KapStone Paper and Packaging's (KS) CEO Roger Warren Stone on Q2 2016 Results - Earnings Call Transcript

| About: KapStone Paper (KS)

KapStone Paper and Packaging Corporation (NYSE:KS)

Q2 2016 Earnings Conference Call

July 28, 2016 11:00 AM ET

Executives

Roger Warren Stone - Chairman and Chief Executive Officer

Andrea Tarbox - Vice President and Chief Financial Officer

Matthew Kaplan - President and Chief Operating Officer

Analysts

Ketan Mamtora - BMO Capital Markets

Scott Gaffner - Barclays Capital, Inc.

Gail Glazerman - Roe Equity Research

John Babcock - Bank of America

Chris Manuel - Wells Fargo Securities

Adam Josephson - KeyBanc Capital Markets, Inc.

James Armstrong - Vertical Research Partners LLC

Debbie Jones - Deutsche Bank Securities, Inc.

Paul Quinn - RBC Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] And as a reminder this call is being 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 July 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 Roger Stone, Chairman and CEO. Sir, you may begin.

Roger Warren Stone

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 second quarter financial results. Matt will bring you up-to-date on our operations, I'll follow with some closing thoughts and then we'll open the phones for questions.

Andrea Tarbox

Thank you, Roger. The presentation for today’s second quarter 2016 financial results is located on our website www.kapstonepaper.com in the Investors Section.

On Slide 3 is a summary of our second quarter results compares year-over-year and sequentially from Q1 2016. On June 1st, 2015, we completed the acquisition of Victory Packaging and therefore 2015 results include just one month of Victory’s operations.

For Q2 2016, new sales were up 17% to $785 million year-over-year. Adjusted EBITDA decreased $13 million or 13% from Q2 2015 to $97 million. Adjusted net income was down $15 million, or 39%, to $26 million year-over-year and adjusted diluted EPS was down $0.17. Keep in mind that there was about $0.06 per share of amortization expense related to the purchasing according and tangibles that are included.

On Slide 4, we've bridged our net sales and adjusted EBITDA results between the Q2 2015 to second quarter of 2016. Our net sales were $114 million higher in 2016 due to full quarter Victory results in 2016 versus only one month in 2015. Our price mix was $24 million unfavorable due to lower container board prices for both domestic and export sales, lower prices on export kraft paper and lower corrugated products prices. Product mix was also less favorable with increased export line of linerboard sales and lower Durasorb volume partially offset by higher kraft paper volume. Mill tons produce were down 2% compared to Q2 2015 primarily due to a 36 hour electrical service interruption along the same store local provider out there and more production tons were lost due to plant maintenance outages.

Sales volume was down 6,000 tons on lower mill shipments partially offset by higher corrugated products, up 6.6% on an MSF basis.

Adjusted EBITDA of $97 million was $13 million lower primarily due to negative price mix and $8 million of plant maintenance outages reflecting a change in time for some outages from the second half of the year in 2015 to Q2 in 2016.

For the 2016 year, plant maintenance outages should be approximately $5 million less than 2015. I’d also like to point out that the outage expense in the second half of 2016 should be $18.7 million less than the first half of 2016. And loss tons due to plant maintenance outages are expected to total 6,100 tons for the second half of 2016 and should be about 11,600 tons less than the first half of 2016. Page 15 of this industrial presentation gives mush more details of these plant outages.

Finishing up the quarter bridge on Page 4, Victory and synergies derived from it added $18 million benefitting from the full quarter of Victory results. Adjusted EBITDA for Q2 also benefited from $3 million of lower fiber and energy cost, partially offset by higher salary, wage and medical benefits costs. Matt will discuss the positive trend in fiber and energy shortly.

Moving on to Slide 5, we’ve analyzed our net sales and adjusted EBITDA sequentially from Q1 2016. Our net sales were $47 million higher in Q2, due to seasonally higher Victory sales and increased volumes at legacy KapStone. Average mill selling price was relative flat as $624 per ton. Adjusted EBITDA increased sequentially by $9 million to $97 million primarily from Victory and deflation from lower fiber and energy costs. Productivity gain was $3 million include cost savings from lower headcounts, partially offset by lower mill production.

Turning to Slide 6, net debt was $1.57 billion and our weighted average interest rate as of June 30th was 2.1%. Operating cash flow increased $17 million year-to-date versus the prior year. This increase was due to lower income tax payments and contributions from Victory.

In Q2 2016, operating cash flow declined by $45 million year-over-year primarily due to $43 million of higher receivables reflecting new cash flow seasonality for KapStone, as sales particularly for Victory accelerated late in the second quarter. This change in working capital timing and lower EBITDA was the primary reason our net debt-to-EBITDA ratio increased to 3.98 times for the credit agreement. If we did not have the seasonal increase in working capital, our debt-to-EBITDA would have remained relatively unchanged from the prior quarter.

Collection of Q2 high receivables and Q2 will give a nice boost to our third quarter cash flows. And we should see our net debt-to-EBITDA ratio come down as we move through the year benefiting from the seasonality of our cash flows.

