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Graphic Packaging Holding Company (NYSE:GPK)

Q2 2008 Earnings Call Transcript

August 7, 2008 10:00 am ET

Executives

Scott Wenhold – VP and Treasurer

David Scheible – President and CEO

Dan Blount – SVP and CFO

Analysts

Vic Kumar – South Coast Partners

Mark Kaufman – MLK Asset Management

Kevin Doherty [ph] – Prospector

Kishore [ph] – Lehman Brothers

Mike Ortel [ph] – Vernor Capital [ph]

Operator

Good morning. My name is Mendy and I will be your conference operator today. At this time, I would like to welcome everyone to the Graphic Packaging Holding Company’s second quarter 2008 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. (Operator instructions) As a reminder ladies and gentlemen, this conference is being recorded today August 7, 2008.

Thank you. I would now like to introduce Scott Wenhold, Vice President and Treasurer of Graphic Packaging. Mr. Wenhold, you may begin.

Scott Wenhold

Thank you, Mendy. Good morning everyone and welcome to Graphic Packaging Holding Company’s second quarter earnings call. Commenting on results this morning are David Scheible, the company’s President and CEO and Dan Blount, Senior Vice President and CFO.

Before we get started I would like to remind everyone that statements of our expectations including but not limited to the achievement of synergies and debt reduction, pension contributions, capital spending, interest expense and integration expenses constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Such statements are based on currently available operating, financial and competitive information and are subject to various risks and uncertainties that could cause actual results to differ materially from the company's historical experience and its present expectations. These risks and uncertainties include, but are not limited to, inflation of and volatility in raw material and energy costs, the company’s substantial amount of debt, continuing pressure for lower cost products, the company’s ability to implement its business strategies including productivity initiatives and cost reduction plans, currency translation movements and other risks of conducting business internationally, the impact of regulatory and litigation matters and the company’s ability to fully integrate Altivity Packaging, and fully recognize the anticipated benefits of combining the operations of Graphic Packaging International Inc. and Altivity Packaging. Undue reliance should not be placed on such forward-looking statements as such statements speak only as of the date on which they are made and the company undertakes no obligation to update such statements. Additional information regarding these and other risks is contained in the company's periodic filings with the SEC.

With that David, I’ll turn it over to you.

David Scheible

Thanks, Scott. First, I need to apologize for my voice this morning. I have been battling a tough cold and this is about as good as I can do this morning. I want to thank you all for joining us today. This morning I would like to begin my remarks with a brief overview of our consolidated results for the quarter, next I am going to comment on the impact of rising raw material cost and the steps that we have taken to ensure we stay ahead of this cost inflation. Then I will talk to you the progression of Altivity integration and the synergies that we have seen after just one quarter. Finally, I will close my remarks with review of our key segments and their performance in relation to general industry trends. Following my comments Dan Blount our CFO will walk you through our financial results for the period in greater detail. Once we have concluded our remarks, we will open up the call and look forward to answering your questions.

Last night we reported adjusted net income of $0.01 per share compared to a net loss of $0.11 per share and a pro forma net loss of $0.07 per share in the prior year quarter. I am encouraged by our performance during the second quarter especially given the difficult operating environment, increased pricing, solid new product commercializations, benefits from our cost-cutting initiatives and achievement of integration synergies all contributed to more than offset the negative impact of cost inflation. This is the seventh quarter in a row that we have reported increased operating income versus the prior year period and our position in the marketplace is strengthening. As I had mentioned, Dan will discuss the financial results in more detail. In order to give you more of an apples-to-apples view, his comments will include comparisons to 2007 second quarter results on a pro forma basis assuming the combination with Altivity had occurred on January 1, 2007.

At the risk of stating the obvious, the current economic environment has proved to be challenging, a few economic indicators have shown sign of much strength. The cost of our key raw materials such as energy, fiber and chemicals has risen to historic levels and has placed a considerable strain on the business. Between the end of 2006 and the end of the second quarter 2008, the prices of oil and natural gas rose 161% and 145% respectively. Needless to say, we have been operating under difficult conditions. Overall, inflation had a negative impact of roughly $46 million in our pro forma second quarter results. Similar to the first quarter, the inflationary impact during the second quarter was driven mostly by our increased cost of fiber and chemicals. On average, fiber was up $20 per ton for the quarter and chemicals were up roughly $9 per ton versus 2007. Although energy also adversely impacted results, we (inaudible) the natural gas hedges in 2007 that have helped mitigate its negative impact this year. On average, energy costs were up about $8 per ton in the quarter. Unfortunately the second quarter represents the last quarter that we hedged rates significantly below current stock market. Going forward, we will see more of a direct impact from natural gas during the remainder of the year.

