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Executives

Paul Stecko – Executive Chairman

Mark Kowlzan – Chief Executive Officer

Tom Hassfurther - Executive Vice President, Corrugated Products Business

Rick West - Chief Financial Officer

Analysts

Mark Weintraub – Buckingham Research

Chip Dillon – Credit Suisse

George Staphos – Bank of America

Rick Skidmore – Goldman Sachs

Mark Wilde – Deutsche Bank

Mark Connelly – Credit Agricole

Claudia Shank Hueston – JPMorgan

Michael Bolosi – Voyant Advisors

Andy Feinman – Iridian Asset Management

Joshua Zaret – Longbow Research

Packaging Corp. of America (PKG) Q2 2010 Earnings Call July 20, 2010 10:00 AM ET

Operator

Thank you for joining Packaging Corporation of America’s Second Quarter 2010 Earnings Conference Call. Your host today will be Paul Stecko, Executive Chairman. Upon conclusion of the narrative, there will be a Q&A session.

I will now turn the conference call over to Mr. Stecko. Please go ahead when you’re ready.

Paul Stecko

Thank you and good morning. And welcome to PCA’s second quarter earnings release conference call. I’m Paul Stecko and with me on the call today are Mark Kowlzan, our CEO; Tom Hassfurther, our Executive Vice President of the Corrugated Products Business; and Rick West, PCA’s Chief Financial Officer. Thanks for participating in the call and as usual, after we complete the presentation, we’ll be glad to take any questions.

As I think most of you on the call know, we recently announced the separation of the Chairman and CEO roles at PCA, with Mark Kowlzan being named as CEO. Accordingly, after I make some opening remarks about the second quarter, I’ll turn it over to Mark, who will provide you with the specific details of our second quarter results and operations, as well as, our third quarter outlook.

We had an outstanding quarter operationally in both our mills and our box plants in the second quarter. Earnings were significantly higher than we expected entering the quarter, driven by stronger volume, a faster pass-through of our April containerboard price increase to boxes, a richer mix of corrugated and containerboard shipments with more displays and value-added products and a lower volume of containerboard exports.

In all phase, these all our operations we executed very well, especially considering the significant challenges we face with major annual maintenance outages at three of our four mills and our relatively low level of containerboard inventory.

With respect to revenues, our sales in the second quarter came within $5 million of our all time record, which was set in the third quarter of 2008 and the third quarter is usually our strongest quarter sales-wise.

Entering the third quarter this year, we are much better positioned capacity-wise with all of our maintenance outages completed for the year. However, at our current containerboard inventory levels, our mills will continue to need to run well in order to meet demand begin to replenish inventories, which in turn will help us reduce our freight costs.

With that brief introduction, I’d like to turn it over to Mark, who will get into the specifics of our results and operations.

Mark Kowlzan

Thank you, Paul. I’d also like to thank everybody for joining us this morning. Yesterday, we reported second quarter earnings of $38 million or $0.37 per share, which included an after-tax charge of $1 million or about 1 penny a share from asset disposals related to the Counce and Valdosta major energy projects.

The reported results for the second quarter of 2009 were net income of $109 million or $1.07 per share, which included $80 million or $0.79 per share from alternative fuel mixture credits. The net sales for the second quarter were $615 million up 12%, compared to $549 million in the second quarter of 2009. Excluding the asset disposal charge, net income was $39 million or $0.38 per share versus the second quarter of 2009 earnings, excluding alternative fuel mixture credits of $29 million or $0.28 per share.

The increase in earnings per share compared to last year was driven by higher containerboard and corrugated products prices and a richer mix of $0.12 per share, higher volume of $0.08 per share and lower energy costs of $0.02 per share. These increases were partially offset by higher recycled fiber costs of $0.06 per share, increased wood costs of $0.03 per share and higher transportation costs of $0.02 per share.

Excluding the alternative fuel mixture credits and energy project related asset disposal charges, net income for the first six months of 2010 was $52 million or $0.50 per share, compared to $54 million or $0.53 per share in 2009. Year-to-date sales were $1.17 billion, compared to $1.06 billion in 2009.

Our corrugated products demand was up 8% over last year’s second quarter in both total shipments and shipments per work day with the same number of work days.

As you might recall, our demand started picking up in the second quarter of last year, so we are starting to compare against stronger year-over-year comps. Demand in April and May was up a very strong 8.8% and 9.6% respectively, compared to last year. June demand, while not quite as strong as April and May was up a healthy 5.8% over last year.

Our outside sales of containerboard were up about 12,000 tons or 12% over last year’s second quarter. We were limited in what we can sell to this market due to our low inventory levels and strong demand for board to supply our own box plants.