CapEx for the quarter was $36 million and the full year estimate is a $125 million which is an adjusted to include some plant investments that Matt will touch on.

With that, I’ll now turn the call over to Matt.

Matthew Kaplan

Good morning, everyone, and thank you again for joining us. Today I plan to review our Q2 operational performance including a summary of our mill production and update on our cost reduction initiatives, Victory packaging integration progress, market highlights and key assumptions for Q3.

Beginning on Page 7, our mills ran reasonably well in 2Q. Mill production for the quarter totaled 668,000 tons compared to 690,000 tons in Q1. Two factors, one planed and one unplanned impact the Q2 when compared to Q1. At long view, we experience an unplanned loss of electrical service which reduced production by 4,300 tons while at Roanoke Rapids, our planned annual outage reduced production by approximately 12,000 tons.

Q2 mill production would have been within 1% of our all-time Q1 production results are record all time Q1 productions absent these two events.

It is important to understand that our mill leadership team believes strongly that future mill production will exceed our Q1 record as our ongoing process improvement project gain traction. We continue to believe that we have substantial upside particularly at Charleston.

Q2 sales of paper and packaging products totaled 704,000 tons far exceeding our production. Our mix improved slightly in Q2 versus Q1 as we ship more domestic container board in specialty paper grades and fewer export container board enroll pulp tons.

Average selling price per ton for our mill products declined by $43 compared to Q2 in 2015. The price deterioration impacted Q2 revenue by $20 million and is primarily attributable [Technical Difficulty] increased competition. Compared to Q1 2016, Q2 mill product prices were $4 million lower reflecting a full quarter of the Q1 index reductions.

Q2 corrugated products shipment measured in billion square feet exceeded the previous shipments by 6.6% and were 7.6% higher than Q1 of 2016. Q2 box prices measured in dollars per ton were unchanged compared to Q1 and down 1% compared to 2015.

Moving on to Page 8, we continue to make progress on reducing our mill costs. These savings are a function of ongoing process improvement initiative as well as the ramp up of benefits associated with certain capital projects.

I’ll comment briefly on three important cost components, headcount, fiber and energy. Mill headcount was reduced by 89 positions during Q2 2016. We estimate savings from headcount reduction by $2 million a quarter. Compared to Q2 last year, mill headcount has declined by 142.

Fiber costs were reduced by about $6 a ton reflecting lower virgin fiber cost at all of our mills. This $6 savings is net of the modest increase in OCC experienced during Q2. As you know, KapStone has limited exposure to OCC cost escalation when compared to many of our peers. Expectation for Q3 versus Q2 is an additional savings of $2 million.

Energy costs were reduced by over $2 per ton Q2 versus Q1. The reduction would have been greater, but startup energy expenses associated with the Roanoke Rapids outage totaled $3 per ton. During the same time last year, startup energy costs were only $1.50 per ton.

Page 9 summarizes Victory Packaging’s Q2 performance. After a seasonally weaker Q1, Victory results improved as expected during Q2. Prior to synergies, Victory Packaging earned $18 million in EBITDA in sales of $252 or a 7.1% margins. AS a reminder, typically Q1 is Victory’s weakest quarter and Q2 and Q3 are much stronger. Q4 is weaker than Q2 and Q3 but traditionally stronger than Q1. Assuming that historical trends remain relevant, I believe Victory is on track to meet our exceed our 2016 expectations.

The process of integrating Victory Packaging’s purchases into our box plants continues to move forward. During June, we accomplished our initial goal of achieving 115,000 ton per year run rate at the end of Q2. I am pleased to report that container volume manufactured at our plant is sold to Victory during Q2 was 25,000 tons, while June sales were approximately 9,500 ton in line with our goal.

During Q2, we continue to pursue other opportunities to further integrate increase the integration associated with the Victory Packaging acquisition. In our previous call, I mentioned four examples of potential path forward. To review briefly, we discussed growth in capacity in existing KapStone plants, the acquisition of undersold geographically aligned convertors, joint ventures with undersold geographically aligned box plants they comment to consuming KapStone container board and finally convincing non-integrated Victory Packaging suppliers to consumer KapStone container board.

While we have made progress in these areas, today I’d like to highlight the recent Central Florida Box acquisition, let’s look at Page 10. Central Florida Box was established in 1979 by the Ramsey family. It is a well-managed, well-equipped facility with capabilities far behind its current level of sales. It has a strong diverse sales book consisting of long term loyal customers. It is a profitable business with significant upside. Jeff Ramsey will continue to manage the plant moving forward.

Our plan is simple; first take advantage of the underutilized equipment. We believe that with the portion of Victory’s local purchases combined with additional opportunities with current KapStone customers, we will substantially increase both sales and profit.

Second, we will self-manufacture of or buy Central Florida Box’s sheets from a manufactures that consumers our container board. This will allows us to capture the integration benefits within our mill system. Post synergies, we anticipate 20,000 to 25,000 tons of integration benefit and a $3.4 million of annualized EBITDA. Needless to say, we are excited about owing Central Florida Box and welcome its employees and customers to the KapStone family.

