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Resolute Forest Products (NYSE:RFP)

Q1 2014 Results Earnings Conference Call

May 1, 2014, 9:00 a.m. ET

Executives

Rémi Lalonde - Vice President, Investor Relations and Senior Legal Counsel, Securities

Richard Garneau - President and Chief Executive Officer

Jo-Ann Longworth - Senior Vice President and Chief Financial Officer

Analysts

Sean Steuart - TD Securities

Paul Quinn - RBC Capital Markets

Stephen Atkinson - Dundee

Operator

Good morning, ladies and gentlemen. Welcome to the Resolute Forest Products' first quarter 2014 earnings call. I would now like to turn the meeting over to Mr. Rémi Lalonde, Vice President for Investor Relations. Please go ahead, Mr. Lalonde.

Rémi Lalonde

Thank you. Good morning, everyone. Welcome to Resolute's first quarter earnings call. Today, we'll hear from Richard Garneau, President and Chief Executive Officer; and Jo-Ann Longworth, Senior Vice President and Chief Financial Officer.

You can follow along with the slides for today's presentation by logging on to the webcast, using the link in the Presentations and Webcast page under the investor relations section of our website or you can download the slides. We provide additional financial and statistical information, including a reconciliation of non-GAAP financial measures, in our press release and in the slides.

As always, certain subjects we will cover today involve forward-looking information. Our statements are based on our current assumptions, beliefs, and expectations, all of which involve a number of business risks and uncertainties and accordingly can change as conditions do.

Richard?

Richard Garneau

Good morning, everyone, and thank you for joining us today. We generated $40 million of adjusted EBITDA in the first quarter compared to $110 in the previous quarter, and $73 million in the same period last year. This is a disappointing outcome, as this winter’s extreme cold caused a material increase in energy costs, production disruptions, equipment failures, and also distribution constraints.

We generated adjusted EBITDA of $3 million in newsprint, down 35 from the fourth quarter. We were a negative 2 in specialty papers, down $33 million. We made $31 million in market pulp, down $8 million, and $20 million in wood products, up $2 million from the previous quarter.

Operating costs generally peak in winter, but this winter was severe, [briefly] overcoming the favorable effect of the weaker Canadian dollar. The abnormally cold winter is responsible for the $55 million drag on earnings caused by, first, $17 million of [various team] costs due to higher pricing at most of our mills and an increase in usage, especially in the U.S. southeast.

Second, a $16 million increase in electricity costs at our Ontario mills as a result of volatility and sharp increases in market based power rates. Third, $9 million associated with pulp and paper production loss due to natural gas curtailments, electricity costs, and other process limitations. And fourth, a $13 million hike in the cost of freight, fiber in the U.S., labor, chemicals, and maintenance.

Distribution constraints for lack of carrier availability also caused increases in inventory. What is more, this quarter we also encountered greater than expected levels of operational disruptions including mechanical failures in Catawba, Saint-Felicien, and Augusta. These operational disruptions which were unrelated to the cold weather accounted for about 25,000 metric tons of lost production in the quarter, in addition to $7 million of additional costs.

Let’s review market conditions. Total North American newsprint demand weakened by 7% through March, reflecting a 9% reduction from newspaper publishers and a 4% increase from other users. Globally, demand decreased by 5% through February, including a 5% decline in Asia and 11% in Latin America, most of which was Venezuela. Western Europe also was up only 1%.

Consistent with North American industry exports, we increased the international portion of our pool of shipments to 42%. Compared to the same period last year, North American producers’ export was down 5%.

With the timing of industry production adjustments lagging demand declines, the shipment to capacity ratio slipped to 89% this quarter compared to 91% in the year ago period. Our average transaction price slipped by $13 in the quarter, mostly because of the weaker Canadian dollar, sales mix, and price deterioration in certain export markets.

Contrary to earlier expectations, shipments also slipped this quarter, but it was due to weather-related disruptions and mechanical failures at August and shipment timing. Accordingly, we expect to work down inventory in Q2. With recent industry conversion announcements such as [higher operating rates] later this year, prices could continue to erode in certain areas.

North American demand for uncoated mechanical paper slipped by only 3% in the first quarter. Demand for super brights and high brights together rose by 4% and demand for supercalender grade was flat. But lightweight grades, of which we have only a small presence, were down by 20%.