Our mills ran extremely well producing 589,000 tons of containerboard. During April and May, we lost about 35,000 tons of production with our 15-day extended annual maintenance outage at Valdosta and five-day annual maintenance outages at Tomahawk and Filer City mills.

The earnings impact from the annual outage downtimes, including higher operating costs was about $0.07 per share during the quarter. All three mill outages were completed as planned with very good startups, which were critical considering the low inventory levels.

June was the first month since August of 2008 that the mill did not have maintenance or marketing related downtime, giving us an opportunity to run at full capacity. All of the mills ran extremely well, setting a new production record for tons produced per day, as well as, a new record for most tons produced in any 30-day month.

Despite running well and reducing the outside sales of containerboard, we ended the quarter with our containerboard inventory level lower than we would liked to have had about 18,000 tons below last year’s June level, when corrugated demand was much lower. Fortunately, we now have all of the annual maintenance outages done, so capacity-wise we’re in much better shape for the second half of the year.

As reported by the FBA last Friday, industry inventories remain at historic lows with June ending inventories at only 1,999,000 tons or 3.4 weeks of supply. This is the lowest June ending inventory in 30 years. Also, industry corrugated products demand was up 3.7% for June and up 4.6% for the quarter compared to last year.

Moving to pricing, we realized the remainder of the earnings benefit from our first quarter box price increases in the second quarter and we essentially completed our second quarter box price increases by July the 1st.

From an average price standpoint, we realized about third of the earnings benefit from our second quarter box price increases in the second quarter with the remaining earnings benefit expected in the third quarter.

Our mix of both corrugated and containerboard shipments was also richer with more display business and more board shipments to our own box plants, higher prices and a richer mix improved earnings compared to last year’s second quarter by about $0.12 per share.

Moving to cost, industry published prices for old corrugated containers or OCC, excluding delivery costs increased about $77 per ton in the second quarter of 2010, compared to the second quarter of last year. Even with our low usage of recycled fiber, which is about 17% of our net fiber purchases, the OCC price increase reduced our earnings by about $0.06 per share. Recycled fiber prices have turned down and the July price is about $15 a ton below the second quarter average.

Wood fiber costs were up about $0.03 per share compared to last year’s second quarter, but are down about penny per share compared to the first quarter. We expect our wood fiber costs to continue to trend down gradually during the summer with continued good weather especially at the Counce containerboard linerboard mill.

Our other mills were not hit as hard by the bad weather this winter so their wood cost should continue to decline some, but not quite as much as the wood costs at the Counce mail.

Transportation costs were up about $0.02 per share, compared to last year’s second quarter driven by our low containerboard inventory levels, which required us to ship about 10% more tons to our box plants by truck instead of rail.

Freight costs were also impacted by the higher diesel costs, which were up about 30% from the second quarter of 2009. Energy costs were lower than last year’s second quarter by about $0.02 per share and chemical costs were lower by about penny and half per share.

I’m now going to turn it over to Rick West and he will continue the discussion about cash position and uses of cash during the quarter.

Rick West

Thank you, Mark. Capital expenditures were $92 million during the quarter, which included $50 million for our Counce and Valdosta energy optimization projects. During the quarter, we repurchased 150,000 shares of our common stock for $20.74 per share or a total of $3 million and we currently have $62 million remaining under our share repurchase authorization.

We ended the quarter with $182 million cash on hand, down $16 million from the end of the first quarter driven by capital spending for the mill energy projects, annual maintenance outage costs and share repurchases.

We received no cash payments from alternative fuel mixture credits during the quarter. However, we did benefit from $41 million of these credits, which were used to reduce our second quarter federal cash tax payments.

Since we became a registered alternative fuel mixture -- mixer, we produced 370 million gallons of alternative fuels and qualify for a credit of $0.50 per gallon for an earned total of $185 million in credits. We have applied a total of $89 million in credits against our federal cash tax payments and we currently have remaining credits of $96 million.

In a memorandum dated June 28, 2010, the IRS concluded that black liquor qualifies for the cellulosic biofuel producer credit of $1.01 per gallon of biofuel produced in 2009. As a result of the IRS guidance, PCA has filed an application to receive the required registration code to claim the cellulosic biofuel producer credit.

We expect this registration to be received during the third quarter. PCA has not yet filed a claim for any black liquor credits earned in 2009, since our tax -- 2009 tax return is not due until September 15, 2010.