We believe that additional bolt-on deals of this nature are achievable and look forward to sharing them with you at the appropriate time.

Turing to Page 11, the markets that we participating continuing to be challenging in some areas and statically slightly improving in others. Demand in general is reasonably good and mill backlog are adequate and improving. We are experiencing solid demand for domestic container board, prices are stable. Export demand for board is good, prices has stabilized for export board as well. Our kraft paper business is improving, domestic demand is growing slightly and prices appear stable. Export paper demand is reasonable good and we have experienced modest price improvements. Demand for other specialty grades such as saturating kraft and Kraftpak is stable while pricing in unchanged.

Looking ahead to Q3 2016 on Page 11, we have a summary of key assumptions. With the acquisition of Central Florida Box on July 1st, 2016, we will include a full quarter of their sales and earnings in Q3. Maintenance outage in during Q3, our expense will be approximately $13 million lower than Q2. Fiber cost should be $2 million lower in Q3 versus Q2, as virgin fiber costs are declining, while OCC prices are increasing.

The benefits of our headcount reduction initiative will reduce Q3 expenses by $2 million. Capital expenditures are estimated at $35 million during Q3 and $125 million for the year. Our effective tax rate will be 35%.

Now, I’ll turn the floor to Roger for some closing comments.

Roger Warren Stone

Thank you, Matt. Quarter two was solid improvement over quarter one especially considering that we experienced $13 million of higher mill outage cost. We also think our industry had a very strong June and July looks to be as a good as June. Hopefully this trend will continue as we look forward to a much stronger second half.

We realize that one month does not make a year but the industry seem to be trending towards a healthy balance of good operating rates and low inventory.

Frankly, I am more optimistic than I’ve been in sometime and we’re actually anytime during the last eight years. In fact it’s worth noting that inventories are at the lowest level since December 2014. Also at KapStone, we are moving at a good speed in our integration plan and our outage plans as Matt said will be far or less costly. And we project lower fiber cost for the balance of the year. Clearly I look forward future investor calls.

I want to thank you for your interest. And now we’ll open the floor to your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Ketan Mamtora from BMO Capital Markets. Your line is now open.

Ketan Mamtora

Hi, good morning.

Matthew Kaplan

Good morning.

Ketan Mamtora

First question Matt or Roger, can you provide an update on the two Greenfield box plans that you all talked about last quarter?

Matthew Kaplan

Sure. So we’re - just like last quarter, we’re not prepared to talk specifically about location. We’re fairly far down the road with respect to the first Greenfield plan, it will be located in the area where there are lots of opportunities associated with Victory’s purchases. I might note that the reason there are CapEx projection for 2016 has increased from 115 to 125. The reason for that is the equipment associated with that Greenfield startup.

With respect to the second location which I think Roger said during the first call, we anticipate should be online sometime the middle of next year where we’re really kind of in the planning stages for that particular location. So that would be the update I provide you at this particular point.

Ketan Mamtora

That’s helpful. And then on the first plant, is the plant still to, started up by the end of 2016?

Matthew Kaplan

Yeah, that’s the current plan.

Ketan Mamtora

Got it. And then just relating to that, what would you expect your integration rate to be let’s say over the next 18 to 24 months, what is your internal target?

Matthew Kaplan

Well I think what we said last call and we really haven’t changed our position on this is that in the near term, we’d like to increase our integration by somewhere between 100,000 and 150,000 tons. We still believe that that’s doable and we’re pointing towards that goal, achieving that goal.

Ketan Mamtora

Got it. That’s very helpful. And then just turning to the maintenance outlook for the second half, I note that relative to your prior quarter’s guidance, the Q4 number has come down significantly, I don’t know whether it’s just a function of kind of deferring something to 2017 or you guys just doing a better job of it, any color there will be helpful?

Matthew Kaplan

Okay. So first all of I think we are doing a better job. But I think more importantly is that we’ve gone to - we’ve been working with insurance companies and state regulators and we’ve actually been able to move some of our boiler recovery shutdowns during 18 month cycle versus a 12 month cycle. So we’re able to push out some of those Q4 expenses into sometime next year and resident being on a 12 months cycles, we’ll be on an 18 month cycle moving forward.

Ketan Mamtora

And which mill will this be Matt?

Matthew Kaplan

You know I am going to have to get back to you with the specific answer to that. I know we’ve done it in two mills but I am reluctant to say which one is because offhand, I might be misleading you.

Ketan Mamtora

Okay, that’s not a problem. That’s all for my side. Good luck in the back half of the year.

Matthew Kaplan

Thank you.

Operator

Thank you. And our next question comes from Scott Gaffner with Barclays. Your line is now open.

Scott Gaffner

Thanks. Good morning.

Matthew Kaplan

Good morning.

Scott Gaffner

Just a quick follow-up there for a minute. So as a percentage, where do stand on vertical integration at the moment?

