Graphic Packaging Holding Company Q2 2009 Earnings Call Transcript

| About: Graphic Packaging (GPK)

Graphic Packaging Holding Company (NYSE:GPK)

Q2 2009 Earnings Call

August 5, 2009 8:30 am ET


Scott Wenhold – Vice President, Treasurer

David Scheible – President, Chief Executive Officer

Daniel Blount – Senior Vice President, Chief Financial Officer


Sandy Burns – Stern Agee

[Roger Smits – Banc of America]

William Hoffman – RBC Capital Markets

Joseph Stivaletti – Goldman Sachs

[Richard Cass – Jefferies]

[Jeff Hollis – Barclays Capital]


I would like to welcome everyone to the Graphic Packaging Holding Corporation's second quarter 2009 earnings conference call. (Operator Instructions) I would now like to introduce Mr. Scott Winhold, the company's Vice President and Treasurer.

Scott Winhold

Good morning everyone. Welcome to Graphic Packaging Holding Company's second quarter 2009 earnings call. Commenting on results this morning are David Scheible, the company's President and CEO and Dan Blount, Senior Vice President and CFO.

I would like to remind everyone that statements of our expectations on 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 debt reduction targets, declines in raw material, commodity prices and expected effect on the company's results, additional synergies from the Altivity transaction, consumer purchasing trends, pension contributions and the performance of our Multi-Wall Bag business 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 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 place 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.

David Scheible

We are pleased with overall second quarter results. This is the second quarter in a row in which we delivered EBITDA growth and significantly higher EBITDA margins. The strong operating performance is resulting in substantial cash generation and therefore net debt reduction.

Pro forma adjusted EBITDA which excludes alternative fuel tax credits and expenses related to the Altivity combination as well as other non reoccurring items improved to $148 million the second quarter, up from $130 million in the first quarter of this year and $139 million in the second quarter 2008.

For the last six months, pro forma adjusted EBITDA improved to $278 million compared to $266 million last year. Pro forma adjusted EBITDA margins have improved to 14.2% in the second quarter which compares to 12.7% in the first quarter this year and 12.3% in the second quarter of last year. That's 150 basis point sequential improvement and 190 basis points year over year improvement in our margin on lower volumes.

As we have said previously, generating cash to pay down debt and improving our debt ratios remains a top priority. Last night, we issued a press release indicating that we plan to redeem and pre-pay approximately $20 million of principal and interest on our 2011 8.5% senior secured notes at par value.

In the second quarter we generated $121 million operating cash flow and received approximately $52 million of alternative fuel tax credits. We are ahead of our cash flow projections and are raising our full year net reduction target to approximately $200 million from operation which excludes any benefit from the alternative fuel tax credits.

We have not built these credits into our debt reduction target due to the uncertainties with how Congress may act on this credit. Our alternative fuel tax credits are averaging roughly $10 million a month.

We continue to drive improved EBITDA performance. In the quarter we generated $25 million in on going synergy savings and an additional $30 million of cost reductions from continuous improvement programs and other initiatives.

Cost to achieve these synergies were roughly $34 million resulting in approximately $21 million of net performance improvements in the quarter. As we said on the last call, our merger related synergies have exceeded $92 million and we have now far surpassed these synergy goals.

Working capital in the quarter improved $51 million and we are tightly managing our CapEx as well. Dan will talk more about these in his remarks, but we are planning to maintain the reduction in working capital. Throughout our synergy efforts, we have seen significantly higher levels of productivity in both carton and mill assets and with our two largest individual capital projects, the Kalamazoo Carton expansion and our IG integration projects winding down this year, see significant opportunities to continue to improve productivity at overall capital expenditure rates lower than our historical levels.

Our teams are doing a terrific job of tightening our supply chain across the board and their efforts are clearly showing in our results.

On the input side, trends are generally favorable with most of our major raw material costs being flat to down. So far, this trend has continued through the end of the July with the only exception being a modest price increase on OCC fiber used in our recycle board mills. Dan will talk more about input prices in a moment.

On the demand side, we saw modest sequential improvements in second quarter volumes and this trend has also continued into July. While volumes are still down year over year, we remain cautiously optimistic that volume trends are beginning to move in the right direction.

The nature of our core food and beverage business make it less susceptible to fluctuations in the economy than the Multi-Wall Bag business, so our core food and beverage continues to perform exceptionally well in this environment and it accounted for roughly 84% of our total sales in the second quarter.

