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Rock-Tenn Co. (NYSE:RKT)

F4Q07 (Qtr End 9/30/07) Earnings Call

November 8, 2007 9:00 pm ET

Executives

Steven Voorhees - CFO

James Rubright - Chairman, CEO

Analysts

Bill Hoffman - UBS

Taylor Hood – J.P. Morgan

Christopher Chun - Deutsche Bank

Operator

Good morning. My name is Rosy and I will be your conference operator today. At this time I would like to welcome everyone to the Rock-Tenn Fourth Quarter 2007 Earnings Call. (Operator Instructions). As a reminder, ladies and gentlemen this call is being recorded today, November 8, 2007. Thank you.

Your speakers for today's call are Mr. Steven Voorhees, Chief Financial Officer and Mr. James Rubright, Chairman and Chief Executive Officer. Mr. Voorhees, you may begin your conference.

Steven Voorhees

Thank you. Good morning. Welcome to Rock-Tenn's conference call. During the course of the conference call we may make statements that are not historical in nature and may involve forward-looking statements within the meaning of federal securities laws. For example, statements regarding our plans, expectations, estimates, and beliefs related to future events are forward-looking statements, which involve a number of risks and uncertainties, many of which are beyond our control and that could cause actual results to differ materially from those discussed.

Additional information regarding these risks and uncertainties is contained in the documents we filed with SEC. These documents include the Company's Form 10-K filed for the year ended September 30, 2006 and the 10-Qs filed for the quarters ended December 2006, March 2007, and June 2007.

During the call, we will be referring to non-GAAP financial measures. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are contained in our press release, which is available on Rock-Tenn's website at rocktenn.com.

Let me now turn to Rock-Tenn's results for the quarter. Rock-Tenn's fourth-quarter net sales were $605 million, up $35 million or 6.2% when compared to last year's fourth quarter. Segment income of $54.2 million was $3.7 million higher than we reported in the same quarter of last year.

Rock-Tenn reported fourth-quarter net income of $19.7 million, $0.50 per share.

I'd like to call your attention to two items that are included in this quarter's result. The first item is restructuring cost of $2.4 million, $0.4 per shares. This is primarily from the closure of the Stone Mountain folding carton plant announced in June of this year. The second item is the $1.7 million or $0.3 per share impact of the downtime associated with planned increase in the capacity of our Battle Creek coated recycle board mill. This project increased Battle Creek's annual capacity by 11%. This amounts for 16,000 tons per year.

During the September quarter of last year, the company recorded $0.1 of expense in restructuring charges and $0.6 of income from review of our state tax provision. After adjusting for these items, we are reporting $0.57 on adjusted EPS of $0.5 improvement over the $0.52 adjusted EPS recorded last year.

Realized prices for all paperboard and pulp grade increased $36 per ton over the last year's fourth quarter. On a sequential quarter basis, average prices for all paperboard and pulp grade increased $9.00 per ton.

Turning to energy cost. Energy cost were up about $1 million in the quarter. This was primarily due to the expiration of the long-term steam contract at our St. Paul mill.

Based on current market conditions, the average NYMEX closing price for the December quarter will be about $0.50 higher than the $6.56 per mmbtu; NYMEX closing price in the December quarter of last year. We do not have any natural gas hedge positions on for the winter.

Rock-Tenn's cost of recycle fiber was $137 per ton in the quarter. This is up $36 per ton over the last year, and up $10 per ton from the June quarter fiber cost of $127 per ton. As a result, our recycled fiber costs were $10 million higher than in the same quarter of last year.

Markets for recycled fiber continued to be higher than last year. The November index of OCC in Chicago is $110 per ton, as compared to the average index of $62 in the December quarter of 2006.

[Paper] products were $1.9 million lower than last year. This continues to reflect the trend from previous quarters of our process improvement programs regarding our transportation management.

The company bought back $2.1 million shares of Rock-Tenn stock in the quarter, at an average price of $27.41 per share. We currently have $38 million shares outstanding. This is approximately the same number as we had outstanding one year ago. Our share repurchases have offset the new shares that we've issued from option exercises.

