Smurfit Kappa's (SMFTF) CEO Gary McGann on Q2 2014 Results - Earnings Call Transcript

Jul.30.14 | About: Smurfit Kappa (SMFTF)

Smurfit Kappa Plc. (OTCPK:SMFTF) Q2 2014 Earnings Conference Call July 30, 2014 9:00 AM ET

Executives

Gary McGann - Group CEO

Tony Smurfit - Group COO

Ian Curley - Group CFO

Analysts

James Armstrong - Vertical Research

Gerard Moore - Investec

Operator

Good afternoon ladies and gentlemen. Welcome to the Smurfit Kappa Half Year Results Conference Call. Throughout the call, all participants will be in a listen-only mode, and afterwards, there will be a Q&A session. Just to remind you, this conference call is being recorded.

Today, I am very pleased to present, Gary McGann. Please begin your meeting sir.

Gary McGann

Thank you, operator. Good morning or good afternoon ladies and gentlemen, and thank you for taking the time to join our first half earnings call. I am joined on the call by our President and COO, Tony Smurfit; our CFO, Ian Curley. And before commencing, I just want to refer you to the note on forward-looking statements set out in our press release, which also applies to our discussion here today.

In the first half of 2014, EBITDA increased by 10% to €564 million, and the EBITDA margin improved to 14.3%. This strong earnings performance reflects the strength of the business, supported by our integrated business model, despite short term volatility in European containable prices.

Through the delivery of increasingly innovative packaging solutions to our customers, organic and acquisition led growth, particularly in the Americas, and consistent cost takeouts. We have fundamentally improved our business performance in recent years.

The Group's European operations are continuing to show demand improvement in both corrugated and containerboard, and our operations in the Americas are performing well, with volume growth expected to improve in the second half of the year.

As a result of continued demand growth, a fundamentally stable containerboard supply outlook, and consistently high recovery of paper costs, we have announced a price increase of €60 tonne from the 1st of August in recycled containerboard, and €50 a tonne from the first September in kraftliner. These initiatives will underpin current year corrugated prices, and when successfully implemented, will provide scope for further corrugated price recovery in 2015.

We continue to deliver strong free cash flow. In the first six months of the year, free cash flow amounted to €135 million, an increase of 87% year-on-year. This underpins our ability to drive our medium-term capital allocation initiatives through the cycle.

A sustained strong business performance, robust cash flow generation capability, and continued debt reduction supports our progressive dividend policy. As previously indicated, we are pleased to confirm a 50% increase in the interim dividend to 15.375 cents payable on October 31.

Looking at our first half operating performance in more detail; European revenues in the first six months increased by 3% year-on-year to over €3 billion, with an improved underlying performance in both corrugated and containerboard, together with a smaller contribution from acquisitions. European EBITDA of €421 million in the first half was €50 million or 14% higher than the same period in 2013. This was primarily driven by a combination of higher volumes and higher corrugated pricing.

Growth in European packaging volumes has continued at steady levels with a 1% growth in box volumes in the year-to-date, and an improving trend in quarter two. Volume in shift have decreased year-on-year, this is more than offset by good performances in countries such as Germany, the U.K. and Spain.

Average corrugated pricing has remained steady over the course of the second quarter, and 2% higher year-on-year. Successful implementation of our recent containerboard price increase announcements will underpin 2014 corrugated prices, and further support price recovery in 2015.

As mentioned, we have announced our intention to increase recycled containerboard prices by €60 tonne from the 1st of August. Demand for containerboard has been strong, with year-on-year growth driven by relatively good market demand. OCC prices have also remained at a relatively high level, which has acted as an underpin to pricing during the recent period of softness. Overall OCC demand remains strong, with the underlying trend expected to be upward, as capacity additions are implemented.

In kraftliner, a price increase of €50 a tonne has been announced effective from the 1st of September. This increase reflects the positive developments in the recycled containerboard markets, and the tight kraftliner markets. The Group's 1.6 million tonne European kraftliner system provides a significant strategic advantage, as recycling rates reach upper thresholds in Europe, and adequate availability of recovered fiber continues to be a strategic consideration for industry participants.

Turning to the Americas, our business has performed well in the year-to-date, with an EBITDA margin of 17.4% in the first six months. The majority of countries delivered strong underlying performances, reporting good volume growth, pricing progression, and delivery against cost takeout targets in the majority of countries.