Let me take a moment to touch on both our Folding Carton and Multi-Wall Bag businesses. Sales in our Folding Carton and beverage businesses increased 3.7% sequentially from the first quarter but decreased 1.6% from the second quarter 2008. The beverage business was very strong and continues to show resiliency. In beverage, we saw particular strength in domestic beer and sales in soft drink category have begun to improve. On the food side, dry and frozen take home products performed very well.

While our overall consumption across food and beverage continues to be relatively flat, we are benefiting from a shift towards value based take home items. In the current environment, consumers continue to eat and drink more at home and less in restaurants and bars. In addition, they are buying more cook at home products in the center of the store rather than the pre-cooked or prepared meals. As a result, volumes are up on the take home side of our business and down on the away from home side.

In food, the shift continues to be towards items like pasta, cereal, and frozen food and away from items like candy, bakery goods and pre-baked items. According to AC Neilson, some of the better performing food categories in the second quarter were dried dinner mixes, up 8.9%, frozen pizza snacks up 11% and refrigerated products up 5.3%.

If you look at beverage and beer, the shift continues towards domestic beers, store bought take home products and anything in a can. Year to date take home beer volumes across the industry are up by nearly 3%. On the flip side, imports, bar and restaurant products and bottled products are all down.

In carbonated soft drinks, the economy continues to have a negative impact on the take home channel as consumer's trade down from branded cola's to private label and tap water, which is up 12% year on year. Although volume was down, improved pricing and mix contributed to sales being flat year over year in this sector.

Let's look at Multi-Wall Bag business. This business is less defensive that food and beverage and more impacted by economic conditions; specifically, in the building and construction markets. The Multi-Wall Bag business accounts for roughly 11% of our total sales right now. We do expect volumes in this business to improve faster than food and beverage as the economy rebounds.

Sales in our Multi-Wall Bag business decreased 7.6% on a sequential basis from the first quarter and 19.7% on a year over year basis. We've taken the necessary steps to right size and optimize this business and we will continue to manage it from a cash flow basis. As conditions begin to improve in the end markets, volume margins should recover. However, this will likely be a lower EBITDA margin business than our food and beverage.

Even in a difficult market however, this business generates healthy cash flows and a return on capital above our weighted average cost of capital.

Turning to the mills, they had a very strong operating quarter, improving all performance and integration metrics and exceeding our financial targets. On a tons per day basis, which is a key through put metric, improved and we look and we took no market down time in our core CRB or SUS plants.

The new management operating system at West Monroe, Louisiana mill continues to yield excellent results and productivity, energy conservation and fixed cost reductions. Additionally the Kalamazoo mill started their lean initiative roll out during the quarter and is making excellent progress.

Lean initiatives across the mill system include our Battle Creek, Michigan, Middletown, Ohio, Macon Georgia, and Santa Clara, California mills, all resulting in improved performance across the system.

With respect to raw materials, we saw favorable variances in energy; wood and secondary fibers which helped drive EBITDA and cash generation to strong levels. So far, with the exception of some modest increases in OCC, these favorable trends have continued into the third quarter.

Now partially offsetting these positives were price erosion and lower than expected sales volume, particularly in the non core container board and uncoated markets. As a result, we took 17 days of down time on the West Monroe, Louisiana number one medium machine and 16 days of downtime in our uncoated mill in Pekin, Illinois.

We are quite pleased with the progress and performance of the mills and believe there are further improvement opportunities throughout the year.

Let's talk a little bit about performance improvements. As I mentioned, we issued $21 million of net performance improvements in the second quarter. The major driver behind this continues to be number one, plant closures and rationalizations, number two, optimizing our mill mix and three, procurement and transportation improvements.

We have announced the closure of eight converting plants; five in 2008 and three in 2009. All of these plants are scheduled to be closed prior to the end of 2009. In mill optimization to date, we have integrated nearly 70,000 tons of SUS and CRB and URB and are operating at around an 80% integration level between carton and mills.

We have been able to successfully integrate tons in each of our businesses and the benefit from this initiative has provided a valuable offset to some of the economic challenges in today's marketplace.

On procurement and transportation, our teams are working hard to internalize freight and improve transportation across the entire supply chain. We have been able to markedly reduce the total number of warehouses across the system this year, and expect more reductions in 2010 as we complete the realignment of our converting footprints.

Let's talk a little bit about new products. This has continued to be a good source of growth in margin for Graphic. New product sales were more than $20 million in the second quarter. As we have said before, the shift towards more value driven products during the current economic cycle has dampened the new product development side, but this continues to be an important part of our business and differentiating factor.

