Graphic Packaging Holding Co Q3 FY2021 Earnings Call

Hello everyone. Welcome to the Graphic Packaging Third Quarter 2021 Earnings Call. My name is Harry, and I'll be your operator today. I'll now hand the call over to your host, Vice President of Investor Relations, Melanie Skijus. Melanie, please go ahead.

Good morning and welcome to Graphic Packaging Holding Company’s third quarter 2021 earnings call. Joining us on our call today are Mike Doss, the company's President and CEO; and Steve Scherger, Executive Vice President and CFO. To help you follow along with today's call, we will be referencing our third quarter earnings presentation which can be accessed through the webcast via self-directed slides and also in the Investors section of our website at www.graphicpkg.com. Before I turn the call over to Mike, let me remind you that today’s press release and the presentations made by our executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections. These risks and uncertainties include, but are not limited to, the factors identified in our filings with the securities and exchange commission. Now, let me turn the call over to Mike.

Thank you, Melanie. Good morning to everyone joining us on the call and webcast this morning. Our performance in the quarter was strong. We successfully navigated a complex supply chain and labor environment. We raised prices where necessary to offset accelerated commodity input cost inflation. We received the required regulatory approvals for our AR Packaging acquisition and made significant strides towards completion of our transformational CRB platform optimization project. All of these accomplishments are aligned with the goals we established with Vision 2025 and have us on track to meet or exceed our long-term aspirations for the business. Demand for more sustainable and circular packaging options continues to accelerate globally. The ongoing evolution to practice and promote more environmentally responsible behaviors is evidenced by the increasing number of new pledges made by global corporations to eliminate waste and increase the focus on recyclability, all supportive of commitments to lowering carbon footprints. The examples include proactive announcements by retailers around the world moving to minimize the impact that packaging has on our planet. Consumers are making their preferences known, and companies that are serving them are responding to fiber-based packaging solutions we are developing, which provide consumers with packaging choices to promote a more sustainable and circular economy. This gives our employees an immense sense of pride, which shows through our continued innovation in new product development initiatives. We’re establishing Vision 2025 in September of 2019, and have demonstrated a very real pivot to organic growth since that time. While Q3 organic sales declined slightly, we still expect to deliver organic sales growth in 2021 at the high end of our 100 to 200 basis points annual target on top of the 4% organic growth we generated in 2020. Moving forward, we've been successful in positioning the company to capture growth opportunities in this very strong demand environment—we're growing with existing customers and ramping up with new ones in new markets. Momentum for fiber-based consumer packaging solutions is materializing at a time when we’re experiencing unprecedented inflation, supply chain bottlenecks, and labor market challenges. We estimate that the constraints in supply and labor markets resulted in approximately $25 million in delayed sales in the third quarter. We delivered strong adjusted EBITDA growth of $284 million, up 14% year-over-year. EBITDA growth was driven by positive price realization of $53 million and favorable net performance of $79 million, which offset unprecedented commodity input costs inflation of $88 million experienced in the quarter. The current environment, with all its twists and turns, is not deterring us from our focus on meeting or exceeding our Vision 2025 goals and capturing global demand for sustainable packaging solutions. Our dedicated teams are working tirelessly to keep customers supplied, as backlogs remain elevated across all our paperboard substrates. As a result of the continued inflation and commodity input costs, we have taken swift pricing actions to recover the price-cost dislocation we are experiencing this year. We committed to you that price would offset commodity input costs over time, and that any dislocation would be short-lived. We are delivering on that promise. Approximately $650 million in pricing initiatives have been implemented and will be recognized over the 2021 and 2022 time horizon. We recently published our latest comprehensive ESG report, outlining the many initiatives underway to further drive sustainability across operations and innovation in product development with the end customer in mind. We intend to continue investing in innovation and promote progress in sustainability to support the migration to a more circular economy. We have been pursuing the required regulatory approvals for the AR Packaging acquisition announced in May of this year. I'm pleased to report that we have received the final regulatory approvals this month, and we are working towards the November 1st close. Our CRB platform optimization project remains on track for the startup of coated recycled paperboard production on our K2 machine in the fourth quarter. Turning now to additional highlights from the third quarter—our innovation powerhouse combines AR Packaging to create a large distributed footprint with 25 converting facilities across Eastern and Western Europe, offering significant scale and cost efficiency benefits. The completion of this transformational acquisition extends our global reach, expands our service offerings, and advances our commitment to sustainable packaging solutions for customers around the world. We intend to share our growth plans and milestones for the integration of AR Packaging along with an update on Vision 2025 when we report our fourth quarter and full year results. We look forward to hosting many of you in person at an investor meeting on February 17th in New York City and providing a webcast for those unable to attend remotely. I'll now turn the call over to Steve.