However, the segment reported a 7% and 4% decline in revenue and EBITDA respectively, reflecting the negative effect of adoption the Sicad I exchange rate in Venezuela in quarter one. Against that however, operations in Colombia and Mexico reported particularly good performances, with underlying volume increases of 6% and 3% respectively. We expect good growth for the remainder of the year in these markets.

Despite continued challenging economic environment in both Argentina and Venezuela, the Group is performing well in these markets. Smurfit Kappa Orange County also continues to perform well, with higher year-on-year EBITDA with the business clearly benefiting from increased cross-border activity with the U.S.

Our disciplined focus on pricing in Smurfit Kappa Orange County, at the extent of some lower margin volume, has resulted in a 2% increase in the EBITDA margin year-on-year, and we expect a stronger second half performance, as a result of underlying demand growth, and improved productivity.

Looking at our first half financial performance in more detail; revenue for the half year grew by 1% to approximately €4 billion. Underlying growth in both Europe and the Americas increased revenues by 5%, which was partly offset by negative currency movements. EBITDA for the first half of 2014 has increased by €52 million to €564 million, higher comparable earnings in both Europe and the Americas.

Allowing for net negative currency movements of €43 million, and a contribution of €2 million from net acquisitions, the underlying move was an increase of €93 million or 18%.

The gross margins for the six months benefited from the relatively strong growth in EBITDA, and increased at 14.3% from 13.1% last year. Operating profit before exceptional items for the half year increased by 18% to €363 million. Exceptional items amounted to €9 million and related to losses on the translation of non-Bolivar denominated payables in Venezuela in quarter one, following the changes of the Sicad I rate.

Operating profit after exceptional items for the half year was €354 million, a 29% year-on-year increase. Free cash flow of €135 million in the first half of 2014, compared to €72 million in 2013. The increase of €63 million reflects higher EBITDA, lower cash interest and lower exceptional charges, partly offset by higher capital expenditure. Working capital increased by €117 million in the first six months, broadly in line with the 2013 level. The working capital deferred ratio was 8% compared to 8.7% in June 2013.

Capital expenditure amounted to €152 million on the first half of 2014, approximately 78% of depreciation, compared to 75% in 2013. There would be higher capital expenditure level in the second half of the year, as projects are progressively implemented.

Looking to our capital structure, as a result of the Group's strong free cash flow generation, our net debt has decreased by €141 million to below €2.7 billion at June 2014. Our net-debt-to-EBITDA has reduced to 2.3 times in June 2014 from 2.7 times last year, and has remained broadly flat since March 2014, despite a €71 million outflow in May, relating to the 2013 final dividend payment.

On the 3rd of July, we completed the refinancing of our €500 million, 7.75% senior notes through 2019, with a seven year bond at a rate of 3.75%, the lowest ever bond coupon achieved by Smurfit Kappa. The transaction will save an annualized €23 million in cash interest, and marks the completion of a two year program, in which over €3 billion of debt has been refinanced. As a result, the Group's balance sheet has been fundamentally repositioned as an unsecured corporate credit, with diversified funding sources, and materially lower interest costs.

Turning to cost takeout, our EBITDA margin of 14.3% in the year-to-date, is underpinned by the achievement of cost takeout initiatives, which primarily offset inflationary pressures. Almost €650 million in costs have been taken out of the business since 2008 and the Group is committed to continue its focus on delivering efficiencies in future periods.

At June 30th, our 2014 cost takeout program has delivered cost savings of €50 million, predominantly in the areas of raw material usage, with further material savings in the areas of labor and energy. The Group will deliver at least €100 million in cost takeout for the full year 2014 as previously guided.

Under the heading of Branding, Smurfit Kappa did launch a differentiation initiative across its total system, following on almost 18 months of empirical research, as to how the company can work with its customers to improve the cost efficiencies, and enhance the value of the offering in their end markets.

This will be done through better insights, increasing innovation initiatives, and a strategic value selling focus. These initiatives will be advanced over the next couple of years under the value proposition up in the future, an example of some such initiatives can be seen on our micro-site, at openthefuture.info.

