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Graphic Packaging Holding Company (NYSE:GPK)

Q4 2008 Earnings Call

February 27, 2009 10:00 am.

Executives

Scott Wenhold – Vice President, Treasurer

David Scheible – President, Chief Executive Officer

Daniel Blount – Senior Vice President, Chief Financial Officer

Analysts

[Jeff Hollis – Barclays Capital]

[Faz Abit – D. A. Capital]

Joseph Stivaletti – Goldman Sachs

[Gerard Worshton – U.S. Steel]

Sandy Burns – KBC Financial

Matthew Armas – Goldman Sachs

[Raza Alliace – Nike]

Terry Dougherty – Capital Source Bank

Aaron Rickles – Oppenheimer

Operator

At this time I would like to welcome everyone to the Graphic Packaging Holding Company fourth quarter and full year 2008 earnings call. (Operator Instructions) I would now like to introduce Mr. Scott Wenhold, the company's Vice President and Treasurer.

Scott Wenhold

Good morning everyone. Thank you for joining us on Graphic Packaging Holding Company's fourth quarter and full year 2008 earnings call this morning. Commenting on our results this morning are Dave Scheible, the company's President and CEO, and Dan Blount, Senior Vice President and CFO.

Before we get started 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 declines in raw material and commodity prices, consumer purchasing trends, 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, cutbacks in consumer spending that could affect demand for the company's products, continuing pressure for lower cost products and the company's ability to implement its business strategies, including productivity initiatives and cost reduction plans.

Undue reliance should not be placed on such forward-looking statement 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.

David Scheible

Good morning. Thank you for taking the time to be with us today. As we've done in the past, Dan Blount, our Chief Financial Officer and I will split the duties on this call. Once we've concluded our remarks, we'll open the call and look forward to answering any questions you may have.

What a year 2008 turned out to be. We faced runaway inflation early in the year, a global recession as the year closed and sandwiched in between was the combination with Altivity. The last three quarters of 2008, we operated as a combined company and I'm pleased to report our integration efforts have exceeded expectations.

Our network of manufacturing facilities is increasingly more efficient, and we are investing in the right places to create a productive, low cost manufacturing footprint to maintain our number one market share position. This has translated into solid debt reduction despite the economic headwinds.

Last night we reported results for the fourth quarter and full year 2008. A quick recap shows the fourth quarter adjusted net loss was $0.11 per share compared to an adjusted net loss in prior year quarter of $0.04 per share.

On a full year basis, despite incurring approximately $240 million of cost inflation, pro forma EBITDA of $502 million was relatively flat to 2007 pro forma EBITDA of $510 million. I'm also pleased to say that despite a difficult operating environment, we reduced net debt by approximately $119 million since the combination with Altivity last March.

We believe our business is headed in the right direction and we are taking the necessary steps to navigate through this unprecedented market and improve our year on year results.

Our combination with Altivity increased our position in the food and beverage end use market and while no sector of the global economy is unaffected by the current recession, we do so more stable volumes and customer performance as a result of this focus.

During 2008 we reduced our cost structure, we enhanced our liquidity position and we focused on generating cash in a market where cash is clearly becoming king. We know these steps will not only help us continue to help us manage through the current environment, we believe they will position us well for the eventual market rebound.

Dan's going to discuss our quarterly and full year results in more detail and similar to our past calls, we will include comparisons to the 2007 fourth quarter and full year results 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.

Let's talk a little bit about volume and price. The global economic crisis initially manifested itself in 2008 has continued to worsen as economic headwinds such as rising unemployment, falling real estate prices and an increasingly difficult credit environment are driving major shifts in consumer purchasing behavior.

Consumers are deferring purchases not only big ticket items, but of durable goods as well. As a result of these external forces, we experienced a slight decline in volumes during the fourth quarter as our customers chose to use up existing inventory in an effort to convert working capital to cash as concern over the broader health of the financial system remained in question.

We were conscious of this decline and made the decision early in the quarter to remain focused on inventory control and stay committed to managing production to reflect demand. As a result, in addition to the permanent shut down of our number two paper machine and the idling of our media machine for the last two weeks of the year in West Monroe, Louisiana, we also elected to take a total of 43 days of market related downtime across our recycle board mill system in the fourth quarter.

As a result of this aggressive management of working capital, including an inventory reduction of over $37 million, we generated $140 million of operating cash flow in the fourth quarter alone. Despite the uncertain macro environment, we believe that we have navigated this market well and will continue to stay ahead of the cost curve and remain focused on driving bottom line improvement for our shareholders.

For the full year 2008, we were able to make considerable gains in pricing versus 2007 levels. We achieved two solid open market price increases in both NCRBC substrates and we recognized contractual pricing increases on the carton business. In total, price increased about 2.5% offsetting almost 50% of the cost inflation we experienced in 2008.

Throughout 2009, a large number of our carton contracts will reset with new pricing based on the changes in cost of board experienced in 2008 and we will continue to see pricing as an effective tool to counter the negative impact of inflation this year.

Looking forward, the challenge will be to maintain general market pricing given the operating environment, but we are committed to balancing our own production to match demand. Based on fourth quarter trends, for the first time in over a year, we can say that we have started to experience a moderation in the cost of some of our key production inputs, particularly secondary fiber and energy.

