KapStone Paper & Packaging (KS) Roger Warren Stone on Q1 2016 Results - Earnings Call Transcript

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KapStone Paper & Packaging Corp. (NYSE:KS)

Q1 2016 Earnings Call

April 28, 2016 11:00 am ET

Executives

Roger Warren Stone - Chairman & Chief Executive Officer

Andrea K. Tarbox - Vice President & Chief Financial Officer

Matthew S. Kaplan - President, Chief Operating Officer & Director

Analysts

Scott L. Gaffner - Barclays Capital, Inc.

James H. Armstrong - Vertical Research Partners LLC

Debbie A. Jones - Deutsche Bank Securities, Inc.

Ketan Mamtora - BMO Capital Markets (United States)

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

John P. Babcock - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Chris D. Manuel - Wells Fargo Securities LLC

Wes Swanson - RBC Dominion Securities, Inc.

Operator

Good day, ladies and gentlemen, and welcome to the KapStone Paper & Packaging Corporation First Quarter 2016 Earnings Conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. As a reminder this conference may be recorded.

The information in this earnings call contains certain forward-looking statements within the meaning of federal securities laws. These statements reflect management's expectations regarding future events and operating performance and speak only as of April 28, 2016. These forward-looking statements involve a number of risks and uncertainties. A list of the factors that could cause actual results to differ materially from those expressed in or underlying any forward-looking statements can be found in the company's filings with the Securities and Exchange Commission such as its annual and quarterly reports.

The company disclaims any obligation to revise or update such statements should reflect the occurrence of events after the date of this earnings call. I would now like to introduce your host for today's conference Mr. Roger Stone, Chairman and CEO. Mr. Stone, you may begin.

Roger Warren Stone - Chairman & Chief Executive Officer

Thank you. Good morning and thank you for joining us. Both Matt Kaplan, our Chief Financial Operating Officer and Andrea Tarbox, our Chief Financial Officer, are with me today. After my opening remarks, Andrea will cover our first quarter financial results. Matt will bring you up-to-date on our operations and I'll follow with some closing thoughts and then we'll open the phones for questions.

First quarter is usually one of our weakest. Considering the poor pricing environment and our low level of integration compared to our major competitors, we had a good quarter with a strong production of a poor mix, excellent cash flow and began our aggressive plan to increase our integration which will improve our mix as well as our prices.

We are currently executing our plan to build a new, modern converting operation which should be in full operation by the end of this year. Hopefully, a second plant will be in the works in the second quarter and finally, we are pursuing strategic acquisitions that will provide additional immediate integration.

And now, I'll turn it over to Andrea.

Andrea K. Tarbox - Vice President & Chief Financial Officer

Thank you, Roger. Good morning, everybody. The presentation for today's review of the first quarter of 2016 financial results is located on our website www.kapstonepaper.com in the Investors section.

On Slide 3 is a summary of our first quarter results compared year-over-year and sequentially from fourth quarter of 2015. First quarter was an exceptional quarter operationally and this improvement in productivity was able to offset the rather steep deterioration in prices and product mix more heavily weighted with exports.

Net sales were up 35% to $738 million year-over-year. Adjusted EBITDA increased $1 million, or 2%, from Q1 2015 to $88 million. Adjusted net income was down $7 million, or 24%, to $22 million year-over-year and adjusted diluted EPS was down $0.10. The drop in adjusted net income and adjusted EPS despite an increase in adjusted EBITDA is primarily due to $6 million of higher amortization expense, or about $0.04 per share, for purchase accounting intangibles resulting from the Victory acquisition.

On Slide 4, we've bridged our net sales and adjusted EBITDA results between the first quarter of 2015 to the first quarter of 2016. Our net sales were $192 million higher in 2016 due to Victory and volume improvements for legacy KapStone. Mill tons produced and sold were up 5% and 6% respectively. Our corrugated shipments in MSF were up 4%. KapStone's large exposure to export markets was the primary driver of the $28 million unfavorable price/mix variance resulting in a $58 per ton drop in average revenue.

Adjusted EBITDA of $88 million was slightly higher year-over-year on $13 million of benefits from Victory. When assessing Victory's performance, we must consider the seasonality of this business. Q1 is typically Victory's seasonally weakest quarter and these results were actually slightly higher than last year's Q1 and our expectation. Also keep in mind that the synergy benefits from Victory are in our Paper & Packaging segment, not in Victory's numbers.

Adjusted EBITDA for Q1 also benefited from $13 million of productivity improvements and lower costs offset by lower prices and unfavorable mix. Inflation (05:25) and one of our largest costs, fiber, is trending down.