In summary ladies and gentlemen, we are pleased to report another strong quarter and first half year. These results reflect the resilience of our earnings profile, underpinned by our integrated model, together with the benefit of geographic diversity. We have a robust capital structure, and strong free cash flow, which will support the delivery of previously announced capital allocation decisions.

With year-on-year earnings growth expected in 2014 alongside considerable cash interest reductions, the Group is increasingly well placed to deploy capital to enhance returns for shareholders. I would like to thank you for your attendance for today, and operator, we are now happy to take any questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of James Armstrong from Vertical Research. Please go ahead.

James Armstrong - Vertical Research

Hi Gary, congrats on a good quarter.

Gary McGann

Thank you very much.

James Armstrong - Vertical Research

My first question is actually on the ability to pass-through pricing into the boxes. A large competitor of yours talked about the market in Europe being weak, and likely not being able to pass along any paper prices in the boxes, as we go into the back half of this year and into 2015. Whereas historically, you have been able to do a very good of that. Could you just talk to that issue a little bit, and tell us your opinion?

Gary McGann

And we've got Tony to take that one James.

Tony Smurfit

Hi James. Yeah I mean, obviously, its never going to be easy to pass price increases through. But the reality is, we didn't get any increase -- enough of an increase from the paper increases we had last year, and into the early part of this year. So the necessity for us in the industry, will be if the full 60 go-through, is to get some box price recovery and obviously, while not easy, its going to happen. We will have to make it happen.

Gary McGann

Remember James, about 42% of our business is indexed or formula driven. The Formula driven business tends to happen in any event, and it will be up and down, depending on the timing and phasing. The open negotiated pricing, I think its informative to remember that through the decline in paper pricing in quarter two, which was a self inflicted issue, and I think its important to know, we did flag at the end of quarter one on our call, that we didn't see any structured problem, and that this was an inventories problem, which the industry could fix the same way as it caused and the industry seems to have, in its own systems, on something to address it, because inventories are now 506,000 tonnes, which gives pricing power in paper.

But in the negotiated pricing, we held our corrugated price increases, even though paper prices were dropping. Part of the value of the integrated model number one, but number two, our business is packaging. Really, paper pricing up or down is interesting, but the main issue for us as a business is packaging, and packaging pricing and packaging value add for the customers. And therefore, in a way we have no choice but find a way to get this done, and certainly, the confidence ever will be, naturally [ph] our guys are able to do that.

James Armstrong - Vertical Research

Very good. And then addressing that self-inflicted wound, what are you guys doing to keep inventories under control into the back half of the year, and are you willing to get inventories get, maybe even a little too tight, going through the Christmas holiday season, just to make sure what happened, and the Christmas and winter season of this year doesn't happen again next year?

Gary McGann

Tony, do you want to take that?

Tony Smurfit

I think it’s a little bit too early to look at it James. I think what we are doing right now, is we are concentrating on the recovery of the price increase that we currently are putting through into August and September, and then obviously we have, as you know, a rebuild paper machine starting up in January, end of January, and that's something we will make sure that we don't lead with our -- do something that's really silly and introduce new tonnage -- effectively new tonnage, even if it is replacing our existing tonnage, that we have taken out. And with a -- we are not going to do anything silly.

Gary McGann

James, its worth noting at the end of quarter one, if you remember, Tony indicated that we would -- we were a part of the inventory build, and when I say self-inflicted wound, its worth bearing in mind, the back end of 2013 containerboard inventories, recycled containerboard inventories have got tight, and we were going into Christmas expecting 2014 recovery to start over there. It has been leisure, I mean, half year to-date, our volumes were up 1%. Second quarter, they are up 2%, so you can see the phasing is more into quarter two, and we believe trend-wise continuing that way. But as a result of those two actions, the inventory is built; and we took 18,000 tonnes of down timing in quarter two, to address our inventory levels, and recognizing the consequence of excess inventory, we are not going to let that happen. So we take whatever appropriate actions within our system are necessary to keep our systems balanced.

James Armstrong - Vertical Research

Very good. Thank you very much.

Gary McGann

Thanks James.

Operator

Thank you. (Operator Instructions). Our next question comes from the line of Gerard Moore from Investec. Please go ahead.

