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Domtar, Inc. (NYSE:UFS)

Q2 FY08 Earnings Call

August 8, 2008, 10:00 AM ET

Executives

Pascal Bossé - IR

Raymond Royer - President and CEO

Daniel Buron - Senior Vice-President and CFO

Richard L. Thomas - Senior Vice-President, Sales

Marvin D. Cooper - Executive Vice-President and COO

Paul Quinn - RBC Capital Markets

Analysts

Claudia Shank Hueston - JPMorgan

Mark Connelly - Credit Suisse

George Staphos - Banc of America Securities

Mark Wilde - Deutsche Bank Securities

Bill Hoffman - UBS

Benoit Laprade - Scotia Capital

Steven Chercover - D. A. Davidson

Joseph Reagor - John Tumazos Very Independent Research

Daryl Swetlishoff - Raymond James

Operator

Good day ladies and gentlemen and welcome to Domtar's Second Quarter 2008 Financial Results Conference Call. At this time, all participants are in a listen-only mode. But following the presentation, we will conduct a question-and-answer session. [Operator Instructions].

And now I would now like to turn the meeting over to Pascal Bossé.

Pascal Bossé - Investor Relations

Yes, thanks Sylvie. And good morning everyone, welcome to second quarter 2008 earnings call.

Joining me today are President and CEO, Raymond Royer; Executive Vice President and COO, Marvin Cooper; Senior VP and CFO, Daniel Buron; and Senior VP of Sales, Dick Thomas.

Remo and Daniel will start the brief remarks on the results and then we will open up the call to questions from the investment community. Just as a reminder, our speakers will make references to supporting slides and you can find those in the investor section of the website.

I wish to remind our listeners that this call will contain forward-looking statements based on a number of estimates and assumptions that are subject to risks and uncertainties that could cause results to materially differ. I invite you to review Domtar's filings with the Securities Commissions for a listing of those. Finally certain non-U.S. GAAP financial measures will be presented and discussed and you can find the reconciliation for the closest GAAP measures in the appendix of this morning's release and on our website.

So with that, I'll turn the call over to CEO Remo Royer. Remo?

Raymond Royer - President and Chief Executive Officer

Thank you Pascal. And good morning to all our listeners.

Domtar reported this morning good results despite continued input cost pressure and weak paper demand. Sales in the second quarter stood at $1.6 billion, a 3.5% increase compared to the second quarter last year. This performance is quite impressive because the volume impact on sales was a negative $69 million year-over-year, so all the top-line growth changed through prices.

EBITDA before items increased 6.5% to $212 million, although the impact of foreign exchange was a negative $26 million compared to last year. Costs other than raw materials and freight were a favorable $40 million, when compared to the same period last year, so clearly synergies are showing through our results. Another highlight of this quarter is the results in our wood business that were much better than recent quarters. And finally, we continue to make progress with debt repayment and further reduce net debt by $104 million since December. This bring our net debt to cap ratio to 40%.

Our commitment to paying down debt and improving our credit profile is slowly bearing fruits with S&P raising our long term corporate credit rating as well as our senior secured and unsecured debt ratings in late July. So this gives us an overview of the quarter, a solid performance in quite a challenging period.

I will turn over to Daniel for the financial review.

Daniel Buron - Senior Vice-President and Chief Financial Officer

Thank you Remo and good morning everyone.

Starting with the sequential review of our results on slide 4, sales were down $26 million in the quarter due to lower volume offset by federal prices. Cost of sales were favorable $6 million although inflation on fiber, chemical, energy, and freight included in this number was negative $37 million.

SG&A declined in other $18 million in the second quarter and this is in addition to the $24 million reduction in the first quarter. Finally interest charges were at $2 million lower while our tax rates stood at 42%. The tax rate in the low 40s remains a good forecast for the year.

Now on slide 5; reported net earnings for the second quarter were $24 million or $0.05 per share. There were three non-recurring item this quarter. The sale of trademarks contributing $4 million closer and restructuring costs of $7 million. And $5 million related to synergies and integration costs, all on an after tax basis. So excluding these items, earnings were $32 million or $0.06 per share.

Turning to cash flow on slide 6, cash flow from operating activities amounted to $113 million in the second quarter, a significant increase compared to the first quarter in which we had seasonally invested in receivables and inventories. Cash taxes amounted to $18 million in the quarter.

I would like to mention that in the second quarter, we made pension contributions of $42 million over and above the accounting expense. We do not anticipate any other major contribution above the expense for the remainder of the year. Capital expenditures amounted to $36 million in Q2 or 31% of D&A. Finally, net debt was reduced by $83 million in the quarter for a total debt to total capitalization of 40%.

Now turning to the sequential it did our bridge on slide 7. In the second quarter, we benefited from higher selling prices in all our business for an overall positive $47 million in the quarter. Cost reduction and synergies of $23 million, lower usage mostly weather related, energy weather related are favorable $13 million and a favorable exchange rate variance of $2 million. These positives were offset by inflation in materials and freight of $37 million, higher plant maintenance for $17 million and lower volumes and mix for $15 million.

Now turning to papers on slide 8. The segment posted an operating income before item of $106 million in the second quarter on a D&A charge of $110 million. This translates into an EBITDA before items of $216 million compared to $210 million in the first quarter. Paper shipment were 68,000 tones lower than the first quarter, while pulp shipments stayed the same. Our shipments to positional ratios to that 99% in the second quarter, compared to 103% in the first. Once again our capacity was in balance with our customer demand.

Transaction prices were strong with tuck-in offset [ph] prices, up $38 and $41 per ton respectively on a sequential basis. The 30 portfolio [ph] mix whereby prices for hardwood rate increased by $36 per metric ton, while softwood prices didn't really move compared to Q1.