The industry shipment to capacity ratio was 87%, compared to 89% in the first quarter of last year and 92% for the full year 2013. Coated mechanical demand fell by 7% in the quarter. Imports were 10% lower than the previous quarter, and 24% lower than the same period last year, helping in part to alleviate the supply/demand balance.

The industry shipment to capacity ratio was 88% compared to 92% in the same period last year and 87% last quarter. Reflecting shifting end use markets, our average transaction price for coated mechanical grades was down by $37 per short ton in the quarter and down $16 per short ton in supercalender grades.

Shipments were down, affected by seasonality, weather related disruptions, and the mechanical failures at Catawba. We expect the coated paper portion of these specialty segments to remain under pressure as a result of the low operating rates.

Overall, demand for market pulp slipped by 1% compared to the first quarter of last year. China rose by 2%, but North America was down by 2% and Western Europe, the world’s largest market, was down by 4%.

Global demand for softwood pulp was flat, but down 1% for hardwood. Softwood mills ran at 93% shipment to capacity ratio in Q1, unchanged from the same period last year. Hardwood mills, however, were at only 87%.

We recorded average transaction price increases across each of softwood, hardwood, RBK, and fluff grades for a $22 per metric ton increase overall. Unfortunately, shipments were down this quarter, in part because of shipment timing and internal consumption, but also because of unforeseen events such as shipment constraints and production disruption associated with the severe weather as well as the mechanical failures.

As a result, we did not benefit in full from favorable market conditions. Nevertheless, we expect to work down inventory in Q2, but it remains difficult to predict the impact of worldwide capacity increases, mostly in hardwood grades, expected over the course of the year.

We’ve also planned to do the annual outage at two mills in the second quarter, Coosa and Calhoun, which will affect production by about 20,000 metric tons.

U.S. housing starts have been sluggish this quarter, likely due to weather. Seasonally adjusted housing starts averaged about $925,000 in the first quarter, compared to an average of about $960,000 in the first quarter of last year.

Our average market price rose by $6 per thousand board feet. Though higher than the first quarter of last year, shipments slipped by 27 million board feet, as a result of the winter impact on demand and also on carrier availability.

I’d like to take a moment to highlight some important developments. First, we announced in February that unionized employees at four of our U.S. pulp and paper mills voted overwhelmingly in favor of a five year renewal of their master collective agreement.

Our total U.S. pulp and paper operations represent almost half of our total pulp and paper production capacity. We are pleased to have quickly reached an agreement with union leadership and members to ensure we remain a competitive employer, but also one that maintains its competitive edge.

Second, we announced in March a significant upgrade to our Calhoun, Tennessee pulp and paper mill, including the installation of a modern continuous digester and other chip processing equipment. When completed, by mid-2016, this will help to significantly lower the mill costs, increase its pulp capacity, and improve its great flexibility.

With the ability to produce a range of products from specialty papers such as our line of uncoated freesheet substitute, to value added grades, the mill will better be able to adjust with the market.

We also continue to make progress to grow our sawmill capacity as our Atikokan and [unintelligible] sawmill projects are moving on schedule to begin production in early 2015. As part of ongoing efforts to optimize the asset base, we recently started the idle paper machine number five at Calhoun to produce mechanical grades.

While we were pursuing opportunities to continue to operate the biomass [unintelligible] and electricity producing steam turbine, it appears that we will not be able to successfully reposition the rest of the Fort Frances mill, including the specialty machine presently under expanded market outage. We spent about $9 million in the first quarter to keep the mill in idle mode.

Finally, on March 21, on the UN 2014 International Day of Forests, we launched www.borealforestfacts.com to provide a new digital resource to highlight our ongoing efforts to promote sustainable forest management in one of the world’s most vibrant ecosystems. The site includes information about boreal, the forest product industries, and the future of this renewable forest, upon which so many of us depend.

I would like to remind everyone that less than 0.25% of boreal is harvested each year, with five times the amount affected by natural disturbances such as fire, disease, and insects. Of course, in the Ontario and Quebec boreal forest, about 75% of the forests naturally regenerate, and the other 25% is promptly reseeded or replanted.

It is also worthwhile to point out that over 40% of the boreal is completely out of bounds for the forest product industry in both Quebec and Ontario. Of the remaining area that constitutes the managed forests, a significant portion has already been set aside for conservation, biodiversity, and other purposes.

I’ll close by saying that we are presently at the bargaining table discussing the renewal of labor agreements covering 11 of our Canadian pulp and paper operations. Eight of those mills, representing about 35% of our total pulp and paper production, now have the ability to take work action.