Moving on to Slide 5, we've analyzed our net sales and adjusted EBITDA sequentially from Q4 2015. Our net sales were $26 million lower in 2016 due to lower seasonal Victory sales and lower prices and unfavorable mix. Q1 is typically our least favorable quarter from a product mix perspective with more linerboard and pulp tons being sold in the export markets. Therefore, the average mill selling price per ton declined by $37 from Q4 to Q1. Both mill production and sale of tons were up 5%. However, those gains were slightly offset by our corrugated shipments which were seasonably down 1.2% in MSF.

Adjusted EBITDA increased sequentially by $6 million primarily from much improved productivity and lower client outage expense. Lower fiber cost down 2.8% from Q4 and lower energy cost primarily contributed to the deflation. Victory's adjusted EBITDA was down $7 million on seasonably lower revenues.

Turning to Slide 6, you can see the strong and significantly improved cash flow that KapStone generated in Q1 2016 compared to previous Q1s. Q1 cash flows are typically the lowest cash generating quarters due to several large annual payments required during this quarter. However, in Q1 2016, we increased our operating cash flow over the prior year's Q1 by $63 million. This increase was accomplished due to lower income tax payments, contributions from Victory and other improved working capital items.

The net debt-to-EBITDA ratio of 3.7 times per the credit agreement was up slightly due to lower trailing 12 months EBITDA. Net debt was $1.5 billion and our weighted average interest rate as of March 31 was 2.1%. CapEx for the quarter was $36 million and the full-year estimate is $115 million. With that, I'm now going to turn the call over to Matt. Thank you.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Good morning, everybody, and thank you again for joining us. My plan today is to review our Q1 operational performance including the significant progress that our mill division has made in a couple of key cost areas, comment on broad market trends, highlight some capital investments and head count initiatives and finally discuss Victory Packaging's performance, the progress on our initial integration plans and future opportunities to better take advantage of the Victory Packaging acquisition.

Beginning on page seven, our mills ran very well in Q1 producing 690,000 tons. Our Q1 tons per day production represented an all-time high. Q1 2016 production increased by 5% compared to both Q1 and Q4 of 2015.

Q1 sales of Paper & Packaging products were 692,000 tons, slightly greater than mill output. Our mix however was unfavorable as we shipped more tons to the export markets. Average revenue per ton per mill sales declined by $58 per ton compared to Q1 2015. The price erosion affected first quarter revenue by $26 million which was related primarily to weakness in the export markets but also was impacted by the reduction in domestic containerboard prices as reported by industry publications.

Q1 box shipments measured in billion square feet increased by 4% while selling prices for containers were flat. It is important to note that our box shipments when discounting the Victory Packaging integration underperformed the market, a trend that should not continue moving forward.

Looking at page eight, we've made significant progress in several important cost areas. Before discussing the details, I'd like to point out that in early 2014 we recognized that we had some meaningful opportunities to improve in these areas. The KapStone leadership team developed the appropriate improvement plans and we have achieved some success. The savings that we have achieved is a function of process improvements, benefits from capital investments and to some degree, lower input pricing. It is very important to know that we expect to make additional improvements in these areas in the future.

With respect to head count, in the mill division alone, we have experienced a reduction of 280 people since Q1 2014 and 200 people in the past year. The average savings of each person eliminated is roughly $90,000 to $100,000 per year.

We've made nice progress reducing our energy costs. Total cost per ton is down roughly $11.50 since Q1 2014 and the associated Q1 2016 savings were $7 million. Approximately 75% of the savings are attributable to reduced consumption while the balance is due to lower natural gas and coal costs.

Our chemical costs are also trending down. Total cost per ton has declined $3 since Q1 2015 and total savings are $8 million per year. Usage improvements account for 60% of the gains, while pricing reduction equates to 40%.

In addition to head count, energy costs and chemical costs, we're also experiencing lower fiber and logistics costs as a result of operational changes and lower pricing. Fiber costs exiting Q1 were $3 per ton of fiber consumed, lower than average Q1 cost, and we expect the Q2 fiber cost will be consistent or lower than the Q1 exit level, resulting in Q2 savings of roughly $5 million to $6 million.

Turning to page nine, our markets in general continue to be challenging in some areas and static in others. We're enjoying reasonable demand on the domestic kraft containerboard and kraft paper sides of the business; prices are stable. Export demand for both board and paper is good. Pricing appears to be stabilizing, particularly in the overseas paper markets. Our specialty grades, both Kraftpak and saturated kraft are static, although we have seen some weakening of demand for our DuraSorb grade.

We're experiencing the traditional pickup in demand in our container business, consistent with seasonality. We expect this to continue through fall. It's important to recognize that agricultural box demand in the Pacific Northwest should be stronger this year barring any unusual weather conditions. This should be a definite positive for the KapStone western box plants.

I wanted to highlight a couple of exciting developments noted on page 10. At both

Roanoke Rapids and Charleston, we're in the process of modernizing our woodyards. We have contracted with a third-party who is constructing new facilities and will manage the daily operations under a long-term agreement. The projects are in the initial stages and we expect to generate benefits beginning in early 2017. Our portion of the capital spend is negligible and we estimate that these projects will increase annual EBITDA by $10 million.