In term of our variances, the increase in operating income versus the first quarter came from higher selling prices for paper and pulp, benefits from our synergy program, lower usage, mostly weather related energy usage and terrible foreign exchange rate. These were mitigated by higher cost for raw material and freight, higher costs related to plant maintenance and lower paper shipment. Once again, we did not take any lack of orders on time in our paper operations during the quarter. Finally, paper inventory increased 6,000 tons and pulp inventories decreased 17,000 metric tons in the quarter.

Moving on to merchant on slide 12. The segment posted an operating income of $2 million in the second quarter including a D&A charge of $1 million. Higher average selling prices were more than offset by lower deliveries and a $1 million D&A charge. The first quarter of 2008 was an all time record in terms of paper deliveries for the Domtar Distribution Group. So while volumes are down sequentially, we remain up 7% for the first six month of the year compared to the same period last year.

Finally turning to the wood business on slide 13; the segment posted an operating loss of $12 million in the quarter much better than the $22 million loss on the first quarter. The EBITDA narrowed to $5 million and this is due to higher selling prices for a longer and byproducts shipment and also lower cost and better productivity at several operations. Thanks to efforts made our employee to minimize cash losses. This was partially offset by higher D&A charge.

Now on slide 15; normally there is changes for plan maintenance cost in the second half of the year with a small decrease in the third quarter compared to the second.

And finally on slide 16, we've made some changes to our key financial assumptions for 2008. The range of annual capital expenditures has been reduced by $60 million to be between $180 million and $210 million. Pension contribution above the accounting expense should be complete, and we do not anticipate any major... any other major contribution for the remainder of the year. Additional D&A has been reduced $20 million to be between $460 million and $480 million, and finally annual interest charge has been reduced by $10 million to be between $140 million and $160 million.

So this concludes my review. And with that, I will turn the call back to you Remo.

Raymond Royer - President and Chief Executive Officer

Thank you.

As Daniel presented, price realizations were strong and have more than offset input costs... input cost increases this quarter. So we're catching up with inflation and this consistent with our engagement to expand margins beyond the synergy program. Oil prices have pulled back a bit. But cost for raw material and freight continue to trend higher.

So the announced price increase in June for business papers, commercial printing, as well as converting as converting and other specialty papers, are necessary to keep up with the inflation. These increases cover a substantial portion of our paper product offering and they will contribute to further expand margins in the third and the fourth quarter.

I would like to say a few words about the results in our wood business, where we have a much better operating performance this quarter. Selling prices did play an important role in the improvement. But no less significant is all the work of our employees to reduce costs, improve productivity and reduce cash losses in the business.

The $5 million EBITDA loss in the second quarter was at an average foreign exchange rate of about 99%. This is quite remarkable given the weak housing market. So while our lower lumber prices may negatively affect results in the coming quarters, the cost savings and productivity improvements are significant, and we have good reasons to believe that the worst is behind us.

In this period of slow economic growth, our synergy program plays a vital role within the company's operations. In the quarter, we proceeded with the closing of five replenishment centers across North America. We closed our turbine upside [ph] converting operation. We finalized the closure of Port Edwards mill and we've transferred grades to more efficient mills.

The progresses we've made with the various synergies have been tremendous and our team have worked relentlessly, looking at the projects, thus saving objectives and the tracking of the results. I am very happy with the progress thus far. And in light our progress made to-date, we have raised our run rate target to $250 million worth of synergies by the end of this year. I have the firm belief that we can meet this revised target.

Moving on to our outlook, we anticipate fine paper demand to continue to be under pressure from the weak economy effecting white collar employments and advertising dollars. Under the circumstances and due to the impact of our reduced capacity from the closure of our Port Edwards mills, Domtar paper shipments are not expected to increase for the second half of the year. Low inventory levels across the industry and recent capacity reductions by Domtar and its peers, will help keep the supply-demand balanced.

I am encouraged by these developments and by the structural changes we've seen in our industry. Input costs continue to increase, but I am confident that the efficiency of our operations on power generation and our footprint will continue to mitigate high energy prices.

Over the last year, Domtar has been able to grow the top-line revenues and prices; and at the same time, expand EBITDA from cost reductions and synergies. Our company demonstrates that it can sustain 5% plus demand declines and on usually high inflation cycles, by assuming a leadership role in managing its capacity and by successfully raising prices.

I look forward to seeing continued margin expansion in the upcoming quarters, coming from three main areas: first, higher price realizations for uncoated freesheet papers; second, further benefits from synergies; and third, a stronger dollar against the Canadian dollar having a positive impact on our Canadian mills.

With that I'd like to thank you for your support. And I'll turn the call over to Pascal.

Question And Answer

Operator

Certainly, sir. [Operator Instructions]. And our first question will now come from Claudia Hueston of JPMorgan. Please go ahead.

Claudia Shank Hueston - JPMorgan

Thanks very much. Good morning.

Raymond Royer - President and Chief Executive Officer

Good morning:

Daniel Buron - Senior Vice-President and Chief Financial Officer

Morning.

Claudia Shank Hueston - JPMorgan

I was hoping you could just maybe provide a little bit of color on uncoated freesheet markets as we sort of come out of the quarter, and maybe if you've got any insights into July thus far. The June data from the industry seemed a little bit better than what we've seen in the prior months. So, I just wondered if you had any update there on what you're seeing.

Richard L. Thomas - Senior Vice-President, Sales

Claudia this is Dick, I'll try to respond to that. Good morning.

Claudia Shank Hueston - JPMorgan

Morning.

