I rarely get a letter from all my customers telling me thanks for the price increase so we will start with that. On the other hand, you have got to remember that our customers, they honor their contracts as we honor ours; and as we got behind the curve in some of the inflationary impacts, we honor that but when it changes, they do as well. So, some of you will get some margin improvement if raw materials continue to drop and if pricing will not necessarily follow that. I think the key thing for Graphic Packaging as Dan said is that we need to make sure that we are not making products we cannot sell. As we look at paper machine number two CUK board, off of that machine, we made, I think we used roughly 40,000 tons of board in 2008 of that machine. As I look forward we just say we do not need that demand so we are shutting that machine down and so that will help sort of balance what we are doing appropriately from a working capital standpoint. Our operating rates are much like the industry on CUK and CRB we are in the upper 90s, on those board substrates right now. And that seems to be where the market is. And while there is certainly a demand drop, it is not necessarily in some of this food based products. Right now ready to eat cereal is still growing. It is still a better deal than eating out on the way to work. So that volume continues as we look to the fourth quarter to be solid, as does pizza, beer and those kinds of structures.

Bill Hoffman – UBS

Right, thank you I appreciate that. And then I guess this is the final question. With regards to the mills that you sold, can you give us an indication what the EBITDA generation of this? Some idea of the valuation that came out of that.

Dan Blount

I think David talked about the cash received in terms of the EBITDA; for most mills, based on the current run rate in 2008, we expected them to be around $10 million for the entire year.

Bill Hoffman – UBS

It seems like a pretty low multiple

David Scheible

Well I do not know how to factor a low multiple for a business that is sold under DOJ restrictions, I mean it was not as if it was open auction that allowed us to sort of think through the process. We sold it because it was required by the Federal Government to close the merger and we did that. And so what I will tell you is that we have an ongoing supply agreement with them, we are glad to get the assets sold so that we can consummate the business. I will tell you we like the four CRB board mills that we have left in our business; if you think of Kalamazoo, Middletown, Battle Creek and Sta. Clara, if you look at the average cash cost of making CRB in those four board mills, I am pretty sure that by far we are the average lowest cost in the entire industry. So taking Philadelphia and Warbash out of our mix from an overall cost standpoint did not hurt us by any means.

Bill Hoffman – UBS

Thanks, it is shame to see those unintended consequences.

David Scheible

That is the price of the addition.

Operator

Your next question comes from [Beau Hunt] – Bank of America.

[Beau Hunt] – Bank of America

Hi guys. If you would, I would like to talk a little bit more on the contract, in particular, I am wondering, how long does it typically take to realize price increased from contractual pass throughs and inflationary costs, it differs by contract. But I would just like to get a feel for the average there.

David Scheible

In many ways you answered your question, it does depend on individual contracts not only when the escalators go through but on what products; it also talks about when is the expiration of that contract or the next period for that contract may occur. But if you look at what we are doing, we are averaged, year-to-date we are $82 million on pricing recovery. And in this quarter, I think Dan said we are roughly $25 million right so you can sort of see an accelerated rate in that process but I think for the most part, it sort of smoothens out the business from a pricing standpoint. And as we said earlier, I will expect interior overpricing probably another $50 to $60 million in pricing just based on just what we sort of know now. Having said that, with everybody, all the lawyers in the room, the answer is I do not know what the economy is going to do and I do not know where inflationary will go exactly but that is roughly my over-the-trenche sort of the look on pricing for what I know in '09. Beyond that I do not really know how to lay it out any better.

[Beau Hunt] – Bank of America

Okay. So there is not a specific, you know we have not [5911] the triggers at the end of the March 31 quarter and three months later we have XYZ price increase. That is not the way it works.

David Scheible

Generally not; I mean generally it is based on previous board price movement or reset for some economic figure and when that calendar time hits it, it goes up; a board price increase that rolls through that with the reflected. And it rolled throughout the percentage of the cost of the board and you know all sorts of different escalators. As many contracts as we have, we have different levels of escalators. Every customer has his own preference in the process. I think in most cases you end up at the same place but nonetheless it is sort of all over the map.

[Beau Hunt] – Bank of America

Okay, I understand. And when commodity prices are falling you do experience the exact same lag time, you know, you get to enjoy the full benefit of the decline?

David Scheible

That is right.

[Beau Hunt] – Bank of America

Does it work out generally, you know I have spoken before about expecting the recovery level was 70%-80% of your 08-09 cost inflation, do your contracts generally call for a partial pass through over time or is it a 100% pass through over time; it just takes a while to fully reflect itself.

David Scheible

Again every contract is different and that is why we are saying you know it all really depends, on which raw material is going up or how that structure is, whether it is based of board movement or direct inflation; some of them are based on economic expansion, GDP deflators and so forth. So what I would say, is typically from input inflation, will eventually get it, but it takes a while.

[Beau Hunt] – Bank of America

I should have known better. And then just a last thing on this, roughly what percentage of your contracts would have on that pass throughs and in case contracts do not, do they tend to behave roughly the same except it is more of a negotiated base?

David Scheible

Really I do not know of any contracts that we have that do not address escalators. If we have a contract, that is one of the reasons we have it right and so and a majority of our business is under contract, then the pricing is done almost on a transaction basis, on an order by order or shipment by shipment basis. That is a small percentage of our business as you can imagine, we are not doing business with Kraft or General Mills or Anheuser Bush on a call it up and we will price an order, but in some of the smaller businesses, it tends to be transaction based.

David Scheible

Alright Rachel, I think we are going to end it there.

Operator

Okay.

David Scheible

I want to thank everybody for joining us on our third quarter call.

Operator

This concludes today’s conference call. You may now disconnect.

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