Earnings Call Transcript - PKG Q3 2022

Mark Kowlzan, Chairman and CEO

Thank you, Matt. Good morning and thank you all for participating in Packaging Corporation of America’s third quarter 2022 earnings release conference call. I’m Mark Kowlzan, Chairman and CEO of PCA and with me on the call today is Tom Hassfurther, the Executive Vice President, who runs our Packaging Business and Bob Mundy, our Chief Financial Officer. I’ll begin the call with an overview of our third quarter results and then turn the call over to Tom and Bob, who will provide more details. I’ll then wrap things up and then we’d be glad to take questions. Yesterday, we reported a third quarter net income of $262 million, or $2.80 per share, excluding special items, third quarter 2022 net income was $266 million, or $2.83 per share, compared to the third quarter of 2021 net income of $257 million or $2.69 per share. The third quarter net sales were $2.1 billion in 2022 and $2.0 billion in 2021. Total company EBITDA for the third quarter excluding the special items was $477 million in 2022 and $464 million in 2021. Third quarter net income included the special items expenses of $0.03 per share primarily for certain costs at the Jackson, Alabama mill for the paper to containerboard conversion related activities. Details of all special items for the third quarter of 2022 and 2021 were included in the schedules that accompanied the earnings press release. Excluding the special items, the $0.14 per share increase in third quarter 2022 earnings compared to the third quarter of 2021 was driven primarily by higher prices in mix in our packaging segment of $1.60 and paper segment $0.23. Lower interest expense, $0.04, a lower share count resulting from share repurchases, $0.04, and the lower tax rate, $0.02. These items were partially offset by operating costs which were $0.70 per share higher primarily due to inflation-related increases in the areas of energy, repairs, materials and supplies, chemicals, labor and benefits expenses, as well as several other indirect and fixed cost areas. We also had inflation-related increases in our converting costs which were $0.04 per share higher. The negative impact of lower volume was $0.52 per share in our packaging segment, and $0.05 in our paper segment. Freight and logistics expenses were $0.20 above last year, and scheduled outage expenses were $0.10 higher. We also had higher depreciation expense of $0.07, and other expenses of $0.04. The results were $0.03 above the third quarter guidance of $2.80 per share primarily due to the very sound implementation processes around our previously announced price increases in the packaging and paper segments, as well as the continued benefits generated from our mills and plants through process efficiency optimization efforts and material usage initiatives. Looking at our packaging business, EBITDA excluding special items in the third quarter was $467 million, with sales of $1.9 billion resulting in a margin of 24.1% versus last year as EBITDA of $467 million with sales of $1.8 billion and a 25.5% margin. Our teams did a tremendous job of implementing our previously announced price increases. However, demand in our packaging segment was well below our expectations for the quarter. Tom will discuss this further in a moment. The containerboard mills operated in an efficient and cost-effective manner as we balanced our supply with current domestic and export demand. As part of the effort, we began the scheduled maintenance outage in the first phase of the No. 3 machine conversion to containerboard at our Jackson Alabama mill a few weeks earlier than originally planned. Total economic-related downtime for the third quarter was approximately 128,000 tons. The outage and conversion work at Jackson will be completed in the fourth quarter. And we will remain committed to ramping up our internal capacity according to our customers' demand requirements. Finally, although we are still experiencing historically high inflation within our operating and converting costs, our mills and plants continue to remain focused on delivering numerous cost reduction initiatives, efficiency improvements, and integration and optimization enhancements and capital project benefits that helped minimize the impact.

Tom Hassfurther, Executive Vice President

Thank you, Mark. As Mark mentioned, we continue to get excellent realization from the implementation of our previously announced price increases across all product lines. Domestic containerboard and corrugated products prices and mix together were $1.54 per share above the third quarter of 2021 and up $0.35 per share compared to the second quarter of 2022. Export containerboard prices and mix were up $0.06 per share compared to the third quarter of 2021 and up $1.00 per share compared to the second quarter of 2022. The lower demand in our packaging segment that Mark spoke of was driven by several items, the combined impact of which resulted in our volumes being much lower than we anticipated. Corrugated product shipments were down 6% in total and per workday, compared to last year's third quarter. Outside sales volume of containerboard was 57,000 tons below last year's third quarter and 61,000 tons below the second quarter of 2022. The ongoing inventory correction in the retail channels is larger than originally thought and significant inflation continues to negatively impact consumer purchases of both durable and non-durable goods. In addition, various events and issues in 2021 and this year, including the recent hurricane in Florida, continue to have a negative effect on the agriculture and protein markets. Demand is beginning to experience headwinds from the cooler housing markets as well. These things combined with rising global interest rates, deterioration in US economic conditions, economic weakness in China and Europe, along with China's zero-tolerance COVID policy all negatively impacted domestic containerboard and box demand. As we look from the third quarter into the fourth quarter, we expect the majority of these conditions to continue. Additionally, there are four fewer shipping days in the fourth quarter compared to the third quarter. Now I'll turn it back to Mark.