Recently, we have seen some positive trends on the cost side. Crude oil has pulled back from $140 level to the low $120s and similarly natural gas prices have declined the $13 range to roughly $10 per MMBtu. This pullback is certainly welcome but there will be some lag bringing positive trends for input costs. While we expect our results to be adversely impacted by these higher costs through the remainder of 2008, we believe our margins will continue to improve as we recapture inflation to increase pricing, recognize merge-able synergies and achieve other cost reductions. Although we are pleased to see the recent downtrends in cost, we are not going to rely on broader inflation pull back for our results. Our primary tool to combat inflation is through ongoing price increases to our customers. During the second quarter, improved pricing positively impacted our pro forma results by over $29 million. For fiscal year 2008, we expect our pricing initiatives both contractual and market driven to offset a little more than half of the inflation impact in our business. In response to rising input cost inflation, we have recently announced price increases of $40 per ton on our coated unbleached Kraft paperboard as well as a $50 per ton increase for all of our coated recycled and uncoated recycled board. Both of these price increases will take effect in Q3. Additionally, we are in the process of renegotiating free delivery charges with our customers.

On the contractual carton side of our business, at the beginning of the second quarter, we were able to eliminate the last of our fixed cost beverage contract and incorporate an inflation recovery index into the new agreement. However, generally speaking, our customer contracts reset the start of each calendar year as a result most are tied to the inflationary impact we experience from the prior year. Taking this lag into account, we expect to have the ability to use price to offset more than 70% of our 2008 and 2009 projected inflation by the end of 2009 with further recovery into 2010. Although Graphicpackaging has a strong reputation for low cost manufacturing, we determined it was necessary to idle certain older assets, higher cost assets at one of our facilities. This action was necessary for us to remain competitive and continue providing high-quality innovative packaging to our customers while also generating positive returns for our shareholders. As we announced on June 20, we elected to temporarily shut down our number two coated paper machine in our West Monroe, Louisiana mill. As I mentioned earlier, the recent run up in price of crude oil has translated into higher cost (inaudible) production input like fiber, natural gas and petro-based chemicals. The decision to temporarily suspend production compared for machine number two help streamline our overall cost structure. Customer orders will continue to be met due to production from our other lower cost CUK machines.

While we are clearly motivated by the impact of inflation on our business, we have not lost focus on driving synergies. This is the first full quarter of the combined company; I am extremely pleased with the progress we have made across the organization. We feel well on our way to implement our integration plan. Our leadership team at all levels are impressed in working, we have begun transitioning to SAP across the board, customer plants are in place and being executed and our plant optimization effort is ahead of schedule. Our integration team has been at work unlocking the full value of the combination with Altivity. After only one quarter, I am pleased to report that on an annualized basis, we have already achieved in excess of $15 million towards our announced goal of $90 million of total synergy. Given the negative impact of unexpected inflation, we have put a greater focus on recognizing synergies and have actually provided the time table for achieving the previously announced $90 million target. We now expect to hit this goal by 2010 as opposed to the originally planned 2012.

As part of our synergy program, we continue to take actions related to the overall realignment in consolidation of our operations with Altivity. On April 23, we announced plans to discontinue folding carton production at Middletown, Ohio facility and cease lamination operations at our Elk Grove Village, Illinois plant and on July 10 we announced an agreement to sell two coated-recycled board mills located in Philadelphia, Pennsylvania and in Wabash, Indiana. The sale of these mills is subject to review by the U.S. Department of Justice. Just to note the proceeds from the sale of these two mills will be used to pay down our existing debt.

However, we are considering all of our options not just focusing solely on plant rationalization and closures; we are also actively exploring expansion opportunities as part of our process to realize additional synergies from the combination with Altivity. On July 16, we awarded economic development tax credits in support of our planned $27 million expansion in our Kalamazoo, Michigan facilities where we operate both the coated recycled paperboard mill and manufacture folding cartons for a wide variety of food and consumer products. We believe an opportunity exists in this facility to establish a company-wide model for efficiency and manufactured productivity. The Kalamazoo mill and carton complex will convert roughly 400,000 tons of recycled board into cartons in this newly expanded facility. We believe this will represent one of the lowest cost of such complexes in the world.