On a company-wide basis, we have refocused our efforts to reduce head count. Towards the end of Q1, we reduced head count by approximately 125, with an annual benefit of $8 million to $9 million per year and a one-time severance charge of $3 million. Please note that these savings are incremental to the mill reductions that I referred to earlier.

Victory Packaging performance is outlined on page 11. As we have mentioned on earlier calls, Victory's business is highly seasonal, with Q1 being by far its weakest quarter. During Q1, prior to synergies, Victory contributed $7 million of EBITDA, slightly above our expectations, and generated $6 million in cash. Results for the balance of the year should be much stronger and in line or better than our initial projections.

The process of integrating Victory's box purchases into the KapStone system continues as planned. During Q1, Victory purchased 20,000 tons from KapStone plants. March production for Victory Packaging was almost 9,000 tons. We should meet our initial estimate of achieving a 115,000 ton run rate by the end of the second quarter.

It is important to understand that while we established an initial goal of integrating 115,000 tons of Victory Packaging purchasing into KapStone's operations, we believe that the future opportunities are significantly greater. Some of the potential areas for integration above our original estimates are growth in capacity in existing KapStone's box plants, acquisition of undersold box plants, joint venture with box plants with unsold capacity that commit to consuming KapStone containerboard and convincing non-integrated Victory Packaging suppliers to consume KapStone containerboard.

Please note that the progress in these areas will be lumpy, but I'm hopeful that by the end of 2017 we should substantially increase the integration associated with Victory beyond our initial goal. In the future, it is likely that we will continue to rely significantly on outside suppliers.

As indicated on page 12, the following factors will impact our results in Q2: the residual effects of the January, February published decline in containerboard price. Product mix should improve as box demand increases seasonally and exports decline. Victory Packaging will benefit significantly from stronger seasonal demand. Planned Q outage cost will exceed Q1 cost by approximately $13 million. Fiber cost will be lower; we estimate the Q2 benefits versus Q1 to be between $5 million and $6 million. Lower salaried head count expense. We expect CapEx to be $32 million in Q2 and $115 million for the year and income tax rates would be 35%.

At this point, I'll turn the floor back over to Roger for his closing comments.

Roger Warren Stone - Chairman & Chief Executive Officer

Thank you, Matt. In closing, it's worth repeating that our earnings and cash flow volatility are strongly influenced by our low integration rate. Strategically, this is why we bought Victory and it will play an important part of our future growth plans, as Matt pointed out, as we build more converting capacity in key markets. Also acquisitions as well as joint ventures should play a big role in reducing our export volume. We obviously believe that as we move forward with our plans, we will find that the best is yet to come.

Thank you for your interest. And now, we'll open up the phones for questions.

Question-and-Answer Session

Operator

Our first question comes from the line of Scott Gaffner with Barclays. Your line is now open.

Scott L. Gaffner - Barclays Capital, Inc.

Thanks, good morning. Hey, Matt, nice to have you on the call.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Thank you.

Scott L. Gaffner - Barclays Capital, Inc.

You mentioned, Matt, a couple of new converting operations, it sounded like those were Greenfield operations, can you talk a little bit more about those facilities and where they might be located?

Matthew S. Kaplan - President, Chief Operating Officer & Director

Well we're really – first of all, Roger mentioned specifically a couple of new operations, I was talking about in more broad terms. But regardless of that, we're really not at liberty to discuss where those operations will be located. Roger gave you some insights in terms of his expectations on when those facilities might be opened up. I should say that if you look at our math of box plants, and you look at where Victory is represented strongly, the areas that are probably the most attractive to us are Florida, some northeastern location maybe a mid-Western, Ohio kind of operations, Southern California, those are really the areas that we're concentrating our search and our efforts right now.

Scott L. Gaffner - Barclays Capital, Inc.

Okay.

Roger Warren Stone - Chairman & Chief Executive Officer

And essentially, those most likely will be Greenfield plants. The one that's in – that we're building is A Greenfield, a modern Greenfield plant.

Scott L. Gaffner - Barclays Capital, Inc.

Okay and those are part of the achievement above and beyond the 115,000 tons integration, correct?

Matthew S. Kaplan - President, Chief Operating Officer & Director

Precisely, yes.

Scott L. Gaffner - Barclays Capital, Inc.

Okay. All right and then as far as the (19:50) $15 per ton decline that we saw in January, I mean, what's been the overall impact on your box pricing around that, has it had a meaningful impact or not?