Matthew Kaplan

So, we’re somewhere in the 50% range right now. We produced about 1.7 tons of container board annually. And so 150,000 tons assuming we achieved the top end of our goal would be roughly another 8% to 9% integration.

Scott Gaffner

Okay. And Matt, you made it down, is it maybe there is some more small Central Florida Box type acquisitions that could be achievable in the market, is that fair to say?

Matthew Kaplan

Yes, that is fair to say. And that’s included in the numbers that we’re putting forward as well. So these smaller deals that I referred to without getting specific, our part of that 100,000 to 150,000 tons estimate.

Scott Gaffner

Okay. And then I guess when you go over this Slide 11that you mentioned Matt, the very first bullet point there is continues to be challenging and when I look down all of the bullets on that slide, everything is stable, good, solid and Roger, you are talking about I think the most optimistic you’ve been in eight years, is there a note of caution there, I mean I guess I am just wondering why overall maybe you are not more positive in that first point would leave me to believe?

Roger Warren Stone

It’s a good question. First of all it’s good I’ve seen inventories drop as much as they did in June and operating rates stay reasonably high. And that’s always a good sign in this business. Secondly, demands are just lower activity there and for us and more opportunities and I suspect we are not unique in that regard. And thirdly, I believe that our growth potential for the integration plan maybe will be a little faster than that said that I suspect that it could be. And so I don’t see much bad news out there. I see nothing frankly but good news and that of course as a perennial optimism that makes me optimistic.

Matthew Kaplan

Scott, the one point that concern that we probably should mention is we continue to have exposure the export markets and as the dollar strengthen to associated with bright set, that could have an impact. It’s not clear what that impact. As a matter of fact in Q2, our export prices were actually up versus Q1. So you know we’re not seeing any immediate signs of price changes overseas but it’s something that’s of some concern.

Scott Gaffner

Okay. Well, it looks like there is a lot of tailwind in the second half relative to the first half, so I look forward to it. Thanks.

Matthew Kaplan

We do too. Thank you.

Operator

Thank you. And our next question comes from Gail Glazerman with Roe Equity. Your line is now open.

Gail Glazerman

Hi. Good morning. I apologize if you quantified this and I missed it. Would it be possible to give the financial impact of the long view electric outage?

Matthew Kaplan

Well, we lost 4,300 tons, you know there were some excess maintenance costs associated with getting things back online. You know I don’t have that number in front of me, but I’d say it was probably somewhere around 1.25 million to 1.50 million.

Gail Glazerman

Okay, thanks.

Matthew Kaplan

Andre is saying $2 million.

Andrea Tarbox

Yeah.

Gail Glazerman

Okay, thank you. And the 6.6% box growth is that I presume that the full benefit of - full quarter of Victory within the mix and some of that you integrated, I don’t suppose you could give any sense of kind of same store perspective what your trends has been relative to kind of the flattish industry?

Matthew Kaplan

Well, what I can tell you is that in Q1, sales to Victory were 20,000 tons and in Q2, it was 25,000 tons. So you can kind of take 5,000 tons off the top and figure out where we were without Victory on your own.

Gail Glazerman

Okay. And just on the kraft -

Matthew Kaplan

Sorry, I didn’t hear that.

Gail Glazerman

Can you just give a little more color on what you are seeing on the kraft market, it sounds like maybe it sounded 4 picking a little, I mean to what extend have you been able recoup, if it all what you lost with the port issues last year?

Matthew Kaplan

So demand domestically is fairly strong. Prices as I mentioned earlier are relatively stable. Export kraft paper which was really very, very difficult during the winter months and throughout the first quarter, we’ve seen both a pickup in demand, we’ve seen prices bounce off the bottom. So our mill bookings with respect to kraft paper are very firm right now.

Gail Glazerman

Okay. And just one last question. Just - it seems pretty clear given your strategy for integration but just to quantify it. Do you feel that where you are given the run rate with Victory your existing converting assets as a standard pretty tapped out and that any future integration is going to take either investments or external action?

Matthew Kaplan

Well, some of our facilities are kept our, obviously where we have opportunities to put Victory business into undersold facilities, we fully take an advantage of those opportunities. So - but the nice thing about the converting business is as long as your corrugated capacity, it’s fairly cheap to create more converting capacity. So from a CapEx standpoint, where we have plans that are located favorably with respect to Victory’s purchases and we have corrugated capacity for a fairly modest amount of capital, we can increase our converting capacity and increase the integration benefit associated with Victory.

Gail Glazerman

Okay, thanks very much.

Matthew Kaplan

Yeah.

Operator

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

John Babcock

Hey good morning, guys. I just wanted to quickly ask on the export side of things. How exports currently stand right now relative to cash cost and is there any way to sort of quantify that at this point?

Matthew Kaplan

Well, I don’t think that’s something that we’ve really spent a lot of time commenting on in the past, but you know we’re still - it’s still profitable to us to export paper and we don’t expect that trend to end anytime soon.