Richard L. Thomas - Senior Vice-President, Sales

July to us felt a bit weaker, but part of it was we came out in maintenance in the May, June periods. So we really had more volume in the commodity system. As the month ended, it really was a pretty average month. So we actually did kind of better than it felt from a shipment standpoint. So I don't see any dramatic change. The... perhaps a little more spot availability from coated manufacturers making some uncoated and things like that. So that was topic of a lot of conversation. I'm not sure that it had a material effect on the supply-demand balance. I think there were some orders taken, but I'd say July was a bit weaker than the second quarter, but not dramatically so.

Claudia Shank Hueston - JPMorgan

Okay, that's really helpful. And then I guess just looking at the CapEx provision, I was just wondering if you could explain what drove the downward revision to capital spending and if you've got any thoughts on capital spending for next year?

Daniel Buron - Senior Vice-President and Chief Financial Officer

A little bit... Daniel speaking to give an outlook for next year. But the... I think we have fired the center with the merger of Weyerhaeuser fine paper business and Domtar assets with DAV [ph] that's we are going to start first by reducing costs without using CapEx. We are doing that aggressively with our synergy program. So we are not understanding. We have a very well maintained assets and very good spending. So it's just a question of priority right now in the business is we reduce cost without investing in the CapEx and we should go back. I mean our overall goal or objective is still the same. We believe that this business should be able to... or should receive 60% of the D&A in capital when we are going to get to a normal run rate but we're not there yet.

Claudia Shank Hueston - JPMorgan

Okay, that's great. Thank you very much.

Daniel Buron - Senior Vice-President and Chief Financial Officer

Thank you.

Unidentified Company Representative

Thank you.

Operator

Thank you. And our next question will now come from Mark Connelly of Credit Suisse. Please go ahead.

Mark Connelly - Credit Suisse

Thank you, a couple of things. Remo, you're raising your synergy target. Can you give us a little bit of a sense of where that's coming from? What kind of synergies are moving up and what might be moving down? And second I wonder if you could talk about just where we are in the reorganization of the mills? Are all of the major initiatives well advanced now or is there still more that we should be expecting?

Richard L. Thomas - Senior Vice-President, Sales

Mark, I'll take the question on synergies. We've... at the beginning of this issue; we have something like a little bit north of 600 different projects that were in line. So we had to assume that not all will come to an end. And that all will be successful. I think the only change in our target is... we are... we have a success rate that is higher than expected. I think this is a sign that the entire organization is behind the synergies and really trying hard to reduce cost in this very challenging environment. Maybe the environment is helping to motivate the throughputs a little bit.

So there is no new project in fact because we slowed the synergy definition very early in the process. We are working on all costs, but we are not adding to projects. So it's just a question of success rate. In terms of the organization, the one that we had in mind at the inception of that insured again are done. The last leg of that the closure of Port Edwards. But that's a continuous process. Market demand is moving down, is declining more than what we expected, so we're balancing our supply with our demand and if there is a need for further action, we'll make further action, but not at this time.

Raymond Royer - President and Chief Executive Officer

And as for the organization, I reviewed with the Board... this is Remo speaking, I reviewed with the Board the succession planning for all the major functions, and we are very well organized.

Mark Connelly - Credit Suisse

Okay. I wonder, if you could talk about what's going on in the specialties. Raymond, you have said in the past that, they were... where you were focusing your attention later in the process, clearly a lot of specialty producers have felt a lot of pain because of the lack of integration on the pulp side. Can you give us a sense of how you feel about your specialty system right now competitively?

Raymond Royer - President and Chief Executive Officer

First on the specialty, I have to say that we have now task force reviewing every one of our operation to be sure that we can draw all the results that we should from these result... these operations. But in the specialties, we feel good about them, because we are long in pulp. And we can draw on the expertise that is coming from so many great companies that form the new Domtar. So for the time being, we are very strong and very supportive of our specialty areas.

Mark Connelly - Credit Suisse

Okay thanks very much.

Richard L. Thomas - Senior Vice-President, Sales

Let me just add; this is Dick. Our business is pretty good in the specialty side. It's been strong; a lot of this gives us a bit of a portfolio diversification in the food packaging and products like that. Specialty areas that are a bit kind of cyclical. So we feel pretty good about how that business... those businesses really have behaved this year.

Mark Connelly - Credit Suisse

That's helpful, thank you.

Operator

Thank you. Our next question will now come from Chip Dillon of Citi. Please go ahead.

Unidentified Analyst

Good morning, it's James Armstrong calling for Chip. How are you? Congratulations on a good quarter.

Unidentified Company Representative

Hi James.

Unidentified Company Representative

Thank you.

Unidentified Analyst

The first question is your shipments were down less than the industry average, implying that you are picking up market share, where do you think the market share is coming from or is it just a bigger drop and grave that you are not focused on showing up on the industry data?

Richard L. Thomas - Senior Vice-President, Sales

This is Dick. Let me try to respond to that. I think we are about even may be just a touch above the industry if you look at the first six months this year versus last, so I don't... I think our market share is up nominally. So it's not our intent necessarily to gain market share. It's certainly we want to maintain market share improve our margins. And where things click in terms of our value proposition for a given market segment or a given product, we would plan to grow shares.

So I think we feel good about that. Where have we gained? I got to be honest I think we gained through combining the products that Domtar made and the products Weyerhaeuser made, bring them together have customers understand how they truly work together, how they can ship together, how they add value together for customers and they are buying boat. So, I think it took a while for that benefit of the merger to settle in with the customers, but I think it has. So that's where I would see it.

Unidentified Analyst

Perfect. And the second do you have any hedges in place? And if so can you get us some color on that and maybe what prices that they are hedged at?