In the second quarter we launched and won a number of new product programs. In beverage we won a new Z-Flute contract for a new kids drink pouch carton that was chosen because of its ability to highlight Disney graphics. We launched our Z-Flute package for a 10 count Minute Maid pouch from Coke, and a private label product, a top beverage in the U.K. that expands our market and takes volume from [Shrink Ville].

We also captured a new energy drink carton for Brawls, Guaraní and No Fear. In addition, we placed brand new beer and soft drink machines at Inbev in Belgium, San Miguel, in Spain and Matt Brewing in the United States, and finally at Adirondack in the United States as well.

In the microwave segment, we launched a new product that allows customers to crisp their product to their own personal preferences for the Heinz line of Smart One flat breads, a new smart pouch that is a new steaming microwave package, a new susceptor sleeve for Nestlé Lean Pockets, seasoned crust pizzeria pizza that provides pizzeria style browning and crisping in the microwave.

We launched a new susceptor product for a branded line of frozen quiche's in France and a new product for Kirkwood Wings to Go.

On the shrink side we won programs with Kraft, Nabisco and Avery Dennison that provides increased value by replacing corrugated litho packaging with solid fiber solutions. Finally on the commercial side, we launched a major new package in the shape of a lobster for Young Brands Lobster Bites and our Snap to See interactive mobile technology on the Colgate Men's Speed Stick.

I've been encouraged that in this tough environment, customers continue to spend on new value added products and we are capturing a large share of those incremental sales. Dan will walk us through the details behind the numbers.

Daniel Blount

Good morning everyone. As in the past, my comments will include operating results comparisons. The only pro forma results included will be to adjust both net sales and EBITDA in the prior year to exclude the two mills that were divested as part of the combination with Altivity. This will provide you with accurate year over year comparisons. A reconciliation detailing the pro forma non-GAAP numbers is included with the earnings release.

Since cash generation and debt reduction is a top priority, I will start my discussion by going through our cash flow, balance sheet and liquidity metrics, and then come back to a more detailed discussion around the income statement.

The other thing we are doing differently this quarter, when appropriate, is commenting on sequential changes from the first quarter in addition to the year over year changes.

Starting with cash flow, net cash from operations was $172 million in the quarter, an increase of $170 million over the first quarter this year and an increase of $81 million over the second quarter last year. Over the first six months of 2009 we improved operating cash flow by $158 million.

Included in operating cash flow are alternative fuel tax credits. Through June 30, we have applied for $62 million of tax credits and have received $52 million in payments.

Excluding the credits, operating cash flow increased by $107 million over the first six months of 2009. As David briefly discussed, continued productivity and cost reduction improvements as well as lower input costs and the alternative fuel tax credit drove the increased cash flow in the quarter and the six month period.

Now that we have had a year to integrate Altivity, we are starting to see the acceleration in our cash generation that we expected.

One of the key focus areas has been our strict management of working capital, specifically inventory. On a year to date basis, cash flow from working capital improved by more than $62 million from the same period last year. Since the beginning of the year, inventories have decreased $40 million.

The major inventory reduction initiatives include one, supply chain optimization which increases inventory production cycle times, and two, plant rationalization which allows us to meet product demand with fewer facilities.

Capital expenditures were $30 million in the second quarter down from $47 million in the second quarter of last year. Depreciation and amortization was $75 million in the quarter versus $67 million last year.

Our balance sheet leverage ratio liquidity; we reduced debt by $159 million in the second quarter and ended the quarter with cash equivalents of $161 million. Our total net debt at the end of the quarter was $2.9 billion and our net leverage ratio improved to 5.3 times. Under the terms of our credit agreement, we must comply with a maximum consolidated secured leverage of five to one. As of June 30, 2009 our consolidated secured leverage ratio was 3.6 to one.

At quarter end, we had $16.5 million drawn on our $400 million revolving line of credit and our available liquidity was $496 million. In the quarter we extended near term debt maturities with the issuance of $245 million of senior notes due in 2017 and tendered for $225 million of senior notes due August 2011.

As you saw from our press release last night, we plan to redeem and pre-pay approximately $20 million of principal and interest on our 8.5% senior secured notes at par value. Once the redemption is completed, our earliest debt maturities will be approximately $180 million of senior notes due August 2011 and our bank revolver runs through May 2013.