Matthew S. Kaplan - President, Chief Operating Officer & Director

So our box prices actually Q1 of 2015 versus 2016 were absolutely flat to the dollar. So I can't say that we haven't had accounts where contractual obligation necessitated that we reduce price, but in general terms, our box plants have been flat year-over-year. Moving forward, as we noted in the last slide, we do anticipate some modest erosion of box prices moving forward. I would just estimate that to be in $1 million to $2 million a quarter kind of range. But beyond that I think most of the impact of the change in published prices have already been included in the Q1 results.

Scott L. Gaffner - Barclays Capital, Inc.

All right, thanks for all the color.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Welcome.

Operator

Thank you. And our next question comes from the line of James Armstrong with Vertical Research Partners. Your line is open.

James H. Armstrong - Vertical Research Partners LLC

Good morning. Thanks for taking my question. First, was there anything unusual about the seasonality in distribution and could you help walk us through how the quarters shake out in distribution?

Matthew S. Kaplan - President, Chief Operating Officer & Director

So I don't think there was anything unusual, James, about the seasonality. Q1 traditionally is a very weak quarter. In the distribution business particularly for Victory's business we see a significant pickup beginning in the second quarter. A lot of it's associated with just a general pickup in demand in the economy but a lot of it's also associated with the fact it's a moving business, which is an important part of Victory's business tends to be a spring through fall kind of business.

So Andrea commented I did as well that in spite of – if you were to annualize Victory's Q1 results, you might come to the conclusion that it was disappointing but versus last year, Victory actually outperformed and we're totally on track for Victory to meet its expectations. And Q2 and Q3 will be substantially stronger, Q4 falls off a little bit, but not to the extent that we see in Q1.

James H. Armstrong - Vertical Research Partners LLC

Very good. Switching gears, in containerboard, what's your current integration level and where, over the next few years, where would you like to get it?

Matthew S. Kaplan - President, Chief Operating Officer & Director

So roughly we make about 1,700,000 tons of containerboard on an annual basis. Our box plant cut up about 900,000 tons. So I think if you do the math, that's about a 55% integration level. We would really I guess our near-term goal is to increase our integration by 150,000 tons to 200,000 tons a year and eventually we'd like to get to where our peers are, north of 90%. It's going to take a long time, but ultimately that's where we want to go.

James H. Armstrong - Vertical Research Partners LLC

Perfect, that helps. And then, lastly as you enter Q2, what are you seeing in the different segments containerboards, specialty papers and distribution especially with the recent currency moves?

Matthew S. Kaplan - President, Chief Operating Officer & Director

So I think what we're seeing is with respect to exports kraft paper, we've seen that market bottom out and we're actually seeing some very, very modest changes in prices in a positive way in that market. We feel that the export containerboard business is either at or near trough and perhaps building a floor and I don't know how much of that is associated with the change in currency versus just European demand increasing seasonally just like we're seeing here in the United States.

James H. Armstrong - Vertical Research Partners LLC

Okay, thank you very much and good luck in the second quarter.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Thank you.

Operator

Thank you. And our next question comes from the line of Debbie Jones with Deutsche Bank. Your line is open.

Debbie A. Jones - Deutsche Bank Securities, Inc.

Hi, good morning.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Good morning.

Andrea K. Tarbox - Vice President & Chief Financial Officer

Good morning.

Debbie A. Jones - Deutsche Bank Securities, Inc.

I wanted to talk a little bit about the new converting capacity, couple of things here. Do you have – will you go ahead and do this, you don't have contracts for some of this capacity or is the idea that this really all goes into Victory? And then, my other question would be on this do you – my may not seen it, is it little bit underutilized at some of your existing box plants, so is there an opportunity to shutdown some of those over time?

Matthew S. Kaplan - President, Chief Operating Officer & Director

So, with respect to the new capacity, I mean the Victory business will certainly serve an important role in base loading those facilities. But one of our challenges in terms of servicing national account type of business has always been kind of our spotty geographic footprint. So, we're hoping that not only will we put Victory into that business, but we'll have some strong relationships with national account buyers to help us at those facilities and we'll also be concentrating on the local markets at those facilities to fill out those plants. With respect to the underutilized capacity at our existing plants, we don't have any current plans to shut down those plants. Our plan is to build the sales force and build the sales and improve the operations and be more successful than we currently are at those plants.

Debbie A. Jones - Deutsche Bank Securities, Inc.

Okay, thank you, my second question would just be actually a point of clarification on wood fiber, I think in the deck it said $4 million to $5 million. So, you're saying $5 million to $6 million on the call, just wanted to make sure that was the case. And then if wood fiber cost stay at current levels, how would that look at on a year-over-year basis in the back half?

Matthew S. Kaplan - President, Chief Operating Officer & Director

So, first of all, you asked two questions, the first question, Debbie, can you repeat yourself, I'm sorry.

Debbie A. Jones - Deutsche Bank Securities, Inc.

Yes. No problem. I just saw on the deck that the wood fiber benefit quarter-over-quarter would be $4 million to $5 million.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Yes.

Debbie A. Jones - Deutsche Bank Securities, Inc.