We continue to examine all our opportunities to identify synergies, increase efficiency and offset rising raw material cost in an effort to maximize our ongoing results while not sacrificing quality, capacity or customer service. We are taking the necessary steps to ensure the Graphic Packaging remains competitive during this difficult market environment. In addition to combating inflation with increased pricing and synergy achievement, we remain committed to the contest of Six Sigma reliably centered maintenance and lean manufacturing to help improve our processes and remove cost from the production and delivery systems. Because the mills are the source of the majority of our cost structure, the focus of many of our congenious improvement project teams is on lowering ongoing mill costs. We are making excellent progress in reducing our overall reliance on high cost, cost of fuels, usage at our mills by expanding our biomass footprint to generating more power and steam from wood. Utilization of these various continuous improved process allowed us to take out approximately $18 million of operating cost from the system during the second quarter bringing our year-to-date total to over $36 million.

Let’s talk a little bit about our segments, first paperboard packaging. Within this segment are our food and consumer packaging and beverage packaging operations. Historically, the second quarter has been the softest quarter for our food and consumer products division as there tends to be a seasonal lull in advance of the back-to-school push which we typically start to see in mid July. End consumers have experienced the steady increase in inflation in the food gas category. For instance, the US Department of Labor reports that in 2008, year-to-date inflation for the food at home category is 5.6% compared to 3.5% for the same period in 2007. Increase in food and fuel costs are influencing the trends we are seeing on the food and consumer packaging side. Total industry growth in the major packaged foods category that we track to ACNielsen has slowed steadily this year to just 0.5% [ph] in the second quarter. Some of the major segments that we operate in such as cereal and frozen pizza have fared much better growing at roughly 3% and 2% respectively. Our dry food segment also grew at 2.5% in the quarter while the prepared frozen food category contracted almost 3% suggesting that consumers may be choosing lower-priced products in reaction to inflationary pressures. Our sales trends suggest that our major branded and private label customers seemed to be weathering this current economic storm much better than the smaller players in this space.

Our consumer packaging division had a number of successful commercializations during the second quarter. At Kraft we commercialized a new Z-Flute package for the planters’ warehouse product line. We also achieved success at Frito-Lay with our Z-Flute design for Stacy’s Pita Chips warehousing club packaging. With a combination of Graphic Packaging and Altivity, GPI gained printed E-Flute and F-Flute capability as additional options for our customers.

On the beverage side of the business, despite industry data indicating US beer volumes were flat to slightly negative and total US soft drink shipments were off nearly 5%, out total beverage sales were up 4% due to increased pricing initiatives, increased trends towards take-home versus on-premise consumption in a strong international market. We began to supply Inbev, special brewery in Germany, with both wraps and bottle carriers and we successfully introduced the first beer six-pack for glass bottles at Kyoto in Japan with a new wrap design for one of its premium brews. Within Brazil, a basket carrier was also the package format chosen by the Nobel brand making it the first permit paperboard basket carrier in that market. Overall South and Central American markets are showing a lot of potential going into the second half of the year. We are experiencing a migration from film towards paperboard packaging in this region.

Additionally, we continued to have strong success with the energy drink market which demonstrates a growth of 7% year over year for the quarter. For example, one of our biggest wins during the quarter was the Red Bull energy drink in Europe for our French vendor 12 pack designed for export back to the United States. Our plan to push the top line through innovation continues to be successful. During the second quarter just the legacy Graphicalone we experienced strong new product sales estimated at $21 million for the quarter. These results were led by our strength in new age beverage in microwave platforms, year to date our new product innovation sales are slightly more than $40 million for (inaudible) and Graphic. We continue to push our new product development to deliver value added solutions to our consumer and beverage customers.

Turning to Multi-Wall Bag, one of our newly created segments, we made solid progress in the quarter as sales grew significantly from prior year period. Our new Multi-Wall Bag management team has improved operating metrics and accelerated price recovery. Additionally, we are seeing favorable substitution trends back to paper-based bags from plastic as rising revenue cost had disproportionate impact to plastic manufacturers. We have announced significant price increases in this segment and traditionally lag time is far less than our paperboard suffers.

In closing to summarize, we are operating a challenging environment and are required to constantly reevaluate our business to ensure we are taking the correct steps to limit the impact of inflation and rising raw material cost. We believe that despite the inflationary issues there were solid fundamentals driving our business. Volumes remained solid with the focus on core food and beverage sector augmented by continuing success of our new product commercialization efforts. Inflation will remain an issue but the key input to fiber energy seemed to be relaxing from the torrid quarter two rates. We expect to see increase in price recovery through 2008 and into 2009 with already announced price increases and our synergy and cost reduction plans are ahead of schedule which will help drive improvement in margins. We are pleased with the progress that we have made thus far but we realize that we have a difficult road ahead; we remain focused on generating free cash flow to reduce our overall deposition and are confident in our ability to reach our goals.