Total sales; moving to the income statement, second quarter total net sales increased 2.4% sequentially over the first quarter and decreased 7.1% from the second quarter last year. The $80 million year over year decline in total sales breaks down as follows; one, $8 million positive impacts from higher pricing, two, $78 million negative impact from lower volumes primarily in our Multi-Wall Bag and Specialty Packaging businesses, and three, $10 million negative impact from foreign currency.

From a mix standpoint, Paperboard Packaging accounted for 84.2% of total sales, Multi-Wall Bag accounted for 11.1% of total sales and Specialty Packaging accounted for 4.7% of total sales.

Paperboard Packaging segment sales; sales in our core Paperboard Packaging business were strong, increasing 4.6% sequentially over the first quarter and decreasing a modest 3.4% from second quarter last year. Net tons sold in Paperboard Packaging increased 5.1% sequentially from first quarter and decreased 3.7% from the second quarter last year.

For discussion purposes, I will break down the Paperboard Packaging segment into three primary areas. One, North America folding carton which sells predominantly beverage and food packaging, two, open market non converted paperboard and three, international.

North American folding carton sales which is the vast majority of the segment were strong, decreasing a modest 1.6% from second quarter of last year. This strength was led by the beverage business which increased low to mid single digits on both higher volumes and price.

Driving the improvement in the beverage category was strength in their products which recorded a high single digit increase from both volume and price. Soft drink related sales are showing improving trends and were flat with last year.

Food and other consumer product sales decreased low single digits on declines in volume partially offset by increased pricing. Open market sales of non converted paperboard decreased mid single digits versus second quarter last year on both volume and pricing declines. The volume decrease is primarily the result of our exit of the liner board business which we did by shutting down the West Monroe number two paper machine.

Finally, international sales declined 11.8% from second quarter last year primarily due to unfavorable changes in foreign currency exchange rates. International carton volumes were slightly better than the prior year.

Multi-Wall Bag and Specialty Packaging segment sales; our two smaller segments, Multi-Wall Bag and Specialty Packaging sell products used in the building, construction and industrial supply sectors. As such, these businesses have suffered double digit year over year sales volume declines. As the economy improves, we expect Multi-Wall and Specialty to materially benefit.

Sales of Multi-Wall Bag products decreased 7.6% sequentially from the first quarter and 19.7% from the second quarter last year. The sequential decrease was driven primarily by pricing declines while the year over year decrease was driven by volume declines.

Sales of Specialty Packaging products decreased 8.9% sequentially from the first quarter this year and 29.4% from the second quarter last year.

EBITDA, moving to EBITDA, second quarter EBITDA improved significantly on both a sequential and year over year basis. Second quarter EBITDA of $163 million increased by $48 million from the first quarter and by $33 million over the second quarter last year.

Second quarter adjusted EBITDA of $148 million which excludes merger related charges, the loss on the early extinguishment of debt and alternative fuel tax credits, improved by $18 million sequentially and by $9 million year over year.

The majority of the $9 million year over year increase was made up of the following; a $21 million positive impact from performance improvements, an $8 million positive impact from higher pricing, a $13 million negative impact from lower volumes and an $8 million negative impact from inflation.

Second quarter EBITDA and adjusted EBITDA margins increased significantly. EBITDA margin of 15.6% increased 430 basis points sequentially from the first quarter this year and 410 basis points from second quarter last year. Likewise, the adjusted EBITDA margin of 14.2% increased 150 basis points sequentially and 190 basis points year over year.

With Paperboard Packaging making up nearly 84% of our total sales, it is worth pointing out that the Paperboard Packaging EBITDA margins are the highest in the company at around 19%. While Multi-Wall Bag and Specialty has significantly lower EBITDA margins, both businesses are generating healthy cash flows and have a return on capital above our weighted average cost of capital.

Input costs and product pricing; turning to input costs for a moment, we generally saw favorable sequential and year over year trends in most of our major raw materials including natural gas, virgin and OCC fiber and chemicals.

Because of the two to three month lag between lower input costs translating into cost of goods sold, we expect Q3 to have a higher benefit from lower input costs than Q2. In the second quarter we did experience about $8 million of inflation primarily driven by employee retirement benefits.

Through the end of July, input costs have remained relatively stable. We have seen a slight increase in OCC pricing around $15 per ton. Offsetting this however, are price decreases in other areas such as chemicals and virgin fiber.

Factoring in our hedged natural gas positions, our average blended cost of natural gas per mmbtu was approximately $8.24 for the first six months of 2009. On an annual basis, we typically use around 10 million mmbtu's of natural gas. If rates remain at the current spot levels, we could realize a significant benefit in 2010.