Gerard Moore - Investec

Hi, good afternoon gentlemen, thanks for taking my question. Again, just two follow-on questions. One, I was wondering if you could say a word about some of your other products within the Group, such as the Bag-in-Box business and how that performed within the quarter or maybe year-to-date, so maybe a word or two about some of the other greats like sack kraft paper etcetera?

And then second question in terms of, I was wondering -- if Ian, perhaps you can give us some guidance on it, so your cash interest charge, what you expect it to be now? Thanks.

Gary McGann

Tony, you're good on this subject.

Tony Smurfit

Gerard, thanks for the question. I think that basically our Bag-in-Box continues to improve and go from strength-to-strength. You know, we are seeing very strong order books and very strong developments in that area, hence the reason we have just completed the rebuilding, as Ian would have mentioned earlier of new plants down in Spain, where we spent €28 million on developing new facility there. So that business continues to do very well.

The other grades that you're referring to are, you have two mills in Northern Spain, one in MG Papers and one in sack kraft, and both of those business are exceptionally strong right now. We have very long order books, and some predicated on European recovery, and some predicated on global expansion in our grades and new markets, for specifically MG Papers, which we have announced a development of -- investment of some €27 million into the MG Paper mill, whereby we will remove 60,000 tonnes of containerboard and replace it with some MG Papers, it will take about 18 months, two years to get that done, but that will happen in early 2016.

Gary McGann

Ian, on the cash interest?

Ian Curley

Cash interest, if you take 2013, the 197, in 2014 it will be 143, and on a like for like pro forma basis, it will be 130, during 2015, Gerard.

Gerard Moore - Investec

That's very clear. Thanks a lot.

Gary McGann

Thanks Gerard.

Operator

Thank you. Our next question comes from the line of Patrick [indiscernible] from Schroders. Please go ahead.

Unidentified Analyst

Hi, good afternoon gentlemen. Hello. Just if I could ask you to expand a bit more on your acquisition strategy. I know its further down your list of what you're going to do next, but if you can guide us to how you're thinking about accretive acquisitions, how much you're willing to pay, how would you finance that etcetera, that would be great please? And if there is any potential targets you're looking at in terms of geographies and size, that would be great as well.

Gary McGann

Sure. Ian?

Ian Curley

In relation to the focus of the business, the focus of the business is on acquisitions, so that would be our priority number one. I have already said, is when you look at the cash flow dividends, there has been a 50% increase. The capital structure, we just renewed there slightly and we have a BB+ credit there. Capital expenditure, under 10% [ph] depreciation over the next three years. So our focus is very much on the M&A side. And within that, countries that we like are, those that we are in, where we get synergies. For example, in Orange County, in Mexico, we employ 3,700, they employ 2,000. We are able to extract a lot of synergies in that country. So where we have got a presence, also those adjacent countries, where we would have the ability from an operational point of view, to extract synergies as well. So they will be the main areas.

Latin America, Eastern Europe, and then within the States itself, our focus is on integrating the foreign mills. Our focus then would be sort of [indiscernible] the purchase up, standalone market plan. And then, with regards to natural site stuff, I suppose the focus really is that, a number of years ago, was on sort of -- debt paydown leverage was an issue. We have hit our leverage targets. We always said that we wanted to be BB+ credit, and that's our focus, we've achieved that now. So within that, we can do a reasonable sized acquisition quite frankly, and if you would just sort of solve [ph] per se, 2.7 times EBITDA, you can see the size there. But we have put out there, something in the order of like €300 million per year, something that we can equate quite easily too.

With regards pipeline, we have a reasonable pipeline, we look at acquisitions within those various criteria as I outlined. Plus, we have nothing that we wouldn't -- until we complete something, that's when we would announce.

Unidentified Analyst

Okay. That was very helpful. If I may just add on to that, would you be looking straight purely into sort of paper packaging that you're doing now? Would you be willing to go slightly wider in the packaging space? I am not talking very off the grid, sort of glass or anything or metal or anything like that, but slightly -- if you know what I mean, sort of paper-based packaging, but maybe not as straightforward as your products at the moment?

Gary McGann

We have, Patrick, its worth bearing in mind, we have a small growing leading position in the Bag-in-Box business, which includes also, basically a pouch business with taps -- based on the tap technology as well. And this is an area where we have skills, expertise and a track record, which is purely an area of interest, in terms of -- A, its growing as a sector, and B we are an important player in it. So that clearly will be something that is definitely on our agenda.