With that I will turn the call over to Dan Blount for a detailed review of the financials. Dan?

Dan Blount

Thanks, David. Good morning everyone. Before I start, I would like to remind everyone that this is our first full quarter reporting combined results with Altivity. As we discussed last quarter, financial statements solely prepared in accordance with GAAP are not conducive to evaluating the financial performance of recently merged companies. Specifically our GAAP results do not look for run rate performance very well because they include non-recurring transaction cost and Altivity results only from the March 10, 2008 closing date forward. In addition our GAAP comparison to prior year is not very meaningful since it only includes legacy Graphicresults. To aid in understanding year-over-year financial performance, we prepared pro forma financial results that assume the combination with Altivity had been completed as of January 1, 2007. We believe the pro formas give us an apples-to-apples comparison to the prior year. We will use these pro formas to better guide us in our discussion of Q2 and year-to-date financial performance. Also as part of today’s discussion, we will reconcile the pro forma results to the GAAP results so you will be able to clearly tie out the source of our adjustments. As a further aid, reconciliation tables for our justice and pro forma results were provided as attachments to last night’s earnings release. Now after the operating performance review, we’ll provide comments on synergy delivery, cash flow, and credit agreement compliance.

First, a couple of comments about the preparation of the pro forma financial results. We used audited financial results from both Altivity and Graphics to prepare the pro formas that combine 2007 company results. The year to date 2008 results are also prepared pro forma to include Altivity results prior to the February 10 closing. Pro forma comparisons will include both revenues and EBITDA. Now before moving to the Q2 and year-to-date analysis, I will highlight our full-year 2007 pro forma numbers. With Altivity revenue of just over $2 billion and EBITDA of $173 million, pro forma 2007 consolidated combined company revenues totaled $4.4 billion and adjusted EBITDA totaled $513 million. 2007 pro forma adjusted EBITDA includes add-backs for non-recurring costs associated with the sale of our mill in Sweden. On a pro forma basis, the last 12 months LTM numbers are $4. 470 billion in revenues and $530 million in adjusted EBITDA.

Now, let’s move to second quarter and year-to-date financial performance. We’ll start with a reconciliation of pro forma adjusted EBITDA. Year to date 2008 straight EBITDA calculated from our GAAP financial statements is $205.1 million. As I stated before, this number includes non-recurring transaction costs and partial year Altivity results. After adjustments, year to date 2008 pro forma adjusted EBITDA calculates to $267.3 million. The $62 million of adjustment consists of one, the Altivity stub period of January 1, 2008 through March 10, 2008 EBITDA of $30.8 million and two, adding back non-recurring transaction related charges of $31.4 million. The transaction related add-backs are net of the $11 million share value gain on the interest rate hedging contracts assumed from Altivity. For the 2008 second quarter to get from straight EBITDA calculated from our GAAP financial statements to adjusted EBITDA, we added back net charges associated with the business combination of $9.1 million. This gives us a 2008 adjusted EBITDA for Q2 of $138.1 million.

With those comments, I have completed the reconciliation of the GAAP numbers to pro forma and adjusted numbers. We believe that the pro forma and adjusted 2008 and 2007 financial results we prepared provide a more accurate presentation of operating performance and therefore they will be used to describe financial results in the remainder of my discussion today. On a pro forma basis, reported operating results, considering the high inflationary environment show strong financial improvement. Here is a summary of our second quarter and year-to-date results. Second quarter net sales at $1.140 billion is 2.3% higher than 2007. Pro forma year-to-date net sales at $2.260 billion is 3.3% higher than 2007. Second quarter adjusted EBITDA at $138.1 million is 5.9% higher than 2007’s pro forma adjusted EBITDA of $130.4 million. Second quarter adjusted EBITDA margin improved by 40 basis points to 12.1%. Year-to-date pro forma adjusted EBITDA at $267.3 million is 15.8% higher than 2007’s pro forma adjusted EBITDA of $230.9 million. Year to date, pro forma adjusted EBITDA margin improved by 120 basis points to 11.8%.

Given this is the first quarter we are providing pro forma results fully incorporating Altivity, I will focus on comparing the financial results for the first six months of 2008 to the first six months of 2007. By doing so, we will be able to fully capture the second quarter as well as the first quarter numbers. As you know, we were not able to provide a combined company analysis during our last quarter earnings call. Given that we were still in the process of auditing Altivity 2007 results, concentrating on the year-to-date comparison will allow us to catch up with our reporting to you. Should you need additional data on just the second quarter numbers, please reference last night’s earnings release or ask a question during the Q&A portion of this call.