Daniel Buron - Senior Vice-President and Chief Financial Officer

Yes. The only hedge that we have in place, are in the currency. We have I mean close to 50% of our net and is in our flow adds for the next 12 months. And that's range forward. So between a parity and $0.95... $0.94 something like that. And we also have some natural gas hedges. I think it's 26%, 28% of the next twelve month, and then after that decrease a little bit for the 12 month after the natural gas hedges are definitely very positive. They are hedges that we took a few months back when the natural gas was lower than that. That's about it in terms of hedges.

Unidentified Analyst

Okay, perfect; thanks.

Operator

: Thank you. Our next question will now come from George Staphos of Banc of America Securities.

George Staphos - Banc of America Securities

Thanks good morning everybody. Congratulations on...

Unidentified Company Representative

Good morning.

Unidentified Company Representative

Good morning, George.

George Staphos - Banc of America Securities

...on the quarter. I just want to come back to the synergy discussion as we look at it. Could you remind us how much have you accomplished on your run rates so in effect how much is left to go over the back half of the year and as you look at the $15 million increment to your target, should we assume that all of that is driven by cash benefits or are there any non-cash benefits in that synergy number.

Daniel Buron - Senior Vice-President and Chief Financial Officer

First part of the answer will be this there is no non-cash benefit in all that, our definition of synergies was... it has to be a bit better it has to be cash and no non-cash and all that.

In terms of what's in out P&L right now, if you look at page 20 in the slide show that is available. If you look at the Q2 last year versus Q2 this year, you can see that there is the a column that is named other costs that they represent $40 million improvements at the second quarter last year. In that column, I have also the inflation on the rest of our cost other than metal and freight, so our run rate is that time four plus a little bit.

George Staphos - Banc of America Securities

I got it.

Daniel Buron - Senior Vice-President and Chief Financial Officer

So we're very close to the $200 million; we haven't reached that yet. But we are very close. What's left? We have the P&L is the $50 million that we just had to the target.

George Staphos - Banc of America Securities

Okay. That helps a lot, I appreciate it. Do you have, I realize there is no capital that you need to spend to get to the remaining $50 million or so? But is there any other cash expense that you need to incur to get their remaining 50.

Daniel Buron - Senior Vice-President and Chief Financial Officer

Nothing significant.

George Staphos - Banc of America Securities

Okay.

Daniel Buron - Senior Vice-President and Chief Financial Officer

I mean we closed on some solution center this quarter that maybe $1 million that we spend in letting go some people and moving the paper around to the new solution center. So there is a little bit of cut, but nothing that is significant.

George Staphos - Banc of America Securities

Okay. Last question and I will turn it over on the cost side: if we hold inputs where they are right now and I realize that's moving target, no one is going to hold it to this. Would you expect that in the third quarter your inflation sequential change would be positive or negative given what you know right now? Thanks guys.

Unidentified Company Representative

I think the... inflation pressure is still there. We have 30 some... $37 million I think in the quarter. This is not something that happened at the beginning of quarter that's fully ramping up in the quarter. So if everything was to stay the same, we'd still see inflation. I think the message there also is that, we don't believe that our cost structure reflects a barrel of oil at 120, as it is right now. I think the... we've worked with suppliers to extend the pure... which we have to have them on that front. So I think we should expect that we are going to have again inflation for the foreseeable future.

George Staphos - Banc of America Securities

Okay. Thanks very much guys.

Unidentified Company Representative

But to that point, on the other side or the flip side of that, we've announced price increases at the end of June implementation in July and August. And that should benefit also our results.

George Staphos - Banc of America Securities

Okay. Good luck in the quarter.

Unidentified Company Representative

Thank you.

Unidentified Company Representative

Thanks, George.

Operator

Thank you. Our next question will now come from Mark Wilde of Deutsche Bank.

Mark Wilde - Deutsche Bank Securities

Good morning. First a few questions on the paper side; I wondered, Dick is this possible to get a sense of what your export volume is doing on coated freesheet. And what contribution our year-over-year basis that might be making to your volume?

Richard L. Thomas - Senior Vice-President, Sales

Sure. You recall in the third quarter of last year we had an inventory overhang right after we had put the two companies together, and we exported a significant amount of roll volume. And at the conclusion of that quarter we talked about the roll volume and the cut-size being... that we treated them differently and thought about them differently so what we've done so far this year is maintained our cut-size position. We like that business. As we've said before, it helps us try to get us some of our global customers and allows us to ship on both here and over there. At so that volume and cut-size has remained pretty even it's probably smoothed out a bit. I think it was a bit I think it was a bit more variable last year month to month.

On the roll side, we have not needed at this point to step up the volume to export. So we think the opportunity is there to do it if we need to; but at this point we need not. So it has not affected... lower volume to export has not affected our second quarter volume.

Mark Wilde - Deutsche Bank Securities

But if we look at sort of second quarter this year versus second quarter last year, there is a positive impact from exports. Is that right?

Richard L. Thomas - Senior Vice-President, Sales

No, it's really, because really the... we shipped very little rolls in either quarter, either last year or this year.

Mark Wilde - Deutsche Bank Securities

Right, and on the cut-size?

Richard L. Thomas - Senior Vice-President, Sales

It's been pretty steady, maybe a couple of thousand more tons in the quarter this year than last, but nothing significant.

Mark Wilde - Deutsche Bank Securities

Okay.

Richard L. Thomas - Senior Vice-President, Sales

Our cut-size export was in place at the beginning of the second quarter last year, and maybe we haven't explained that before; but that was already happening.

Mark Wilde - Deutsche Bank Securities

Okay, all right. Other question on the papers side; can you just talk with me about how you are thinking about freight costs right now when we were up in Montreal about six weeks ago? You had a kind of an interesting graph that showed how far $500 worth of fuel got you and it was only about 20 to 25% of what it was five or six years ago. Are you using surcharges? Are you differentiating in the price that you charge customers based on how far you have the shift or are you just rolling it into the overall average price?

