Andrea Tarbox - VP and CFO
KapStone Paper and Packaging Corporation (KS) Bank of America Merrill Lynch US Basic Materials Conference December 10, 2013 2:05 PM ET
[Call Starts Abruptly]…KapStone and its Chief Financial Officer, Andrea Tarbox are here to present at BAML’s Basic Materials Conference again. Andrea as many of you know was appointed KapStone’s Vice President and Chief Financial Officer back in January of 2007 after a very long career in financial management and accounting.
Meantime, KapStone itself has been a very dynamic Company. Continue to evolve most recently with the acquisition of the Longview Fibre Paper and Packaging assets. So without any further delay I give you Andrea Tarbox to tell us about KapStone, Andrea?
Okay. Alright, well good afternoon. I have to say I am really delighted to be here. Today is my inaugural showing at this BAML conference and I am delighted that George invited KapStone to participate, so thank you George.
I’ve entitled this presentation as, the best is yet to come. That was a line that Roger Stone my boss used in the third quarter earnings call. And I think that line nicely sums up KapStone’s position. Hopefully you’ll understand why we believe -- and believe in this after this presentation, if not I would have failed in -- failure is not an option, so. So you got to tell me you believe.
Please consider yourself duly warned about today’s content.
KapStone provides a compelling opportunity for investors to co-invest with two successful veteran entrepreneurs in the paper and packaging segment. Roger Stone and Matt Kaplan, Roger, Matt and their immediate family are collectively the largest shareholders and own or control approximately 11% of the Company.
Our management’s focus is totally aligned with shareholders since management is so heavily invested in the Company. KapStone is relatively new Company and was formed in August 2005 raising $120 million in an IPO. During the period of 2007 until August 2009 an additional $102 million was raised from warrant exercises. There are no more outstanding warrants.
Total shareholder funds invested totaled $222 million and today KapStone’s market cap is almost really $2.6 billion and about $2.5 million in growth including the 95 million special dividend paid in December of 2012.
This slide gives you a view of how we have built KapStone so far and I say so far because we intend to keep building the Company opportunistically. The growth on our sales of 41% compounded annual growth rate since 2007 and adjusted EBITDA growth of 37% compounded annual growth rate, represents the successful acquisitions that KapStone has made.
In January 2007 we bought IP’s Kraft paper business at a 3.3 times trailing 12 months multiple. In July 2008 we bought MeadWestvaco’s Kraft paper business for a purchase price of $466 million at a 5.8 times trailing 12 months multiple. In October 2011 the U.S. Corrugated acquisition was completed for a purchase price of $332 million or a 6.4 times trailing 12 months EBITDA. Our latest acquisition Longview Fibre was completed on July 18, 2013 for a purchase price of 1.25 billion or a 6.1 times trailing 12 months EBITDA or a 4.7 times adjusting for known containerboard price increases and $10 million of synergies. We are now the fifth largest U.S. containerboard manufacturer.
Let’s take a closer look at the Longview acquisition. Because we closed on the acquisition on July 18, we have included 75 days of Longview’s results in Q3. However, even with just 75 days, Longview contributed $198 million of net sales, adjusted EBITDA of $54 million and adjusted diluted EPS of $0.47 and that’s after deducting the additional interest in financing fees incurred related to the debt.
Previously we identified $10 million of expected synergies to be realized over the first 18 months. At this point, we transacted on opportunities that have an annual run rate of $6 million consisting primarily of staff redundancies and fees. Q4 2013 earnings will begin to reflect the benefits of these actions. We have raised our total synergy target to $18 million in annual benefits and we expect to be at this run rate by the end of 2015. The additional $12 million of synergies to be captured consist primarily of efficiencies and opportunities in purchasing fiber and freight.