With that, let’s look at the details of the year-to-date net sales and adjusted EBITDA improvement. First net sales, on a pro forma basis, year-to-date 2008 net sales of $2.257 billion compares to 2007 pro forma net sales of $2.285 billion. The $72 million improvement was driven by improved pricing, improved product mix and foreign exchange rates. Pricing improvement reflects negotiated and contractual inflationary cost pass-throughs as well as price increases in open market paperboard sales. For the six-month period, higher pricing contributed $56 million. This price improvement by segment consists of $45 million in the paperboard packaging segment, $8 million in the Multi-Wall Bag segment and $3 million in our Specialty segment. Volume mix activity resulted in a net sales reduction of approximately $3 million. The small decline principally resulted from our decision to exit certain low-margin open market business in Europe and sales softness in certain consumer product packaging lines. Overall, beer volumes year on year were up 2%. The net EBITDA impact from the volume mix sales decline was actually slightly positive. As we have stated before, we continue to actively manage our mix by refocusing our assets towards higher margin, integrated packaging business. The remainder of the year-to-date pro forma sales improvement is from favorable foreign currency exchange.

Now, we’ll cover EBITDA. On a pro forma basis, year to date 2008 adjusted EBITDA of $267.3 million compares to 2007 adjusted EBITDA of $230.9 million. The $36.4 million of improvement results from $56 million of improved pricing, $76 million from improved performance, continuous improvement activities and other cost reduction initiatives. Approximately $40 million of the cost reduction resulted from continuous improvement programs and merger synergies. The remainder is from improved manufacturing performance and other cost reduction initiatives. Of particular note is the $10 million improvement we are seeing at our West Monroe, Louisiana mill as investments made in 2007 to upgrade the mill infrastructure are now paying dividends.

Overall year-to-date results show $132 million of improvement from price and cost reduction, offsetting a substantial portion of this improvement is $95 million of input cost inflation. The current rate of inflation is approximately double the rate experienced in 2007. We believe that inflationary pressure will continue to negatively impact results for the remainder of 2008 at a rate above the rate experienced in the first half of the year.

Energy costs are expected to be the primary driver of the inflationary increase either through direct purchase or through their impact on other raw material prices. While oil pricing has recently declined, it is still above the first half of the year’s average. In regards to natural gas, through June we benefitted from our hedge program and incurred natural gas costs of approximately $8 per MMBtu. For the remainder of the year, we are hedged 70% in the range of $11 to $12 per MMBtu. On an annual basis, we use approximately 13 million MMBtus of natural gas. In summary, based on our current view, we expect total inflation to be in the range of $230 million to $250 million for the full year of 2008.

With the high rate of inflation, the most important question is what does Graphic management expect the net impact will be on 2008 results? As David discussed, we expect price recovery from indexed escalators and sales contracts, negotiated price increases and open market board increases to offset more than 70% of 2008 inflation. The majority of this recovery however will be realized in 2009 due to the lag between inflation and price increase. For 2008, we expect full year price improvement resulting from the recovery of 2007 inflation and partial recovery of 2008 inflation to be in the $110 million to $120 million range. The remaining 2008 GAAP created by inflation is expected to be more than offset by our continuous improvement projects combined with the acceleration of other cost reduction initiatives.

In summary, looking at the cost reduction had to deliver and the price we expect to realize we project full year 2008 pro forma adjusted EBITDA will be improved over 2007 pro form adjusted EBITDA.

Before turning to cash flow, I will make a few comments about our integration process and synergy delivery. Through the end of June, synergies of $3.8 million have benefited financial results and we ended the quarter with annualized synergies in excess of $15 million. Our synergy teams are accelerating the timeline for delivery and the expected $90 million of benefits. By the end of 2008, we expect to have annualized synergies of $40 million to $50 million. Additionally, we expect to achieve the $90 million in annualized synergies by 2010, two years sooner than the 2012 we originally projected.

I will end my discussion with a few comments about cash flow, debt levels and the divestiture of the two CRB mills. As we communicated last quarter, we are tracking cash flow from April 1 going forward due to the financing of the transaction in March. As of the end of June, we had $319 million of availability under our $400 million of revolving credit facility and debt totaled $3.1 billion. Debt was reduced by $47 million during the quarter. Over the next two quarters, we expect to reduce debt by an additional $70 million to $90 million, which will bring debt reduction since the merger to the $110 million to $140 million range. This debt reduction projection only includes operating cash flows and does not include the sale of the two CRB mills. As David discussed, we recently entered into an agreement to sell the Philadelphia, Pennsylvania and Wabash, Indiana mills. The total sales price is $35 million, $28 million to be paid at closing and $7 million payable within two years based on an earn-out formula. The two mills combined have an annual EBITDA of approximately $10 million. The proceeds from the sale will be used to pay down debt.