Thanks, Mike and good morning. Moving to Slide 9, let’s focus on key financial highlights. Net sales increased 5% or $84 million from the prior year period to $1.8 billion. This year-over-year increase in sales was driven by higher pricing flowing through the business and acquisitions. Adjusted EBITDA increased 14% to $284 million, resulting in an improved adjusted EBITDA margin of 15.9%. Adjusted earnings per share grew 31% to $0.34 a share. Finally, our integration rate increased to 73% as we continue to internalize all paperboard into our converting operations. On Slides 10 and 11, you’ll see our revenue and EBITDA waterfalls. The drivers of the 5% year-over-year increase in sales were $53 million in pricing, $20 million of higher volume mix, and $11 million of favorable foreign exchange. Adjusted EBITDA increased $34 million or 14% year-over-year to $284 million in the third quarter versus the prior year period. The increase is notable given accelerated commodity input cost inflation, which materialized in the quarter. Adjusted EBITDA growth was driven by $53 million in pricing, $3 million in volume mix, and $79 million in improved net productivity. Adjusted EBITDA was unfavorably impacted by $88 million of commodity input cost inflation and $13 million of labor. To add additional financial and market detail, our Food Service business continued to recover from last year, growing 11% year-over-year, while food, beverage, and consumer sales improved 3% including acquisitions. Mike pointed to $25 million in delayed sales resulting from supply chain and labor market constraints during the quarter. All supply chain bottlenecks impacted all areas of our business, with labor availability challenges being more specific to our Food Service business as we continued to ramp up production from declines experienced in 2020. Without these delayed sales, our sales growth would have been flat for the quarter in line with our expectations. AF&PA industry operating rates were strong again in the third quarter, with CRB at 95%, while SBS improved sequentially to 96% at the end of the quarter. Our CUK operating rates continued to be well above 95%. These operating rates reflect the strong demand environment for paperboard. AF&PA third quarter data also revealed continued declines in industry inventory levels, with balances at multi-year lows. Backlogs are elevated at eight plus weeks across the UK and CRB and over six weeks in SBS. We ended the quarter with net leverage of 3.97x. We have clear visibility to bring leverage down to 3.5x or lower at the end of 2022, after it peaks in the fourth quarter due to financing for the AR Packaging acquisition. Global liquidity was $1.8 billion at the end of the third quarter. Importantly, after we fund and complete the AR Packaging acquisition, our global liquidity will remain substantial with approximately $1 billion available. Turning now to full year 2021 guidance on Slide 13. We’ve updated our guidance to reflect additional price actions, higher commodity input cost inflation, higher net performance, and the assumption AR Packaging will be part of our business effective November 1. 2021 adjusted EBITDA is projected to be in a range of $1.04 billion to $1.06 billion. The component for the EBITDA guidance change is the accelerated commodity input cost inflation occurring in the second half of 2021. As Mike mentioned, we are actively taking the price actions necessary to offset this increased level of inflation. We anticipate cash flow will be in a range of $100 million to $150 million for the year. Capital spending has increased modestly due to inflation across raw materials and the labor required to complete critical strategic projects on time. On Slide 15, I will wrap up my prepared remarks with a look into 2022. We continue to be confident in the guardrails we provided last quarter for adjusted EBITDA in the $1.4 billion-plus range. Importantly, on this slide, you can see the components and the walk to the substantial estimated EBITDA growth we will be driving next year. AR Packaging and Americraft are expected to contribute $160 million and $30 million before synergies, respectively. For the base business, it is reasonable to assume at least $20 million from our traditional EBITDA drivers of volume mix and net performance, more than offsetting labor, benefits, other inflation, and foreign exchange. The first $50 million of incremental EBITDA from our Kalamazoo project and a minimum recovery of $170 million of 2021 price cost dislocation provides a clear step change higher to adjusted EBITDA of $1.4 billion-plus in 2022. This significant expected growth in EBITDA, coupled with our commitment to meaningfully lower capital expenditures next year following the large capital project at Kalamazoo, results in significant cash flow generation. The material EBITDA growth and cash flow generation projections give us visibility to year-end 2022 leverage at 3.5x or lower. We look forward to providing you with more detailed 2022 guidance when we meet with you in February. Thank you for your time this morning. I’ll now turn the call back to the operator for questions.