I believe you said $5 million to $6 million in your commentary, so I just wanted to make sure that it is actually $5 million to $6 million. And then if wood fiber costs were to stay at current levels, what would we expect the kind of year-over-year benefit to be in the back half for KapStone?

Matthew S. Kaplan - President, Chief Operating Officer & Director

So, you know, I think that $5 million is certainly a number that I'm comfortable with. Andrea pointed to me out as I was talking that I was saying something inconsistent with our presentation, so I'm sorry for I've done that, but I think $5 million is a fairly safe number.

And in terms of the year-over-year fiber costs, I would say that we ought to be able to save the same $5 million that we're forecasting to save in Q2 over Q1 in Q3 and Q4, and hopefully the trend that we experience with downward fiber costs will continue and those savings will even widen as the year goes on.

Debbie A. Jones - Deutsche Bank Securities, Inc.

Okay, thanks that's helpful.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Right, Roger just pointed out to me that last year wood fiber costs were going up, particularly at Charleston and Longview Fibre and those trends have reversed itself, so I think we're in a pretty good spot with respect to fiber cost moving forward.

Debbie A. Jones - Deutsche Bank Securities, Inc.

Great, thanks a lot. I'll get back in the queue.

Operator

Thank you. Our next question comes from the line of Ketan Mamtora with BMO Capital Markets. Your line is open.

Ketan Mamtora - BMO Capital Markets (United States)

Hi, thanks for taking my question. Just wanted to talk about the export kraft paper market, Can you talk about what you are seeing there? And then, recently there was a 14.9% import duty levied by China. Can you just briefly touch upon that? And then there is also some trade speculation on one of your customers potentially bringing in some kraft paper into North America, so what does that do to your sales volumes, if you can talk about that?

Matthew S. Kaplan - President, Chief Operating Officer & Director

Okay. So with respect to the export kraft paper markets, they were – the tail end of 2015, the beginning at 2016, demand was weak and pricing was weak as well. We've seen demand pick up in those markets, and as I mentioned early, we're seeing prices stabilize in those markets.

With respect to the Chinese tariff, we do have this 14.9% penalty that's being imposed upon us, which is making it very difficult for us to compete in China. Some of our competitors were imposed with higher penalties, some with no penalties at all. So what we're seeing in that market is we're seeing kind of a shift around of supply. The worldwide supply hasn't changed. It's just the demand is coming from different areas, and companies that are more suited to supply in China will and those that are being charged with tariffs will probably look elsewhere for their business.

And the last question you asked I think was about a customer of ours in the United States that has European mills that to some degree has made the decision to supply those mills from Europe. That's obviously affecting us and could affect us in the future as well. But I guess that's something that we kind of always knew was a possibility and we've been planning for that and I think we're pretty well positioned if in fact that does happen in a bigger way in the future.

Ketan Mamtora - BMO Capital Markets (United States)

Got you; thanks for that. And Andrea one question for you. Am I remembering this correctly that in the last quarter you all had talked about cash taxes of 35%, so it's lower now about 25%?

Andrea K. Tarbox - Vice President & Chief Financial Officer

It's 28% now for this year and that's primarily due to the refund actually that we got in this quarter based on the really late end of the year tax change that came about last year. So, this year will be about 28%. Next year, we expect the cash tax rate to go back up and approximate the regular (32:11) – the book tax rate.

Ketan Mamtora - BMO Capital Markets (United States)

Understand. That's very helpful. I'll turn it over, thank you.

Operator

Thank you. And our next question comes from the line of Adam Josephson with KeyBanc Capital Markets. Your line is open.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

Morning everyone. Matt, welcome.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Thank you.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

A couple for you. One on the converting capacity that you're talking about adding; it seems like there is already more than sufficient converting capacity in the U.S.; obviously the Trade Press just discussed that issue last weekend. Would you agree with that, and if so, why would you contribute to the broader problem by adding yet more converting capacity to the U.S. market, if you're not going to shut some of your existing capacity?

Matthew S. Kaplan - President, Chief Operating Officer & Director

Adam, there has always been a tremendous amount of excess converting capacity in this business. I mean box plants for many, many years were one and half to two shift operations and this is not a new phenomenon when converting capacity exceeding demand. So our intention in opening up these plants is not just for the sake of adding converting capacity, it's because we want to take advantage of the Victory tonnage and become more integrated.

Roger Warren Stone - Chairman & Chief Executive Officer

Yeah, capacity is usually a problem that the industry has with mills, not converting plants. Converting plants you build where the demand is. And where we can grow our demand, that's where we'll do it, and it will increase our conversion. So capacity is an industry problem when it comes to the mills and historically.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

Right, okay.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Adam, the only time that people talk about having too much converting capacity is when prices are a little soft on the containerboard side of the business. It's really containerboard prices that drive our success on the long-term. It's really not a function in my mind anyway of how much converting capacity there is versus demand.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

Fair enough. Thank you for that. A matter, Andrea, in terms of the sequential drag you're expecting from the January price index reduction, can you quantify what that expected sequential drag is and what the annualized EBITDA impact is? I know last quarter you indicated would be $20 million to $26 million, I was hoping you could update that number.