In terms of other cash projection guidance, CapEx is expected to be in the $180 million to $200 million range for the full year. Year to date we have spent $83 million on CapEx. Cash interest is expected to total $200 million to $250 million. Year to date, cash interest expense was $87.6 million. Pension plan contributions are expected to total $60 million for the year, approximately $40 million more than the non-cash pension expense. Finally, as you may have noticed, we included our credit agreement to EBITDA calculation in our earnings release. We are currently and expect to continue to be comfortably within compliance with the consolidated secured leverage ratio.

With that operator, we will open the line for the question-and-answer session.

Question-and-Answer Session

Operator

(Operator instructions) your first question comes from Vic Kumar from South Coast Partners. Your line is open.

Vic Kumar – South Coast Partners

Hi guys, great results. Just wanted to ask about the interest rate swap that you guys mentioned in the press release and in the call earlier, what exactly is that and what is the expectation on that going forward?

Dan Blount

What happened there is we inherited about $550 million interest rate swap from Altivity during the merger of the two companies. We did not get hedge accounting on that swap during the first quarter and that caused us to have to market to fair value and that resolved in $11 million gain for the quarter from the fair value mark to market on the swap. Since that time, you will not see a mark to market as we are qualified for hedge accounting on that particular swap, so it will not really impact financial results going forward.

Vic Kumar – South Coast Partners

So, it will just be hedging your interest expenses going forward?

Dan Blount

Yes, it hedges the great expenses going forward and since we get the hedge accounting, the mark to market will go through equity rather than through P&L.

Vic Kumar – South Coast Partners

Got it. Then the last question I had is what are your thoughts now that on the total I guess integration expenses to get everything integrated and to achieve your synergies over the next couple of years?

Dan Blount

As we put out, overall we had guidance of about I think in terms of overall CapEx it was about $200 million this year. We expect spending next year to be in about the same range and then we will come back in 2010 to more of a normalized range to $150 million to $160 million for CapEx. So, overall in terms of CapEx, that increase that we are experiencing is really the result of integration type activity.

David Scheible

This is David Scheible. You may have seen our announcement on the Kalamazoo expansion for example. We spent $27 million in that facility that will allow us to consolidate a number of other facilities, moves and process and create a much lower cost overall carton facility and that is really where a lot of – those are the kinds of projects that we are spending, in fact, that’s probably the single biggest CapEx project we have relative to integration plans. So, that is one of the reasons we did it first.

Vic Kumar – South Coast Partners

So, that is the CapEx, what about I guess through the P&L, are there any additional expenses to think about or?

Dan Blount

Yes, there are going to be additional expenses to the P&L. We have done it in two ways. In the purchase accounts, we were able to put some reserves up from shut down in some of the Altivity locations and that if it impacts really our Graphic Packaging legacy location, it will flow through the P&L. But if you look at those overall numbers, there is going to be an impact, I would put out a number of $30 million to $40 million from those activities. Also what we need to consider when we talk about the cash impacts is when we exit a location that creates a location that is available to be sold so we should have some additional cash from really sale of our plant locations going forward as well and additionally we should have benefits from working capital reductions at the same time. So, I don’t think the $30 million to $40 million will translate into actual cash reduction going forward, I think it will actually be up when we consider all three of those components.

Vic Kumar – South Coast Partners

The working capital and –

Dan Blount

And the sale of the plant locations that we are vacating.

Vic Kumar – South Coast Partners

Okay, those are my questions, thanks guys.

David Scheible

Sure.

Operator

Your next question comes from Mark Kaufman from MLK Asset Management. Your line is open.

Mark Kaufman – MLK Asset Management

Hi, I was just wondering if you could comment on the Inbev and Anheuser-Busch combination and how that might impact you or what opportunities you might get from that?

David Scheible

Well, I won’t certainly talk much about Inbev and AB specifically for what they are doing but Inbev is a large company of ours in Europe, AB is an important customer here. Really, if you look at our beverage business in the last three years, we have seen nothing but a number of combinations SAB acquiring Miller, Molson Coors and then now SAB, Coors Molson and in every one of those combinations we fared pretty well. As Dan said in his results, beer volume, take-home volume was up. Our mix has improved in that space. So, overall, the consolidation in that space has been a positive for Graphic Packaging, I see no reason why the Inbev and Anheuser-Busch combination won’t be the same thing.