Thank you. Our first question comes from Mark Wilde of Bank of Montreal. Mark, your line is now open for your question.

Thank you. Last quarter I believe you indicated that the rollover impact from inflation at that point in time to 2022, you would have gauged at roughly $50 million to $75 million if I remember correctly. If you were to update that number today, where would it stand?

Hey, Mark. It's Steve. Good morning. Yes, we’ve updated obviously for this year, the inflation now midpoint of $310 million and the rollover effect is in the $100 million to $125 million range, assuming everything stays as is. So the cumulative two-year inflation right now is in the $400 million to $425 million range. Obviously, we shared with you today that our cumulative price activity over that same period of time is the $650 million that we shared with you today.

Okay, great. And so just to make sure I fully understand that. So I think you had – just trying to get to side, here we go. So you talked about $510 million on the pricing side for 2022 recognizing that there certainly can be a lot more inflation or not from where we are today. So if we think about the price cost, if things were to be fixed today, can we take the $510 million and subtract the $100 million to $125 million and that would be a starting number for 2022, again, recognizing that we can get more inflation here. Is that fair? Or am I missing something?

Well, I think the way you want to make sure you think about it Mark is we have very clear line of sight to $510 million of pricing next year based upon known and recognized activities. That’s roughly $250 million a ton across the three primary substrates along with our cost models. So if you compare that, of course, to the flow-through on inflation, you’ve got $310 million this year, another $100 million to $125 million next year leading into the low 4s. Therefore, we need to, as we committed on the slide with the – to the $1.4 billion plus is that we’ll first recover the $170 million of dislocation this year and then whatever inflation comes next year, obviously we have plans in place to recover that as well. The $100 million to $125 million is what would be known carryover today. Does that give it to you specifically?

That does. Thank you very much. Okay, great. And just lastly, if I could. Level of confidence in getting that $510 million on pricing, is that pretty contractually established? How much work is needed to achieve bringing those numbers to the bottom line? What level of confidence should investors have about that at this point?

Yes. Good morning, Mark. It’s Mike. They should have a high level of confidence and this is contractually driven. These are multi-year contracts, so it’s flowing through an execution of the contractual terms of those agreements.

Thanks, Mark.

Thank you, Mark. Our next question comes from Ghansham Panjabi. Ghansham, your line is open now if you’d like to proceed with your question.

Yes. Thank you. Good morning, everybody. Just as a follow-up to Mark’s question, can you comment on the velocity of inflation that you’re seeing currently versus how things were recently? I know there’s a lot going on with OCC for labor and random events like the China curtailments that are affecting other industries. But at this point, are you starting to see a plateauing sequentially?

Yes. Good morning, Ghansham. I’ll start. This is Steve, and Mike can add on. I think certainly what we saw throughout the quarter was an acceleration of inflation. As we've discussed during the quarter on occasions where we had the opportunity to do so, we took more pricing action, which kind of flowed through in the incremental $100 million of inflation since last time. The inflation has been widespread; about $100 million, half of it is well chronicled relative to chemicals, energy, and resin all moving up. We also saw OCC move up, which was another significant part of the $100 million. Of course, the ongoing challenges on the logistics front in terms of rates for truck, rail, and ocean have also contributed. The $120 million we’re guiding for Q4 is representative of what we’re seeing today. Obviously, we don’t try to hypothesize whether they’ll move up or down from here. Mike, anything you want to add to that?