It is important to point out though that we expect to drive substantial benefits from numerous operating efficiencies to be realized and programs in progress that should far exceed the synergy targets that we’ve identified. Also one of the less obvious benefits of the acquisition is the pension plans that are overfunded by approximately $70 million. As a result, KapStone will have no cash contribution to make to these plans for the foreseeable future and we even don’t have to make the 4 million or 5 million that we were making for our legacy KapStone. So that was a nice benefit.
KapStone today -- well today we have four paper mills which provide us total mill capacity of 2.7 million tonnes and they are very flexible regarding the fiber furnish. With Longview coming aboard and being able to flex from anywhere 100% virgin, theoretically to 100% recycled fiber, KapStone’s total virgin capacity runs anywhere from up to 91% virgin assuming that Longview ran only virgin-fiber to 50% virgin that the Longview mill ran only recycle.
The current mix for total KapStone for virgin-fiber is approximately 80% virgin. Now in addition to this flexibility, the Longview acquisition also brings excess pulping and recovery boiler capacity that would enable KapStone to add an additional 300,000 tonnes of virgin capacity at a significantly reduced cost without permitting issues.
KapStone views this as a significant asset that could be utilized when demand is strong and steady enough to assimilate these tonnes without market disruption. KapStone has no present plans to add this additional capacity in the near-future. KapStone now has 32 converting plants located throughout the United States, which are capable of producing 18 billion square feet of boxes and sheets. Currently, we’re producing about 12 billion square feet or 860,000 tonnes.
This slide depicts our locations. Our mills are well positioned in the Southeast and the Northwest where fiber supply is abundant and they are well located to transportation. The Kraft plants are also well located across the United States providing us with a national footprint.
KapStone has five product lines, the largest is Kraft containerboard. We produce approximately 1.7 million tonnes annually of Kraft containerboard of various grades and bases weight. And we are a leading producer of the high performance lightweight linerboard grades, which are becoming increasingly popular with our customers. We produce approximately 600,000 tonnes of Kraft paper annually including high performance multiwall and we are the only U.S. producer of the high performance extensible grades.
DuraSorb or Saturating Kraft is used in various high pressure laminates including furniture countertops and flooring. Therefore demand for this product is closely correlated to construction activity. We expect to produce approximately 250,000 tonnes a year. Kraftpak is an unbleached folding carton board and is used in gift boxes, drink carriers, so as filter frames and we produce about 120,000 tonnes of that. And finally we produce about 850,000 tonnes of Corrugated Packaging including boxes and sheets.
Generating cash is the primary focus for us. This slide summarizes our cash flow through September 30, 2013 from inception. And here you can see the $222 million invested by our shareholders in our initial IPO and the proceeds from the exercise of warrants prior to the expiration in 2009. We have borrowed $2.2 billion. We used $2.2 billion of the cash to buy businesses and invested another $268 million in those businesses. Since inception, our operations have generated almost $1 billion of cash, enabling us to quickly de-lever debt shown in the next slide.
KapStone has clearly picked up the pace of generating cash and we’re paying down our debt rapidly. In Q3 2013, we generated $75 million of free cash flow, up $48 million or 182% over the prior year and up $35 million over Q2. Free cash flow per share was $1.54 versus $0.55 a year ago, up 180%. On July 18th, we significantly increased our debt to fund the acquisition of Longview resulting in a net debt-to-EBITDA ratio as of July 18th, 3.8 times. However, by September 30th, or just in 75 days, we were able to reduce that to 3.2 times.
KapStone’s new blended interest rate is 2.6% based on the current LIBOR rate, and at September 30th, KapStone had net debt of approximately 1.3 billion consisting of two term loans and the $36 million revolver borrowing. At September 30th, we have an available revolver balance of $359 million.
As we look ahead to 2014, here are some of the assumptions to keep in mind; 2014 will have the benefit of a full year of Longview acquisition versus just 5.5 months in 2013; we should also have a full year’s benefit of the domestic containerboard and corrugated price increases versus just seven months in 2014; depreciation and amortization expense for the 2014 year is expected to proximate $140 million, $35 million per quarter.