We generated $97 million of operating cash flow in the quarter. This allowed us to fund the share repurchases of $58.7 million, capital expenditures of $19.3 million, pay our dividend of $4 million and still pay down $11 million in debt. Rock-Tenn's $97 million in operating cash flow in the September quarter was $42 million more than in the same quarter of last year. Much of this improvement was from improved working capital management, particularly in the receivables and payables categories.

The Company's credit agreement debt-to-EBITDA ratio was 2.55 times as of September 30, 2007. When we filed our 10-K for this fiscal year, we will have achieved a credit agreement debt-to-EBITDA ratio below 3 points for two consecutive quarters. We will have a right to cause the release of the lien on our Senior Credit Facility.

Our capital expenditures for the quarter were $19.3 million. Our capital expenditure for the year was $78 million, which is well below our annual depreciation and amortization of $104 million. For the fiscal year 2008, we expect capital expenditures to be in the range of $75 million.

Rock-Tenn's financial results for the year reflect record results for our business. Rock-Tenn's credit agreement-to-EBITDA is $286.5 million, which is 12.4% of sales. Our segment income was $211 million, our net income was $82 million, and our EPS $2.07 or $2.17 on an unadjusted basis.

We will now turn to our operating results and outlook, and Jim will cover that. Jim?

James Rubright

Thank you, Steve. Our business has really performed well in the fourth quarter. $0.57 in adjusted earnings is at the high end of what we expected to achieve given the high fiber prices that we saw at the outset of the quarter and that is expected to continue through the quarter.

Our operating result for the segment level was very good, showing continued growth in the underlying profitability of our businesses. As Steve mentioned, total segment earnings were up in the quarter $3.7 million to $54 million with each of our segments posting higher earnings on year-over-year quarter basis.

The reduction in segment earnings from third quarter of 2007 can really be explained by two events. The fist one is the outage at our Battle Creek Mill, which Steve has mentioned, and the second is higher recycled fiber pricing, which were $10 higher per tone in the fourth quarter than they were in the third quarter. The results that we produced were really a function of excellent execution of our operating strategies.

I want to start with packaging. In folding cartons, we saw a small improvement in return on sales, even though physical volumes were down slightly. So, we mentioned our strategies to continue to focus on visits that we can make money on in connection with the planned rationalization that we put in place, following the Gulf States acquisition that was part of our integration plan.

In addition, our cost reduction in productivity initiatives were mostly evident in the packaging sector, where as I mentioned, we maintained margins, even though board price increases substantially affected input costs.

The issue for cost reduction in our businesses, and what we see from our competitor is really not how much cost reduction you can get, but how much net cost reduction you can achieve, net cost reduction versus the underlying inflation of your businesses. We view inflation not as commodity price changes, fiber prices and energy prices. Those are commodity input costs that are in cyclical and which will vary, but the underlying inflation, such as wages, healthcare cost, insurance and alike. We believe that the result of all our cost reduction and productivity initiatives outpaced underlying inflation during the year by about $14 million, which we think is a significant achievement.

In last quarter's call, we said we expected to see continued recovery of paperboard price increases in the fourth quarter. We did achieve higher pricing in the quarter, which as Steve said, was about $9 per ton over all [grades].

The reason, I think, why we are at the high end of our expectation going into this quarter, is that we did very well in continuing to recover from price increases from our paperboard mills.

But in addition, the productivity of our mills was exceptional in a period of strong demand. We again took no economic downturn in our bleached board, coated recycled board, corrugated medium and gypsum liner mills. And our total tons produced in the quarter were very strong given the planned capital outage at our Battle Creek Mill.

Demand for corrugated packaging and merchandizing displays continued to be very good during the quarter. And we also did well there, particularly in the corrugated business, passing through higher paper costs, as we did as well in displays. Volumes at our corrugators and display manufacturing continued to grow, and of course in Alliance we had record sales of $85.5 million.

As we noted in our press release, we are increasing the stated capacity of our paperboard mills, since we're continuing to produce paperboard at rates that exceed our previously stated capacity. We're increasing what we believe to be our stated capacity by 62,500 tons per year, which is a 4% increase.

The largest increase is at our Battle Creek Mill, wherein the September project we referred to was very successful, increasing capacity by at least the 16,000 tons that we stated. Battle Creek manufactures a premium grade of coated recycled board with what many of our customers tell us was the best recycled printing surface in the industry.