Turning to product pricing; year to date we have recognized a net increase of approximately $33 million primarily from contractual inflationary recovery.

Now guidance; finally let me summarize a few targets that we mentioned in various places on the call. First, we have raised our net debt reduction target to $200 million. This excludes any amounts from alternative fuel tax credits. If you include the $75 million in tax credits, we have earned through the end of July, then our annual net reduction target increases to $275 million this year.

While we cannot be certain whether the alternative fuel tax credits will continue through the end of the year, we will apply any additional credits to further debt reduction.

Our capital expenditure target for this year is approximately $150 million. As David said, we see significant opportunity to operate with capital spending lower than historical levels.

Our cash pension contribution for 2009 is set at $65 million. Improvements in working capital driven primarily from inventory reduction is expected to result in $50 million of cash this year.

In closing, I just want to reiterate how focused we are on generating strong, sustainable cash flows to strengthen our balance sheet, improve our leverage ratios and drive shareholder value. Going forward, cash flow should benefit from the full impact of the synergies and performance initiatives, lower cash interest costs and disciplined capital spending.

With that, I will now turn the call back to David for his closing comments.

David Scheible

In closing, I would like to reinforce strategically, I think we're firmly positioned as the dominant value added packaging supplier in food and beverage sectors. Our global footprint, vertical operations and efficient operations, and ability to create new industry leading products, enable us to compete globally on both price and innovation.

With the industry likely to continue to consolidate around bigger global consumer products companies looking for focused and integrative partnerships of packaging suppliers, we think Graphic Packaging is in a great position to grow the business and continue to deliver improving financial results.

Our strategic direction is really standing on three principals. The first is improving our core business by focusing on improved operating efficiencies in customer metrics. We know which businesses we are in and which ones we are not.

The second key strategic principal is growth. Given our leading market share position in the folding carton, food and beverage markets, our ability to deliver new, innovative products and expand our global geographic footprint, we absolute believe we are in a position to grow and emerge as the stronger player in a global consolidated market.

As mentioned, there are some early signs that volumes are beginning to improve sequentially, and we are cautiously optimistic that demand volumes have troughed in this economy.

The third principal is improving our financials, specifically accelerating cash flow to reduce debt, to strengthen our balance sheet and improve our leverage ratios. We have now produced two quarters in a row of improving operating EBITDA and delivered over $174 million of operating cash flow over the first six months of this year.

Our EBITDA margins are improving significantly both quarter to quarter and year over year and we see further opportunity to improve.

So in closing, let me just say we like the positioning of the business today, and I know we need to growth the business and drive shareholder value, and we are focused on execution each and every day.

I want to thank all of our dedicated hard working employees who are making it happen. Thank you.

We would now like to open the call to your questions.

Question-and-Answer Session


(Operator Instructions) Your first call comes from Sandy Burns – Stern Agee.

Sandy Burns – Stern Agee

Could you remind us, I guess the relationship with the major soft drink companies given that Pepsi is now buying back in their bottlers, does that really change anything in terms of your relationship or create any new opportunities or issues that you see?

David Scheible

PepsiCo has for a long time sort of centralized their purchasing organization for the bottlers as well. Our relationship, we continue to be the ship to locations. So I think it will remain pretty much the same. We certainly will work with PepsiCo as they work their integration synergy targets.

It's unknown to us yet and probably to them to some extent if there's going to be any change to the bottler network, but it shouldn't materially change our relationship with them or our financial association with PepsiCo.

Sandy Burns – Stern Agee

On the Black Liquor proceeds you mentioned that you mentioned you look at about $10 million a month, yet in the second quarter you had accrued for about $55 million. Is that just more because, is the $55 million in the high end number just because of seasonality or is the $10 million just trying to be conservative for the time being.

David Scheible

If you remember in the second quarter that was more than just the second quarter period. I think we started generating Black Liquor credits in January and so second quarter was a reflection of what we have accumulated year to date through that period.


Your next question comes from [Roger Smits – Banc of America]

[Roger Smits – Banc of America]

Was the Q2 '09 SG&A high because it includes that $34.4 million of cost reductions?

Daniel Blount

That's correct.

[Roger Smits – Banc of America]

Does the other income of $71.8 million, does that include that $52 million of Black Liquor tax?

Daniel Blount

That's correct. We made a management decision to include it in other income and not disrupt gross margins.

[Roger Smits – Banc of America]

That other income number is still fairly high. Is there still something else in there between the $72 million and $52 million?