Andrea K. Tarbox - Vice President & Chief Financial Officer

Yes, last quarter when we gave that number we sort of were assuming worst case that the index decline moved all the way through our corrugated business as well and what we have found, and as Matt pointed out in the flat box prices, is that it really hasn't. And so therefore our new estimate is probably more in the annualized $11 million per year and he said, in fact, first quarter we already took most of that in. So, I'd expect an annualized amount of about $11 million a year impact.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

So, Andrea, that's just a function of what flowed through to your box business and you made certain assumptions that proved not to be the case?

Andrea K. Tarbox - Vice President & Chief Financial Officer

Yes, because when – these contracts are quite complicated in whatever and there are lot of provisions. But the fact is that since the movement wasn't significant enough to trigger changes. We didn't have to give up that pricing.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Adam, this may fall into the category of too much information.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

Right.

Matthew S. Kaplan - President, Chief Operating Officer & Director

But if the index were to move down further, the fact that we had many customers where the change in containerboard prices are reflected in the publication in January and February was not large enough to trigger a change, a subsequent change may actually be magnified because we would have to pass along the new change as well as the change that was not.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

Right because it's a cumulative number right.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Exactly.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

Yes, yes. Thanks for clarifying that, Matt. Just a couple others, Matt, if I heard you right you mentioned your box shipments excluding Victory lagged the market in the first quarter. If I heard that correctly, what would you attribute that to and by what extent did you underperform?

Matthew S. Kaplan - President, Chief Operating Officer & Director

So I would say we underperformed by like somewhere between 2.5% to 3% and I would attribute the underperformance to a couple of reasons. Number one, we operate cheap feeders in a couple of markets where business became very competitive and we were resistant to meeting the new levels of prices. So we lost market share in the first quarter on the sheet side of the business and we also had some large local accounts that just seem to be slower than normal in the first quarter. So it's our view that that trend should reverse itself. I mentioned that as the produce season in the Pacific Northwest kicks in, we expect the demand to be really outsized this year versus prior year and getting competitive in some of these markets where we slowly will also help us regain some of our market share. Roger is going to add here.

Roger Warren Stone - Chairman & Chief Executive Officer

Just about the April numbers it would seem to us that we're gaining market share again and that demand is pretty good. So whatever it was, it appears to a first quarter event.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

Right, right. Thank you, thank you. Just two others. Matt, one industry question, just on inventories, containerboard inventory, obviously higher than historical averages. I know last year many of the producers talked about logistics, significant logistics problems. Now we're not hearing that any longer, yet inventories remain considerably higher than historical averages. So what would you attribute the current inventory levels to if not logistics problems?

Matthew S. Kaplan - President, Chief Operating Officer & Director

Well, you know, first of all, I'm not convinced that these logistics issues that cause people to increase their inventories have really subsided to a large degree. Other people may have different opinions on that, but with respect to – once you built the inventories and demand does not exceed supply by a large amount, it takes a while to bring them down. And I think that the industry is in the process of going through that and we saw about a 55,000 ton decline in March and we'll see the April numbers before too long but I am not that concerned about inventory level. I know a lot of people are. I think inventories are appropriate given kind of the logistic challenges that we face and the level of demands that we're currently enjoying today.

Roger Warren Stone - Chairman & Chief Executive Officer

(40:17).

Matthew S. Kaplan - President, Chief Operating Officer & Director

Yes, Roger just mentioned to me that a lot of companies have expanded the number of grades that they provide to the marketplace and obviously as the industry moves towards more light weight, higher compression type of grades, it's going to necessitate holding more inventory at box plants and in the mill divisions.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

But presumably companies do not to carry more working capital than absolutely necessary, right. I mean, why would any company want to do that?

Matthew S. Kaplan - President, Chief Operating Officer & Director

Because it becomes a matter of servicing your customers adequately.

Andrea K. Tarbox - Vice President & Chief Financial Officer

And the cost, with the cost of capital so cheap and there are still surcharges for expedited shipping and stuff like that. So, economically it still makes sense to hold higher inventory levels.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

Thanks and just, Matt, just one just last one on Victory and the strategic fit, can you just remind us kind of why it fits KapStone better than it did perhaps some of your containerboard competitors that have gotten out of that business in recent years and also how much of Victory's business is boxes versus other products? Thank you very much.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Yes, so Victory's business is a lot different than some of our peers that were in the distribution business. Ours peers' distribution businesses were heavily weighted towards white cut paper grades. Victory is kind of a brown industrial box business. In terms of Victory's business I don't know how publicly we've really expressed this, but we can tell you that 370,000 tons of their business is boxes, their total revenue was about $1 billion last year, so you could impose some kind of reasonable price per ton on the boxes and come up with a pretty good estimate of how their business is divided between boxes and other products. And it's not just other products, you know Victory is also a provider of fulfillment which there is no product involved. You're just performing a service for the customer in that particular case.