Once the cellulosic biofuel registration is received, PCA can claim the cellulosic biofuel producer credit of $1.01 per gallon instead of the alternative fuel mixture credit of $0.50 per gallon. This would increase our total 2008 and 2009 tax credits to about $370 million or $230 million after-tax, compared to alternative fuel mixture credits of $195 million or a $45 million increase. This increases our remaining tax credits from $96 million to $141 million, which we really use to offset future federal cash taxes owned until the tax credits are fully utilized.

Mark Kowlzan

Thank you, Rick. Looking ahead to the third quarter, we expect higher earnings from a full quarter benefit of our second quarter box price increases and from higher sales volumes and increased mill production. Recycled fiber, wood fiber and fuel costs are also expected to be lower. Considering all of these items and excluding any additional income from black liquor, we currently estimate our third quarter earnings at about $0.60 per share.

With that, we’d be happy to entertain any questions, but I must remind you that some of the statements we’ve made on this call constituted forward-looking statements. These statements were based on current estimates, expectations and projections of the company and involve inherent risks and uncertainties, including the direction of the economy and those identified as risk factors in our annual report on Form 10-K on file with the SEC. Actual results could differ materially from those expressed in these forward-looking statements.

With that, I’d like to turn it over for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mark Weintraub with Buckingham Research.

Mark Kowlzan

Good morning, Mark.

Mark Weintraub – Buckingham Research

Okay. Congratulations. Good quarter. I guess, what’s really striking to me is you’ve got $182 million in cash, you’ve got the $140 million in or $141 million tax credits. I do know, obviously, you’ve still got some more spend on the energy projects, but if you take the third quarter earnings run rate, you’re already at $2.40 and obviously, if the August price increase goes through and eventually you get the benefits from the energy projects, I mean, those numbers potentially at some point can move a lot higher. What plans or what perhaps can you share with us as to what you would be intending to use, or where would you be directing these increasing cash flows?

Paul Stecko

Yeah. Mark, this is Paul. Let me take that one. Somewhere I’ve been working on a long time. As you rightly said, our cash flow improves historically in the third and fourth quarter. They’re our strongest cash periods and hopefully, that will continue to be the case and, obviously, with $0.60 per share guidance, that would support your assertion.

And we are looking -- what we would do with the cash, we started to buy a few shares the last quarter. And quite frankly, with the uncertainty in the market, we think things are happening externally that really may or may not affect PCA but it probably has affected our stock price at times more than we think it should.

And so, starting on share buybacks seems to be the best first step to take. As you know, share buyback is a singular event unlike a dividend increase, which you have to plan for the long-term. There still is some uncertainty in the marketplace with regard to the so called bubble dip.

And so our first use of cash would be directed at share buyback. There’s also some uncertainty on a tax treatment of dividends. We’d like a little more information on that when that does become available. We do still have about $62 million authorization under an existing share buyback approval from the board, so that’s a long-winded answer to a simpler answer is, our first step will probably be in the share buyback area.

Mark Weintraub – Buckingham Research

Okay. That’s really helpful. And can you remind us on the cap spending. I think you had initially indicated about $300 million for this year, maybe something closer to $200 million for next year, including all the spending on the energy projects, is that still a reasonable starting point?

Paul Stecko

Exactly, Mark. We’re still on track with the original plans. Projects are proceeding accordingly. Everything is on schedule, looking good, but your assumption is correct on the cap spend for this year going into next year.

Mark Weintraub – Buckingham Research

Great. Thanks very much.

Mark Kowlzan

Next question?

Operator

Our next question comes from Chip Dillon with Credit Suisse.

Chip Dillon – Credit Suisse

Yeah. Good morning. A question about how July might be looking. I know you sometimes give us a view of the current quarter and certainly, I recognize that the comparisons as was mentioned are getting tougher?

Mark Kowlzan

Yeah. If you think about July, we’re looking at nine out of the first 21 days and if you consider that it, although it’s a 21-day month, it’s really a 20-day month. The way the holiday broke this year, Friday ended up being pretty much an off-day on July 2. So it turned it into a 20-day month.

That being said, if you look at the bookings and billings, we are up about 3.5% over last year’s month on bookings. Billings are up about 1% over last year. The good news is, after the holiday weekend was over, over the last week, the numbers have come back and they are looking fairly good, as we would have expected at this point. But, again, reminding you that Friday and Monday were essentially holiday days.

Chip Dillon – Credit Suisse

Got you.

Mark Kowlzan

At least for us in our box plant and then Tom, you might want to amplify on that a little bit.

Tom Hassfurther

Well, I would just say that July might be this year more representative of the years we had prior to 2007, where it started out a little slow at the beginning of the month, then it ramped up towards the end of the month, leading into the busy season of August through October.

