Brad Ankerholz – Investor Relations
David W. Scheible – President, Chief Executive Officer & Director
Daniel J. Blount – Chief Financial Officer & Senior Vice President
Ian Zaffino – Oppenheimer & Co.
Mark Kaufman – Rafferty Capital Markets
Graphic Packaging Holding Company (GPK) Q1 2010 Earnings Call May 6, 2010 8:30 AM ET
At this time I would like to welcome everyone to the Graphic Packaging first quarter 2010 earnings conference call. After the speakers’ remarks there will be a question and answer session. (Operator Instructions) Now, I would like to turn today’s call over to Mr. Brad Ankerholz.
Welcome to the Graphic Packaging Holding Company’s first quarter 2010 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 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 related to product price reductions, movement in raw material and commodity prices and the expected effect on the company’s results, cost reduction benefit, capital expenditures, cash pension and contribution and pension expense, appreciation and amortization, interest expense and net debt reduction 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.
This risks and uncertainties include but are not limited to the company’s substantial amount of debt, inflation of and volatility in raw materials 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 business strategies including productivity initiatives and cost reduction plans. Undue reliance should not be placed on such forward-looking statements as such statements speak only as of the date on which they are made and the company undertakes no obligation to update such statements. Additional information regarding these and other risks is contained in the company’s periodic filings with the SEC.
David, I’ll turn it over to you now.
David W. Scheible
We are pleased with our first quarter results. Our margins continued to improve and it was very encouraging to see some demand improvement across our business as tons sold increased both sequentially and versus the prior year period in all three of our segments. Execution on our cost reduction plans and improving operating efficiencies in both the mills and converting plants contributed significantly to continued earnings growth.
When comparing to last year’s first quarter adjusted net earnings per share improved to $0.04 a share from a loss of $0.04 a share in 2009. Adjusted EBITDA increased more than 11% to $145 million and our adjusted EBTIDA margin increased roughly 170 basis points to 14.4%. We also ended the quarter with a net leverage ratio under 5.6 and believe we are in excellent position to continue reducing our debt levels this year.
Although volumes increased, sales in our core paperboard packaging segment declined a modest .7% versus the prior year quarter. The decrease in net sales was primarily driven by lower pricing from contractual pass throughs related to raw material deflation that we experienced in 2009. Paperboard packaging demand for both CUK and CRB strengthened during the quarter. In total, volumes in this segment increased 1.7% over the prior year quarter.
We produce approximately 2.3 million tons of paperboard every year and our mills ran full in the first quarter with operating rates in the mid to upper 90s. We saw order activity in the quarter as both CUK and CRB backlogs are currently a full week longer than a year ago. Performance at the mills was excellent in the quarter through a series of ongoing improvement initiatives we continue to reduce [rate] to grade cycle times and increase trim roll utilization at our mills. The result was record levels of paperboard production in both grades.
At the same time we maintained tight control of our inventory levels and sold this higher production on the open market or used it internally in our carton plants. While external paperboard market demand remains strong, our level of paperboard integration is at an all time high. We’re using more and more of our own board as we have significantly reduced the amount of SBS and CRB tons we are purchasing from external suppliers. Since the combination with Altivity, we have successfully integrated over 75,000 tons of externally purchase board in to our mill system and our paperboard integration levels now stand roughly at 82%. This increase integration helps improve our mix and resulting margins.
Despite a lagging economy, folding carton demand continued to be solid with first quarter volumes up on a sequential basis and down in the low single digits from the prior year quarter. Looking at first quarter AC Nielsen data for the broader market categories, dry food units increased roughly 2%, frozen food units increased just under 1% and refrigerated foods increased 3.6%. On the non-food side, packaged detergents were up almost 8% and facial tissue was down roughly 6%.