Mark Kowlzan, Chairman and CEO

Thank you, Tom. Looking at the paper segment, EBITDA excluding special items in the third quarter was $33 million, with sales of $165 million or a 20% margin compared to the third quarter of 2021 EBITDA of $18 million and sales of $150 million or a 12% margin. Prices and mix were up 21% from last year's third quarter and moved 6% higher from the second and into the third quarter of 2022 as we continued to implement our previously announced price increases. Sales volume was about 9% below last year's third quarter primarily due to this year's scheduled outage at our International Falls mill as well as last year's third quarter that included paper sales from the Jackson mill's No. 1 machine. The outstanding efforts around implementing our latest price increase, together with optimizing the cost structure, inventory, and product mix delivered excellent margins in the paper business. Now I'll turn it over to Bob.

Bob Mundy, Chief Financial Officer

Thanks Mark. Cash provided by operations and free cash flows are at all-time quarterly records at $431 million and $251 million, respectively. The primary payments of cash during the quarter included capital expenditures of $180 million. Common stock dividends totaled $117 million, $77 million for federal and state income tax payments, pension and other post-employment benefit contributions of $51 million, and net interest payments of $4 million. In addition, we repurchased 1,032,000 shares during the quarter at an average price of $137.60 per share for a total of $142 million. We ended the quarter with $794 million of cash including marketable securities, and our liquidity on September 30, was $1.1 billion. Lastly, our planned annual maintenance outage expense for the fourth quarter is now expected to be about $0.38 per share, or $0.11 per share higher moving from the third quarter to the fourth quarter. I'll now turn it back over to Mark.

Mark Kowlzan, Chairman and CEO

Thank you, Bob. Looking ahead as we move from the third and into the fourth quarter as Tom mentioned, we see most of the issues and economic conditions and higher global interest rates that impacted third-quarter packaging segment demand continuing. Our box plants will have four less shipping days compared to the third quarter. We also expect a seasonally less rich mix in corrugated products as well as lower average export containerboard prices. We will run our containerboard system based on this demand outlook along with completing the Jackson mill's scheduled annual maintenance outage in the first phase of the containerboard conversion work on the No. 3 machine. In our paper segment, we will continue to implement our previously announced $60 per ton price increase on all office printing and converting grades that took effect on September 6. However, volume will be lower compared to the seasonally stronger third quarter. As Bob mentioned, scheduled annual outage expenses will be $0.11 per share higher than the third quarter. Lastly, we expect slightly higher operating costs, primarily labor and benefit expenses, along with anticipated colder weather resulting in higher energy costs. Considering all of these items, we expect fourth quarter earnings of $2.22 per share. With that we'll be happy to entertain any questions but I must remind you that some of the statements we've made on the call constituted forward-looking statements. The statements were based on current estimates, expectations, and projections of the company and involve inherent risks and uncertainties including the direction of the economy and those identified as risk factors in our Annual Report on Form 10-K and subsequent quarterly reports on Form 10-Q filed with the SEC. The actual results could differ materially from those expressed in the forward-looking statements. And with that Matt, I'd like to open up the call for questions please.

Operator, Operator

Our first question will come from George Staphos with Bank of America Securities.

Sandy Liang, Analyst

Hi, this is Sandy Liang on behalf of George Staphos, he had a small conflict. First, can you please discuss your early fourth quarter booking and billing trends? And to the extent that you can share are customers continuing to destock in the supply chain? Thank you very much.