Inflation continues to moderate, but remains above our internal expectation as chemical costs have not yet dropped in line with the petrochemical complex changes seen globally. Inflation will continue to be in our favor in early 2009 as fuel charges are significantly less than a year ago and the secondary fiber market continues to be soft as reflected in the price of OCC.

However, we are starting to see some tightness and community stock collection, particularly on the west coast, and if this trend continues we would expect OCC prices to increase somewhat later in the year.

Latex and TIO2 used in board codings are beginning to drop, but we have seen no material change in the cost of caustic soda and expect none until new capacity comes online later this year.

Inflation in January was in line with our expectations, but I believe we could see some raw material costs further abate as we head into quarter two.

Let's talk about cost and synergies. Turning to cost management, our integration team ended 2008 on a high note as we achieved annualized synergies of over $67 million well ahead of our pace towards our original target of $90 million. We executed well on our plans for plant closures and integrating tons between the two legacy companies which combined, drove a significant portion of this favorable variance.

Although we are well ahead of our goal of achieving $90 million by 2010, due to the deteriorating economy, we have accelerated many of our original business cases and we are developing additional ones as well.

Recently, we announced the closure of four additional manufacturing facilities. While it is important to note that these closures were part of our original planned integration efforts to optimize the combined company's manufacturing system, in light of the current economic conditions, we continue to evaluate all of our manufacturing facilities based on casting costs, flexibility, operating efficiency and proximity to raw materials and customers.

We intend to operate the optimal combination of plants that will allow us to continue to compete as a truly low cost producer of high quality consumer packaging.

2008 was also a very successful year in ongoing, continuous improvement cost take out as we reduced costs by over $70 million on a pro forma basis. This marks the fifth year in a row we have significantly reduced cost through our continuous improvement processes.

Further, based on the expectation of the economic conditions remain challenging for some time; it is going to be important that we be prudent and conservative. As such, we have announced a salary freeze for all of our executives and non production salary employees for 2009 and have reduced our work force where appropriate. We've also reduced discretionary spending and will not improve pension or health and welfare benefits while the cost to maintain current benefit levels sharply escalates.

We are making the necessary adjustments in this environment to not only ensure we survive this difficult economy, but emerge as a much stronger company on the other side.

Let's talk a little bit about the markets. 2008 was characterized by slowing economic growth and increasing inflation for most of the year. According to the U.S. Department of Labor CPI data, inflation in the food and home category averaged about 6.4% in 2008 compared with roughly 4.5% in 2007.

In contract to overall inflation that averaged about 3.8% for the year, but declined to 1.5% in the fourth quarter, inflation in the food and home category remained at the 6% to 7% level in the fourth quarter as higher input costs worked their way throughout the system.

When we look at packaged goods retail sales data provided by A. C. Neilson, it suggests the changing economic conditions are affecting both the type and amount of packaged goods purchased. Aggregate annual unit growth in the major packaging categories did increase by about 1.3% in 2008, but this is far less than the 4% growth seen in 2007.

The categories that grew more than average were staples like cereal, dry dinner mix, breakfast foods, pizza, snacks and yogurt. The data suggest the consumers have adjusted to changing economic circumstances by shifting their purchases to lower priced food products and buying less non food items. People are returning to the center of the grocery store where you typically find lower priced and budget extending items.

The Paperboard Council reported that in 2008 folding carding industry sales declined by about 1.5%. Our sales exceeded these industry averages as sales to food and consumer product markets increased by 2.1%. The markets where we enjoyed good year on year growth were cereal, dairy and frozen pizza. Both branded and private label products grew well in 2008 and we see those trends continuing here early in 2009.

January sales for our food and consumer packaging were solid as demand for staples increased. This trend is in line with consumers managing grocery budgets with less participation in new product offerings and a focus on such items as cereal mixes and dinner kits.

That does not mean that there were not new products during 2008. In fact, during the fourth quarter, we continued to develop and commercialize value added packaging solutions in both consumer and our beverage businesses. We experienced solid new product sales at about $7 million for the quarter that were led by our strength in new age beverage and microwave platforms.

For the full year, Graphic Packaging achieved approximately $60 million in new product sales based on these growth platforms. These new product sales marked a record performance for the company and were 20% ahead of last year's total.

On the consumer side, we saw increased opportunities for Graphic Packaging innovation. During the quarter, we commercialized a new in store donor carton with Wal Mart using recycled paperboard and a unique and proprietary polyethylene barrier coding. We were also able to growth our street platform with two new product launches.

The first one was a Kali Kashi warehouse cereal package for Canada, our first use of lightweight technology. The second launch was Kraft's Triscuit Warehouse club package, a shrink solution that also incorporated our film laminated grease masking technology.

Graphic Packaging also had its first major launch of the exciting Snap2C mobile technology which connects consumers to the internet via cell phone and a printed QR code on the package. Finally, we're working with Kimberly Clark. We executed our annual Queen Holiday promotion which included a light up tissue carton.

Looking at the beverage market, our fourth quarter sales to North American beverages markets were about 1% lower than compared to last year. The slight decrease was attributable to a continued softness within the soft drink sector. Domestic beer however, showed strong sales all year as consumers have trended back to lower priced point domestic brands versus imports. 2008 was a reverse of trends of previous years where domestic brewers recaptured share from importers.