More specifically, for graphic packaging food and consumer product packaging demand continues to be steady. When adjusting for low margin business that we consciously exited as part of the Altivity merger in the second half of 2009, volumes were flat to up both on a sequential basis and over last year’s first quarter. Center of the aisle take home products continue to outperform away from home products. Cereal continues to be our most resilient and sustainable category followed by dry and frozen foods like pizza. Our most challenging markets are refrigerated and dairy, quick service restaurants and cosmetic and toiletries. These are largely discretionary products and they reflect budget conscious consumer’s buying behavior most directly.
The facial tissue market also remains relatively weak from a historical basis but recent wins in this category have led to higher volumes in the first quarter. Similar to what we experienced in the previous quarter the US beer market remains sluggish, down an estimated 2% in the first quarter. Continued high unemployment rates in the key 21 to 30 year old age demographics and the construction rate is clearly impacted demand in the US beer market. While the rest of the economy has seen some modest improvement in employment, the blue collar segment has not as many in this segment have been out of work for more than a year and rates are still hovering well above 14%.
Several of our major beer customers have indicated publically their belief that beer volumes will improve as the economy bets healthier and people in this demographic get back to work. While there’s still a trade down trend away from premium offerings, consumers are actually drinking less beer overall. Wine and spirits conversely are accelerating and growing again which may provide some insight in to how unemployment within demographics is impacting overall demand.
The US carbonated soft drink market also moderated a bit in the first quarter declining an estimated 1%. However, our shipments of core branded 12 and 24 pack multipack products increased year-over-year and we continue to see signs that our core multipack soft drink business is stabilizing. I’m optimistic about buying trends in this sector for the immediate future.
Looking at multi-wall bag and specialty, I was encouraged to see the first quarter volumes in our multi-wall bags segment and packaging were up about 5.1% sequentially and 4.6% over the prior year quarter. While dollar sales were negatively impacted by the divestiture of the two businesses in the second half of 2009 and price reductions triggered by lower raw material costs in 2009, we are encouraged by the recent buying trends in this business. Backlogs remain ahead of prior year levels and it looks like volumes may have bottomed out and we can see a gradual improvement as the economy slowly improves.
Similarly, on the new products innovation side, we have seen a sequential pickup in the pipeline of new products over the past several months. We clearly see our major consumer goods companies investing again behind their brands at an increasing rate. Our machine trial orders and structural design requests have historically been a good key leading indicator and both were up over 30% in March versus 2009 which bodes well for the second half of this year.
Convenience, sustainability and brand building remain key trends in today’s marketplace and we continue to focus our new product development efforts around these areas. Our innovative microwave susceptor provides browning and crisping straight out of the microwave and Graphic Packaging dominates this growing sector. Our strength in barrier products offers better value to customers, better shipping and display efficiencies to manufactures and better sustainability. As a result, we continue to substitute solid fiber cartons for corrugated and plastics and believe this is a long term positive trend for Graphic Packaging and the paperboard industry.
Finally, in our label business we continue to see growing demand for a newly developed technology that provides better printability to plastics and aluminum objects such as paint cans, sprayer bottles and utility buckets. While this is still a small business right now we think it has potential to have widespread applications and show growth in the long term.
Let’s talk about inflation and pricing. Overall raw material costs in the quarter were about flat to the prior year period. Lower costs for energy, primarily natural gas and chemicals somewhat offset increased costs for both virgin wood and secondary fiber. As I have mentioned in the past, we consume about one million tons of secondary fiber annually of which about a third is OCC. On average, for all secondary fiber we paid about $70 per ton more than a year ago.
Looking just at OCC as a benchmark, after a slow decline in 2009 prices rallied considerably in the first quarter to over $160 a ton. On average, this represented about a $100 per ton increase over the first quarter of last year. Fortunately, we have seen a modest pullback of OCC prices in April of over $30 per ton as a result of weaker demand in China and weather improvement in the Southeast US. We expect market prices for both OCC and pine costs to continue to moderate in the short term as availability increases with an improving economy.