John Babcock

Okay, that makes sense. And then with regards to exports kind of longer term, I mean where do you with Victory and with some of the other integration opportunities that there are, how of - how much will exports be as a percent of the kind of total container board business?

Matthew Kaplan

So, you know right now, our export container board business is probably around 300,000 tons a year out of a 1.7 million. If we’re successful meeting our goal of increase integration of a 100,000 to 150,000 tons over the next 12 to 18 months, most of that will come right out of the export markets. So I would expect to see exports assuming the production doesn’t increase to decline by the same amount that our integration goes up.

John Babcock

Okay. And then another question I had is on the transportation side, we’ve been looking at rail there and it seems like rail shipments of paper and pulp and realizing not all that is directly comparable to your business, but those numbers have been down substantially. And I just want to get a sense, I mean are you guys increasingly using trucks and other transportation methods now then you are using rail you know relative to a year ago or how should we kind of think about that?

Matthew Kaplan

I don’t think our mix truck versus rail has changed dramatically over the last six months or so. But you know honestly speaking I really don’t have a lot of inside into that.

Roger Warren Stone

We’d obviously like to be as much real as we can, because rail questioned to be lower than truck deliveries but that has to do individual markets and individual suppliers.

John Babcock

Okay, okay, that’s all I have for you. Thanks again.

Roger Warren Stone

Thanks.

Operator

Thank you. And our next question comes from Chris Manuel with Wells Fargo Securities. Your line is now open.

Chris Manuel

Good morning, guys. Just a couple of pieces, I wanted to kind circle back to make sure I am not double counting you are thinking at different things. When you had done Victory of a little over a year ago, you were in a neighborhood of 15ish percent integrated at the time and I think you were bringing in 115,000 tons of reserves. I think there is a - right now you talked about being at that rate, so I am going to make sure when you are referring to an incremental 100,000 to 150,000 tons over the next 12 to 18 months, is that inclusive of what you, this 115 that you’ve done with Victory or is it not, A. And then B, how would I think about the opportunity, I think last quarter you talked to us about expanding the opportunity to do more there?

Matthew Kaplan

So with respect to your first question, the 100,000 to 150,000 ton go is all incremental to Victory, so that does not include any of the Victory business. And I am not sure that I understood your second question.

Chris Manuel

Well, okay, so that it doesn’t include the 115, from last quarter you had - last quarter or maybe the quarter before you talked about trying to do more than just the 115, so I am guessing then this incremental 100 to 150 you are talking about includes some of further stuff that you wanted to do and then as well as things like the Florida Box acquisition et cetera, is that?

Matthew Kaplan

Right, for example the Central Florida Box acquisition, a lot of the increase integration is associated with putting Victory purchases into that operation, that will be above the 115, so we would be taking future advantage of the Victory beyond the 115.

Chris Manuel

Okay, that’s helpful.

Roger Warren Stone

Additional operations will be a more of Victory but not in the 115.

Chris Manuel

Okay, that’s helpful. The - how long does it take to you know shuffle some - kind of more some of those tons that 20 to 25 around, is that something that our contracts in place a few months, three months, six months or how quickly can you had for those?

Matthew Kaplan

So as soon as the facilities are repaired to run that business, we’re at liberty to transfer the business. Now with respect to Central Florida Box, we’re going to have to bring on extra people and train those people, so additional shifts and converting equipment in order to make those boxes. I’d say that that’s probably a one quarter exercise. And after that the business will move relative quickly.

Chris Manuel

Okay, thank you. And then just two last topics, one is kraft paper, it sounds like things have stabilized and price effect getting a little bit better here. Could you maybe help us with what we get very good data on container board and some of the other export markets and pieces here, but the kraft piece is a little tougher. Could you maybe give us a sense on a year-over-year basis how much reduction you’ve had in kraft paper prices, I think you’ve given us kind of the whole company like $24 or so year-over-year, is most all of that coming out of the kraft side or how would I think about that?

Matthew Kaplan

So domestic kraft prices are down by down relatively modest and - are relatively modest amount. We saw some substantial reductions in kraft paper prices on the export market. I think that’s really all we’re prepared to say with respect to kraft paper prices.

Chris Manuel

Okay, that’s helpful. So is there a market difference between extensible grades and some of the other specialty grades there?

Matthew Kaplan

Oh, yeah, very much so.

Chris Manuel

You know I mean of what prices done year-over-year?

Matthew Kaplan

You know again I don’t think we’re prepared to talk about that.

Chris Manuel

Okay, that’s fine. Thank you, guys.

Roger Warren Stone

Extensible pricing is still very good domestically, export is difficult.

Chris Manuel

Okay, that’s helpful. Thank you, guys.

Operator


Thank you. And our next question comes from Adam Josephson with KeyBanc. Your line is now open.

Adam Josephson

Good morning, everyone. Roger, I hope you are doing well.

Roger Warren Stone

Thank you, Adam

Adam Josephson

Just a few industry questions, Matt or Rogers, just on back to exports for a second, do you expect industry export volumes to continue to grow in light - despite the recent rather significant price declines and if so, why?