Additionally, we saw a global trend in 2008 away from on premise consumption to take home. Consumers were eating and drinking out less and so packaged goods sales as a percentage of the total increased in '08. We see this trend continuing for the near term as well.

We do continue to see new product growth with our major global customers. In the fourth quarter packaging was able to gain new business with the Miller/Coors joint venture in the U.S. as we were awarded the new 12 pack business for the Blue Moon brand as well as the 18 and 20 pack business for Coors Light which included the Super Bowl promotional packs.

Soft drink softness continued in the fourth quarter as really no major retailer did particularly well during the quarter. With the exception of retail promotional pricing on two liter plastic bottles, advertising activity pertaining to the December holiday was largely non existent and as you would expect volume suffered.

We have seen improving trends into 2009, again most driven by at home consumption, but we overall expect carbonated soft drink sales to be a best moved sideways in 2009. Alternative non carbonated products continued to do very well in 200. Building on our growth strategies in the fourth quarter, we completed our co-packer incubator strategy with the shipment of our last two energy drink packaging machines to two customers giving us a coast to coast presence in the independent bottler system.

This move will provide us with a leading market share in the functional drink category with sales for energy multi packs expected to grow rapidly in the U.S. market over the next several years.

Let's talk about our multi wall bag business. This is roughly 10% of our total sales and it was clearly most affected by the economic conditions as this business depends more on construction and general industrial sectors. Fourth quarter multi wall bag sales reflected the softness in building materials and chemical sales.

Both sectors are experiencing unprecedented sales decline. In light of the deteriorating market conditions, the multi wall bag quickly adjusted their manufacturing facilities through targeted down time and successfully decreased system wide inventories. Over the last five months of 2008, inventories in this business were reduced by $22 million despite shipments being off by roughly 4%.

With respect to 2009, the general economic consensus is that U.S. construction and industrial sectors will continue to struggle until at least mid 2009. As such, management focus remains on maintaining high levels of synchronization between demand and production levels, overall cost reduction strategies and very strict management of working capital.

In the mills, manufacturing results were down slightly during the quarter compared to the prior year quarter primarily due to lower fixed cost absorption. The lower absorption was driven by the permanent shut down of West Monroe number two paper machine, along with the market related down time taken on the West Monroe media machine and across the entire CRB mill system. These negative impacts were partially offset by reduction in the price of secondary fiber.

Overall softness in the consumer durable business resulted in significant down time in the month for key Containerboard producers. Softness in the Containerboard industry has continued into January. Noting the fact I received the question from an investor since then, I would like to state that Graphic Packaging's extremely small presence in the Containerboard industry with less than 100,000 tons sold externally annually, our exposure is extremely limited.

On the contrary, over 85% of our revenues are derived from converted products supplied to the food and beverage end use market.

Despite recent moderation in the cost of energy, we do not expect this to be a long term scenario and we continue to look for ways to reduce consumption of volatile high cost raw materials by keeping our sustainability efforts in the forefront. In the fourth quarter, we achieved a major milestone as our Santa Clara recycle board mill completed a recovery retrofit project that will save the company 250,000 MMBTU's of natural gas annually.

According to Pacific Gas and Electric, Graphic Packaging's investment in waste heat recovery at the mill has resulted in one of the highest natural gas savings on record. By adding state of the are heat exchange recovery technology to its co-generation plant, the paper mill can now recapture recycled valuable waste energy from the exhaust gases.

As a result, duct burner consumption of natural gas has been cut by 50%, eliminating more than 15,700 tons of CO2 emissions annually, equivalent to the removing of 2,200 cars per year off the road.

Looking forward, in 2009 we have been paying very close attention to inventories and volume trends. While I believe they will be very difficult to predict for the entire year, we are pleased to see January demand and volumes return to planned expectation levels. I would remind you that generally we do not get too far in front of ourselves in forward projection, and in 2009, that is particularly important.

I like our position in key end markets of food and beverages. I continue to believe they will fare better relative to other sectors, but it really is going to drill down to execution for Graphics. As we've developed our policy deployment goals for 2009 across Graphic Packaging, they are pretty simple; our focus will be on our core businesses and customers, we will recover our contractual pricing, we will accelerate our cost take out and synergy plan, we will build on our new product commercialization successes from 2008, and we will balance production to demand, all targeted to deliver better margins and increase EBITDA and better cash flow for debt reduction in the year.

With that, I'll turn it over to Dan Blount to review the financials.

Daniel Blount

Good morning everyone. As David discussed, we are carefully managing our production capacity to align with demand and are aggressively managing working capital. As a result of this disciplined management, we generated $140 million of operating cash flow in the fourth quarter and have reduced net debt since the combination with Altivity last March by $119 million.

Our efforts are and will clearly remain on cash generation. Along with our disciplined cash management approach, we have and will continue to focus on high return synergy projects, cost reduction investments and product innovation efforts. These actions will position the company for incremental performance and improvement while strengthening cash generation.

Moving to a more detailed review of financial performance, first we'll cover operating results and then turn to cash flow and liquidity. But before getting into the financials, a reminder that in order to provide an apples to apples comparison and an effective measure of operating EBITDA performance, I will use adjusted pro forma financial results in my discussion.

These pro forma results include the following adjustments; we included Altivity results from January 2007 to the merger date in order to provide a full year of Altivity results for 2007 and 2008.