As a company, we believe in succeeding together, where every member’s contribution is important to reach our collective goals and to ensure our long term success. Both sides of the table have been engaged for almost two weeks now, and we are making progress. Out of respect for the process, I will not comment on the discussion yet, except to highlight that it is absolutely in everyone’s best interest to reach an agreement that works for both sides.

I’ll now invite Jo-Ann to review our financial performance.

Jo-Ann Longworth

Thank you, Richard, and good morning everyone. Today we reported a net loss of $26 million in the first quarter, or $0.27 per share, excluding special items, on sales of $1 billion. GAAP net loss was $50 million.

The special items included a $16 million noncash loss on the translation of Canadian dollar net monetary assets as well as an $8 million charge for idling and cleaning costs at Fort Frances and accelerated depreciation for a machine closure at Iroquois Falls. Total sales were $1 billion, down 12% from the fourth quarter.

Shipments fell in each of the segments, 6% in newsprint, 11% in specialty, 20% in market pulp, and 7% in wood products, which reflects the impact of the severe winter, the operational disruptions, seasonality, and shipment timing.

Overall, pricing had a $2 million unfavorable impact on sales, with increases of 3% in the average transaction price of market pulp and 2% in wood products, which more than offset declines of 2% in newsprint and 3% in specialty papers.

First quarter cost of sales was down $53 million or 6%. Excluding the effect of volume, cost of sales rose by $7 million. We did not experience the full benefit of the weaker Canadian dollar, or $23 million, nor the $6 billion of lower pension and other post-retirement benefits, or OPEB, expenses because of an increase in overall manufacturing cost.

Such manufacturing cost suffered because of the greater than expected operational difficulties of $7 million and the $40 million of additional cost associated with the abnormally cold winter. The $50 million impact to operating income that we’ve been talking about includes not only the $40 million of additional manufacturing cost, but also extra freight costs and lost margin.

Newsprint delivered cost was $623 per metric ton, up $44, or 8% from the previous quarter, mostly because of the severe winter driven higher costs of electricity in the province of Ontario and the absorption of fixed costs over lower shipments, offset in part by the weaker Canadian dollar.

The delivered cost in specialty papers rose 8% to $774 per short ton because of higher steam and freight costs due to the severe winter, additional costs following the mechanical failures at Catawba, and fixed cost absorption once again. These unfavorable items were only partially offset by the favorable effect of the weaker Canadian dollar and increased cogen production.

Market pulp delivered cost rose by 5% to $674 per metric ton due to the costs associated with the severe winter, the operational disruptions at Saint-Felicien, and fixed cost absorption, despite the favorable effects of lower ongoing maintenance costs and the weaker Canadian dollar.

Finally, delivered cost in our wood products segment fell by 2% to $347 per thousand board feet as a result of the weaker Canadian dollar and the reversal of certain export duties, despite an increase in log costs.

Looking forward, we expect to feel some of winter’s aftereffects in Q2, though the impact should not be anywhere near as harsh as Q1. In particular, the price of natural gas and of power in Ontario have, for the most part, normalized in April.

Distribution constraints continue, however, and will be felt through the second quarter, as carriers gradually ease the accumulated backlog, which will be all the more difficult given the spring weight restrictions. These elements will weigh on shipment volumes as well as freight and warehousing costs in the second quarter.

The cogeneration assets we use to sell power to the market improved our costs by $13 million, a full $3 million better than in the previous quarter. With Thunder Bay and Gatineau now fully operational, this is also $4 billion better than the first quarter of last year.

Closure costs and related charges were $10 million, down from $33 million in the previous quarter. Q1 included mostly idling and cleaning costs at the Fort Frances mill and accelerated depreciation for machines closed at Iroquois Falls in mid-April.

Turning to the balance sheet and cash flow items, cash and cash equivalents decreased by $82 million to $240 million. Balance sheet working capital increased to $705 million. Net cash used in operating activities was $41 million compared to net cash provided of $96 million in the fourth quarter.

Working capital increased by $32 million due in part to a $64 million increase in inventories, including $22 million of raw materials, almost all of which is a seasonal buildup in roundwood and $38 million of finished goods, partially offset by a $29 million reduction in accounts receivable, largely on lower sales. This compares to a working capital decrease of $57 million in the fourth quarter.