While the total inflationary impact was negligible in the quarter we did experience $21 million of lower pricing on our products this quarter as a result of the deflationary environment we experienced in 2009. As I’ve mentioned previously, the majority of our business is contractual and just about all of those contracts include some sort of price adjustment for both raw material inflation and deflation. Given the strong demand for paperboard and high industry operating rates, we continue to announce price increase for our paperboard, specifically a $40 per ton CRB increase took effect in early January and we announced an additional price increase of $45 per ton that took effect in early April and just last week we announced a $40 per ton price increase on our CUK substrates. We believe that paperboard pricing will continue to improve.
If you look for the remainder of 2010 as the economy gradually improves, we are becoming more optimistic about improvement in demand. We are already beginning to see this as volumes increase across the businesses for a year ago. While the multi-wall bag and specialty businesses are more cyclical the stability of our core food and beverage markets makes it less susceptible to economic swings both on the up side and on the down side. I expect volumes in our food and beverage will improve as more Americans get back to work.
We expect contract pricing to continue to move lower but at a much slower pace than you saw in the first quarter. I don’t think anyone can predict what raw material inflation will do but our lower hedge rates for natural gas should continue to provide some offset to volatility fiber prices. This should allow the benefits of cost cutting initiatives to fall straight to the bottom line and meet our annual objectives.
Now, I’ll turn it over to Dan with a more directed review of the financials.
Daniel J. Blount
As David indicated, we are pleased with our first quarter results which continue to show year-over-year margin improvement and position us well to achieve the full year targets that we shared during our last call. Now, I will turn to the first quarter financials for more detail. First, we will discuss revenue and EBITDA performance then move to cash flow, leverage and liquidity. As a reminder, when I refer to EBITDA and EBITDA margin in my discussion I am referring to adjusted numbers. These adjustments are detailed in attachments to our earnings release which is posted on our website.
They principally relate to the non-recurring charges incurred during the integration of Altivity and the refundable alternative fuel tax credit that expired in 2009. Both current year and prior year EBITDA results are adjusted to produce comparable financial reporting. We will continue to see integration charges through mid year but the level will decline meaningfully in the back half of the year as the integration efforts are substantially complete.
Starting with net revenues, we see that total volumes increased 2% over the prior year while as a result of lower pricing overall sales declined 1.5% to $1,004,000,000 in the first quarter. The $15 million decline in sales breaks down as follows. First, $8 million increase from stronger volumes in all three reporting segments. Volumes in the paperboard packaging segment grew 1.7% and multi-wall back and specialty packaging grew by a combined 4.6% over the prior year. Second, a $21 million decline from lower pricing. The lower pricing results principally from deflationary adjustments related to lower raw material costs in 2009. Because the majority of the raw material deflation occurred in the first half of 2009, we expect the year-over-year price delta in the second quarter to be in the same range as we saw in Q1.
Looking forward to the second half of 2010, we expect the impact of contractual price adjustments to be relatively minor or potentially even net positive as we release recently announced price increases. Third, a $9 million decrease from the mid 2009 divestiture of the Handschy ink business and Salt Lake City bag equipment business. These divestitures were part of our integration with Altivity. Lastly, a $7 million increase from favorable foreign currency exchange rates.
Moving to EBITDA; EBITDA was $144.8 million in the first quarter up 11.5% over the prior year. We continue to see improvement in our EBITDA margin which increased 170 basis points to 14.4% over the prior year. The gain was driven principally by continued performance improvement in our paperboard packaging segment and the reduction of SG&A expense. Paperboard packaging improved its EBTIDA margin to 17% on the strength of continued cost reduction. In the multi-wall bag and specialty packaging segments EBTIDA margins held steady at approximately 8% as favorable volume and performance offset lower pricing.
In total, first quarter consolidated EBITDA increased by $14.9 million. The drivers of this change were first, the $21 million negative impact from lower pricing principally deflationary pricing give backs. Second, inflationary factors were actually, as David indicated, net neutral for the quarter as favorable energy and other inputs negated higher rates for inputs such as fiber and resin. We will talk more about inflation later, but as David discussed, we did see a substantial increase in the cost of secondary fiber.