We expect overall fiber cost to remain relatively stable. To give you an idea of the flow and magnitude of our planned maintenance outages, I have prepared this summary. In Q1, we expect $11 million of expense primarily due to the necessary downtime. In Charleston on the paper machine number three in order to complete the $29 million capital project, we previously announced to upgrade the machine to run high performance light-weight linerboard and to run at higher speeds. While we expect to lose about 10,000 tonnes of production in Q1 due to this downtime with the higher speed this machine should run at, we anticipate the volume should be recaptured as we move through the year.
And looking at that 70 million in Q4 is when we take our annual cold mill outages at both Roanoke Rapids and Charleston. Our estimated tax rate from operations is 35% and the cash tax rate for 2014 should slightly exceed the booked tax rate as we were able to accelerate some cash tax benefits into 2013, 2013’s cash tax will therefore be about 5% and 2013’s Q4 cash taxes should be about $5 million.
As noted previously, no cash contributions to the pension plan are expected and finally we would expect the interest rate pricing good to be reduced late in Q1 by about 25 basis points.
Roger and Matt’s original investment thesis in 2005 centered around their belief that the paper and packing sector primarily brown paper segment and then even more specifically containerboard was rapidly improving. They sighted significant industry consolidations. They also accurately foresaw the divestment of trees from the paper business would force the paper business to be profitable on its own.
The industry has been operating at higher rate over 95% for an extended period of time. Growth of supply particularly for virgin board is extremely difficult to accomplish. And growth of recycled board capacity brings with it the risk of driving OCC prices higher and making new OCC production much less profitable, a serious deterrent to the construction of new capacity. Therefore a long-term cost increase is expected for OCC, should serve as deterrent to new entrant.
Also conversions of paper machines from other products to containerboard are risky, expensive, and unproven. With supply and demand relatively balanced, inventory levels reasonable and high operating rates, it’s not unreasonable to anticipate significant upside when worldwide economy is improving -- I’m going to say I don’t when that is but it will happen someday. So I think we’re in pretty good shape there.
Our intention is to continue to grow KapStone profitably and opportunistically by investing in brown paper and packaging assets. We are committed to maximizing capital returns by optimizing the operations of the companies we acquire and focusing on generating cash. I believe as the graph on this page clearly shows KapStone’s success compared to our peers and the S&P 500 paper and packing index, as well as the S&P 500 index. And I have to say, I always say this, this is Roger’s very favorite slide, he loves this and he should.
Finally, KapStone’s well situated in an industry that we believe is well situated. There are compelling industry fundamentals and the dynamic combination of KapStone with Longview should produce substantial benefits far in excess of the $18 million of synergy benefits identified to-date. And increasing the utilization of converting facilities should enable KapStone to grow revenues and profit, quickly de-lever our debt and to continue providing strong returns to our shareholders. Because of all of these things that’s why we believe the best is yet to come so anyway thank you and…
Thanks Andrea. Any question from the audience to start? Maybe I’ll take the first question, given your experience with Longview I guess five months into it, what have you been most pleased with, pleasantly surprised with, with the acquisition, where have you been, if not unhappy, what have been the biggest challenges if any at all with the acquisition and integrating it? And then I had follow-on to that.
Well I have to say and now we have done a number of acquisitions and I did a whole lot of them back when I was at Gartner. And the thing that was surprising about this acquisition is that usually the surprises that come after you have signed off and it's yours are usually on the negative side. I mean people, sellers don't want to emphasize those things. The interesting thing in this case was the surprises were on the positive side. They were more, far more positive, things that we discovered as time went on so that made this acquisition unusual.
And one of the things that I think that we really love the best actually are the people that we got. The people that came from Longview it's truly an extraordinary management team and is working very well together with our management team and it’s just -- I think it’s going to be a very colorful benefit for KapStone as we move forward. So that's certainly one of the things that we're very pleased to see.