Adam Jesse Josephson - KeyBanc Capital Markets, Inc.

Thanks a lot, Matt. Really appreciate it.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Sure.

Operator

Thank you. And our next question comes from the line of John Babcock with Bank of America Merrill Lynch. Your line is open.

John P. Babcock - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Hey, good morning, everyone. Just a couple of quick questions here. I guess, first of all, it sounds like with the improved weather on the West Coast there that that's going to have a benefit certainly on the containerboard market and I know your exposure is a little bit more in the Pacific Northwest there, but just want to get a sense as to how much of that particularly in the California market might impact you.

Matthew S. Kaplan - President, Chief Operating Officer & Director

So we're not a big provider to the California produce market. We provide some containerboard to some independents that are in that market. So it's really not going to affect our box demand substantially. It will affect our demand for containerboard in a positive way. And you're right the weather has improved dramatically in that California market and they're expecting a much stronger season this year than they had last year.

John P. Babcock - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Okay, and did you guys – you talked about the box shipment impact in the first quarter, did you provide any sort of guide as to how it's been so far in Q2?

Matthew S. Kaplan - President, Chief Operating Officer & Director

Well what Roger said was that shipments so far in April are back on track and he believes as do I that this situation where we underperformed in Q1, taking the Victory growth out of our box numbers will not be a trend that continues moving forward.

John P. Babcock - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Okay great. And just another one kind of tag along to Adam's question there on Victory. I just wanted to understand a little bit here I mean Victory buys about 370,000 tons from the outside has about a $1 billion of revenue, as prices fluctuate whether it will be up or down how does that impact that Victory business and their earnings there?

Matthew S. Kaplan - President, Chief Operating Officer & Director

I would say that Victory's contractual arrangements are very similar to a company like ours or our peers so there are triggers in their agreement that depending on the level could cause prices to go up or down as the published price changes. Victory also serves a pretty broad base of small customers that might not be as sensitive to these indexes than some of our customers historically are.

John P. Babcock - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Okay perfect, thanks for the color. That's all I have for now.

Operator

Thank you. . Our next question comes from the line of Chris Manuel with Wells Fargo Securities. Your line is open.

Chris D. Manuel - Wells Fargo Securities LLC

Good morning, everyone. I jumped on a few minutes late, so I hope I'm not repeating anyone and you don't have to repeat yourself, but a couple questions. First if I could start with – and you did some labor reductions, some head count reduction. Where – are those mostly in hourly, was that across corporate, and then could also give us an update on kind of the situation in Longview, specifically? We were thinking it was largely resolved, but it sounds like there has been some more back and forth.

Matthew S. Kaplan - President, Chief Operating Officer & Director

So with respect to head count, what we talked about a little bit earlier was that the mill division has reduced its head count, primarily hourly head count, but there are some salary included as well, by 280 people in the last two years and 200 in the last year.

In addition to that, late in the first quarter, outside the mill division primarily, KapStone reduced its head count by about 125. And some of those people, particularly on the Victory side of the business, were hourly people, but a good portion of those people were salaried people. We expect the benefit of that, the late first quarter head count reduction, to be somewhere in the $8 million to $9 million range and we mentioned that the one-time cost associated with doing that was $3 million.

With respect to the Longview Fibre, or the Longview mill labor situation, first of all, let me begin by saying that we continue to believe that we offered a very fair and competitive package to the employees. The contract at this point has been implemented. The people there are terrific; they're working safely; they're working productively. I mean you could see in the Q1 numbers, Longview contributed significantly to our record production in Q1. We've had some favorable rulings from the NLRB with respect to impasse and I'm not sure how and when the situation will be resolved, but right now everything is running very well and we anticipate that will continue to happen as we move forward.

Chris D. Manuel - Wells Fargo Securities LLC

Thank you. Two last questions I had; the next was, and we saw your export numbers picked up quite a bit, but even some of your outside sales to other customers here in North America that presumably independents and such, it looked like it stepped down. I mean, I guess that you're going to be internalizing a chunk of that to balance of the year, but you didn't have Victory a year ago.

Just help me with kind of the thought process there. I mean, look, given – I'm guessing from a variable cost perspective, had there been very marginally if at all profitable business on the export side, how do you think about that balance and I'm guessing – they're showing me a note here – but that ticks down later in the year, but still, how you think about the balance of the domestic customers export and when you need it?