Capital expenditures were $36 million, in line with the previous quarter. For 2014, we continue to expect spending on maintenance of business of between $135 million and $160 million, and we expect spending on value-creating projects, including many carried over from 2013, to be between $75 million and $125 million. Spending will pick up with the pace of construction at our Atikokan and Ignace sawmill projects in the second quarter.

Availability under our ABL credit facility at the end of the first quarter was $548 million, for a total liquidity of $788 million.

Pension contributions were $39 million against an $8 million expense. Our combined pension and OPEB expense, which is allocated to the segments, was $6 million lower and will be going forward, because of the lower unfunded pension liability and amendments to our U.S. OPEB plans. These amendments, together with contributions and a favorable currency impact, caused a further $110 million drop in the balance sheet net pension and OPEB liability to $1.2 billion.

For 2014, we expect total pension contributions to be approximately $160 million, of which an expense, estimated at $25 million, will be included in our operating income.

We are pleased to recognize that both Quebec and Ontario have now adopted the regulations needed to update the previous funding relief measures following the agreement in principle we reached with company stakeholders in those provinces in 2013.

Compared to the previous structure, we will make CAN30 million of incremental annual contributions going forward, but the onerous corrective measure mechanism has been eliminated. Our actual 2013 contributions reflect the application of the regulations, given the additional CAN30 million we paid in the fourth quarter in anticipation of the regulations.

Rémi Lalonde

Thank you, Jo-Ann, thank you Richard. Operator, let’s open the call for questions, please.

Question-and-Answer Session

Operator

[Operator instructions.] The first question is from Sean Steuart of TD Securities.

Sean Steuart - TD Securities

Richard, it showed up in your Q1 results, you’ve seen some marginal price weakness in your newsprint price realizations. Could you maybe just comment regionally where you’re seeing it, and has this erosion continued into Q2? And I guess how much of it would you chalk up to weaker Canadian dollar and that feeding into the U.S. dollar pricing environment for the commodity?

Richard Garneau

I think overall, yes, we had a reduction of $13 per ton, and it was across, when I look at Canada, Latin America, and Asia, and also the U.S. The U.S. was small, but the Canada price went down more than the average, as well as Latin America and also in Asia. So there was pressure in all the markets.

[unintelligible] certainly by the operating rates. When you look at shipment to capacity at 89%, I think it’s certainly one of the challenges that we have in the industry. So when you look at the Canadian dollar it has some impact. Obviously the euro is still strong, and it helped somewhat for the volume that we export. But I think that the issue is really there’s also some capacity conversions that have been announced, so I think it’s certainly, until it happens, it’s going to keep probably pressure on pricing.

But there is a machine that is going to be converted in the south, as you’re aware, and it’s going to remove material volume, and I think that certainly until then we are going to see pressure. And what domestic does is going to stabilize somewhat in the third and fourth quarters.

Sean Steuart - TD Securities

The Calhoun capital project, the $105 million, can you talk about over what period you’re spending that capital, and then if you can go through the expected returns on that project as well?

Richard Garneau

It’s going to be done in the next few years, and we are looking for starting up this new digester with the other modification that we’re going to make sometime in 2016. And on the benefit itself, I’m not going to give you the return, obviously, but I can tell you that we’re going to improve the yield, because now we have nine batch digesters. We’re going to have only one.

We’re going to make also savings on the chemicals, and it’s also material. We’re going to save also on energy, and obviously we’re going to benefit on the mix. There’s certainly, with the improved quality that we’re going to have, we’re going to have more volume, more capacity, because the pulp drier was not used at its full potential, because of a lack of slush pulp. So I think that all that together is going to bring the cost down.

And one of the advantages of Calhoun, we have the growth rate of the hardwood is very high, and wood cost is very, very competitive. And so the mill that is well located, and obviously with only one continuous digester, compared to the eight or nine that just we have, it’s going to reduce the pressure on maintenance, going to cost less, and I think there are other savings that are difficult to estimate at this point.

But I think all that added together is going to make this mill more competitive. And obviously there is some also assistance that we get from the state [unintelligible] and also [unintelligible] that is going to certainly shorten the payback on this project.

Operator

The next question is from Paul Quinn from RBC Capital Markets.

Paul Quinn - RBC Capital Markets

It looks like in specialty papers you’ve got a similar problem to newsprint in lower operating rates, but what’s required here to get that market back in balance?

Richard Garneau

On the uncoated mechanical?

Paul Quinn - RBC Capital Markets

Yes.