We excluded fourth quarter 2007 results for the two recycle board mills that were divested last quarter. For 2008, we added back $15.5 million on non recurring non cash charges principally related to the permanent shut down of our paper machine number two in West Monroe. And finally, also for 2008 we added back charges associated with the combination with Altivity including severance related to synergy delivery.

A reconciliation table detailing the pro forma adjustments is included as an attachment to last night's earnings release. Now to simplify today's discussion, unless I specify otherwise, when I refer to net sales and EBITDA I will be referring to the pro forma adjusted numbers.

Now turning to fourth quarter results, first we'll cover the change in net sales, then bridge EBITDA to the prior year. Fourth quarter net sales came in at $1.48 billion which is a modest $16 million or 1.5% lower than the prior year. Included in fourth quarter net sales is pricing improvement in all business segments. Overall pricing improved by $28 million or 2.6% in the quarter.

Net sales volumes in the quarter declined 3% or $34 million. Paperboard packaging carton volumes which are principally for food and beverage applications, held up well and were nearly flat to the prior year. The largest volume decline, approximately $18 million was in Containerboard open market sales which include liner board and corrugating medium.

We also experienced marginally lower demand for our multi wall bag, specialty packaging and open market CRB board sales.

Given the economic environment, our volumes really held up well. Even with the modest decline in fourth quarter sales, full year 2008 sales improved by 2.1% to $4.4470 billion, primarily as a result of price increases and mix improvements.

Now let's discuss EBITDA. During the fourth quarter we stayed committed to cash generation and as a result took down time in both our mill system and our converting operation in order to match production with demand. Overall, fourth quarter EBITDA had $103 million is $17 million lower than the prior year.

Let's look at the four primary reasons for the change in year over year performance. The first reason, in the fourth quarter we took market related down time on CRB and Containerboard paper machines, plus down time in selected converting plants. The downtime was for two reasons. The first reason is due to demand declines most notably in Containerboard, multi wall bag and CRB open market.

The second reason and which is really the primary driver of the CRB down time is to permanently lower on hand inventory levels. The merger and synergy of integrating supply chain operation has enabled us to operate with lower overall inventory on hand.

The EBITDA charge resulting from unabsorbed fixed cost is $13 million for the quarter. The overall fourth quarter impact is not only fixed cost absorption however, but it also includes a temporary margin reduction on CRB sales because the inventory we took out of production or took out of on hand inventory levels was the highest cost inventory. Total impact including absorption and margin is estimated to be the in $15 million to $17 million range.

While these decisions lowered, EBITDA they are clearly the right ones as they dramatically improved cash flow and will improve working capital efficiency on a go forward basis.

Second reason, input cost inflation during the quarter was $53 million. The inflation impact is $20 million less than we experienced in the third quarter but does not reflect the current lower cost of key inputs such as secondary fiber, energy and certain chemicals.

As it takes two to three months for inventory to cycle, the first quarter 2009 is expected to benefit further from key raw material cost declines.

Third reason, cost reduction initiatives which include integration synergies and continuous improvement delivered $34 million of benefit. $17 million of the $34 million is from integration synergies. We continue to be ahead of schedule, with the post merger integration programs are well on our way to achieving $90 million of annual benefit by early 2010.

The fourth and final reason, rounding our the change in fourth quarter EBITDA, improved pricing delivered $28 million of benefit and volume changes net reduced EBITDA by about $10 million.

To summarize fourth quarter performance, we realized price increased of 2.6%. Our volumes held up well due to our strong position in food and beverage markets. We reduced operating costs by $34 million and we effectively managed production capacity to maximize cash generation.

For the full year, despite approximately $240 million of cost inflation, and demand weakness in the fourth quarter, we delivered EBITDA of $502 million which is relatively flat to the prior year. Benefits from increased pricing, cost reduction and synergy delivery were instrumental in offsetting inflation, and with our strong presence in stable food and beverage markets, our volumes held up well.

I will end my discussion with comments about cash flow and liquidity. Let's start with liquidity. At December 31, we had strong liquidity availability of approximately $391 million, about $80 million than at the end of the third quarter.

We were comfortably in compliance with our debt covenant as we reported a secured debt leverage ratio of 3.6 to 1 which is well within our required five times. Additionally, we have no significant debt maturities until August 2011.

In terms of cash flow, for 2008 we measure from the Altivity transaction date forward. Over this time frame, we reduced net debt by approximately $119 million. As you heard previously, in the fourth quarter we aggressively managed production capacity, reduced working capital, and as a result delivered $140 million of operating cash flow.

Heading into 2009 our liquidity levels are strong and we are well within compliance with our credit agreement.

In conclusion, given the difficult economic environment, Graphic delivered a solid 2008. Looking to 2009 we expect to realize further price increases as contracts containing inflationary price escalation clauses reset, and additionally, we expect to deliver substantial cost reduction.

We are well ahead of pace with realizing our integration targets and now forecast $90 million to be the minimum amount of synergies to be realized from the combination with Altivity. In 2009 we will continue to manage the business with the same discipline demonstrated in 2008 to maintain strong cash generation.

As a result, we expect debt reduction to exceed 2008 levels. Our 2009 debt reduction projection includes pension contributions of $60 million to $70 million, cash interest of $210 million to $220 million and capital spending of $170 million to $190 million.