Fortunately, it’s a big machine, it's just got bigger, and it has very low operating cost that just got lower.

There were a large number of other capital projects and other productive gains that account for the balance of the increase in capacity, all of which is in paperboard grade where we have been sold out for some time.

As Steve mentioned, we brought back 2 million shares of our common stock at $27.41 per share, which is somewhat above yesterday's closing price. Put this in perspective, from our view, as we looked at the transaction, $27.41 per share is 13 times 2007 earnings. $27.41 is also only 6.5 times 2007 cash flow from operations less CapEx. We saw that the investment on our own equity is compelling. This raises the question of how we see business conditions going forward. Demand for paperboard, packaging and displays all started out strong in our first quarter and mill backlogs from bleached and coated recycled board remained strong. We also expect to recover more price increases in the next quarter and next year.

First, last quarter we had just begun recovering our July announcement of $40 per ton on bleached paperboard. And as you know, we expect to produce about 330,000 tons of bleached board in 2008. We expect to continue to recover some coated recycled board price from our previous announcements last year, under deferred price adjustment provisions in some of our larger contracts.

We also have just begun recovering in September the $40 per ton increase on corrugated medium that was announced last summer. Our average corrugated medium pricing will increase in the December quarter.

Fourth quarter is typically our seasonally weaker sales quarter as in November and December demand for products reduces with outages and downtime at our customers and our results in that quarter are reduced by the annual outage of our bleached board mill. But we have completed that outage. It was completed in October, and it was very well executed although it was a large outage and the startup went well. So, the financial impact of the outage should be consistent with our expectations and consistent with last year's experience.

In our folding carton business, demand for our products started out again very strong in the quarter, we were pleased to see, and we essentially have completed the folding carton integration and restructuring that we undertook following the Gulf States acquisition. So, we do not expect to incur any significant or material restructuring costs in fiscal 2008 from the fold plant closures that we -- affected as a result of the Gulf State's transaction.

Recycle fiber pricing continues to be relatively high on a historical basis, but the most recent market movement was down and therefore in our favor. Currently we are seeing some contraction in transaction spreads of published index prices. So, we expect to see some further moderation in fiber cost next month in November and through the quarter on seasonally stronger generation and current global sourcing trends.

Last, in summary, if demand for our products does not more than continue at current levels, we believe we are well positioned to post another year of sales and earning growth and strong cash flow.

That concludes the prepared remarks that Steve and I had, and we are now -- would welcome questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from Mark Connelly of Credit Suisse.

Mark Connelly - Credit Suisse

(inaudible).

Operator

Excuse me sir, we can barely hear you.

Steven Voorhees

Operator we cannot hear the question.

Operator

Our next question comes from Mr. Bill Hoffman of UBS.

Bill Hoffman - UBS

Yes, good morning. Just a couple of questions just on sort of business conditions, you mentioned some of the pricing pass-through here, that you are seeing in the fiscal fourth quarter. Does it feel like business conditions are tight enough where you can gather further price momentum going into 2008? Obviously given the seasonality, it makes it a little more difficult to know that, but we're just trying to get a sense on how tight market conditions feel in the CRB business?

Steven Voorhees

Right Bill, I cannot comment on the prospect for further price increases for legal reasons, and so I will not do so. But the conditions in our paperboard mills, with the exception of the uncoated mills, which as you know, the small exposure that we have are very strong. Our CRB mill backlogs by historical standards continue to be very strong, and bleach board have actually increased over the last, I'd say 6 to 8 weeks. So, the underlying demand for paperboard and the apparent supply-demand balance in North America for the grades that we manufacture appears to be very strong.

Bill Hoffman - UBS

Thanks. And just with regards to the URB side of the equation, it's obviously a small piece, and you are seeing some softness there. Strategically what are you doing with regards to that market, are you straddling that capacity or production at this point?

James Rubright

No, about half of our capacity in uncoated recycled board goes to our own converting operations and businesses that are stable-to-improving. The largest single exposure that we have in uncoated recycled board is into our interior packing joint venture with Sonoco.

Bill Hoffman - UBS

Right.