Unidentified Company Representative

We've chosen not to do surcharges. These are difficult for our customers to process. Pay and pass through. So, we hear from our customers that if we can build into the price, that's the way to go. It's administratively and from a mark-up standpoint, much easier for them to do it that way. So we debate this and have debated it over many years. But the feedback we get from the marketplace is to put it in the place. So that's what we've have chosen to do up till now.

We do certainly factor in the geography, the freight, the net back. We will be looking at our net backs by product, by customer, by region of North America and try to make our pricing decisions based on that. So yes, we will charge more in extended high cost area. Charge more for the product than we will in some cases where it is an average freight.

Mark Wilde - Deutsche Bank Securities

Okay. And I wonder if you guys can talk at all about any energy projects that you are doing at the mills right now. Most of the other companies are pretty active on this count. In terms of incremental co-gen or biomass or anything like that?

Unidentified Company Representative

I don't know, I guess... Marvin, you want to take this one?

Marvin D. Cooper - Executive Vice-President and Chief Operating Officer

Well okay, we've looked at all of the opportunities that we have for co-gen within the system and we have one here in South Carolina that looks good. It would have... it would beat the threshold target that we talked about as 30% internal rate of return. The co-gen projects that are not under construction now take quite a while to finish the delivery dates or out to 2.5 years or so. So there is... the equipment manufactures don't have the capacity in their shops to build this stuff.

Mark Wilde - Deutsche Bank Securities

What about the biomass Marvin?

Marvin D. Cooper - Executive Vice-President and Chief Operating Officer

We don't have any active projects in the biomass area. We, like all others in the industry, are in the early stages of looking at what the opportunities might be as far as cellulosic ethanol projects and so forth are concerned. But we don't have any concrete plans in the works right now.

Mark Wilde - Deutsche Bank Securities

Okay. And then finally, I just want to turn to the merchant group. But, it looks like the EBITDA margins are running just over 1% right now, which is lower than I recall them being a few years ago, also looks to be lower than some of the peers that are out there. Can you talk with us a little about what's going on in the merchant group?

Unidentified Company Representative

The portion of the reason is we are doing a lot more direct shipment in the current market than we used to do. And that typically dollar shipment are lower margins, big volume, but lower margin. Also I think the merchant business is the one that's in the period of price increases like the one that we are witnessing since a couple of years are the one that are squeezing between the end customers, the printer and the manufacturer. So it typically takes them more time. And since there... the price increase are falling in other one, their margins are a bit squeeze. That should, I mean go back to the 2% to 2.5% margin as prices are more stable.

Mark Wilde - Deutsche Bank Securities

Okay, very good; thank you.

Unidentified Company Representative

But at the same time Mark, I should add that they really reinforce our multi-channels competency, and when you look at their return on capital employee, it is very good.

Mark Wilde - Deutsche Bank Securities

Okay, so that's that still looks like a strategic business to you then?

Unidentified Company Representative

Yes.

Mark Wilde - Deutsche Bank Securities

Okay, very good; thank you.

Unidentified Company Representative

Thanks, Mark.

Operator

Thank you. And our next question will come from Bill Hoffman of UBS. Please go ahead.

Bill Hoffman - UBS

Hi, guys; good morning.

Unidentified Company Representative

Good morning.

Unidentified Company Representative

Hi Bill.

Bill Hoffman - UBS

I wonder if you guys could talk a little bit about your operating strategy in the mills as you go forward in this declining demand environment and also maybe if you could give some thoughts on calibrating how much demand softness you can really start to see here in the second half.

Unidentified Company Representative

Well, the operating the strategy will remain the same. We have our goal to balance our supply with customer demands. So we are not price taker, we are not forcing. So we're going to adjust our capacity based on the customer demand and take lack of orders on time if we need to adjust that. And again, if there is sufficient lack of orders on time to...for us to question the existence of a paper machine will do. So that strategy has not changed and we're going to continue to apply it with all the rigor that we've applied it in the past.

In terms of demand, that's very tough question to answer. I'll see whether I believe they can... you'll add to that. But we've seen since the beginning of the year more or less 5% declines. I think there is a... there is always an early feel that you always comparing first half with compared to last year fist half; second half will be flat as last year's second half. I would be surprised if we see an even the decline. So I think there was a 5% for the full year, as may be the good forecast. But that's tough to see.

Bill Hoffman - UBS

Thanks. I guess the... just a question on operating rates, can you give us some kind of quantification of what level of operating rates you expect? I mean in the second quarter you had all the down time, but for maintenance. But if you look into the third quarter, what average operating rates you expect to be in on the paper side, and then let also get a sense on where you're... what your operating rates are in the Lumber business right now?

Daniel Buron - Senior Vice-President and Chief Financial Officer

The only place where we believe we want to operate 100% this quarter is the quarter grown wood business. We took few days of lack of orders on time in July. The rest for the time being would be our view of the market and review of our capacity; we don't believe we are going to take down time this again, that's something where adjusting every second week when we do our southern operation meeting. The lumber business; we have $606 million... sorry, $600 million and STM... the capacity [ph] that is running as we speak right now. It's very similar to what we had in the second quarter.

Bill Hoffman - UBS

And as out of your total availability, what is the...

Daniel Buron - Senior Vice-President and Chief Financial Officer

Double that, we have almost half of our saw mills that are not operating.

Bill Hoffman - UBS

Okay, thank you.

Operator

Thank you. And our next question will now come from Benoit Laprade of Scotia Capital. Please go ahead.