No. I think what you’ve seen Ghansham is that with OCC it has kind of moved up for 11 months in a row, and in the last couple of months, it’s shown signs of plateauing. We’re closely monitoring such matters. However, as Steve said, it’s quite challenging to predict future inflation. Each month brings new commodity challenges. Investors should look at our pricing actions as delineated by Steve; we’re positioned well for whatever inflation emerges moving forward.

Okay. That’s very helpful. Thank you for that. And then for my second question, every inflation cycle has customers trying to mitigate price increases to consumers by reducing packaging size and also decontenting material to some extent. How do you see that dynamic playing out in the current inflation cycle, which is much more severe in magnitude? Do you see the lightweighting and packaging size shift as a volume risk for you in 2022? Thanks so much.

Yes. Thanks for that question. I appreciate it. I think if you look at packaging in general across a wide swath of different mediums, they’re all inflating at relatively similar rates. The substitution piece will likely be minimal based on our observation. In terms of lightweighting and packaging optimization, these are issues that we discuss with our customers regularly, and actually create some opportunities for us, particularly on the fiber-based side. We actually see that as more of an opportunity than a threat going forward.

Okay, great. Thanks so much.

Thanks, Ghansham.

Thank you, Ghansham. Our next question comes from George Staphos from Bank of America. George, your line will be open now if you would like to proceed with your question.

Thanks very much. Hi, guys. Good morning. Thanks for all the details. I wanted to ask two questions: one on volume and then the other on Kalamazoo. In terms of volume, you documented pretty well what you were affected by in the third quarter concerning lost revenue. A lot of that impact hitting you appeared to be food service. What comfort do you have that the supply chain and labor issues that affected you will moderate here such that volume should be as expected in the fourth quarter? And aside from food service, can you talk a bit about where you’re seeing particular strength for your products, especially the new products? And I ask that partly in response to some recent news content where one of the major QSR chains is moving from a poly-coated paper cup back to plastic. So, where do you stand with your defense of that transition with a PLA-coated cup?

Yes. Thank you for that, George. If you take a step back, and we’ve outlined this a little in our prepared comments, year-to-date through the second quarter, we saw our volumes up 3% across the board. As you remember, we reiterated that point in our high-end expectations of 100 to 200 basis points. As Steve mentioned in his comments, we anticipated challenges in Q3. Four key factors impacted organic volumes declining by 1%: customers faced supply chain challenges, labor availability affected our food service side and significant delays, specifically linked to Hurricane Ida, which flooded a Northeast facility for two months. While we encountered noticeable difficulties, we expect these issues to moderate as we advance into the fourth quarter. We have solid demand across our markets and have made progress towards staffing, so we anticipate volume growth aligning closer to the higher end of our anticipated 100 to 200 basis points leading into the new year.

To add to Mike’s point, our momentum in fiber-based conversions—such as the continued conversion of foam cups to fiber-based solutions or KeelClip solutions expanding globally—implies substantial growth opportunities. We are inclined to maintain our organic growth targets as we step into 2022.

I guess, Steve, I was hoping for an update on PLA-coated cups. If you have that, well, maybe you’ll save it for the analyst presentation in February. Then my second question quickly—I commend you on keeping the Kalamazoo project on track, earlier than your initial budgeting and guidance. There have been reports about community reactions to Kalamazoo's growth. Can you comment on how you're being received in the community? There’s also been discussion around your tax benefits from the facility—anything we should be aware of in terms of how the project will drive return and growth for Graphic going forward?

Yes. Thank you for the question on our project. Yes, we're on track to begin paperboard production in the fourth quarter. Given the strong demand for customers, it’s crucial that we start producing. We’ve encountered some odor complaints, but I’d characterize those as normal course of business—we’re managing them through the standard channels. The return on our investments exceeding $600 million in this state-of-the-art facility, which is vital for community engagement, jobs, and production growth.