Chip Dillon – Credit Suisse

Got you. And when you look at the guidance to the third quarter, I would assume that you probably put very little of the August increase into that. Just -- and would it be probably prudent to sort of maybe see half of it, maybe less than half of it in the fourth quarter and not to really expect it till the first?

Paul Stecko

Chip, let me tell you what’s really prudent. We can’t talk about forward pricing. We can only talk about the past with regard to pricing. So I cannot comment about that. The company cannot comment about that. So we’re going to have to take a pass on that question.

Chip Dillon – Credit Suisse

Okay. Understood and last question for Rick. On this incremental credit, how should we see this $141 million flow in? Would it -- I guess a simple way to think about it is, we should look at what we think your cash taxes would have been as we go forward, so we do our own forecasts and then until you actually get up to $141 million, you just basically don’t pay cash because you can apply the credit. Is that the way to think about it? And I guess there’s a second part to that. Will you have to actually pay cash to the government for black liquor and then wait to get it back two to one in terms of the cellulosic credit?

Rick West

I’ll take the second question first. No, because we did not apply for any payments from the government. Instead, we have only been taking credits against our federal cash taxes owed. We do not owe anything back to the government. It’s just been going against our federal cash tax payments. Therefore, we’re different than most in that we treated it from the first day as an income tax credit rather than an excise payment.

On the first question, you’re correct in the way we would -- you would look at it. Essentially, our federal cash tax rates are same as the effective federal tax rate. The only taxes we will be paying in the future until we fully utilize the tax credit would be our state income taxes.

Chip Dillon – Credit Suisse

Got you. But just to be clear, I know, Rick, if there is a timing difference that you would otherwise have, so your -- usually, your cash tax rate is a little bit less than your statutory rate. Would your credit again go against the actual statutory rate or against the cash tax rate?

Rick West

Against the cash tax rate.

Chip Dillon – Credit Suisse

Okay. Thank you.

Operator

Our next question comes from George Staphos from Bank of America.

Mark Kowlzan

Good morning, George.

George Staphos – Bank of America

Hi, guys. Good morning. Congratulations again on the new responsibilities. I just wanted to, to the extent it’s possible, discuss your views on the energy projects and how they’re evolving. Obviously, the benefit from these aren’t going to be received for another year or two but how is the project going? And what do you think about the returns that you’ve got it to thus far, given the way the process is going?

Mark Kowlzan

Yeah. Let me -- the Valdosta annual outage was the first big step on the piece of the energy at the Valdosta mill. We completed the paper machine reconfiguration and achieved more than the expected results on energy conservation, steam reduction, efficiencies on the paper machines. So, besides the machine coming up and running exceptionally well, we’ve over-achieved our expectations on energy reduction on the machine.

The rest of the project in Valdosta is proceeding on schedule with the boiler, building erection taking place and all the associated infrastructure around the new boiler and turbine being built. Counce is on schedule. The first big piece of the project at Counce will be in October when we start up the new turbine generator. Again, that is on schedule. And the boiler rebuilds are tracking on schedule for beginning next June.

So right now, everything’s looking good. Again, as far as the capital commitments, we’re where we expected to be with the majority of the commitments taken care of and again, we’re in good shape from where we expected to be.

George Staphos – Bank of America

Okay. The next question I had for Mark and Paul, do you sense that there’ll be, looking out the next three to five years, any adjustments to the strategy that the company’s had, which has worked very well for the company over the last 15 years or so or do you think it will be pretty much that which you’d been employing, which is low cost at the mills and margin up on the box side?

Mark Kowlzan

Again, I think if you look at our model over the years and you’ve heard Paul talk to this point, we don’t have any particular programs. We just go out every day and we tackle all the difficult tasks, all the hard-to-do things, whether it’s in the box plants or the mills. And one of our strengths, obviously, is we’ve got a tremendous organization and that being said, I don’t see a change in that strategy.

Our success has been based on our ability to go and execute and continue to focus on opportunities and realize these opportunities. So, to answer your question, no, I don’t see a change in that direction, that truly is a key to our success and we continue to build on that.

Paul Stecko

Yeah. And that’s not to mean, we don’t have a few new tricks up our sleeve. But we have a model that works. It’s very -- as Mark said, people-dependent. We’re not into big restructurings and things of that nature because our model has been fairly successful. But there will be enhancements made but in the end, it comes down to doing 100 things better and better each and every day. And that part, as Mark said, won’t change.