Benoit Laprade - Scotia Capital

Thank you. Maybe Daniel just on the SG&A line, it obviously dropped significantly from Q1 to Q2, some of it is the $6 million of the trademarks sale. Would it be where also the $9 million of integration costs would have been and can you give us some guidance in sort of integration costs for Q3 and Q4 and therefore what this SG&A can look like?

Daniel Buron - Senior Vice-President and Chief Financial Officer

Okay. First of all I mean, we've made a lot of effort to reduce our SG&A; that was the key element of our synergy. So, we definitely see that it's paying off. There is SG&A as I think I'm seeing often, but I think it is important to repeat, is often a place, where you have a lot of aid and other type of expenses. So the... in the quarter, we had a very good quarter. I think the normal run rate for the business in terms of SG&A should be per quarter between $95 million and $100 million.

To the second part of your question, Benoit, yes this is where the integration cost are and we do expect a similar integration costs for the two quarters that are coming Q3 and Q4.

Benoit Laprade - Scotia Capital

So, about $9 million?

Daniel Buron - Senior Vice-President and Chief Financial Officer

To about $9 million to $10 million, there is... we had the... those integrations costs are all linked to exiting transition service agreement with Weyerhaeuser. There was a big deadline that we've crossed at the end of July, where we've welcomed the finance system and the low maintenance systems, two very important system for a business like ours. So that's done, what's left is infrastructure. This is still a big project that will take probably three quarter to complete... three to four quarters to complete after that will be done.

Benoit Laprade - Scotia Capital

So that say a 100 plus 10 run rate should be good until say the end of Q3.

Daniel Buron - Senior Vice-President and Chief Financial Officer

Yes, more or less the other items that land and the SG&A.

Benoit Laprade - Scotia Capital

Great, thank you.

Daniel Buron - Senior Vice-President and Chief Financial Officer

You're welcome.

Operator

Thank you. And our next question comes from Steve Chercover of D. A. Davidson. Please go ahead.

Steven Chercover - D. A. Davidson

Good morning everyone.

Unidentified Company Representative

Good morning, Steve.

Unidentified Company Representative

Good morning.

Steven Chercover - D. A. Davidson

Thank you. I just want to focus a little bit on lumber. First of all, were there any log revaluations, the inventory changes that contributed to that performance in the quarter?

Daniel Buron - Senior Vice-President and Chief Financial Officer

No. good question, because we've seen that others in the industries have changed our company policy, we have not. So there is no change in the log value. So that's the true profit that you see true results that you see in our numbers.

Steven Chercover - D. A. Davidson

Well, that's great. And so given the comment that you said that you think you're beyond the worst in the progress that you are making do you reassess in any way future of lumber within Domtar?

Raymond Royer - President and Chief Executive Officer

No, we are not. This is Remo speaking. First our employees have done tremendous efforts to control the losses and improve the productivity and the progress that they have made are very impressive.

But there's some thing else that is happening of course is the currency, because all the lumber costs are in Canadian dollars, the currency this morning was below $0.94. So this should improve eventually the results, but this business is non-core and we are still looking for a good home for our people.

Steven Chercover - D. A. Davidson

Okay, well, I am sure that they have bolstered their own long-term survival, so that's great; thanks so much.

Raymond Royer - President and Chief Executive Officer

Thank you.

Operator

Thank you. Our next questions will now come from Paul Quinn of RBC Capital Markets.

Paul Quinn - RBC Capital Markets

Yes, thanks and good morning.

Raymond Royer - President and Chief Executive Officer

Good morning, Paul.

Paul Quinn - RBC Capital Markets

Just two questions one is and I sort of got on late, but one is on succession plan going forward here and the second one would be what's required in terms of financial results before you reinstate the dividend.

Unidentified Company Representative

well two questions, the first one on the succession, when we announced in the first quarter that we have started the process, we said that by the of the day this years in the suddenly in the third or first quarter, we would be able to make an announcement and I have no announcement to make.

But we really believe that during that time or at the set time we'll be able to make the announcement. So as for the dividend when we made the decision on the dividend, it was based on very different or very special thing and we said that rather than paying a dividend we wanted to create value for our shareholders through debt reduction, because we thought it was the best way. And this month we this month we or this quarter we achieved our long-term targeted leverage ratio of 40%.

So we're very pleased about that. But at the end of the day, we are a new organization that it is committed to one business, and there is limited track record there. And we want to really test what we are doing and test the industry to be sure that things are going the right way. So, so far it shows that we have taken the right route, because S&P has already upgraded us one notch. But we believe that we should keep on improving our financial statement and we said that we believe that we would have to be down between $400 million to $4500 million of debt and this is what we are trying to do and we believe that we will be able to show good results very soon.

Paul Quinn - RBC Capital Markets

Great. Thanks guys.

Operator

: Thank you. Our next question will now come from Alex Uche [ph] of Goldman Sachs. Please go ahead

Unidentified Analyst

Good morning.

Unidentified Company Representative

Good morning.

Unidentified Analyst

Can you please comment on what impact you think energy usage will have in the quarter relative to second quarter? I noticed there was a nice positive impact in the second quarter.

Daniel Buron - Senior Vice-President and Chief Financial Officer

Yes, the impact between the first and second is easier, because your transferring from winter to summer. From summer to fall, it's a little bit more difficult. So it's all weather related, so I would assume that is going to be zero impact and we'll see how the weather will be.

Unidentified Analyst

Okay. And then looking at volumes from the seasonal point of view, it's the volumes turned up in the third quarter relative to the second?