Richard Garneau

To get the market in balance, well, there are two ways to get the market in balance, better demand and a closure of machines. So it’s that simple. And I think that when you look at what we have done on the site, closing the machine at [unintelligible], we closed a machine at Laurentide. We closed a machine at Fort Frances.

So I think that in terms of capacity, we remove capacity to basically take into account the client demand, and I think that it’s difficult to, when there’s only one machine running at the mills, difficult to close more than that. So I think that certainly we’re looking at developing new products, and it’s the case in Calhoun that we’re in the [unintelligible] business, and have been successful in producing these new grades.

And I think we’re also looking at Calhoun, at increasing our [unintelligible] substitute, coated freesheet substitute. And obviously with the improvement on the pulp side on the pulp mill, certainly a portion of it is to continue to work on value-added rates or take advantage of the location of the mill as well as better quality.

And the uncoated freesheet substitute, I think it’s certainly an area that we are looking at that would provide certainly an opportunity for the company to address this issue of low operating rates or shipment to capacity that is lower than what it should be.

Paul Quinn - RBC Capital Markets

And on the inventory bill that you had in Q1, do you expect to be able to ship all that in Q2, or is that going to drag into Q3?

Richard Garneau

I think that certainly we’re going to have the impact in Q2 and there is still congestion into the real system as you’re probably aware, and I think that now we are in the [spring weight restriction], this time of the year, it’s going to last well into May. But I think we’re considering that by the end of June, the inventory, while maybe not going to the level that we would like to see on inventory, but it’s certainly going to be a situation that is going to be an improvement compared to the end of the quarter.

Paul Quinn - RBC Capital Markets

And just on the sawmill projects, Ignace and Atikokan, if you could remind us what the total capacity there is, and the total capex you’re going to spend, and what you’ve spent to date?

Richard Garneau

It’s about $250 million, or close to $300 million of capacity, and the capex is about $75 million for both sawmills. And we’ve spent about $20 million to $25 million. We’ve started to pour concrete, foundation, and we’re now ready to start the [unintelligible] of the building, so it’s going to certainly increase the cash requirement. And certainly we’re well-positioned now to be able to get the benefit of additional capacity by early 2015.

Operator

The next question is from Stephen Atkinson from Dundee.

Stephen Atkinson - Dundee

In terms of the previous provincial government that, shall we say, had a unique approach to supply and cost, have you got any insight with the change in government as to how they will approach the timber supply?

Richard Garneau

To answer your question, on this one we expect to have an industry meeting with the new minister of forests in the short term. I think that decision from the premier to appoint a forest minister is certainly a positive development for the industry. I think that there are other companies in the industry that are also raising questions on the additional cost of this new [unintelligible] system. We have been, as a company, quite vocal on the impact on cost.

I’m going to repeat again what I’ve said many times. Compared to 2011, and when I look at our forecast for 2014, it’s an increase now of about 25%. And I think that one of the most significant impacts on costs is planning. And I think now it’s the government that’s in charge of planning, and it’s at the point where we’re going to certainly try to do that with the new minister. So you know, when planning is not done by the company, it’s very difficult to basically build a road.

And just to give an example, if you can start to build a road in September or October, that’s not going to provide enough time for the road to dry, and you have additional costs and so it’s one example, but I think we know that there are many other small examples that could provide, certainly, opportunities to reduce the cost.

I’m not trying to change the system. There are things in this new [unintelligible] system that have to be improved. It would not cost anything to the government, but it would bring the cost down. And it would not be insignificant.

Stephen Atkinson - Dundee

Can you compare it to the Ontario system right now?

Richard Garneau

In terms of costs, it’s higher than Quebec, there’s no doubt. So it’s not insignificant.

Stephen Atkinson - Dundee

Okay, so there is a precedent for them to go back to what they did before. But would there be an increase in maintenance this quarter?

Richard Garneau

In the second quarter, we’re going to have two mills, the [unintelligible] and Calhoun, that we’re going to [unintelligible] each for the pulp mill on maintenance. And we’re going to also, with Saint-Felicien [unintelligible]. It’s not the annual maintenance, but the recovery boards. We have to do some work on this. So it’s the 20,000 tons that I mentioned.

But you know, we changed also the way that we account for that, so I think that when we spend, it’s spread over the period until the next outage. So the impact is less significant, because it’s just evening up the costs, instead of adding everything into the quarter. So you have a charge that you spread over the other quarters until the next outage.

Rémi Lalonde

Thank you, everybody, for joining us today.

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