George Staphos – Bank of America

Paul, last question for anybody who can take it, I realize you might not necessarily be in a position to talk about whether you are actually in the market right now repurchasing your stock. But would there be any technical reasons why you couldn’t be in the market right now repurchasing? Thanks very much. Good luck in the quarter.

Mark Kowlzan

There are no technical reasons why we could not.

George Staphos – Bank of America

Okay. Thanks very much.

Operator

Our next question comes from Rick Skidmore with Goldman Sachs.

Mark Kowlzan

Good morning, Rick.

Rick Skidmore – Goldman Sachs

Hi. Good morning. Thanks. Just wanted to ask a couple of questions really about the market. Specifically, given the levels of profitability that you did in the second quarter in your -- the third quarter guidance and the implied returns. How do you feel about any competitive risk from additional capacity coming to the market, either through conversions or through restarts that might ultimately be competitive risks to the business?

Paul Stecko

Well, you always are worried about anything that goes on in the marketplace. And you know, new capacity coming in has always been with us, always will be with us, as is closures. But on the margin, I don’t think they’re big numbers in terms of a lot of capacity coming in or a lot of capacity going out. I think we look for this market to be fairly stable. And going forward, what’s going to, I think, help it or hurt it the most will be on the demand side as opposed to the supply side. And so we don’t see anything out there that would, on a supply side, either help a lot or hurt a lot for -- at least in the short-term.

Rick Skidmore – Goldman Sachs

Okay. And then just to follow-up on that, just two follow-up questions. I think in the prepared comments you mentioned that June growth slowed versus April and May. Was that just on a year-over-year basis or was that sequentially you’ve seen some things slowing? And then your comments about July, is that a normal July -- sequential change that you’ve seen in July versus June?

Mark Kowlzan

Yeah. That was a year-over-year basis.

Rick Skidmore – Goldman Sachs

Okay.

Mark Kowlzan

Another good thing about June, we had 22 shipping days. So it was a big month. I mean, up from -- what were we up, three…

Rick West

Well, in fact, June total shipments were greater than April and May.

Mark Kowlzan

Yeah. So we were up a bunch on a short -- on a long month in terms of 22 work days, so total volume was also quite good. We didn’t mention that but I’m glad you brought that question up.

Rick Skidmore – Goldman Sachs

Okay. And then just -- maybe just one last question, either for Mark or Paul. You talked about inventories in your -- at PCA being at really low levels for an extended period of time. Is this kind of the new normal level for inventories? Would you expect that you’d have to -- that you’ll be building some or is this kind of the new levels of inventories, either for PCA or for the industry as you see it?

Paul Stecko

No. For PCA, again, because of the extended outage in Valdosta coupled with the strong cut-up in our own box plants, we had a tough second quarter to take care of business. And fortunately, we had all three of our mills out of the four were down during the second quarter. So now we’ve got to take an opportunity to rebuild some inventories and get back to typical standard inventories, which -- that’s the goal for the rest of the year.

Rick Skidmore – Goldman Sachs

Thank you.

Paul Stecko

Yeah. The other comment I’d make is that this is not normal. We are incurring additional freight expense, which will not be necessary. It’s not a good way to run the business. It’s a lot more cost-effective to have the right amount of inventory at the right places as opposed to making emergency shipments just to keep up. So, freight’s become a bigger and bigger piece of this business. And we’ve got to work hard to get our freight costs down and having the right inventory level is paramount to that.

Rick Skidmore – Goldman Sachs

Thank you.

Operator

Our next question comes from Mark Wilde with Deutsche Bank. Please state your question.

Mark Kowlzan

Yeah. Good morning, Mark.

Mark Wilde – Deutsche Bank

Morning. I wondered, just in terms of capacity. Mark, it looks like if you back out the downtime, effectively, you guys have annual capacity of about 2.5 million tons now. Is that correct?

Mark Kowlzan

No. Again, if you think about it, we came out of the shutdowns in the springtime, which is typically -- the mills were in tip-top shape. Everything was ready to run and we executed extremely well and took advantage of that and we certainly needed the tons. So if you think about a normal run rate up in the high 90s as far as in a high run rate, we have the ability to run more than 100% -- 103%, 104% coming out of annuals for a period of time when all of the equipment is in great shape and everything is new, relatively speaking. So we took advantage of that over the last two months now.

Paul Stecko

Yeah. We ran at 104% in June, Mark.

Mark Wilde – Deutsche Bank

Okay. So what would be a good annual number?

Paul Stecko

[4%] at forever, as equipment does degrade over time, your operating rates do come down. But as Mark said, when you come out of a shutdown, if you’ve done a great job, you can hum for three or four months.

Mark Wilde – Deutsche Bank

Okay. What’s a good annual number now, do you suppose?