Roger Warren Stone

Well, I really don’t expect it to grow, I expect it to kind flat which of course is get very high level. If we can go that, I think the industry will be very happy. But clearly you know we’re not the only ones that have discovered the export. And so I think people are pursuing that some more aggressively than others, but as Matt pointed out substantially and actually a slight improvement of the bottom. So I don’t expect that for the industry to grow on and I certainly don’t expect that for us to grow. I mean in our case, we are busy trying to replace it.

Adam Josephson

Sure Roger. One on box demand domestically, so year-to-date average week shipments are flat right to the first half of the year, do you think that’s an accurate indicator of the market and if so, do you have any reason to think demand will notably accelerate or deteriorate for the balance of the year?

Roger Warren Stone

Well, I think it might changing in terms of food and beverages has been disappointing in terms of growth and industry growth has been increasing at a pretty good rate and it’s nice to see that after all those - these years of decline in there and so it may be growing. In our case, we’ve been fortunate enough to do going faster than the industry and hopefully new products and new approaches I hope that happen.

Adam Josephson

Okay. Roger thank for that. One of the recent Florio’s [ph] acquisitions of independent convertors that I know you are well aware of, you know what impact do you think all these acquisitions will have on your business and on the industry as a whole? And Roger do you think there will be a time when there fewer remaining and if so what do you think the impact will be box prices and how boxes are sold if there are no independence west?

Roger Warren Stone

Well, I think it depends in general get good prices on that basis, so new ownership might change that. But I suspect what is - as our competitors get more integrated which is what these acquisitions are there will be less pressure I think on the paper - on the container board side. And to a degree the prices - if they improve in the container board side, it will add to more stability and better bottom lines for the industry. Beyond that I really can’t speculate on that.

Matthew Kaplan

So Adam, if I could just add to what Roger has to say. So from my perspective as the independent community shrink and I never - and I don’t think it will ever shrink to zero. But as the independent community shrinks, I think the opportunity for Greenfield recycles paper mills and conversions decline because the investment required to build that capacity is high. And no one, no prudent person would make that investment without having a good idea of where the business is going to come from.

So first of all I think the independent shrink community could put a relative sealing on supply increases moving forward. Secondly, I’ve been thinking about this over the last few months, as the independent diminish, you know you just wonder about the importance of a price index and whether or not box prices are ultimately tie to a price index because as there are fewer independence purchasing paper, I think the - we have an opportunity as an industry to really consider changing how we do things.

Adam Josephson

To that point Matt, how then would - what would dictate box prices if there is no index?

Matthew Kaplan

More just like - lots of businesses and when you go to the grocery store and you buy a bag of Doritos, you don’t ask what their price of corn is, you know there is just - it’s just a negotiated price. And it changes from time to time, but it not hide specifically to an index.

Roger Warren Stone

Which is how I watched so many years.

Adam Josephson

Would you think that would be a beneficial change or do you think the current price structure is actually quite beneficial for the industry?

Matthew Kaplan

I think it would be beneficial for those people that provide a true superior value equation for their customers because their customers wouldn’t feel much pressure as they to do seek out price reductions when these index are chancing. They could better justify maintaining price because the relationship that they are involved in has tremendous value.

Adam Josephson

Thanks, Matt. Just two other related questions, one is to the extend these increasing integration deters future competition in the form of new Greenfield recycle mill or converted newspaper machines, are you thinking about just the existing mills will just get older and older and older and won’t be replaced, I mean that seems to be a logical extension of this, right?

Matthew Kaplan

The existing -

Adam Josephson

Container board mills.

Matthew Kaplan

Container board mills.

Adam Josephson

Yeah.

Matthew Kaplan

I think there will always be a strong incentive for container board mills to become more cost effective. So I think from that standpoint, mills will continue to invest. But I think the market should become much more disciplined moving forward.

Adam Josephson

Just one last question, Matt along this one. What’s your view of the prices being paid in a panic conversion at the moment, you know including the most recent large acquisition and did these multiples make sense to you if they have the benefit of enabling these producers to producing some more and/or to avoid having a short notes?

Matthew Kaplan

Well, that’s kind of a loaded question. So obviously the markets-to-market and I can’t argue that the prices that are being paid are higher and appropriate because that’s the value the people put on, on those acquisitions. With respect to our strategy and what we plan on doing, I can say that we still see lots of opportunities associated with taking advantage of the Victory integration. I mentioned earlier some of the obvious path forwards with respectively Victory in our recent - my formal comments, it may take a little bit longer for us to accomplish the goals that we’ve set, but I think the concentrating on Victory is the best path forward for us, I think it’s going to be lower cost in the long run, I think it’s going to be lower risk in the long run.