Tom Hassfurther, Executive Vice President

Sandy, this is Tom. Good morning. So far, our bookings and billings are running about 5% below last year. You asked about stocking and some inventory issues. I will tell you that I think the good news is, first of all, we didn't predict that it would last as long as it has in terms of this inventory issue. There was obviously coming out of the pandemic retailers and other customers stocked up significantly to try to meet the record-breaking demand that they saw and wanted to maintain that. Of course, that demand has now waned some. In addition, we find that they ordered an excessive number of boxes as well to meet that kind of demand. So we are going through this period right now of pretty severe inventory adjustment. That's what we're seeing primarily in these down volume numbers. And that's going to take a while to work through the system. We thought that it would be in and out in about 30 or 60 days. But this looks like it's going to be probably a couple of quarters to get through this completely.

Mark Weintraub, Analyst

Thank you. So following up on the demand questions. Could you ballpark and I realize this is just judgment, but yours is certainly going to be as good or better than anybody else's? How much that inventory destock might have contributed to the down 6% realizing there are other factors you highlighted as well?

Tom Hassfurther, Executive Vice President

Mark, this time again, it's significant. There's no question about it. And it's the primary number. It's quite interesting that just as of yesterday, we had a fairly large customer at one of our plants, who sent an email in and said, I have finally run down my excessive inventory. I'm now ready to order again. So we probably lost in a lot of cases, one or two of the typical order cycles that some of these customers would go through as they went through this destocking of inventory.

Mark Weintraub, Analyst

You mentioned that what was initially estimated to take 30 to 60 days might actually take a couple of quarters. Is it correct to understand that this situation started in the third quarter, and you're optimistic about resolving it by the end of the fourth quarter? Or could it extend further? Also, do you expect the activity level to remain as high as what we noticed in the latter part of the third quarter?

Tom Hassfurther, Executive Vice President

Well, obviously, I can't predict the future. But I can tell you that I believe that when you look at our fourth quarter, as I mentioned, there are a lot of other factors going into the fourth quarter and including this destocking. So if you look at those numbers, and you think about those, you would see that the trend will probably begin to work our way out of this inventory issue. But we've got some other headwinds as well, as I mentioned, especially like the agriculture business in the South that was impacted by the hurricane, and that those crops are either going to be delayed or in some cases lost completely. So the only comparison I have is the Great Recession. It took a couple of quarters for the cycle to finally turn and for the business to really turn up. So it will take some time to work through the excess inventories, and I think you can expect to see a significant adjustment through the Christmas season.

Adam Josephson, Analyst

Thank you, everyone. I hope you are all doing well. Tom, I have one more question regarding that. Are you noticing this at the retail level with your customers? I wouldn't expect that your customers have enough space to store so many boxes. So I'm a bit confused about where exactly this destocking is occurring and how much longer it might continue.

Tom Hassfurther, Executive Vice President

Well, let me get specific on that. Adam. I mean, what we're talking about destocking is we're talking about customers that built their own inventories of their own products to hopefully continue to meet a demand curve that was quite steep and good for them. All of a sudden, when that demand leveled out, they're sitting on a lot of their own inventory, coupled with the lead times that got out in boxes, they had to store more boxes as a result of those lead times. Those lead times have now come back down to a more normal level. So just by coming back down to a normal level you can miss a whole order cycle.

Adam Josephson, Analyst

Got it, okay. But even though they've returned to normal lead times, they still appear to have much too much inventory.

Tom Hassfurther, Executive Vice President

Yes, in some cases, yes. I just told you about one of our larger customers who is now ordering again, but they didn't order. I provided another example of a very large account of ours, which through mid-year was up a little over 3%, and suddenly, the next month, it was down 50%. Now, this isn't lost business, this isn't anything other than just they've got excessive inventory that they're going to have to work off for a while. So we have to get through this cycle.

Bob Mundy, Chief Financial Officer

Yes, Adam. As Mark mentioned in his comments, we anticipate running our containerboard system with similar challenges as we faced in the third quarter. Taking that into account, I would estimate that about half of the sequential movement will reflect on the volume side. The remaining factors that are likely higher than what we typically expect from the third to the fourth quarter can be categorized mainly into two areas: energy costs for obvious reasons, and labor and benefits, which continue to rise due to the current labor market conditions. Additionally, we are observing some improvement in the freight sector. However, when aligning supply with demand, it's not always possible to optimize our routes, leading to shipments that may utilize different transportation modes or cover longer distances than usual. This is another reason we expect an increase from the third to the fourth quarter.