James Rubright

The area that the end market for that product is the largest end markets or beverage markets for wine and beer, and those markets are healthy and we continue to grow share in those markets. We also have a dedicated mill that is a -- essentially it’s a small mill, it’s a book cover mill, which has continued. The markets continue to be fine and our laminated paperboard business continues to be okay.

So the weaknesses in that portion of our business that serves the independent tube and core manufacturers and our operating rates are in the 89%, 90% overall in those mills. So, we are not ready to position our capacity rationalization, for us would not make any sense. All of our mills are profitable and they have cash flowing to us. But I think people are aware that tube and core markets for example, because there are some fairly large public companies where that exposure is material, are probably the weaker sector that we have exposure to.

Bill Hoffman - UBS

All right, okay. And then just final question, as you look forward, you mentioned $75 million of capital spending in 2008. Do you have any other thoughts on allocations of capital, for your bolt-on type acquisitions or any other direction on further share buybacks?

Steven Voorhees

Yes, we think that there are acquisition opportunities out there that we will see as we talked about in the past, they tend to be episodic. But it really is a question of the use of our capital, if the current market conditions prevail it certainly makes our equity a compelling opportunity for us, but we haven’t made a decision at the present time regarding our plan.

Bill Hoffman - UBS

Okay. Thank you.

Steven Voorhees

Thank you, Bill.

Operator

Our next question comes from Mr. [Taylor Hood] of J.P. Morgan.

Taylor Hood - J.P. Morgan

Good morning.

Steven Voorhees

Hi Taylor.

Taylor Hood - J.P. Morgan

Good morning. I know this place is a little bit of a lumpy business. But can you give us a sense of just how things are shaping up to the first couple of weeks of the fourth quarter here?

James Rubright

Yes, basically I've said all of our businesses look good and I think Alliance display through growth in its underlying customer base and a strong commitment of existing customer base. It appears over the last, at least nine to twelve months that in-store display will continue to drive that business at a higher level of sales than last year, or let's say 2006. So, I think that you are seeing Alliance grow to new level. It is a little lumpy as you commented.

Margins were not as high at this quarter as they were two quarter ago in similar sales. We had some larger than expected expenses in connection with large display program and had some expenses further developing our (inaudible) display program. So, we had some expenses not associated with any revenues that were booked in this quarter. So, that affected the margin. I think the overall margin environment for the business is essentially unchanged, but I think that we are probably taking this business to a higher level of sales than we would have seen in 2005 and 2006.

Taylor Hood - J.P. Morgan

Okay, so if we look in at 2008, that average margin level for 2007 would probably be sustainable as you stand here and look out over 2008?

James Rubright

Yeah. If we see the sales at the same level, we think the margins are sustainable and we hope to be able to do some cost improvements and actually improve the margins somewhat. The hardest thing for us, Taylor is we don't have visibility far into the order pattern change. So, but I think if the customer behavior continues into 2008, the statement you said about our margin is correct.

Taylor Hood - J.P. Morgan

Okay, great. And then non-allocated expense is a little bit higher than we had in our model this quarter. How should we think about this rolling into 2008?

Steve Voorhees

It's about $6.5 million this quarter, there were some, kind of true ups of accruals or in some other, what I'd classify as non-recurring expenses. I think going forward, I would look forward in to a $5.5 to $6 million per quarter range, which is a little bit higher than we've had in historical period.

Taylor Hood - J.P. Morgan

Okay, great. And just lastly, how many shares are left on your re-purchase authorization?

Steve Voorhees

That’s 1.9 million.

Taylor Hood - J.P. Morgan

1.9. Thanks very much.

James Rubright

Thank you, Taylor.

Operator

(Operator Instructions). Our next question comes from Mr. Christopher Chun of Deutsche Bank.

Christopher Chun - Deutsche Bank.

Thanks. Good morning guys. Just following up on that last question, with the stock down at current levels, I'm wondering, I know you can't speak for the entire board but, how do you feel Jim about expanding the re-purchase authorization and how would you weigh that, versus other uses of your cash?

Steve Voorhees

Well Chris, I'd like amplify that, but I really think I answered it before by saying we have not made a specific decision beyond, over 2 million shares that we've just purchased. But if it was attractive at 27 it's more attractive at 25, it's probably more attractive at prices higher than that given the cash flow generation that we've got, what opportunities do you have at 6.5 time free cash flow.