And you know one thing you got to keep in mind, when purchasing these independent convertors and we’ve done a lot of it over the years, you are certainly acquiring assets and you are acquiring high quality people but you are also acquiring the long term relationship with customers that are often owned by the entrepreneur that’s the driving force behind the business or a sales person within the business and there is no guarantee that their entrepreneurs going to around long term. He maybe - he or she may be less motivated because they’ve got a big chunk of cash or they may not want to stick around because they want to enjoy the fruit of their labors, but there are risks associated with those strategies and you have to be mindful of those risk before you move forward.

Now please don’t misunderstand me, you know we haven’t ruled out in any way the possibility of doing a deal like those announced recently, but today we just haven’t found the right one.

Adam Josephson

Thanks so much Matt. That’s all I have.

Matthew Kaplan

Thank you.

Operator

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

James Armstrong

Good morning, guys, thanks for taking my question. First one is on the longer term profitability in you cost takeout programs, it’s falling significantly - profitability per ton has fallen significantly since 2014 beyond just price movements. Do you think with the programs you have in place without further pricing you could get - approach that 2014 level or do you really need pricing to get back to that profitability per ton?

Matthew Kaplan

Well, I think would be difficult to get back to those levels without any price restoration. But at the same time, the opportunities within our system are substantial. I think we just kind of started to scratch the surface. We have lots of good plans in place. But when there is lots of work to do, you have to prioritize and we’re trying to allocate our resources to those areas to give us the biggest return. But once we are done with those programs, I think there are lots of other areas where we could look for further cost reductions.

Andrea Tarbox

Yeah, one of the other areas that you know hit us significantly when you look at the profitability per ton with the inflation on fiber costs they went pretty significantly between 2014 and now, but now we are seeing it come down. So that’s going to be a benefit that you know particularly out in the pacific northwest that trend continues, so we are going to be able to take advantage of besides more the other things that Matt talked about that we can control. So that had a big impact.

Roger Warren Stone

On this subject, I don’t what the future is for the pellet plants and pellet driven energy. If people get less with burning supposed to coal or oil -

Andrea Tarbox

When they get so close.

Roger Warren Stone

Yeah, right. That will help lower.

Andrea Tarbox

Right.

James Armstrong

Perfect, that helps. And then switching gears a little, could you comment on the profitability of the container board papers versus your specialty papers, would it makes sense if it was possible to move completely to making container board right now or is there still a spread between container board prices and specialty paper prices?

Roger Warren Stone

We’re capable and our clearly while we like the kraft paper business and the kraft paper mills over here. We feel about the real growth is in container board. We felt that the kraft paper machines under dedicated kraft paper overtime can be converted into container board and particularly specialty container board. And that’s in our consideration. So we feel very well positioned to growth with the market.

Matthew Kaplan

So I would add to what Rogers has to say, you know our EBITDA percentage is on specialty paper. And when I think about specialty paper, I think about Kraftpak and saturated kraft, not necessarily kraft paper. But our EBITDA margins on Kraftpak and saturated kraft still far exceed the EBITDA margins were able to get on the export container board market. So moving production from those paper grades to container board right now would not make a lot of sense.

Roger Warren Stone

For example, for demand on that has declined what we do to our machine we use the time to run mid medium, good high performance medium, but that’s not nearly as much found as running.

James Armstrong

Perfect, thank you very much.

Operator

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

Debbie Jones

Hey, good morning.

Matthew Kaplan

Hey.

Andrea Tarbox

Hi Debbie.

Debbie Jones

I was wondering if we could talk a little bit about demand trends by region and more specifically kind of east coast versus west coast, are you seeing anything meaningfully different and I guess both on a domestic tonnage basis and then into your export market?

Matthew Kaplan

So you know I’d say that on the west coast we are substantially impacted by the Ag business, we concentrate on areas like cherries and apples and thing along those line. So as those crops vary, really based primarily on weather patterns, we can see some big fluctuations in demand. So our west coast business, cherry season this year was actually a little less, then we anticipated and less than we saw last year because at the end of the season, there were some hot weather that impacted the fruit. Apple season is yet to really get into full speed ahead mode.

But I’d say that box business across the board has been pretty much the same at least based on our experience.

Roger Warren Stone

Yeah, and in terms of export container board, we like a Pacific Rim, it has more profit opportunities but perhaps a less demand then the east coast and South America.

Debbie Jones

Okay, I was just curious to you if you are seeing any differences in terms of customer demand for export just lower shipping rates et cetera and if that was helping drive some of the improvements in your exports add demand?

Matthew Kaplan

Export demand for container board or export –?

Debbie Jones

Across your business.

Matthew Kaplan

So we exported substantially less in Q2 versus Q1, but has we produced more? I think that those markets would have been available to us. So we’re not seeing any substantial trends right now.

Debbie Jones

Okay, that’s helpful. I’ll follow-up with that question later. I am also curious about the comments in your release about higher salary wages, medical cost and just kind of how to think about that going forward, you are executing on the improvement from lower headcount but this kind of actually could tie into discussion earlier about box contracts and how do work things going forward, it just seems like there is always a meaningful impact from higher labor cost don’t get pass through?