And with that, we'll open the line for the question and answer session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first call comes from [Jeff Hollis – Barclays Capital]

[Jeff Hollis – Barclays Capital]

Can you talk about, on your last call you talked about pricing being 2009 being about $50 million to $60 million? Can you give us an update first on the pricing pass throughs.

David Scheible

I think what we said for the year, our pricing in 2008 was roughly $109 million to $110 million worth of pricing recovery in 2009. The fourth quarter was around $30 million or something roughly in price recovery. And that's all pricing. That includes pass through on contracts. That includes board pricing in the open market. So the total pricing across the company, and I think that for the year pricing in total was around 2.5% of our total sales, pretty close to that.

[Jeff Hollis – Barclays Capital]

And how about for 2009 based on your contract pass throughs.

David Scheible

In 2009 we expect our contracts that reflect that to be recovered and in fact in January and February we've already seen some of that. The customer contracts that are written have some escalators based on inflationary cost in 2008 on board price movements and all of those will be recovered throughout the year.

[Jeff Hollis – Barclays Capital]

Are you willing to roughly quantify it?

David Scheible

I'm not going to give a forward look on pricing in 2009. What I would say is that we're comfortable that the 2009 pricing will be in line.

[Jeff Hollis – Barclays Capital]

On inflation, $240 million of inflation, can you talk about how you see inflation? I know you have some natural gas hedging. Where does that stand for '09 and how are you currently planning on inflation?

David Blount

Let me cover the natural gas hedging. Currently we're about 72% hedged for 2009 and if you look at the positions we've taken, that 72% averages about $10.80 in the first quarter and then we're around $9.25 to $9.50 for the remainder of the year.

If you compare that to 2008 approximately we're about $10.00 per MMBTU in 2008 on an average for the whole year. What we've done is, we've gone ahead and put the forward curve for the non hedged piece and if you take that in, we have a blended price rate for 2009 at about $8.50 per MMBTU.

Just another reminder, in terms of our overall energy costs, natural gas is about 60% so the other 40% is from other sources including public utilities.

David Scheible

We use about 14 million or so MMBTU's a year of natural gas roughly. It's primarily in the mills as you can well imagine.

[Jeff Hollis – Barclays Capital]

On the Altivity synergies, what were the actions that brought you from the $25 million to the $67 million and what are the savings expected from the closing of the four plants?

David Scheible

I won't break out the individual plant closure. What I will tell you is really the acceleration of those was from two things. One, it was from the accelerating bringing the plants forward in the closure and then the other was from the integration of tons between the two organizations were the primary driver in this quarter, right now for those synergies.

So what we're seeing is, if you look at our business we're at a $67 million dollar rate. I think your synergies in 2008 to the bottom line generated roughly $27 million, so you can see it's an accelerated rate going forward for 2009. That's why I think that's why Dan and I both are very comfortable that the $90 million level with certainly be met and most likely exceeded.

Operator

Your next question comes from [Faz Abit – D. A. Capital]

[Faz Abit – D. A. Capital]

You mentioned $60 million to $70 million of cash pension contribution for 2009 as an estimate. How much of that goes to our EBITDA number already. In other words, how much is already expensed? What is the extra cash flow deduction we should be thinking about?

Daniel Blount

It's about $13 million to $14 million larger than the expense at the contribution level.

[Faz Abit – D. A. Capital]

We're looking for some color. We understand your contracts have these price increases and you previously mentioned up to 80% of cost inflation is generally with a lag pass through. At the same time you have benefits from raw materials. I guess what we're wondering is if the volumes were to stay constant and there's no change to that, how much price benefit should accrue to you based on current raw material prices and how much prices the lag hasn't come through yet?

David Scheible

We're not going to honestly provide that much level of detail because the big assumption there is what if volume stays the same. So we built a hypothetical model there that's probably not one I'd want to opine going forward. What I will tell you is both Dan and I believe on a go forward basis that in 2009 we do expect our margins to expand.

We do expect pricing to be good and we expect at least in the early half of the year for raw material prices to continue to trend down. As you get to the second half of 2009, it's a little bit difficult to think about it.

For example, one of our primary raw materials is OCC, and right now OCC pricing is very favorable to 2008 levels. However, what we're also seeing is communities picking up less OCC because the price of OCC collection costs is so expensive. What has traditionally happened in that environment is therefore OCC prices start to creep up.

So right now, we would say the margins will clearly stand between the Delta and pricing and raw materials for the entire year, virtually impossible for me to make a legitimate sort of how is that going to work out.

And that is, as you said all tied into assuming volumes maintain in their current trends, and I don't know that I'm comfortable even including beverage giving forward demand curves on that to suggest where it's going to be. I like the early trends but I don't know what it's going to look like in August.

[Faz Abit – D. A. Capital]

In terms of the debt reduction in 2009, did I hear you correctly that you said it would exceed $119 million from 20089?

Daniel Blount

Yes, you heard us correct.

[Faz Abit – D. A. Capital]

Are you giving any guidance on interest expense or CapEx? Any guidance on working capital, compared to last year?

Daniel Blount

I can tell you for last year, when you look at when we initially merged with Altivity, our inventory levels were above $600 million, and we have ended the year substantially lower than that. We're at below $570 million, so there was a substantial reduction in inventory levels. Also, inventory for the end of the year 2008 included much higher inflation which raised our inventory levels. So we saw substantial reduction.