Daniel Buron - Senior Vice-President and Chief Financial Officer

We've reduced capacity by closing the Port Edwards mill at the end of June. We had some down time during the second quarter that's probably a little bit less than the capacity reductions that we have. So I think that if inventories stays the same and manage their volume should be fairly stable from one to quarter to the other. It's all then driven because again we adjust our reproduction with demand.

Unidentified Analyst

Excellent. And just looking at slide number 15, where you talk about the maintenance costs for the rest of the year. So based on the slide, maintenance should be a positive $7 million to $10 million impact on earnings and the third and fourth quarters. Is that the right way to interpret that chart?

Daniel Buron - Senior Vice-President and Chief Financial Officer

Yes, you are absolutely right.

Unidentified Analyst

Excellent. Thank you for your time.

Daniel Buron - Senior Vice-President and Chief Financial Officer

Thank you.

Operator

Thank you. And our next question will come from Joseph Reagor of John Tumazos Very Independent Research. Please go ahead.

Joseph Reagor - John Tumazos Very Independent Research

First guys, congrats on a good quarter.

Unidentified Company Representative

Thank you.

Unidentified Company Representative

Good morning.

Joseph Reagor - John Tumazos Very Independent Research

First question is, your closing costs for five facilities is $1 million second quarter versus 90 in first quarter. Any thoughts going forward if you really have any more towards the cost related to those closings... the second quarter closing or any additional closing?

Daniel Buron - Senior Vice-President and Chief Financial Officer

Closing costs, there is a for GAAP in fact through the accounting principle, there are some costs that you will enter when you're tooling the facility that you cannot book at the time of the decision. So that's the type of cost that you're going to see the P&L in the future.

Most of the costs are typically accrued when it's fine to, when you make the decision. The $11 million in the quarter is more important than a normal quarter. There was a paper machine dismantling in the quarter. That is consuming in fact in the second quarter. I would expect that that type of cost would be lower in the third and very low I think in the fourth as there are no other decisions in terms of capacity rationalization.

Joseph Reagor - John Tumazos Very Independent Research

Okay. And then second question being for your price increases that you announced in June for July and August. Are you feeling any resistance to this price increases and is there a possibility of a delay in price realization to say the fourth quarter or possibly early 09?

Richard L. Thomas - Senior Vice-President, Sales

This is Dick. The only one that has... is proven to be difficult is Coated Gram [ph] was announced for beginning of July in the face of significantly weaker demand. So that one is proven to be a struggle, the uncoated I would simply say that our customers while they don't necessarily like the increases, they understand the reasons why and they've accepted them and we're moving forward. So the prospects and the implementation results so far are very, very good on uncoated.

Joseph Reagor - John Tumazos Very Independent Research

All right, thank you very much.

Operator

Thank you. Our next question will come from Christy Parsons of Celeron Asset Management [ph]. Please go ahead.

Unidentified Analyst

Thank you. Could you outline what debt was reduced in the quarter? I know you gave an amount, but in terms of revolver term loan et cetera?

Daniel Buron - Senior Vice-President and Chief Financial Officer

Term loan is $25 million, the rest is over addressed.

Unidentified Analyst

Okay and your original target of $400 million to $500 million I understood to be for 2008. And if you've done $100 million in the first half, are you still looking for the balance in the second half or is that now on a longer time frame?

Daniel Buron - Senior Vice-President and Chief Financial Officer

The $400 million, $500 million was no deadline, was as cash accumulates. But we hope to be able to do that sooner than later, but there was no time frame attached to that that objective.

Unidentified Analyst

Okay. Thank you very much.

Daniel Buron - Senior Vice-President and Chief Financial Officer

You're welcome.

Operator

Thank you. Our next question will come from Zacks Gladys of Gates Capital Management [ph]. Please go ahead.

Unidentified Analyst

Yes, a couple of questions. The demand number that you were citing, I think you said something like the reduction in units of an order of 5% was that from pro forma numbers for last year?

Richard L. Thomas - Senior Vice-President, Sales

I think... this is Dick. I think that reference was to industry data. It's demand, it's 4.7% so that's demand meaning purchases for North America.

Unidentified Analyst

And... but your sales, I think...

Unidentified Company Representative

Yes, you are right. When we are comparing to last year six months of the Domtar and Weyerhaeuser type of paper business, we are looking as if we were together since Jan 1 on a pro forma basis.

Raymond Royer - President and Chief Executive Officer

But just so that be clear in the press release we have an appendix that shows the shipments and the shipments shown there just as reported; they are not on the pro forma basis.

Unidentified Company Representative

That's right.

Unidentified Analyst

Okay, but where would your production... your production paper production to be year-over-year?

Unidentified Company Representative

We are adjusting to demand our paper production is down as the shipment were.

Unidentified Analyst

Okay. And then on a CapEx can you, what is the reason for the reduction. And has that shifted into next year or what happened to those projects. And it looks like from what you've spent so far at the significant ramp up in the second half for the year versus the first half can you kind of go through that?

Daniel Buron - Senior Vice-President and Chief Financial Officer

The main place where we've reduced CapEx is in the wood business, so that's one that we are definitely given the difficulty of that business. We want to make sure if we invest we are investing for creating value for the long term. So we've reduced CapEx significantly. The rest are just project that I have not been presented or are ready to be presented. We do make no compromise on maintenance CapEx or the asset are well maintained and this time being. But we prefer to reduce cost without using CapEx and look at CapEx as a second wave of way to improve the business. And we're just I think managing a type that we use our capital, and that's the result.

Unidentified Analyst

Okay. But next year in 2009, would you expect CapEx to be up year-over-year or flat or down?

Daniel Buron - Senior Vice-President and Chief Financial Officer

No, I think CapEx should continue to move up until we get to what we believe is a normal CapEx in this business, which is more or less 60% of depreciation.