Adam Josephson, Analyst

Yes, I appreciate that. And Mark just on the buyback. And correct me if I'm wrong, but I think the average price of $137 was comparable to what you did in the fourth quarter of last year. Were you doing that as demand, like before, after demand did what it did? And I'm just wondering about your thoughts about where the stock is now versus what you've been paying for buybacks in recent quarters, in light of the recent demand weakness and otherwise.

Mark Kowlzan, Chairman and CEO

As we went through the third quarter, we saw an opportunity based on where the stock price was at the time that it was a good value for us to buy back. We look at it as a conviction opportunity that we see the value there. We have the cash and took advantage of it. It is historically in line with what we did last year at this same time in the fourth quarter. Long term, I think under the circumstances, we will continue to take advantage and be opportunistic in the same manner. Not necessarily. Again, I think, again, we see value in terms of the stock buyback during the third quarter. If you can imagine where the stock is today, we have that same type of conviction. We'll update you on the January earnings call on what we actually did. But if we do hit the $2.22 number that we're guiding to, we're going to have an $11 earnings year. So again, I want to use the term conviction; we believe strongly that there’s a much higher value embedded in the stock valuation.

Phillip Ng, Analyst

Hey, Mark, Tom, Bob, this is John on behalf of Phil. I appreciate the color. I want to start off with your own inventory levels. I mean, they picked up sequentially ahead of the day three outages as you're planning. But obviously the demand outlook has worsened quite a bit. Can you just give us some color on how you're viewing your own internal inventory levels on the containerboard side, and is there any economic downtime baked into your guidance?

Mark Kowlzan, Chairman and CEO

When we went into the third quarter, historically, the third quarter is always a robust quarter, people are getting ready for holiday activity. You also come out of the second quarter, which is traditionally a bigger annual outage quarter when you've taken mills down, running your inventory down to the lower side. So you will always try to start building back up during that July-August period, which is what we did. Obviously, the demand did not materialize. So we course-corrected and ran to demand. I want to stress that as far as inventory targets, we don't have a specific target. We're looking at what Tom is understanding about what the market is doing on his side of the business and what we would imagine we would need to supply that. We'll continue to run our mills in that regard to meet the demand. We have a lot of flexibility, and we will be finishing up the Jackson work sometime in November. Then we will again be using the term run to our demand.

Unidentified Analyst , Analyst

Understood. I guess leading up to this quarter, you had talked about being still pretty tight on inventories. Obviously, there’s a correction, I'm sure there it's a little bit of a moving target in terms of the inventory levels. But I guess my takeaway is that you're feeling comfortable with your inventory levels. Now there isn't some big destock that you feel like you have to do yourself with the pullback on the demand side.

Mark Kowlzan, Chairman and CEO

No, we're in a good place, and we're in a place now where we can move the tons and inventories where we see we need to move. So we're in a healthy place. No, just again it was a good quarter for us. We've also right-sized the business. We've got International Falls running efficiently now in terms of its split between cut size and offset converting grades. We're in a good place there.

Anthony Pettinari, Analyst

Hi, good morning. We've seen a big step down in OCC over the last couple of months. Understanding you have more of a version-levered system, I think you've made some investments in recent years to add flexibility there. I'm just wondering if you can remind us how much OCC you can consume, how much you can swing into potentially to take advantage of some of these low costs. Any thoughts there?

Mark Kowlzan, Chairman and CEO

I think the best way to look at it is on a percentage basis. If you think about the total capacity of our mills system, it would still be around the low 20% capability of fibering up our mills. So it's whether at a point in time with pricing, you're running 15% recycled to the system, or taking advantage of opportunities on pricing availability and ramping it up into the lower 20% recycle. That's how we look at it.

Anthony Pettinari, Analyst

Okay, that's very helpful. And then there are some competitor capacity projects that maybe will come online by the end of the year or early next year. I think some of those have explicitly targeted the independent box market. You have a very high integration rate I guess, to the extent that you can, are you seeing any of that new capacity in the market? Or entering discussions, or does your integration rate kind of insulate you from that? Just any thoughts about some of these new projects and impact on the market, whether you're seeing it or not.

Tom Hassfurther, Executive Vice President

Anthony, we are number one, as you accurately pointed out based on our level of integration. Achieving a high level of integration has been our goal. However, what others choose to do and the investments they make are entirely their responsibility. We've previously discussed our observations in the independent market, which has changed significantly in terms of size. We are somewhat indifferent to the decisions made by others.