Lastly, the real story behind our improved performance is $38 million of net positive impact from performance improvements related to synergies and continuous improvement initiatives. While raw material price changes and our product pricing will fluctuate with market dynamics, we believe we have permanently improved our cost profile since the merger with Altivity by increasing asset productivity and lowering our overall cost position.
Next, let’s turn back to input cost inflation. As we all saw, the cost of secondary fiber sharply escalated in the quarter. We paid roughly $70 per ton more in Q1 2010 than we paid in Q1 2009. We also due to wet weather experienced a temporary increase in virgin wood pine costs of about $5 per ton. As we use the FIFO method of inventory accounting there is a two to three month lag between purchase of a raw material and the recognition of the cost change in our operating results. Therefore, a significant portion of the fiber cost spike will impact Q2’s financials.
As David discussed, fiber costs have recently begun to moderate. We expect the moderation to benefit the latter half of Q2 but Q3 will see most of the moderation benefit. With the lag between input costs increase and the impact on financial results understood, let’s move to a discussion of Q1 and then Q2 input costs. As we stated earlier, Q1 raw material costs were about flat to the prior year first quarter. Lower costs of energy primarily natural gas and chemicals offset increases for both pine and secondary fiber.
Natural gas per MMBTU for the quarter was approximately $3.70 lower than the prior year and we use about three million MMBTUs per quarter. Now, over the next three quarters we have hedged about 73% of our natural gas needs at an average rate of $5.55 per MMBTU. As we are purchasing the remainder of our natural gas needs in the open market at a rate much lower than our hedge rate, we expect the actual blended rate for 2010 to be well below our current hedge rate. In 2009 we paid $7.26 over the last three quarters.
Given the lag I just described, in Q2 we expect the cost of secondary fiber to increase an average of $40 per ton over the rate that ran through financial performance in Q1 2010. Therefore, looking at the second quarter as compared to the first quarter we expect cost reduction to continue to benefit financial results at the same level seen in Q1. We expect inflation to increase as we absorb the spike in fiber costs and we expect sales volumes to increase at our normal seasonal rate. So in summary, in Q2 we expect to see higher volumes from seasonality, continued substantial cost reduction and the flow through of the first quarter spike in fiber costs. Looking beyond Q2 we expect fiber costs to continue to moderate and we are becoming more optimistic about improvements in market demand. In total, our outlook for 2010 remains unchanged as we continue to expect an improvement over 2009.
Let’s move to the balance sheet, leverage ratio and liquidity. Working capital remains a focus and for the first quarter working capital simply defined as accounts receivable plus inventory less accounts payable declined by about $49 million as compared to Q1 2009. Inventory reduction is a primary driver of the improvement as we have permanently reduced the amount of inventory needed to run the business by further optimizing the supply chain and reducing our manufacturing footprint. We continue to focus on working capital management and believe there is more opportunities in this area.
Capital expenditures were $18.2 million in the quarter. We will continue to manage our cap ex in a disciplined and targeted manner. Although the first quarter was lower than the comparable period last year, we continue to forecast full year cap ex in the $130 to $150 million range. At the end of the first quarter, net debt was $2.7 billion and our net leverage ratio improved to 4.72 times from 6.02 times at the end of the first quarter 2009. Our consolidated secured leverage ratio under our credit agreement was 2.89 times which is well below our maximum allowable ratio of 4.75 times. We continue to operate with a low cost flexible debt structure and have no significant debt maturities until 2013. The calculation of net debt and our net leverage ratio is provided in the earnings release and in a separate reconciliation posted to our website.
At the end of the first quarter we had no borrowings under our $400 million revolver and $105.6 million of cash and cash equivalents. Total liquidity net of letter of credit commitments was $468.6 million. We typically use cash in Q1 to ramp up working capital in preparation for seasonal activity. This was the case in this quarter as we used $44.5 million of cash. This cash utilization was better than our internal expectations and keeps us on track to deliver in the $200 million range of net debt reduction by year end 2010.