Unidentified Analyst

And that's about $250 million.

Daniel Buron - Senior Vice-President and Chief Financial Officer

That's $270 million, $280 million.

Unidentified Company Representative

That's correct.

Unidentified Analyst

Okay. And then the last question on the wood business you've talked about your intent to try and do something with it by year-end, is that still your intent? And would it be... would you consider something besides just a cash there? Would you do something, where you contributed that business and took back notes or an equity... or kept an equity investment, can you talk a little bit about the wood business strategic options?

Raymond Royer - President and Chief Executive Officer

Well, Zacks, this is Raymond. Like any other deal, the wood business is none-core and we want to maximize the value for our shareholders. So, at the end of the day whatever would make sense we would look at it. But we want to create value for our shareholders and it is non-core business, so we'll always have to bear that in mind whenever we negotiate with people.

Unidentified Analyst

Is it still your intend to do something whether by year end?

Raymond Royer - President and Chief Executive Officer

Yes, it is still our goal.

Unidentified Analyst

Okay. And the likelihood of something happening, come down in recent months or do you still feel confident, you can potentially do something by year-end?

Raymond Royer - President and Chief Executive Officer

Well, I started the year by saying that it was one of my first priorities, so I have not changed.

Unidentified Analyst

Okay great. Thanks a lot.

Operator

Thank you. Our next question will now come from Daryl Swetlishoff from Raymond James. Please go ahead.

Daryl Swetlishoff - Raymond James

Well thanks. Good morning guys.

Unidentified Company Representative

Good morning Daryl.

Raymond Royer - President and Chief Executive Officer

Good morning.

Unidentified Company Representative

Good morning Daryl

Daryl Swetlishoff - Raymond James

It's good to see things moving in the right direction. Looking further out, we are seeing some potential for some Latin American competitors perhaps merging and with significant synergy potential. How do you view your global competitive position vis-à-vis some of these off shore producers longer-term?

Unidentified Company Representative

Is that a question for pulp and paper or...

Daryl Swetlishoff - Raymond James

Essentially paper.

Raymond Royer - President and Chief Executive Officer

I think that obviously this depends a lot on exchange rates. Given the range that we've seen in the past couple of years for the dollar, we feel good about our competitiveness. Certainly we've benchmark our mills our paper machines on the commodity side, globally. And while we may in some instances a higher cost for example fiber, we also have lower cost on a delivered basis. So we feel very good about our competitiveness. And I think the results over the years have kind of proven that, you haven't seen, even in a different exchange rate environment, you haven't seen significant increases in the imports of uncoated free sheet into the country. And certainly we feel very good about our ability to sustain ourselves.

Daniel Buron - Senior Vice-President and Chief Financial Officer

Yes. And I would add to that in America anybody wants to export in America as first to input transportation to bring it here and after that as to distribute the paper in America. And when you look at our geographic footprint, this is very difficult to match for anyone.

Daryl Swetlishoff - Raymond James

Okay. Thanks very much for that. And good luck on the coming quarter.

Unidentified Company Representative

Thank you.

Unidentified Company Representative

Thank you, Daryl.

Operator

Thank you. [Operator Instructions]. And our next question will now come from James Jenhill [ph] from Newland. Please go ahead.

Unidentified Analyst

Good morning, gentlemen. I want to take a step back for a minute and just look at the underlying cash generating potential of Domtar. First, great job on the free cash flow line in the second quarter. At the low end conservative math even in a declining demand environment suggest that Domtar can generate upwards a $300 million in free cash flow. Anywhere between $300 million and then upwards of $450 million depending on the wood product variances that will potentially see us that business is divested.

I know that there are restrictions currently due to the Weyerhaeuser deal due to share buy backs, to preventing share buybacks until March, I believe. And I was just wondering if you could, as we move forward, articulate your intentions for the use of free cash flow, as resulting from either buybacks more so buybacks compared to a dividend at this time.

Daniel Buron - Senior Vice-President and Chief Financial Officer

I think the this back to the capital allocation question. We've reviewed that very thoroughly at the beginning of the year, and we've explained that our goal for the time being would be to reduce debt by $400 million to $500 million before re-looking at the capital allocation. We've done $100 million since the beginning of the year, so we're one fourth there.

Unidentified Analyst

Right.

Daniel Buron - Senior Vice-President and Chief Financial Officer

So, as we get closer to that target, we are going to reinitiate internally discussion and we're going to look at the businesses of the new allocation. And if we go to the point, where we can get the returning money to shareholders, then we are going to address the buyback the dividend portion that is always an interesting debate to go through.

Unidentified Analyst

Right. And then just given regardless, I mean your balance sheet is appropriately levered and grant and you are the only paper packaging producer that has near investment grade debt, which is kudos to you all. But just theoretically you guys can take annual cash flow and buyback 10% of the company every year all else equal. I understand that there needs to be other strategic reviews there. But it seems like you are underlying free cash flow story is very much healthy; great quarter.

Unidentified Company Representative

Thank you.

Raymond Royer - President and Chief Executive Officer

Thanks. Sylvie, we're running at about an hour, so we're going to hand the quarter call to you... the earnings call to you. Thanks.

Operator

Certainly, sir. We currently have no other questions.

Raymond Royer - President and Chief Executive Officer

Great. Thanks to everyone and we invite you to join us for the third quarter earnings call in early November. Thank you all and you have a great day.

Unidentified Company Representative

Thank you all.

Operator

Thank you. Ladies and gentlemen, this does conclude your conference call for today. Once again, thank you for participating. And at this time, we ask that you please disconnect your lines. Have yourselves a great day.

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Source: Domtar Corp. Q2 2008 Earnings Call Transcript
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