Daniel Blount

There's some proceeds of some really insignificant assets in there as well that's pushing that number up. And there's also some interest.

[Roger Smits – Banc of America]

Are you making the $20 million redemption on the 8.5% senior notes pursuant to the credit agreement, pursuant to the limit of payments under Section 8.13?

Daniel Blount

Yes we are. The $20 million I think it mirrors our basket.


Your next question comes from William Hoffman – RBC Capital Markets.

William Hoffman – RBC Capital Markets

Can you talk a little bit about international. I was kind of interested that you said you had some placements and I just wonder in the international markets what kind of EBITDA margins you get out of that business and whether you see more opportunity there.

David Scheible

As you know our international business is primarily beverage. We don't have a large consumer products business so when I talk about machine placements, it's because our focus is really on expanding the beverage businesses.

Our EBITDA margins in Europe are not materially different than what we get in the United States, but of course there's a higher working capital component because we make our board here and then ship it to Europe, so you've got the transition costs and so on.

We've struggled in the past in Europe. The past couple of years we've really made a concerted effort in that business and you can see some of the financial results. I think Dan mentioned that of course we had a foreign exchange change this year, but that's not a reflection of the business, more just the economic condition.

So we continue to see growth in international business. We signed a joint venture in China last year and that's very much focused on beverage. Our Japan business continues to be, in fact they had an extremely solid quarter. So it's still a small part of our overall business but I like very much the trends in that business.

William Hoffman – RBC Capital Markets

I just wonder with some of the new product growth, the $20 million for the most recent quarter, is the international one of the outlets that you see providing you some more opportunity in other regions, even going into Latin America, etc.?

David Scheible

The new products business was split actually between beverage and food and some of that new product growth actually was in Latin America, and also in the Caribbean, some work we've done in baskets for example in Jamaica and the Dominican Republic. So yes, it's a fair split on that.

A lot of the consumer based products however in the United States; they don't necessarily translate quite as well into Europe for example. The U.S. distribution system, the network is much different, so we can take advantage of replacing corrugated here in the United States, but as you well know in Europe, that distribution network is materially different.

Microwave is a global product and I mentioned in my notes, we've had some new success in Spain and France in microwave. Our Japanese team has created a microwave product for cooking noodles, so you're starting to see those kinds of expansion.

The $20 million a quarter from a dollar standpoint, not significant, but as I said in the past, those products tend to carry much higher margins; it acts like a bigger business than it really is relative to the financial results.

William Hoffman – RBC Capital Markets

You also talked about a lot of conversation about your debt reduction and upping the targets, etc. What kind of total debt number are you looking at as sort of a target? You've obviously been able to operate with higher leverage than most of the other companies we follow. What point do you start to turn more to pushing growth again?

Daniel Blount

We have a target. We actually clarify our target in form of the leverage ratio. It's three to three and a half times, is our target range for debt. So as we increase EBITDA, as we reduce debt, we're going to start to hit that ratio and at that point we have different decisions to make in terms of how we use our cash.

David Scheible

I guess the only caveat I would say is, I don't know that those are mutually exclusive. The questions was sort of a two part question which is debt reduction with the implication of growth and I would say that we can grow and still reduce our debt.

I think the hard thing to look at right now is the economic impact has a deleterious effect on volumes, but that's not really, I don't believe that's a harbinger of future growth options. It's just the economic impact.

But we're going to be able to continue to invest in growing our business and still meet our debt reduction targets. I think we said a year and a half ago we built a brand new facility in Fort Smith, Arkansas to make our Z-Flute cartons, and quite frankly that facility right now is operating five days a week.

So we've continued to make capital investments for the growth and still pay our debt. So I just wanted to be clear that it's not a, we don't see it as an either/or scenario.

William Hoffman – RBC Capital Markets

I was more focused on more significant acquisition type opportunities, especially now that you're challenged.

David Scheible

I think right now we're 100% go on acquisition stuff. It's an interesting market. I'm not saying we would never look at anything, but right now we're very much focused on that excess cash flow to reduce debt, get our leverage ratios back in areas that make more sense for us long term.


Your next question comes from Joseph Stivaletti – Goldman Sachs.

Joseph Stivaletti – Goldman Sachs

I was wondering if you could talk more about the deflation, the cost inflation. I think you saw if I remember right about $240 million of cost inflation in '08 and I wondered if underlying your assumptions for the full year, what you're thinking you might see for the full year in terms of deflation. It seems like you haven't benefited enormously from that so far.