Rick West

Well, our reported number is $2.43 million, I think and that’s a good number.

Mark Wilde – Deutsche Bank

Okay. And will you pick up anything incrementally when the power projects are all done?

Mark Kowlzan

We have the ability to -- and I think Paul has stated that before, regarding Counce and Valdosta, with the projects that have been just completed on the Valdosta machine, with the energy-related capabilities in pressing and drying, heavyweights mainly, we can produce, if we choose to, shipped grade mixed from Counce to Valdosta and take advantage of fiber costs.

We could produce more heavyweights on Valdosta if we chose to and take tons out of Counce, whether that’s a seasonal opportunity in the winter when energy costs are higher at Counce or fiber costs are higher. So that capability does exist.

Tom Hassfurther

Yeah. Just to refresh your memory, Mark, maybe two calls ago, I pointed out that one of the things we would like to do is get a power boiler off at Counce during the winter. Because you’ve got to heat up all of that lake water, which is about 35 degrees colder in the winter and that consumes a lot of energy. With the Valdosta project, we now have the flexibility to do that.

So our current plans would be, in the winter, try to get -- try to shift maybe 150 tons a day to production at Valdosta vis-à-vis heavyweights and take the steam load down at Counce to get that boiler off and that contributes more to our energy savings.

Mark Wilde – Deutsche Bank

Okay. And then the last question I had for Tom, maybe. Can you just give us a sense of what you’re trying to do in terms of pricing on finished boxes? Are you really just trying to get through the containerboard hike or are you also trying to pick up any -- recover any incremental costs that you may be faced with in your box business because it seems like things like transportation costs and other things have probably gone up significantly in the box business over the last four or five years?

Tom Hassfurther

Well, Mark, I’m not going to comment on anything regarding price. So you know I can’t…

Mark Wilde – Deutsche Bank

But just strategically.

Tom Hassfurther

…I can’t really talk about that. But I will say that, obviously, on the cost side, we’re very focused on taking advantage of every opportunity we have there and we’re very focused on that. And yeah, there are some opportunities going forward with efficiencies now, that as we grow our inventories a little bit and get them back to where they need to be, there will be some opportunities there as well.

You know, what we focus on, Mark, primarily is, is we just make sure that we try to add as much value as we possibly can for our customers. And as long as we do that and we stayed focused on that and the hard-to-do and all the other things we’ve talked about, it’s the most successful strategy for us.

Mark Kowlzan

Yeah. And Mark, and I think this is something you know and again, I can talk about the past on price. Historically, in this business, the price has been a function of supply and demand. And the cost to produce, it has not played as an important role as the market dynamics, which sets the price and those dynamics are basically price/demand -- excuse me, supply/demand and inventory. And you wish you could just simply pass higher costs through but that’s not been the case historically in this industry. The supply/demand has been the big driver. And again, I’m talking about the past. I’m making no projections about the future.

Tom Hassfurther

Understood. Fair enough. Thanks.

Operator

Our next question comes from Mark Connelly with Credit Agricole.

Mark Connelly – Credit Agricole

Thanks. Paul and Mark, just a couple of quick things. First, on the transportation issue, not to beat a dead horse, but Paul, are you concerned about the transportation costs, particularly in Q3? I mean, have you factored in rising transportation costs, given your inventory situation or are inventories back where you’re comfortable and you don’t expect further increase in costs there?

Paul Stecko

Mark, the transportation issue arose out of the second quarter shutdowns primarily at Valdosta. Because of the 15-day outage, everything depended on Counce coming out of its first quarter annual shutdown at the end of March literally in starting up and running. And then the box plant system, our customers had to depend on Counce running extremely well.

And so the transportation penalty that we faced in that second quarter was the effect that, again, we’re paying, in some cases, premium truck costs to move that paper in and out of Counce and to our customer base, to supply what would be normally freight. The cost in the third quarter is not an issue. Also, we have in place a small capital project to add truck docks to minimize the congestion at Counce with trucking.

But in the last few weeks, we’ve also brought the rail truck balance back into balance, as far as what goes out of the mill by truck and rail. So for third quarter and the remainder of the year, we don’t expect freight to be an issue.

Mark Connelly – Credit Agricole

So you’re generally comfortable, then with your inventory levels, even if they’re on the low side?

Mark Kowlzan

No. No, that’s -- again, that will continue to be an opportunity for us to work on and also, not just for the remainder of this year, but we are going to be looking at again starting next summer, when we take the recovery boilers down at Counce for their rebuild. Each boiler is slated to be down approximately 60 days. So we’ve already planned on how we’re going to accommodate our system. But again, this is going to take, through 2011, a lot of strategic planning on how we take care of our customer base. So inventories will remain under pressure until the end of these projects.