Matthew S. Kaplan - President, Chief Operating Officer & Director

Well Roger spent a good amount of his time today talking about the importance of becoming more integrated and how Victory is going to play a huge role in that process moving forward, and there's no question that the export mill nets are substantially less than domestic mill nets and we have to do everything that we can, and basically the answer is becoming more integrated, to reduce our reliance on some of these export markets where profitability is substantially less on a per-ton basis.

Roger Warren Stone - Chairman & Chief Executive Officer

Yes, Well, the question is, we're still running things that were better off with than without. The issue is as we grow our integration, we will move out of those low margin grades, or possibilities, whether they be export or paper or board or pulp, and into more profitable – they can widen the margin. So that the integration will widen our margin just because we replaced the bottom end of our mill sales.

Chris D. Manuel - Wells Fargo Securities LLC

That's helpful. So, it kind of reverses or gets backs to a better spot over the balance of the year and maybe even in the next year. Andrea, once you bring the rest of the stuff in-house and kind of flip the mix around, how are you feeling about leverage? And you also get the laps that it's pretty easy comps in the fourth quarter, but do you think you can get leverage back down, or down to kind of sub 3.0 by the end of the year, or where are you kind of feeling?

Andrea K. Tarbox - Vice President & Chief Financial Officer

Well, I mean, we don't forecast our EBITDA, but I would say that we're off to a great start when you look at this first quarter compared year-over-year as far as generating cash and we plan to keep doing that. So, I think our leverage will be coming down rather quickly as we move through the year, so, yes.

Roger Warren Stone - Chairman & Chief Executive Officer

Without predicting we do plan to reduce debt.

Andrea K. Tarbox - Vice President & Chief Financial Officer

Yes, yes, yes, that is – it's a high priority for us.

Chris D. Manuel - Wells Fargo Securities LLC

And you still had some EBITDA growth to come out in 2Q as you get a better part of this Victory seasonality. I just – I mean directionally if you think you can be – I think as everything comes together, it looks like kind of sub 3.0, I will just kind of trying to get a sense of we were in the right ballpark or not.

Andrea K. Tarbox - Vice President & Chief Financial Officer

Well once again it all depends on your earnings estimates, but I think you're right. If you look at consensus, if you want to use that as your guess, we would be moving down substantially.

Chris D. Manuel - Wells Fargo Securities LLC

Okay, thank you, good luck, guys.

Matthew S. Kaplan - President, Chief Operating Officer & Director

Thank you.

Operator

Thank you

Roger Warren Stone - Chairman & Chief Executive Officer

One more question, please.

Operator

Okay our last question comes from the line of Wes Swanson with RBC Capital Markets. And your line is open.

Wes Swanson - RBC Dominion Securities, Inc.

Yes, thanks, guys. I will keep it quick here. We're approaching the one-hour mark. I just wanted to followup on that on the leverage point. Back in February, I believe you guys amended your credit agreements. Is there any sort of covenants there associated with the amendment?

Andrea K. Tarbox - Vice President & Chief Financial Officer

Well, yes (53:03). So when we amended the credit agreement, we did a couple of things. Just the primary thing is we increased the maximum leverage allowed up to 4.5 times and that goes through 2017. So we did that and we also changed some of the definitions of EBITDA and cleaned up some other things but the primary thing was increasing that maximum leverage ratio and extending it.

Wes Swanson - RBC Dominion Securities, Inc.

Okay.

Andrea K. Tarbox - Vice President & Chief Financial Officer

So you know, yes, so that's what we did. I mean, I don't think we are ever going to be there but you know it was relatively, they say the time to ask is when you don't need it and that's why we asked and ....

Wes Swanson - RBC Dominion Securities, Inc.

Yes I know, just in our financial model, we had debt-to-EBITDA a little bit lower than what you are showing here. You know you are showing 3.7 times I guess is definitional so I just I'd ask.

Andrea K. Tarbox - Vice President & Chief Financial Officer

Yes.

Wes Swanson - RBC Dominion Securities, Inc.

Is that on gross basis then or?

Andrea K. Tarbox - Vice President & Chief Financial Officer

Well there is a bank definition so the 3.7 that we gave you.

Wes Swanson - RBC Dominion Securities, Inc.

Yes.

Andrea K. Tarbox - Vice President & Chief Financial Officer

It's really 3.69, but it's according to the definition in the credit agreement. There are certain add-backs allowed and things not allowed, so that's why ours might be a little different than yours because of the some specific allowed either add-backs or things we had to take out.

Wes Swanson - RBC Dominion Securities, Inc.

Perfect thanks for that.

Andrea K. Tarbox - Vice President & Chief Financial Officer

Yes.

Operator

Thank you. This concludes today's Q&A session. I would now turn the call back over to Roger Stone for any closing remarks.

Roger Warren Stone - Chairman & Chief Executive Officer

Well, thank you very much. Appreciate your interest and hopefully, we'll outperform our hopes.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.

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