Wider than that at this point of time, I think it would be purely speculative.

Unidentified Analyst

Thank you very much.

Gary McGann

Thanks Patrick

Operator

Thank you. Our next question comes from the line of Cole Hawthorne [ph] from Jefferies. Please go ahead.

Unidentified Analyst

Good morning. Congratulations on a good quarter.

Gary McGann

Thank you very much.

Unidentified Analyst

Tony, this question is for you. Just with regards to the operations in Mexico. I know you are working on -- you're taking extra mill capacity in Mexico with the machine you bought online, and I just want to know how that project is going, and what the end result will be? Will you still be net buying, a significant amount of test liner and kraft liner or how will that play outs in Mexico? And then I also wanted to get the general view of how operations are in -- will demarcate down in Argentina?

Tony Smurfit

Okay. Thanks Cole. We haven't pushed the button yet on the paper machine in Mexico. We are laying the groundwork for it, we are getting all the permits. We are making sure that we have sufficient electricity, water, etcetera, etcetera, within the mill system that we know we will get, but we need to get those permits first. And so we are continuing to look at this, and probably will decide fully -- certainly by Q4, as to whether we push the button or not, whether the return is adequate. If it is adequate and we do decide to fully push the button with the machine, the amounted tonnage will be about 90,000 tonnes introduced in 2016, -- middle 2016, and by that, even today, we would still be long about 50,000 tonnes without any market growth -- sorry, short of 50,000 tonnes, without any market growth which we anticipate.

We would still be a significant buyer of kraft liner in the market, so Mexico will still be a big buyer of paper for our system.

On Argentina, basically, well the operating conditions there are difficult in volume terms. We have been able to recover pricing, but right now the market is difficult from a volume perspective, but as we have said before, Argentina is a relatively small country for us, and so therefore, while important, its not something that overly concerns us, in relation to how it affects the Group.

Gary McGann

Its good market. It's a good market position for us. We obviously have balance sheet that's hedged with local borrowings, and a key part of our customer markets are exporters, which obviously are critical to Argentina more than ever, in the context of whatever the outcome is, with the bondholders. So [indiscernible], we've had experience of these type of challenges over many-many decades, quite a number of decades, and have tended always to come through in good shape. So we wouldn't be dismissive of it, but certainly, its not something that's keeping us too much awake at night.

Unidentified Analyst

And Gary, its still a little bit -- in your views, it’s a little bit too early to say whether that would be a position for further expansion, or do you view it as the country risk a little bit too much at this stage?

Gary McGann

I think we always keep it in view. Certainly, it’s the opportunity to a tomorrow, [ph] you would be certainly stopping and pausing. I mean, we have positioned ourselves; Ian and the team has structured the balance sheet in Argentina in a way that has hedged against most of the risks. The challenge is to maintain that type of profile. Ian, I will let you comment on this.

Ian Curley

I suppose from the last banking crisis, the bank market doesn't have a huge amount of debt to us. And if you were, and typically our approach is to go and borrow locally in a country. So that would be an issue for us within that. But otherwise it’s a country, we would be -- in 2002, had become the marketability issue; has issues at the moment. But fundamentally, it’s a very good country.

Gary McGann

And we have gained good business there, and certainly, we have a long term view on this, that's for sure, and including -- potentially and certainly in the future, not right now, a target for further expansion.

Unidentified Analyst

All right. Thanks very much.

Gary McGann

Thanks Cole.

Operator

Thank you. (Operator Instructions). There are no questions registered at this time. I will hand the conference back to you.

Gary McGann

Many thanks. Ladies and gentlemen, again, thank you for participating in today's call. As I said earlier, we are very pleased to report another strong performance in the second quarter and the year-to-date. We have a robust capital structure and a strong free cash flow to support the delivery of previously announced capital allocation decisions. And with the earnings growth expected in 2014, alongside considerable cash interest reductions year-on-year, the Group is increasingly well placed to deploy capital to enhance returns for shareholders. So thank you for your attendance and have a good day.

Operator

Ladies and gentlemen, that does conclude our conference for today. Thank you very much for your participation, and you may now disconnect your lines.

Gary McGann

Thank you, operator.

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