As for the customer trials regarding PLA-coated cups, we are optimistic about the momentum we’re seeing. We’ll share more in February when we present our overall innovation efforts.

Sounds good. Thanks, guys. Good luck in the quarter.

Thank you, George.

Thank you, George. Our next question is from Mark Wilde from Bank of Montreal. Mark, your line is now open, if you’d like to proceed with your question.

Yes. Good morning, Mike. Good morning, Steve.

Hey, Mark.

Mike, I just want to start, if you could help us just unpack what’s been happening in the cardboard market over the last three to six months, because it’s been a significant shift in the market. Please provide insight to how you understand the uptick in domestic demand set against challenges importing bleach board or recycled CRB.

Yes. Thanks for that, Mark. Part of your inquiry holds true. Additionally, please recognize that in 2019 and early 2020, some capacity was removed from the market; one of our competitors shut an SPS mill down, another one closed a paper machine. Concurrently, we have robust demand, having seen compounded volume growth at 3% in the last two years, and a market share approaching 40%. The shipping obstacles that some importers face have led to an increased demand for domestic production, hence the high operating rates at 95% to 97%. Backlogs are at multi-year highs and industry inventories, as Steve indicated, are down significantly. This is the dynamic at play; the timing of the Kalamazoo project aligns perfectly given the growing demand.

Okay. And then just a couple of questions regarding Europe. Last year you faced some machine placement delays, can you elaborate on your current status? Furthermore, what is the impact of European energy price spikes on both your existing and AR businesses?

Yes. Thanks for that, Mark. Currently, machine placements are going smoothly—we have nearly 60 machines operational on the KeelClip side, on top of additional machines that do wraps and baskets. This increase signifies an important growth area for us this year. Concerning energy rates in Europe, as you know, we primarily focus on converting operations there, even with AR Packaging being involved in converting only. Therefore, the impact of natural gas costs on direct operations is comparatively limited. We may face cost surcharges from paperboard purchases, which will be passed along as we mentioned earlier in our communications. These tenders tend to be shorter duration and more frequently adjusted to market shifts.

Okay. That’s helpful. I’ll turn it over. Thanks, Mike.

Thanks, Mark.

Thanks, Mark.

Thank you very much, Mark. Our next question comes from Gabe Hajde from Wells Fargo. Gabe, your line will be open if you would like to proceed.

All right. Good morning, Mike and Steve. Thank you. I hate to focus on the inflation point here, but you are discussing how the industry is trying to preserve margins; price increases are encouraging. However, I want to stress-test the assumptions you provided for the fourth quarter regarding inflation and heading into 2022. Even just in the fourth quarter, or second half, I’d suggest it may be $120 million for the quarter and $210 million for the second half, while you're estimating $100 to $125 million for next year. Is there timing or cadence inherent that suggests things ease in the second half of 2022? Furthermore, regarding labor and benefit-related costs that typically run around the $50 million range, could that run higher at around $60 million, considering the current labor climate?

Yes, Gabe. It’s Steve. To respond to your second question, we anticipate our labor and benefits inflation to trend at the upper end of our historical range for next year. It’s consistent with the realities we've discussed regarding labor availability and wage inflation. Addressing your inquiry regarding commodity input cost inflation: we’re not forecasting specifics for 2022 at this point. However, we acknowledge that much of the acceleration happened in the second half, yielding around $200 million plus. If we assume current circumstances remain stable, carryover concerns would land between $100 million and $125 million, primarily owing to second-half inflation from the previous year.

Okay. And again, sticking with inflation—apologies for being repetitive here. Food and beverage brand owners are discussing potential 20% to 25% inflation as they push that through grocery channels. How have consumers reacted in the past? Should we expect trading down, and would that potentially be a net positive or risk for you going into 2022?

Yes, Gabe. Thanks for bringing that point. It’s a great question. The truth is, we haven’t seen this level of inflation and its impacts before—it’s been decades since we’ve experienced such commodity inflation shocks. I’ll point out that 95% of our production is aligned with food and beverage needs; thus, even as consumers may pivot towards store brands over branded items, the innate human necessity of food and drink remains unchanged. Our diversified portfolio strategically positions us regardless of evolving consumer preferences. However, inflation will indeed be prominent moving forward.