Tom Hassfurther

Yeah. Said another way, although -- especially with the truck dock addition at Counce, we think we’re doing as good a job as can be done on truck freight. For long distance -- longer distance shipping, truck is still more expensive than rail. So we’ve got to get our inventory to a position where our box plants can wait 10 days for paper vis-à-vis rail instead of requiring we get it there in a day and a half vis-a -- higher-priced trucking. So we’ve got to get more rail and less trucking. We can only do that if we get out of the panic mode on getting paper to our box plants.

Mark Connelly – Credit Agricole

Okay. It sounds like you’re counting on a pretty high level of execution.

Tom Hassfurther

That’s what it’s all about.

Mark Connelly – Credit Agricole

And one last question, Mark. You talked about the mix in the quarter and the pickup in display. Do you see that continuing in Q3, the favorable mix?

Mark Kowlzan

I’ll let Tom address that.

Tom Hassfurther

Yeah. We should have, I mean, again, the third quarter is always a very strong quarter for us both in brown side and in display side of the business. So, yeah, we would continue to see that trend going forward.

Mark Connelly – Credit Agricole

Outstanding. Thank you.

Operator

Our next question comes from Claudia Shank Hueston from JPMorgan. Please go ahead.

Mark Kowlzan

Good morning, Claudia.

Claudia Shank Hueston – JPMorgan

Hi. Thanks very much. Good morning. Just going back to the question on cash, you’ve talked before about wanting to get your integration level up a little bit through box plant acquisitions. Where would you prioritize that just in terms of allocation of capital and then what are you seeing in terms of assets available and valuation?

Paul Stecko

Yeah. This is Paul. We’ve already allocated that we may I think I told you on the call, last call, that we had planned to spend $35 million this year and next on our box plants in areas where we were either out of capacity or we expected to be out of capacity, or we had opportunities to provide more value-added products and the returns on these projects were quite good. So, that’s already in our capital planning process.

Claudia Shank Hueston – JPMorgan

Okay. And are you still looking for acquisitions on the box plant side?

Paul Stecko

Yeah.

Claudia Shank Hueston – JPMorgan

Okay. Thanks.

Operator

Our next question comes from George Staphos with Bank of America.

George Staphos – Bank of America

Thanks. Hi, guys. A quick follow-on to the extent that you can cover it because it’s more of an industry question. What we saw in the June industry data was actually if you run through the calculation, inventory that in theory could be in transit actually shrank and so that was different than what we had seen in May. It sounds like maybe you’re in a different position but that’s what we saw from the industry data?

Do you think that that bodes well or maybe adds risk to inventories remaining too low in the inventory in future months as all a sudden, you’ve, other producers have to fill the in transit portion of the pipeline? Thanks again. Good luck on the quarter.

Mark Kowlzan

Yeah. I’ll give you a great answer, George, who knows?

George Staphos – Bank of America

You know, I think, thank you for that.

Mark Kowlzan

In transit is hard to predict and it evens itself out over a long period of time. I think what you said is correct about June and I think you’d probably have to look at May, June as a two-month average because you had two big holidays in there. You had, in terms of in transit you had Memorial Day and now you’ve got the 4th of July. That thing will level out and we got pretty good sailing through Labor Day and then you can usually get a book a lot at Labor Day. But over a long-term and I know three months is a long time for a lot of people, that thing evens out every quarter and I don’t think it really distorts the numbers very much.

George Staphos – Bank of America

All right. Paul, maybe two last quick ones. One, any measurable changes in any of your end markets that we should be aware of either things strengthening or weakening, I realize, obviously, you cover a number of end markets, but any color there would be helpful?

And then, secondly, I know, we’ve covered transportation quite a bit. If you needed to ship things -- ship paper by truck at this juncture, are you having difficulty getting trucks or is that now also stabilized? Thanks again. Good luck on the quarter.

Paul Stecko

On the first question, no, we don’t see a change in the mix, everything is normal as far as mix and also markets nationwide. On the truck transportation, we did see some difficulty during the early part of the second quarter when business in general picked up throughout North America and then, again, we put an unusual pressure on that trucking requirement at the Counce location only. So going forward we don’t see that continuing.

George Staphos – Bank of America

Okay. Thank you, Mark.

Operator

(Operator Instructions) Our next question comes from [Michael Bolosi] with Voyant Advisors.

Michael Bolosi – Voyant Advisors

Hi. Good morning. Thanks for taking my call. I wondered if you guys had the operating cash flow number from the quarter?