Mark Kaufman – MLK Asset Management

Thank you.

Operator

Your next question comes from Kevin Doherty [ph] from Prospector, your line is open.

Kevin Doherty – Prospector

Hello, how are you? Congratulations on the quarter.

David Scheible

Thank you.

Kevin Doherty – Prospector

Just wanted to talk a little bit more about the nature of the contract resets next January, how do those work on average and what percentile of overall inflation would you expect to be captured at that point?

David Scheible

I won’t talk about individual contracts, tell you in general, the escalator process is really made of a couple of different ways. Some of them are directly through board inflation, so as board prices move up, being as board is over 70% of the total cost, they tend to drive the escalators of the reset. Some of the more recent contracts are actually built on cost so as our actual costs go up for fiber, energy or chemicals, then with the lag as the number reset then the customer – we translate that into increase in the selling price. As Dan said, this year we are averaging a little over 50% recovery of our inflationary impact and the primary reason is because it is really sort of unprecedented to see the kind of inflation impact we have had in a single year. So, the contracts are really aimed towards sort of – as inflation rolls up one year it looks basically the same as the following year and therefore you get a high level of recovery. This year we are only going to see about 50% but as Dan said, by the end of 2009, we will see over 70% of the inflationary impact that we will see in ’08 and ’09, we are covered through pricing. Then with continuous improvement result in synergies, you would expect the overall margins to improve as EBITDA in the year to date is sort of an indicator of where the inflation will be rolled through our business and price recovery. About 70% of our business is under contract, some sort of a long-term contract. That number for those of you that call legacy Graphic is down in the past we were well into the mid 80s. So it has changed a little bit, that means more of the business is open or it is done on a transaction basis or it is more open market board which tends to be not under a contractual environment. So businesses like Multi-Wall Bag and some at the open market tend to recover prices faster. We will have to sort of see what the experience is for that because some of that is obviously new for this management team.

Kevin Doherty – Prospector

Thank you.

Operator

Your next question comes from Jeff Harlib from Lehman Brothers, your line is open.

Kishore – Lehman Brothers

Hi, this is Kishore [ph]. Just had a couple of confirmations, the $110 million to $140 million free cash flow number you gave, is that after CapEx and the asset sale proceeds, can you please confirm those?

Dan Blount

You want me to repeat the numbers? I didn’t understand you completely.

Kishore – Lehman Brothers

Yes.

Dan Blount

Okay. The guidance I gave is $110 million to $140 million for the year in terms of debt reduction.

Kishore – Lehman Brothers

That’s after CapEx

Dan Blount

After CapEx, that’s correct. The numbers we gave for the asset sale was a sales price of $35 million, $28 million will come up on the closing day we expect that to happen in 2008 and $7 million will come about based on an earn out formula that could go out as long as two years.

Kishore – Lehman Brothers

Okay, thanks.

Operator

Your next question comes from Ashwin Reddy from Vernor Capital [ph]. Your line is open.

Mike Ortel [ph] – Vernor Capital [ph]

Hi guys, it is Mike Ortel. Quick question, just on your $90 million of synergies, can you talk a little bit about kind of if that number could actually be exceeded and in the past if you have ever, when you did kind of Riverwood graph how that went down from your original guidance to where you ended up?

David Scheible

As we reported already, that $90 million was originally expected to be achieved by 2012. So, we’ve accelerated the achievement to almost two years. Our experience in Riverwood Graphic combination was that we did in fact exceed our external synergy targets. It is somewhat a different market at that point in time. We certainly were dealing with a $120 oil and $11 natural gas but I will tell you if you look at where our synergies are coming from, some of them are in purchasing and a number of them in overhead reduction and also plant rationalization. Those synergies have been very solid and in fact they have been accelerated. As we have combined the two facilities, the two companies, there is a lot more overlap in manufacturing capabilities in this merger than there was in Riverwood. So, what we are finding is we are operating those plants more efficiently than we originally expected which allows us therefore honestly to operate less facilities than we originally expected. So, some of the synergies will come from accelerating plant closures and potentially additional plant closures that originally we thought we might need to operate but based on operating metrics we just will not need to. So, I feel good about the synergy number and the acceleration that we are seeing right now.

Mike Ortel – Vernor Capital

How much did you exceed the synergies back at the last transaction from the original amount?

David Scheible

We exceeded it by a substantial amount, at the last transaction it was closer to double actually. But if you look at the way we actually run the synergy program, first off, the $90 million is at the low end of our synergy range and I think we have told you that before. Secondly, the way we operate this, we have a huge pool of synergy opportunities from which to pick and the $90 million is the projects, are really in process at this point. So, can we go above the $90 million, the answer is definitely yes, and the other guidance we will give you on it is the $90 million is really at the low end of our range.