Andrea Tarbox

Well, you know so on the higher labor cost, so we do have contracts and so our - those wages go up contractually each year. There are medical costs as you are aware and the trend is you know medical costs are going up. We are doing things to reduce our exposure there but medical costs still are going up, so the things that we’re doing, reducing headcount and trying to more efficient. Those are the measure that we are taking to sort of offset those trends.

Debbie Jones

And do you expect the reduced headcount benefit to kind of offset what you are seeing fully on the other higher labor cost?

Matthew Kaplan

So I would expect our productivity gains to offset the wage increases.

Debbie Jones

Okay. Okay. Thanks, that’s helpful. And things that you commented earlier, regarding increased integration I think that’s also helpful.

Matthew Kaplan

You’re welcome.

Operator

Thank you. And our next question comes from Paul Quinn with RBC. Your line is now open.

Paul Quinn

Hey, thanks very much. And just a couple of easy questions just understand the business. Just on the comments you are making on switching kraft paper to container board, it sounds like what I heard there is that doesn’t make sense just because of profitability until exports are zero, am I got that right?

Matthew Kaplan

Well, I mean export prices would have to change before we would contemplate a decision on those lines.

Paul Quinn

Okay, got it. And then you mentioned the significant fiber cost inflation since 2014, can you quantify that?

Andrea Tarbox

Well I think if you’d looked at our say year-over-year impact on an inflation like from ‘13 to ‘14 or ‘14 to ‘15, it was like $24 million-$24 million a year and now we’ve had fiber costs start coming down and you saw we have from deflation and then were few other things in there, but I mean fiber cost were down about $5 million in Q2 and Matt talked about in that number of another 2 million as we move into Q3. So - and one of the other things I’d like to say on fiber cost is I think we have the higher percent of virgin production. So as natural fiber, wood fiber comes down and OCC is going up that sort of helps us in a sort of way.

So I think we seeing benefit substantially from declining fiber cost particularly on that specifically. So it might different contact like I said. So I think inflation for us have been like that was about $24 million-$25 million a year for the last two, four years and that is going to - should be reversed given the trends that we’re seeing now and will be a benefit. Yeah, energy also is going in right direction for us.

Paul Quinn

Okay. And then just on the long view outage, have you got insurance or is it deductible over the amounts that you’ve lost?

Matthew Kaplan

No, the losses were above out - below our deductible.

Paul Quinn

Okay and then just further on the integration side, because I was bouncing around calls here, just it sounds like you’ve got this goal 100,000 to 150,000 over the next 12 to 18 months, 20,000 to 25,000 for CFB, I didn’t get a number on that the two Greenfield box plants, what amount of integration do you expect those two to sum up to?

Matthew Kaplan

They’d be included to that 100,000 to 150,000 number. We didn’t get specific about that.

Paul Quinn

No, what I am saying is, is there anything above there to be able to get i.e. CFB plus the two Greenfields get you to the 100,000 to 150,000?

Matthew Kaplan

No, they wouldn’t get us to 100% of that number. We would have to look toward some of these bolt-on deals that I referred to earlier in my formal comment and as Roger just point out growing our existing business as well.

Paul Quinn

Right, okay. So what - I am just trying to understand the size of the integration opportunity per Greenfield plant, can you give me some help with that?

Matthew Kaplan

Well, I mean so we stated Aurora I think was about three years ago now. I mean I’d be surprised for Aurora next year wasn’t 1.2 billion square feet and you know 80,000 tons of integration. So that would be kind of the outsize of what a Greenfield would do. If we are going to start a sheet plant and then provide the sheets from one of our operations you know the numbers would be much more modest.

Paul Quinn

Okay, so you are saying lot of variability. I get it. Thanks for the help.

Roger Warren Stone

One more question.

Operator

Okay, thank you. We have a follow-up from John Babcock with Bank of America. Your line is now open.

John Babcock

Hey, just keep it short here, the one of the comment in the press release taking about how there was - sales volumes which appears to be due to increased competition in the container board and corrugated markets, just want to get a sense for whether there is any more color you want to provide there you know relative to some of the other comments on the call? Thanks.

Matthew Kaplan

Can you just steer me in the right direction, I am not sure exactly what you are referring to.

John Babcock

Well, so essentially it says in the press release that sales were down or rather there were always sales volume as we face the increased competition in container board and corrugated product markets, and so I just wanted to understand you know I mean where there any sort of loss of business there or how should we kind of read that comment?

Matthew Kaplan

I think that was referencing 2015 versus 2016, so the box business grew by 6.5% or 6.6%, we did see some reductions in domestic container board outside sales and kraft paper business was relatively stable versus the year before. Export container business - container board business was actually up. So most of the decline would have been in the domestic outside container board sales versus a year ago.

John Babcock

Okay, that’s great, thanks.

Operator

And I am showing no further questions at this time. I’ll turn the call back over to Roger Stone for closing remarks.

Roger Warren Stone

Thank you very much for calling in. As you can tell no surprise for me but we will be very optimistic and look forward to the second half and to the next call. Thank you.

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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