Adam Josephson, Analyst

Thanks so much, everyone. Tom, I was just one more thought which is in the third quarter shipments were down six and you're talking about issues, yes, in the fourth quarter your time up, bookings and billings down about five. Can you just remind me how that compares to 2019 levels? And what you think a reasonable expectation for demand is at this juncture relative to '19 level? There have been obviously, so many distortions at the onset of the pandemic and thereafter. I'm just wondering how you're thinking about that issue?

Tom Hassfurther, Executive Vice President

Yes, well, Adam we will still be quite a bit above 2019 levels. In spite of this, and I think that a big portion of this is as I said, inventory restocking, so I haven't changed my viewpoint, even from the last call we had, that we will retain quite a bit of the gains that took place during the pandemic going forward. This isn't severe demand destruction or anything like that; obviously, inflation has taken some toll. But this is more of a couple of quarter phenomenon, regarding these excessive inventories.

Adam Josephson, Analyst

And what gives you confidence in that, that you would hold some of the volume you gained post 2019, just again, given that there was this extraordinary surge with all the government stimulus, you name it, and now we're seeing the other side of that. So I guess what would give you confidence that you would hold those post-2019 gains, if you will?

Tom Hassfurther, Executive Vice President

Well, a couple of things; no different than having a discussion with me about my viewpoints, I have the same discussions with our customers about their business and what they project going forward. Based on their forecasts, what they see, and what they expect to do in their business, the capital investments that they are making in their businesses, etc. I have a high degree of confidence. The other thing that gives me confidence is regarding the consumer themselves; consumer spending and the consumer relative to savings and other things like that have held up pretty well, in spite of this big step up in inflation. So I think some of these phenomena we're dealing with here in the short term are going to wane, and it's going to be relatively positive going forward.

Adam Josephson, Analyst

I appreciate it. I think you mentioned that the impact that COVID lockdowns are having, yes, COVID lockdowns in China, excuse me, are having on domestic demand. Can you just talk about your perspective as to the impact on the US economy from what's happening in China?

Tom Hassfurther, Executive Vice President

We recently achieved an all-time record for onshoring manufacturing in the US during the last quarter, although it hasn't received much attention. This trend may be subtle but is significantly beneficial for our business and is likely to continue. I want to highlight that supply chain issues remain a significant challenge, especially for our customers who depend on specific parts or chips from China, where ongoing disruptions are prevalent. This situation is prompting more onshoring not just in the United States, but also in Mexico and nearby countries, which will greatly advantage our box business moving forward.

Mark Weintraub, Analyst

Thank you. Just, first of all, just a clarification, you had mentioned that outages, I think were going to be about $0.11 higher than you had previously anticipated in the fourth quarter. Did I hear that right? What is that number kind of on a per share basis expected to be in the fourth quarter versus the third quarter?

Bob Mundy, Chief Financial Officer

Mark, it's $0.11 going from the third quarter into the fourth quarter.

Mark Weintraub, Analyst

Got it. So it was like $0.26 or so in the third quarter going to $0.37.

Bob Mundy, Chief Financial Officer

Yes, it was like $0.26, $0.27.

Mark Weintraub, Analyst

Okay. Very good. And then the other question I have is, with the Jackson project, and one of the things that was also going to do was reduce your costs meaningfully? And hopefully under a certain environment that would show up in 2023. Is that dependent on demand getting back to strong levels? Or are there ways you can run your system that benefits are going to show up regardless, do you think? Or again, if it that, it'll show up? But we'll have to wait until that demand is back to stronger levels?

Mark Kowlzan, Chairman and CEO

Yes, you just answered your own question. When you run the mill, the way it's designed in the way we're finishing up the work that we're doing, it will be a low-cost operation for us. We built that capability into it, and we'll be able to take advantage of it. But as we stand by the position that we will run the entire system to demand and that means rationalizing from a nationwide point of view where we need the tons to come from.

Mark Weintraub, Analyst

Okay, so basically, to see the full benefit, obviously, you need demand to get stronger. That's the right conclusion.

Mark Kowlzan, Chairman and CEO

Yes.

Mark Weintraub, Analyst

Okay. Thank you. Mr. Kowlzan, I see there are no more questions. Do you have any closing comments?

Mark Kowlzan, Chairman and CEO

Yes. Thank you for joining us on the call today and we look forward to talking with you in January for the full year fourth quarter earnings event. Take care. Have a good holiday.

Operator, Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.