On the negative side, really it's been pretty much good news, I think I should have a con but I don’t really I mean I guess for me personally it's a little bit harder because we're now, each acquisition has its own character and the prior acquisition you will see was pretty easy to make a determination of what was the better of the two practices. Here we have two what I think were really strong companies and you can have different practices and as one company you can only have one so sometimes picking the best out of two really good ones is a little more difficult. So that’s oddly one of the things we're sort of struggling with, so it’s actually been very good.
Thanks for the results now Andrea. I guess my follow-up question to start would be if you look out three year from now and obviously we'll take pricing out of the discussion, and let's assume also that overtime you are going to see continued improvement in return on capital or operating margin within the business. Where do you expect the disproportionate amount of improvement to occur if you agree with the premise, on the conversion side of your business or within the mills?
Well the mills are just a much bigger piece really, so if you look at it size wise or whatever you are going to expect to see the absolute dollars come from there, but one of the things that we got from this. I talked about management but Randy Nebel who is the CEO of Longview is now running all of our mills, all four of our mills. And he is bringing best practices to all four of those mills.
By Randy coming and doing that it frees up Tim Keneally who was running our mills, who has a superb background and on the container side he has spend his career at IP on the cater side. And so he has moved over there and he is now handling all 21 of the container plants. And I think having that focus and his background I think we're really going to see some nice improvements on that side as well and I have to say at Longview wall hanging fruit the biggest boundary above was fixing the mills.
And so they sort of left the converting plants alone and so there is a lot of opportunity at the converting plants it's just that when you look at absolute dollars not as much as on the mill side but there is substantial opportunity there.
Unidentified Company Representative
Question at the back?
Andrea you referenced a slide that spoke to Roger and Matt’s thesis back in 2005 with respect to the industry that was rapidly improving. More recently though capacity wants to come into the business, the guys have tried to take a lot of downtime to balance the market. There are rumors of some discounting and inventory is up to the extent that we would acknowledge all of those. It’s time to update the thesis on how good this could be or another way to ask that is, how do you not be effected by some of the things happening in the business? Thanks.
I would say absolutely not, I think that the consolidation has brought with it some really good leadership and I think that the -- and rational behavior. I think that all the new supply that everybody keeps talking about coming on yes, the Niagara Falls mills I mean that’s real it’s there. It’s still a relatively small piece of the big picture. You look at some of these conversions, I’d like somebody to show me a conversion that’s running really well that people haven’t spent an incredible amount of money on, now IP put in a mill Seminole and it’s a good mill, but they spend an awful lot of money doing it and you don’t see them doing it again.
So, and then the common denominator of most of its new capacity is OCC, I mean if you believe, I mean OCC at some point has got to come from virgin, right. And it’s going to come from our recycled. We are already recycling 91% of our OCC here in the state. And so it’s unlikely, we’re going to be able to recycle a lot more. So, as you have more and more supply chasing the same, I mean you get more and more demand sorry, chasing the same supply I think that most people when they look at long-term pricing from OCC see it ramping up.
And if you bring out even more capacity that’s using it, you’ve got to think that overtime prices are going to go up, we’re in a period now. Roger usually refers to this as silly season. This is when you see people and more product moves to the export market and it’s seasonally slow, you typically see OCC prices go down at this point of time because demand is slow the Chinese are over there doing whatever they’re doing getting ready for their New Year or whatever.
And this isn’t different I don’t think from two years ago. From that we see, what KapStone sees, we see the business is stable, we say it as steady. We don’t see the system, and I can’t speak for others.
And once again it’s not surprising if they were discounting where there is a new mill. I mean how else are you going to get a customer? But it’s small, it’s regional, it’s spot. I don’t think that is an endearment of the entire industry. So, when we look at our thesis and you look at how it’s moved over the last -- really since 2009, I think it’s pretty positive. And I think that people will continue to think logically, continue to think of return and so that’s what we think. But we might be wrong, but we’re thinking, I mean I still think and Roger because I think what he thinks because it’s good for me to do that.