Included in the $119, we're not giving specific guidance on working capital at this point, is working capital reductions.

David Scheible

What we saw is pretty significant cycle improvement. In fact, in our mills our cycle time in our mills improved almost 30% between 2007 and 2008 quarter on quarter, fourth quarter. So that is allowing us the units are cycling much faster. As Dan said, you've got higher cost running through so the dollar looks different, but the velocity is much more improved.

So working capital of $35 million or $40 million reduction in 2008 certainly we're going to continue to drive ongoing working capital reductions in 2009. We would be very disappointed if we didn't see significant reduction in working capital in 2009.

We're going to continue, again the underlying assumption there of course is where volume, but I will tell you that we will continue to match volume to production. We don't plan market down time and that's sort of not something that we do, but we will continue to match our production output with our demand.

We will not build inventory or put cash in inventory if we don't have a legitimate reason to believe we're going to sell those products in a short period of time.

Operator

Your next question comes from Joseph Stivaletti – Goldman Sachs.

Joseph Stivaletti – Goldman Sachs

On the synergy front, is it correct that you have $27 million that you actually reported in 2008 that you were at a run rate of $67 million by year end?

David Scheible

That's exactly the right number.

Joseph Stivaletti – Goldman Sachs

What do you think is reasonable to assume in terms of a reported number for '09 relative to '08 above and beyond that $27 million?

David Scheible

I guess we could do the simple math and suggest that you would expect to see a $40 million sort of number or an annualized rate of $67 million. We ended up at $27 million so you can sort of see the $40 million for sure as I think we are certainly comfortable with that. Obviously we gave you that math.

I will also suggest that we are looking at accelerating some of the options. One of the things that happens, and you and I have talked about this before, the most difficult thing to forecast when you put integration plans together is how much productivity improvement you get in those plants. As you start to consolidate and you change your run profiles, you get improvement.

So what that allows us to do is to run less overtime in our facilities, less temporary work and in a company the size of Graphic Packaging, 14,000 employees that is not an insignificant number. So what you see is that going through the synergy numbers as well.

It's tough to predict because some of it is based on volume, assuming the volume stays at a certain level. But I would tell you that we would certainly expect synergy numbers to be trending towards that kind of number for the year.

Joseph Stivaletti – Goldman Sachs

I know that it's hard to talk about anything in this environment looking over a 12 month period, but from a volume perspective, is it still reasonable to assume that your volumes for the full year given your exposure primarily in food and beverage would be hold in at least at '08 levels or up because that's very different from so many of our companies indicate for packaging.

David Scheible

Here's how I would answer that question. What I would say, and you know if you've followed us in the past, we tend to approximate GDP. We're sort of a little bit above GDP normally in our business on an annualized basis. So if you sort of look forward, you would expect food and beverage typically to be at the underlying GDP rate if you take out buying of homes and those kinds of things, because that's not really part of it.

So if you look at that business, we would expect it to be pretty stable. You're also seeing some positive trends where people are eating at home, and they're also eating, and they're going to the center of the store. Both branded and private label are both doing well as we start the year, so we don't see a huge trend to some product line or some effort where we don't participate.

So what I would tell you is I would expect, and our early trends are, that volume is hanging in there. It's pretty decent volume. But if the economy continues to deteriorate, I think it's really difficult for us to figure out what people will do, including packaged goods and packaged food services.

When I talk to Kraft and General Mills, and Kellogg's they're not sure as they look forward to where all that works out. So I like where we're starting the year, but I am really reticent to give a long term forecast.

I would certainly rather be making food and beverage cartons than some of the heavy industrial based products, but I'm not going to be tied into telling you what I think volume will do because I'm sure I would be wrong.

Joseph Stivaletti – Goldman Sachs

In your press release, you talked about fourth quarter of '08 being affected by $13 million of costs relating to the shut down of your number two paper mill. Is that severance?

Daniel Blount

No. That cost is unabsorbed burden. It's a fixed cost base for shutting down number two machine. That's what it refers to. We're not operating the machines. There's still some of the fixed costs we haven't got out.

Joseph Stivaletti – Goldman Sachs

Is that something that would be out of the system by now? Is that going to take you awhile to sort of lower your fixed cost relating to it. I'm just trying to understand if that's an ongoing kind of thing.

Daniel Blount

No, that's not an ongoing type of thing. We're taking actions. We're eliminating the costs and we're actually reducing production on some of the other machines because we have an ability to do that because we shut down number two. So I think it's an issue that you will not see in 2009 going forward.

Operator

Your next question comes from [Gerard Worshton – U.S. Steel]

[Gerard Worshton – U.S. Steel]

I had a question regarding the ink manufacturing side of things for the corporation such as Riverdale Industries. Do you have plans to close any of those facilities?

David Scheible

We don't ever really give guidance at what we're looking at across the board. I don't have any sort of real plans right now for additional plant structure changes at this point in time so I can't help you with that answer.

I think you're talking about our Handschy ink facilities which is of course we use to primarily make internally to service our own facilities and right now we continue to operate those facilities.

[Gerard Worshton – U.S. Steel]

I was concerned because of the high cost of material such as chemicals in order to make the ink, if that was affecting your business right now.