Mark Kowlzan

No. We’ll release that with our 10-Q.

Michael Bolosi – Voyant Advisors

Okay. Inventory and receivables then as well?

Mark Kowlzan

Correct.

Michael Bolosi – Voyant Advisors

Okay. Thanks very much. All my other questions have been answered.

Mark Kowlzan

Great.

Michael Bolosi – Voyant Advisors

Bye. Thanks.

Mark Kowlzan

Thanks.

Operator

Our next question comes from Andy Feinman with Iridian Asset Management.

Mark Kowlzan

Good morning, Andy.

Andy Feinman – Iridian Asset Management

Good morning. It says in the press release something about asset disposals related to the Counce and Valdosta mills, was that amount of money that is meaningful?

Rick West

No. As we’ve said in earlier quarters, Andy, there’s some equipment that will be retired when the project starts up. And we’ve been taking that over the remaining timeframe until the assets are retired. And it’s about $0.01 a quarter and it’s going to continue to be $0.01 a quarter, so there’s going to be no change there.

Andy Feinman – Iridian Asset Management

Okay. Thanks for that. Listen, I just wanted to say, as your third largest shareholder that I welcome Mark Kowlzan to his new position and I’m very excited about the dream team management we’ve got of him and Paul, and you, Rick, all working together. And so I, Mark has big shoes to fill but I’m confident that he will be successful?

Rick West

Yeah. I’m only a [9.5 B], so they’re not that big. The thing I’d mentioned to you, Andy, is we do have a solid team here, including Tom Hassfurther, who runs -- who replaced Bill Sweeney and he has filled those size 13’s amicably and he’s off to a great start. So, we’ve got a good team here and I’m glad you appreciate that.

Andy Feinman – Iridian Asset Management

Thanks for the comment.

Operator

Our next question comes from Joshua Zaret with Longbow Research.

Joshua Zaret – Longbow Research

Great. Thank you. Paul, I wanted to get your view on new capacity that’s coming in via machine conversions and in terms of like the nature of the product, and is there any reason, likely whatever, why it may be somewhat a lesser competitive threat either directly to you or indirectly through the industry to you?

Paul Stecko

Well, I can handle it or Mark, let me start. A lot of, there’s not that many conversions. One machine did convert and went bankrupt and I think it started up again but I’m not sure of that. Some machines are designed to make linerboard, some are designed to make medium. They usually run a lot better than a machine that’s designed to run newsprint. Not that you can’t run those grades but unless you put the right amount of capital in, you’re going to have a hard time competing and I’m not saying you can’t, but you can’t do it without the right amount of capital.

And in the end, you need more than just the machine, you need the pulp supply, you need the infrastructure, et cetera. And it’s not the easiest thing in the world to do. Again, it can be done but it is a high -- higher degree of difficulty task than running paper on the kind of machines we have. They’re designed not only for specific grades but specific basis weights over a wide range. So, at Counce, for example, we can run anywhere from what, 35 to 90-pound…

Mark Kowlzan

90-pound. In Valdosta…

Paul Stecko

… and make a good quality product with outstanding physical properties. So we suspect that some conversions will occur. There don’t appear to be a lot on the horizon and we welcome the opportunity to compete against those machines.

Joshua Zaret – Longbow Research

Do these conversions end up with lightweight liner or could they have a broader range than that?

Mark Kowlzan

Well, again, minimizing capital, you end up with a lightweight liner machine. If you’re going to try to compete with the existing linerboard industry grade mix, you’re possibly looking at $75 million, $100 million capital expenditure to convert an existing newsprint machine, when you take into effect changes that have to be done in the pulp mill, stock prep, wet end forming and pressing into the dryer. So this is a very, very high capital requirement to compete in the broad…

Paul Stecko

It’s a hard question to answer, Joshua. It’s, like remodeling a house, how much do you want to spend on it? So it’s a wide variety depending on what your objectives are and what you’re trying to accomplish and what kind of return you’re willing to take or not take. So there’s no simple formula, no simple answer, it depends, is probably the best answer we can give you.

Joshua Zaret – Longbow Research

Well, that’s actually very helpful. Thank you.

Operator

(Operator Instructions)

Mark Kowlzan

With no more questions.

Operator

No further questions, sir.

Mark Kowlzan

If no more questions, I’d like to thank everybody and see you next call.

Operator

Thank you, ladies and gentlemen. Thank you for your participation in today’s conference. This does conclude the conference. You may now disconnect. Good day.

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Source: Packaging Corp. of America Q2 2010 Earnings Call Transcript
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