Christopher Chun - Deutsche Bank.

Okay. And then in terms of your paperboard capacity increase, can you give you us a little more color on what grade capacity increasing?

Steve Voorhees

Chris, I am sorry we are having a little difficulty hearing you. Would you mind repeating that question?

Christopher Chun - Deutsche Bank.

I am sorry. Can you hear me now?

James Rubright

Yes.

Christopher Chun - Deutsche Bank.

I was just wondering about your 62,500 tons per year of capacity increase. What grades are those effects?

Steve Voorhees

It is primarily everything other than, primarily everything other than URB. There is an increase in both bleached and market pulp. Largest since CRB and then the joint venture with [charge] for this gypsum liner machine, which was increased as a result of the capital project that we completed this summer. We have very specific data in our 10-K that we are about to file, but and after this call, we will just go over where the specific changes about what you said.

Christopher Chun - Deutsche Bank.

Okay, great. And Jim, you talked about the fact that there should be some tail still left on some previously announced price hikes. Can you give us an idea of approximately how much, what percentage you've achieved to date and what remains left in the different grades?

James Rubright

The CRB price increases have been pretty much passed through, but we will recover, I think, in the $1 million to $2 million range in the next quarter on CRB. But as I mentioned, the bleached board and medium you should see the majority of that effect in the December quarter, because the July announcement really started to get recovered in early August on bleached board and then medium we started to get back either in the end of September or early October depending. I just can't remember exactly how those contracts flowed in. So on the medium increase of $40 a ton really haven't seen that one, and you are not seeing the majority of the effect on the announced bleached board increase.

Christopher Chun - Deutsche Bank.

Okay, and then looking ahead to the December quarter last year, your adjusted EPS fell by $0.12 based on seasonal factors and you mentioned that there is still price to come and your outage went well. So, would it be fair to say that the quarter-over-quarter decline might a bit less than that this time or is it a too soon to make that call?

James Rubright

Well, first of all, we don't give specific earnings guidance and we also don't know the extent of the seasonal effect, it is a function of order patterns, primarily in our packaging businesses in November and December, to which we have no visibility. So, you and I can sort of reason out where we think it is sort of, but it is not something we like to give specific guidance on.

Christopher Chun - Deutsche Bank.

Okay, fair enough. And then finally Jim, with the Economic News lately, there has been a really fast decline of the U.S. dollar relative to some other major currencies and I was wondering what your perspective was on how and to what extent that will affect to Rock-Tenn?

James Rubright

It's had a very positive effect over the last 12 to 18 months. As you know, the SBS bleached paperboard is an exported commodity. And the important thing for that is, it has a larger installed base in either CUK or CRB, and our view is that those grades effectively make up one large folding carton board market and, so the – but with a difference that SBS is the premium grade and the world assured SBS outside of the United States. The exportability of that commodity is one of the principal factors that affect the profitability of not only that grade which we make, but also the recycled paperboard. So, the continuing weakness of the dollar seems to us to be a positive for Rock-Tenn.

In addition, the strength of the Canadian dollar relative to the U.S. dollar net, is positive to us, because of its affect, again, on recycled paperboard pricing. As you know, the Canadian economy has performed very well, but it's killing its forest products industry and the relative competitiveness of the fairly significant amount of coated recycled paperboard capacity in Canada is affected by the relative dollar movement. So, I think we, I would say that as a North American, particularly U.S. producer of paperboard of all grades, a weak dollar has certainly continued to have the wind behind the demand, behind our back as far demand and pricing of our paperboard is concerned.

Christopher Chun - Deutsche Bank.

Great. Thanks for your help.

Steve Voorhees

To offer you a perspective, there are potential imports threats because other people in the world make paperboard, other people in the world can make folding cartons, but all of those factors, I think, continued to enhance the competitiveness, not only of our own manufacturing but of the downstream manufacturing in the United States by our customers, which may end up over the long run being the most positive of all the trends.

Christopher Chun - Deutsche Bank.

Right. That’s very helpful Jim. Thank you.

Operator

There are no further questions at this time.

James Rubright

Thank you very much for joining us on our call. We look forward to speaking with you over the course of the quarter and then next quarter. Thank you.

Operator

Than you for joining today's conference call. You may disconnect at this time.

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