David Scheible

I don't know that I'd give a target for the note, but I think what I would say is that the expanded EBITDA margins clearly are translating from the albatross between higher pricing and lower input costs. I think our margins have gone, 12%, 3% to 14.7%, so a good portion of that is really the lower input costs year on year.

So I would say that we are benefiting from the lower input cost year on year.

Daniel Blount

I think if you move forward to third quarter, if you look at 2008, when did we start suffering from a lot of the inflation? It was in the second half of the year, and so if you look forward to third quarter, you're going to see a much bigger delta in terms of inflation in our numbers on a year over year basis.

Through the second quarter and with out two to three month lag, you didn't see significant impact from inflation in the 2008 numbers. You saw it in the second half of the year, and you saw it in the first quarter of 2009.

Joseph Stivaletti – Goldman Sachs

I was referring to that $8 million that you were saying…

Daniel Blount

That $8 million has a lot to do with the pension plan because you're aware of what's happened in terms of pension assets and a lot of that extra expense is the partial recovery because we have to expense more because we have to recover in terms of the market value of the assets.

Joseph Stivaletti – Goldman Sachs

The other question I had, just trying as we look out to the rest of the year, trying to understand how much more in terms of synergies and benefits from your continuous improvement program, we should be thinking about versus what actually was reported in your second quarter.

David Scheible

I think our second quarter rate on synergy was around $25 million which is the highest quarter that we've had and as we look forward, you'll see some incremental improvement in that, but I would think that that's pretty much what we would expect to see. You'd sort of see $50 million the second half of the year, you would expect to see $50 million of net synergy contribution.

Joseph Stivaletti – Goldman Sachs

On a year over year basis.

David Scheible

On a year over year basis. And I think we started the year, we started about $90 million, so you do the quarters on $25 million, we're certainly in that $100 million range and I think in some ways, we've exceeded our synergy target in the first year and most of that is because of the execution in the process.

And so what I would say is that I'll probably do less talking about synergies and more just to give direction on cost, net cost reduction so you can have a better feel for what the business is really performing. So we'll continue to look at that net improvement, but annually we average about $50 million to $60 million a year on our cost improvement targets traditionally, and I see no slowing down in that effort as well.

Joseph Stivaletti – Goldman Sachs

So the synergy part of the $25 million in the second quarter year over year, I understand that and that will continue through the rest of the year. The continuous improvement was a separate $50 million to $60 million a year. Where are you through the first half? Is also the second quarter sort of reflective of the run rate or will it bump up from second quarter levels?

Daniel Blount

Year to date in the continuous improvement, so that includes our lean, we're about $25 million through and actually second quarter was slightly higher than first, so the ramp up from, I think we reported first quarter $10 million or $11 million and this at this point $14 million on an ongoing basis, so that sort of gets you to $25 million. And I don't see any reason why third quarter won't be a similar number.

Joseph Stivaletti – Goldman Sachs

So $50 million to $60 million.

Daniel Blount

Yes. We're definitely on that pace. And that's been the story. As you know historically we've been on a combined basis between Altivity wrapping, that's sort of the run rate.


Your next question comes from [Richard Cass – Jefferies]

[Richard Cass – Jefferies]

Could you remind us of your natural gas hedging activities for both the second half of this year and into next year?

Daniel Blount

We're just over 70% hedged for 2009 and that's at around a $9.00 rate. So our overall natural gas costs are going to be somewhat south of $9.00 somewhere between, maybe around $8.00 when you consider the effect we're buying it at $3.50 on the stock market.

For 2010, we're 20% hedged somewhere around the $6.00 rate. We're currently evaluating our hedge activity for 2010, but as we said in the script, we expect significant savings on natural gas in 2010 based on where the spot market is currently.

[Richard Cass – Jefferies]

I know OCC costs have come up considerably, more than the $15 a ton that you were talking about. Can you talk a little bit about the differences and what price you pay versus where the spot market is?

David Scheible

I'm not going to get into individual prices on OCC for what we pay versus those. What I would suggest is, and you know OCC is an arbitrage number because it depends upon geographically where you're located. The Midwest where our three big recycle mills are in Battle Creek, Middletown and Kalamazoo, are in a very good basket.

As you know the Chicago, Midwest basket for OCC is good and the freight which is a big part of that as well is much lower. We'll pay a market rate for OCC and as Dan has said, I expect it to go up a little bit in the third quarter.