David Scheible

It's a good question. When we start talking about the fourth quarter of course is that we really didn't see much of the chemical cost come down in the fourth quarter. Those things have tended to lag, oil prices. But what we are starting to see in the first quarter of course is our chemical prices coming down for most of our products like latex in our codings with the possible exception of caustic soda.

It continues to be pretty high. I think there are other market dynamics at work on caustic soda, but a lot of the input raw materials for those inks which are for the most part petro chemical based for the most part. We have seen them drop and of course we will reflect those as we look at the first and second quarter next year, we would expect those costs to go down.

[Gerard Worshton – U.S. Steel]

Another thing too, I never saw the stock of a corporation so cheap as it is. I think it hit a rock bottom of $0.57. I was concerned if the company at all is going to have a reverse split or any kind of split in the foreseeable future.

David Scheible

I don't think we're going to talk about stock prices here, but no we have no anticipation of a reverse stock split.

[Gerard Worshton – U.S. Steel]

I don't think you ever had a stock split as far as that's concerned in history.

David Scheible

Not that I'm aware of.

[Gerard Worshton – U.S. Steel]

I hope things can prosper for the company as far as the shareholders. Like I said, I never saw the stock this cheap.

David Scheible

I would tend to agree with you. You and I are aligned on that.

[Gerard Worshton – U.S. Steel]

Do you think the stock will go lower here or nobody knows right now as far as the recession and the market place for your company?

David Scheible

I can't provide guidance on stock and I think based on my own portfolio, you certainly wouldn't want to be following my advice on the stock market as well. Who knows? I think what we're going to do as I said earlier, we're going to operate effectively. We're going to reduce our debt, improve our margins in 2009 and we'll let the stock take care of itself. But I appreciate your question.

[Gerard Worshton – U.S. Steel]

Another thing too, I noticed that there was a report that you're building a new plant in Kalamazoo, Michigan, right?

David Scheible

We're not building a new plant, but as we announced in the fourth quarter last year, we're making about a $40 million expansion to our existing facility in Kalamazoo, Michigan. That facility is where we make a lot of cereal and dry food products and we're going to add about 160 jobs or so in that area as we expand that facility.

We've already started the work and yes, that's a very important Kalamazoo mill and Kalamazoo is important to us and we're excited about that investment. So it's not all about the plant take out. In some cases, it's about investment and doing the right things.

Operator

Your next question comes from Sandy Burns – KBC Financial.

Sandy Burns – KBC Financial

In terms of the contract re-pricing that's occurring, does most of that kick in at the beginning of the year, or is it more spread throughout the year? Also, given the environment can you tell us how well it's been going overall?

David Scheible

Our contracts do come out all throughout the year. There isn't like January is a major reset for any individual contract. They roll through whenever those contracts were signed, and they're signed throughout the year.

What I will tell you about our customers are no different than us. Nobody necessarily wants a price increase but our customers under their contracts, just like we did when inflation was going through the roof last year, we honored and sold and manufactured at a tough time for Graphic Packaging.

We haven't had to have difficult conversations with our customers. They understand the benefit they've gotten and that's really not a problem for Graphic.

Sandy Burns – KBC Financial

Anything you can say right now in terms of what you're down time is looking like in the first quarter on either Containerboard or CRB?

David Scheible

Those are three different questions so let's talk about them. In our CRB that primarily drives food and beverage and of course that is a pretty busy time of the year for us as you can well imagine cereal and macaroni and cheese cartons and beverage and beer. So those are pretty busy right now.

The Containerboard business, we only have a small medium machine down in West Monroe, Louisiana. We make less that 100,000 tons externally and we have taken some downtime in January in that machine just because the market demand is offset 19%. It's a pretty small impact overall to the corporation as you can well imagine. It's a very, very small machine, but there is no good reason for us to continue to produce.

Now what we have started to see as we're heading into the end of February and March is that that business is beginning to recover. As I think most Containerboard people will tell you, there is some light at the end of that, but for us, clearly we are the tail wagging that dog. So our major mills are running. If things change, I'll take them down but we have no current plans to take additional down time.

Sandy Burns – KBC Financial

What's the capacity on the number two machine that's being shut?

David Scheible

I think it was 150,000 tons roughly.

Sandy Burns – KBC Financial

So certainly one of the small machines in the system.

David Scheible

One of the small machines in the system. It was what we call the swing machine. We make liner board on it, but when it was full operating it was between 150,000 and 175,000. I'm hesitating because a lot of it depends upon how much, what grade you're making, heavy caliber, low caliber but it's in that range. It's not a 700,000 ton machine like the other ones in West Monroe.

Operator

Your next question comes from Matthew Armas – Goldman Sachs.

Matthew Armas – Goldman Sachs

Can you provide fourth quarter volume numbers by major segments and that being food, beverage and industrial.

Daniel Blount

We do not break that out.

Matthew Armas – Goldman Sachs

Can you provide some qualitative?

David Scheible

As I mentioned, food was pretty flat. Beverage was down only slightly. Beer was up and soft drink continued to decline. On average the difference between '07 and '08 in those businesses was negligible from a carton standpoint.

The volume drop off in our business was primarily around Containerboard or medium if you will, and multi wall bag. That business was mostly affected by the industrial. Our international markets were pretty good. They were pretty much on line with what they did last year. Open market, what we would call board that was sold to other converters. That was slightly down in the quarter as well because that board is not only used in food and beverage, it's used in a variety of applications and they struggled a little bit in the quarter.