Now, as some of you have seen, last week we filed a universal shelf registration form with the SEC which effectively allows us to sell up to $500 million of any combination of various securities listed in the filing. We view this action as prudent corporate finance practice which will provide cost efficient access to the capital markets should we find it appropriate to do so. We do not have any specific action planned at present. Of course, we will communicate appropriately when there is something more to report on this.
Finally, in terms of guidance, let me reiterate the financial targets we laid out on our fourth quarter conference call. These include: capital expenditures of $130 to $150 million; cash pension contributions of $45 to $70 million of which $9 million was paid in the first quarter; pension expense of approximately $32 million; depreciation and amortization of $310 to $330 million; interest expense of $175 to $185 million; and net debt reduction as I said before in the $200 million range.
With that I’ll turn the call back over to the operator for the question and answer period.
(Operator Instructions) Your first question comes from Ian Zaffino – Oppenheimer & Co.
Ian Zaffino – Oppenheimer & Co.
You mentioned some of the cost reductions, can you just get a little bit deeper in to that exactly what are you going to be doing, when do you think we’ll start to see the realization of that? Then the other question would be as far as the growth prospects I know we talked about really secular trend away from plastics in to paper and I think in particularly some beverage containers. Can you give us an update on that initiative to?
David W. Scheible
Let me try the first question. What Dan said was that in the first quarter we saw roughly $39 million worth of year-on-year cost improvement in the business. So what I would say is we are seeing the impact of the synergies and continuous improvement process both in the mills and in the carton plants. We’re offering a lot less carton plants this year than we did last year and we’re a lot more efficient in the mills so we would expect that level of performance to continue for 2010. That’s sort of where we are in the cost reduction.
On the trend in cartons, yes we’ve seen a good substitution for solid fiber in to corrugated as well as in to some plastics. There are some new products being introduced by a number of our customers [inaudible] in the east coast introduced what we call a cap it product which replaces the [hi-cone] rings that traditionally hold bottles together and we believe there is clearly a significant expansion of that opportunity in the carbonated soft drink arena as well.
During the quarter, we also had a number of applications where in club stores where our customers are using our Z-Flute laminated structures to replace corrugated packaging in the process and that honestly helped drive the year-on-year volume demand in board that we sold either internally or externally.
Your next question comes from Mark Kaufman – Rafferty Capital Markets.
Mark Kaufman – Rafferty Capital Markets
I wonder if you could comment a little more on the Altivity merger expenses in the quarter and what you see going forward for the rest of the year on that line?
Daniel J. Blount
I think the non-recurring charges in the quarter were just over $8 million. Firstly, what that is related to is the remaining costs for the plant closures. We have two plants that we announced in 2009 that we are closing in 2010 so a lot of that cost relates to that. Additionally, we have some other activities that we’re going to have some non-recurring charges on in the second quarter and so I think you’re going to see a number in that type of magnitude for the second quarter and then for the third and fourth quarter it should very dramatically taper off. We’ve completed most of the integration activities and you’re just seeing some of the cost roll through based on the accounting rules.
Mark Kaufman – Rafferty Capital Markets
I have one follow on question, any idea what your reported tax rates are going to be for the back half of the year or I should say for the next three quarters? Any type of range? I know you’re not paying any taxes to any great degree.
Daniel J. Blount
What you’re seeing flow through the quarters is pretty much the amortization of goodwill and the way it flows through the tax line. It’s a non-cash item so you’re going to pretty much see that item appear every single quarter at the same magnitude.
At this time there are no further questions. I’d like to turn it back over to Mr. Ankerholz for any closing remarks.
We appreciate the call and we’ll get back to work here and talk to you next quarter.
Ladies and gentlemen this concludes today’s conference call. You may now disconnect.
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