To add onto Mike's comment, the times when the economy slows due to inflation or other factors, our business has historically been defensive. There may be some headwinds, but trading down can also be beneficial to us. Shutdowns on total consumption tend to be modest as a percentage, supporting our confidence in achieving our Vision 2025 growth intentions.

Thank you, guys. We're trying to remain vigilant over here.

Yes, absolutely.

Thanks, Gabe.

Thank you, Gabe. Our next question comes from Adam Samuelson from Goldman Sachs. Adam, your line is open if you’d like to proceed with your question.

Yes. Thank you. Good morning, everyone.

Good morning, Adam.

I was hoping for additional context on the performance this quarter, specifically the net performance line, which contributed positively by $79 million in the third quarter. When we examine historical data, this is among the most substantial quarterly figures you’ve reported. Can you provide a breakdown of this number? Much of your commentary outlined challenges in labor and mill outages rather than productivity gains; thus, I'd like clarity on how you've mitigated some of these cost pressures operationally.

Yes, Adam, it's Steve. I’ll gladly clarify. The headwinds we've described manifested primarily as volume impacts rather than core productivity. We were pleased with our productivity overall; the performance was quite remarkable due to two primary drivers: first, we achieved solid core productivity at $34 million, as expected; second, we encountered significantly less maintenance downtime year-over-year. The vast majority of downtime last year was a concern, which has improved this year and positively impacted productivity numbers.

That’s very helpful. There's been much discussion regarding the pricing-cost dynamic throughout the call. However, as we sit currently and evaluate future movements in commodity markets, have you observed any chemicals starting to decrease, or are these rates more stagnated? Where are you finding the most challenging pockets in the second half of the year?

Yes, Adam, it’s Mike. Regarding your inquiries, I’d suggest that secondary fiber seems to be plateauing. It’s difficult to predict if it won’t rise again, but we’ve observed this trend for a couple of months following its upward trajectory for eleven months straight. In the case of some polyethylenes such as low-density polyethylene, we’ve also seen a slight decrease, though prices remain elevated. We’ve also experienced growth in hardwood and other categories with wood inflation, and all of these factors are incorporated into the forecasts Steve presented for both Q4 and 2022.

Okay. That color is really helpful. I’ll pass it on. Thanks.

Thank you, Adam. Our next question comes from an unidentified analyst from Truist Bank. Michael, your line is open if you would like to proceed.

Thanks very much. Good morning, Mike, Steve, Melanie. I appreciate you taking my question.

Good morning, Michael.

I want to touch quickly on labor. Obviously, there’s a lot of discussion about input cost inflation. You mentioned an impact in food service, specifically given prior layoffs and attempts to rebuild a workforce. Can you talk about your strategies to attract labor? Additionally, have the vaccine mandates influenced labor supply?

Absolutely, that’s a relevant point, Michael. We’ve implemented several actions to attract the talent necessary to operate effectively. We’re offering significant sign-on bonuses along with employee referral bonuses to leverage community networks. It composes a host of tactics, including competitive wage rates for entry-level roles and striving to be an employer of choice within our operational communities. I remain confident we can bolster our staffing levels over the next quarter or two, especially in food service, as many hires are critical to respond to volume needs.

Understood. And quickly on sustainable packaging solutions, could you share insights on commercialization progress regarding these products? Understanding incremental revenue or EBITDA would be particularly useful to help us gauge the potential for growth in sustainable packaging.

I appreciate the question, Michael. Our strategy is centered around three key growth platforms: plastic replacement opportunities, enhanced cooking solutions, and strength packaging. We’ve introduced a clear addressable market, estimated at $7.5 billion, which we’ll update during our February meeting. Our ventures enable faster access to market opportunities, offering great confidence in achieving our 100 to 200 basis points organic growth target. We’ll detail new examples in February regarding our sustainable packaging advancements.

Thanks, and good luck in the quarter.

You bet, Michael. Thank you.

Thank you everyone for joining us today. This concludes the call and you may now disconnect your lines.