But, I think that this industry is still isn’t earning the multiple that it should get for the cash flow returns that it does get. And I think there is still that fair amount of pessimism out there and maybe a lot of people got burned years ago. But the industry has the potential to change to instead. I think it just needs to prove itself. But I think once it does that, I think you’re going to see a nice green light, so that’s my opinion.
Unidentified Company Representative
And it’s stolen from Roger.
One related question, if everything that you’re saying is certainly logical and I think most of us will agree to in terms of most of this capacity that’s coming on it is in fact OCC leveraged and it is probably more upwards and down tension in OCC overtime and it’s certainly that’s what we have in our forecast. If that’s true, why do you think you are seeing mini mills coming in and being announced and conversions if in fact the outlook for profitability for these types of mills might be less if you do see a pickup in input pricing in OCC?
I can’t really say, I can’t speak for who have build their models or what they model in, I can tell we’re sitting on 300,000 tonnes of virgin, potential capacity, that we could put fairly inexpensively, we're not doing it. And so I don't know what these other people are looking at, but like I said I mean if you believe in supply and demand and you believe that that’s going to drive the pricing of OCC overtime and if you believe that China who is, obviously the biggest user, and they're still growing at 6%, they're still going to going to need OCC.
So when you look at all these factors, they're going to need it and these new mills are going to need it. As I said I don't know who builds their models or what they think, all I can say is I know what we do and we're not pulling on 300,000 tonnes of virgin, which -- it wouldn't be subject even to that, so.
Unidentified Company Representative
Thanks for that, next question, Greg?
No one has any, you're going to de-lever this balance sheet quickly by growing and by paying off some debt, at what level do you want to get back into the game of doing deals and is that in fact the preferred way to deploy cash?
Well you know Roger’s known because of who Roger Stone is, he loves the deal, he loves the art of the deal, we're always looking at deals. And I keep using the word opportunistically, you have to be sort of opportunistic and say you may have to jump once sort of the iron talk, so we still have projects lined up, they take a while to work out and in Longview we start looking at it in 2006. And MeadWestvaco took two years to get that Charleston mill, so we're looking at things and when the time and the price is right we will strike. And once again if it’s the right deal, at the right price, it shouldn’t do that much to our leverage ratio, I mean if it’s spiked briefly, as long as we're comfortable that we can bring it down and it doesn't spike too much, we could handle that, but we’re not dying to get over levered either I got to admit.
Andrea what do your customers think about why they like the lightweight linerboard, what’s driving that incremental demand?
They like it because it saves them money, I mean, they save money and we make more money so we all like it, they can -- and deliver a box with the same strength but they're paying less to produce it and they're paying less for freight hedged they like it and that's why we are showing them that they can do, so.
And you can do that without double walling or anything else, it’s just…
Yes, I have some pictures in another presentation but yes, it’s pretty cool, the different combinations that we can put together to give them the same test time. So it’s pretty compelling.
Unidentified Company Representative
If you just wait for the microphone, George?
Yes, lightweighting is more prevalent in Europe, isn't it?
Yes it is.
And do you think that that, I mean that it becomes more adopted within the United States that that could be a threat to the industry?
A threat to…?
To the industry?
Well and I always wondered why there's this, you know because we talk about things in tonnes so we sell it in feet right, so we're selling of lightweight, we're selling a lot more feet in a tonne, right so the revenues are higher because we charge by the square foot. So, and not all machines can run, expect for lightweights and a lot of machines can't or you got to make a significant capital investment to be able to do it, and they might be able to produce as much as a full mill, I don’t -- there's enough other limiting factors that you just couldn’t see everybody convert over to super lightweights and just see the market crushed with that and like I said the revenues per tonne go up because there's more square feet per tonne sold.
Andrea what's the basis weight that you’re producing the lightweights on?
In the 20s, so yes.
In the 20s, yes.
Any other questions for Andrea regarding KapStone, if not please join me in thanking Andrea Tarbox and KapStone for a great presentation.
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