Mike Ortel – Vernor Capital

One more question for you guys. Dave, we had talked to you guys about just kind of the transition from kind of the cardboard containers that were holding beer bottles to kind of the CUK packaging and just kind of increasing just overall volumes and market share because of that, do you think you could talk a little about the progress for that, kind of how you foresee that continuing over the next couple of years.

David Scheible

Certainly we made progress in this quarter. Of course it is interesting because when we started all the projects before, Graphic Packaging only made CUK products and didn’t make, as you said, the corrugated construction. But of course one of the manufacturers of some of that corrugated volume ended up being Altivity. So, we sort of had an improvement in mix and an improvement in gain on the CUK side but that business in corrugated part of it was in our mix, so we sort of swapped that out. But I will tell you what we are seeing in the trends that I mentioned is the plastics right now both films and other core petrochemical based plastic alternatives, we have seen a much higher rise in their cost and ours too from that perspective. We buy a lot of films and (inaudible) and that side of our business has seen unprecedented increases. So, what that translates into as you are seeing more demand in fiberboard, as customers are looking at transitioning from plastics to fiberboard, I mentioned in my comments that even in Latin America, which has traditionally not been a huge fiberboard market certainly in beer, you are starting to see new packages show up in fiber. So, I think our trends are going to be really more around fiberboard transition from film as far as a long-term driver versus just sort of moving from corrugated to solid fiber. I did mention in the quarter that outside of beverage and Z-flute, we saw additional transitions and that is basically the same phenomena, that is moving from a corrugated, laminated structure to a Z-flute, which is a solid fiber and we had great progress in that. So, that trend continues but I think at this point in time we are also seeing the underlying trend of plastics being incrementally disadvantaged if you will to fiberboard inflationary impacts.

Mike Ortel – Vernor Capital

Just finally, can you just repeat a few, if you have already done so just the capacity utilizations you are seeing in CUK and CRB right now?

David Scheible

You mean ours – actually our CUK mills are pretty tight from a capacity standpoint, our operating REITs are well in the upper 90s. In our CRB mills, in light of some of the capacity take-outs that is occurring and customers adjusting for that, that capacity utilization has also moved up dramatically. I am encouraged by CRB because lead times are going out, backlogs are building but we will watch that pretty carefully as we go into the second half of the year. I am certainly not declaring victory on the CRB side of the equation but our (inaudible) has been very, very strong.

Mike Ortel – Vernor Capital

Thank you.

Operator

Your next question comes from Vic Kumar from South Coast Partners. Your line is open.

Vic Kumar – South Coast Partners

Hi guys, I just wanted to ask a follow-up question which is I guess I want to get a sense for your contracts, let’s say inflation in 2007 had been similar to 2008, what sort of percent of inflation would be covered? I know this year you said it will be 50% because inflation is a lot higher but I want to get a sense for what they are in a normalized basis if inflation is similar from one year to the next?

David Scheible

If you crack our results over the last couple of years, we are seeing increased recovery from pricing. We used to really in many – back in 2004, 2005 time we actually had price reductions and inflation going up so our recovery was well below 20%. We have been averaging over 50% the last couple of years and is down going forward. We think by the end of 2009, we will get over 70%. So our price recovery is accelerating with the new structure in those contracts.

Vic Kumar – South Coast Partners

So do you think of 70% as sort of normalized to what we should expect going forward?

David Scheible

You know, talking about normalized is difficult in this environment. So, what I would tell you, based on what we think our inflationary impact that’s a good number. But oil is $120 today, was $147 and I have got people telling me it could be $200. So, it is really difficult to hound [ph] in what I would say is right now, based on what we believe inflation will do, we are looking at 70% plus recovery of our inflationary cost in pricing by the end of ’09. That’s about as good as I can do at this point.

Vic Kumar – South Coast Partners

Does that assume something like oil going up to $200 or –

David Scheible

No. I am planning my business on $200, but I am certainly recognizing where oil has been and recognizing that we have to be able to deal with oil at elevated prices.

Vic Kumar – South Coast Partners

Okay. Thanks.

Operator

At this time, there are no more questions.

Scott Wenhold

All right, Mendy. Thank you everyone for joining us on Graphic Packaging Holding’s second quarter earnings call. Thank you.

Operator

This concludes today’s call. You may now disconnect.

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Source: Graphic Packaging Holding Company Q2 2008 Earnings Call Transcript
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