So our core businesses were flat to slightly up. The rest of it was more dependent upon, other sectors were down.

Matthew Armas – Goldman Sachs

Given that in your distribution of outcomes for the year, it sounds like volumes could be good, volumes could be very bad, you're not willing to call the back half. But looking at your covenant step down in the third quarter, would it be prudent to go back to the bank? Have you started discussions with the bank on potentially amending the step down to provide some more flexibility?

David Scheible

No we have not started any of those discussions. In our forward looks we see no issues with the credit agreement and we really like our credit agreement and the flexibility it gives us to run the business.

Daniel Blount

If you look at the cushion under the calculus, it's over full term, almost a term and a half, so there's no forward scenario that would suggest we should be looking at that.

Matthew Armas – Goldman Sachs

On your natural gas hedging policy, can you remind us what the institutionalized policy on a go forward basis is forward hedging natural gas and have you thought about reigning that in a little bit given that it seems to be the second year of three where you're kind of locked in longer term higher prices.

David Scheible

First of all we do some natural gas hedging just because it's sort of the covenant process with the banks and our credit facility. We typically hedge about 70% of the quarter we're in, and the rest of it we go on the open market. I don't suspect we will do materially different than that. We are hedged significantly into the first quarter of 2010, although we have some small position going into that.

So we'll continue to follow our overall policy. The hedge policy for us is to really just make sure that understand our input costs. We're really not in it for speculation or finding out the low end of the market in the process. It's pretty stable. We use it basically to control cash flow not as an up and down plan.

Operator

Your next question comes from [Raza Alliace – Nike]

[Raza Alliace – Nike]

I wanted to see if you could give me an idea of where your volumes stand right now after the shut downs and integrations and where is your capacity right now by segment?

David Scheible

We don't provide production capacity by segment. I will tell you that we roughly make about 2.3 million tons a year between our capacities. That capacity is down only by the 150,000 or so thousand tons that we took in our paper machine number two. On an annual basis, we see maybe a percent of creep or something like that, so our tons don't move materially so our tons don't move materially around that.

At this point in time, our forward look is that we'll need all those tons globally. If it becomes different, we'll take the appropriate down time.

David Blount

If you look in the 10-K as well, you'll see some additional information in regards to production capacity in the mills.

Operator

Your next question comes from Terry Dougherty – Capital Source Bank

Terry Dougherty – Capital Source Bank

Just a quick question regarding revolver expectations for 2009. While it was noted that you have approximately $160 invested, do you foresee any additional investment draw downs or any repayments in the near term?

David Scheible

We're currently evaluating our lenders and we're looking at what are the appropriate times to really restart our program of borrowing money when we need it, and not carrying excess cash on hand. Currently we're still in the evaluation process and when it's appropriate, we'll adjust back to our original cash management program.

Operator

Your next question comes from Aaron Rickles – Oppenheimer

Aaron Rickles – Oppenheimer

I had a question regarding the credit facility EBITDA and the reconciliation of that to your pro forma EBITDA and really the question is some of the adjustments. How do they roll off in 2009? Can you go through that a little bit?

David Scheible

I don't think I'd like to go through that in detail, but what I will tell you is we have projected out our adjustments and we have modeled our credit agreement EBITDA not only through 2009 but well into 2010 and through that period, we see that we have a substantial cushion of between the credit agreements minimum and the expected amount that is calculated based on business performance. So that's what we've done.

Aaron Rickles – Oppenheimer

You can't be more specific?

David Scheible

Our credit agreement has you can see by the attachment to the press release is very complex. There's a lot of moving pieces in that and it's just not something that you can do on a call like this.

Aaron Rickles – Oppenheimer

Your CapEx, I was hoping you could go into a little bit more depth. The guidance is helpful but is it possible to break that out a little bit more in terms of what you view as maintenance versus reinvestment in the business?

David Scheible

Probably my mill guys would come hunting for me, but I would tell you that Graphic Packaging on a pure maintenance basis, we probably, we run our business on $110 million to $115 million of CapEx. The rest of it is related to our synergies and our IT integration for this year.

Last year we spent $183 million. We expect as Dan said to be somewhere in the $170 million to $180 million this year and still heavily oriented because we're expanding as I mentioned earlier $40 million to our Kalamazoo facility. We've got some IT investment in the process, so CapEx will walk down over time but to run the thing on a bare bones sort of thing, I'm sure we're much closer to $100 million that $180 million.

Aaron Rickles – Oppenheimer

How are you thinking about 2010 in terms of walking it down? Do you think it steps down quickly or are there still things in the pipeline.

David Scheible

I'm trying to get through the first quarter of 2009, so right now I don't mean to be flip but the reality is, looking out to 2010 for CapEx, not sure what volume or needs are going to be from customers is really difficult.

Of course we have a long term three year plan, but I wouldn't want to give you insight into that because I really think we have to figure out what '09 is going to be. I think it will potentially change a lot of different things for companies including Graphics.

So I'm comfortable with our plans for '09. I like the early trends in the business but I don't really want to try to give guidance for 2010 CapEx.

David Blount

Thank you everybody for joining us on our fourth quarter earnings call.

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Source: Graphic Packaging Holding Company Q4 2008 Earnings Call Transcript
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