Your next question comes from [Jeff Hollis – Barclays Capital]

[Jeff Hollis – Barclays Capital]

The $34 million charge, can you talk about what that related to? What actions? I thought most of the Altivity charges had been taken already.

Daniel Blount

We had a lot of activity in the second quarter in particular. Some of our initiatives were in regards to spare parts inventory and consolidation of that and taking some of those benefits. I think overall, we'll see the benefits of that resulting in lower cost of spare parts as we consolidate the buy as well as us being able to operate with lower net inventories.

In regards to the $34 million, $20 million of that is really non recurring charges for the write down of assets and the remaining is ongoing synergy activity in terms of moving machinery around, severance benefits, IT training and those types of things that we've incurred in integration.

I think the key is, how close are we to completing these non recurring charges that are appearing in the P&L and I think $34 million in the second quarter is going to be the highest we're going to see this year and based on our activity, if we look forward, we're expecting to have maybe around $20 million for the remainder of the year in terms of non recurring charges and then our current plan is that that will be the, we will discontinue the practice of adding those back in 2010, even though we might have some straggling activity going on at that point as well.

David Scheible

A lot of it is related to the plant closures, and we've accelerated as I said in my part of the script, some of the plant closure up to first part of the year. Up to this part of the year that we've planned later and in fact some of them were in 2010, and as you do plant closures there are some cash and write offs associated with that process.

But most of those things are behind us at this point in time. That does not mean that we won't continue to evaluate our footprint, but I think that's less of a synergy or integration effort than it is simply to say look, we're operating a lot more efficiently than we thought we were.

If you look at the through put on our mills and you look at the converting metrics, we haven't needed all the assets that we thought we would need in the integration activities because of the through put, and therefore we'll continue to evaluate those high cost plants.

But as Dan said, I think that's going to be more ongoing, continuous improvement objectives which we have done year in and year out and that's the way we'll probably try to characterize those as opposed to getting them confused into integration or synergy. It gives you a better picture.

[Jeff Hollis – Barclays Capital]

So the $20 million write down, was that more just excess assets or was it spare parts inventory?

Daniel Blount

It was a combination of both. It's both excess assets and excess spare parts inventory as we consolidated the buy.

[Jeff Hollis – Barclays Capital]

What was the down time? You said you took medium and then you took some other down time. What mill was that or what types of products?

David Scheible

We have a very small uncoded mill in Pekin Illinois and we took downtime in that because the uncoded market is sort of struggling and we had not fully integrated our own purchases from that mill. Now subsequent to second quarter we've been able to do that.

But the impact on EBITDA from paper machine number one and the uncoded was diminished quite frankly in the process. The key for us in watching down time as you well know is watching our B mills which we took no market related down time in. I will tell you, we will continue to manage inventory and cash flow, so if the markets don't do, we will take down time in those mills, but right now we need to operate the mills to fill our carton demand.

[Jeff Hollis – Barclays Capital]

Where to you stand on your multi-year contract, your beverage contracts? I know you renewed them a few years ago. When do they mature and any discussion on renewals?

David Scheible

They expire over a number of years. I won't go to individual contracts, but we're in negotiation on some customer contract almost continuously in beverage or consumer products businesses. Even if they don't expire until the end of 2010 or 2011, we start talking about them. So that seems to be like an ongoing plan.

But I'm not going to talk about individual customer negotiations.

[Jeff Hollis – Barclays Capital]

But it's safe to say there are no whole slew of major contracts expiring this year that you need to renew?

David Scheible

No. There's not a whole bunch expiring in 2009. There are some that expire in 2010 and 2011. There are some that we have renegotiated already in 2009, but I don't have the complete customer list of expiring contracts.

[Jeff Hollis – Barclays Capital]

Any additional color on food and consumer which is tracking a little weaker than beverage? Is that just the market? Any color on that if you've seen any improvement?

David Scheible

It's interesting because our food business that is tied to what you would consider center of the aisle stuff, so dry food, that' really up. But we have a portion of our food business that's really tied to things like food service or quick service restaurants, and some of that business has been very, very soft because it relies on people eating away from home.

And so in the mix, we were down about 1.5%, but in what you would think about what is consumed in an Albertson's or a Wal Mart or Kroger, that is doing really well. In fact I was in Centralia, Illinois not too long ago and I will tell you that we have been running a press down there January making Macaroni and Cheese seven days a week, and we're not caught up. So what I would say is those kinds of products continue to sell very, very well in this economy.


There are no further questions at this time. Are there any further remarks?

David Scheible

Thank you very much. We'll wrap up this morning's call. Thank you.

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