Earnings Call Transcript - PKG Q1 2023

Mark Kowlzan, Chairman and CEO

Thank you, Jamie. Good morning, and thank you for participating in Packaging Corporation of America's First Quarter 2023 Earnings Release Conference Call. Again, I'm Mark Kowlzan, Chairman and CEO of PCA. And with me on the call today is Tom Hassfurther, Executive Vice President, who runs the Packaging business; and Bob Mundy, our Chief Financial Officer. As usual, I'll begin the call with an overview of our first quarter results. And then I'll turn the call over to Tom and Bob who will provide further details. And then I'll wrap things up, and we would be glad to take questions. Yesterday, we reported first quarter net income of $190 million or $2.11 per share. Excluding special items, first quarter 2023 net income was $198 million or $2.20 per share compared to the first quarter of 2022 net income of $256 million or $2.72 per share. First quarter net sales were $2 billion in 2023 and $2.1 billion in 2022. The total company EBITDA for the first quarter, excluding special items, was $405 million in 2023 and $467 million in 2022. The first quarter net income included special items expenses of $0.09 per share, primarily for the closure costs related to corrugated products facilities and design centers. Details of special items for both the first quarter of 2023 and 2022 were included in the schedules that accompanied our earnings press release. Excluding the special items, the $0.52 per share decrease in first quarter 2023 earnings compared to the first quarter of 2022 was driven primarily by lower volumes in our Packaging segment for $0.95, and Paper segment $0.04. Although recycled fiber costs were lower than last year, overall operating costs were $0.27 higher, primarily due to inflation on chemicals, labor and benefits, supplies, repair materials and services. Energy costs, although trending down, were also higher versus the first quarter of 2022. In addition, we had higher depreciation expense of $0.11, freight and logistics expenses, $0.04; nonoperating pension expenses, $0.04; and higher converting costs, $0.02. These items were partially offset by higher prices and mix in the Packaging segment for $0.58 and Paper segment $0.18. A lower share count resulting from share repurchases we made in the second quarter of 2022 for $0.11, lower interest expense, $0.03; lower other expenses for $0.03, lower scheduled maintenance outage expenses for $0.01, and lower tax rate, $0.01. The results were $0.03 below the first quarter guidance of $2.23 per share, primarily due to the lower volume and lower prices and mix in the Packaging segment. Looking at our Packaging segment, EBITDA, excluding special items in the first quarter 2023, was $392 million with sales of $1.81 billion resulting in a margin of 21.7% versus last year's EBITDA of $464 million and sales of $1.96 billion or 23.6% margin. Demand in the Packaging segment was well below our expectations for the quarter. Tom will discuss this further in a moment. The mills and corrugated products plants responded to the lower demand by remaining highly focused on efficient and cost-effective operations as we balanced our supply accordingly. Our employees continue to deliver on numerous cost reduction initiatives, efficiency improvements, integration and optimization enhancements and capital project benefits to minimize the negative demand impacts in the short term and to remain in position to capitalize on our longer-term strategic goals. These accomplishments were achieved while building less inventory than we had planned and staying committed to ending the quarter at our targeted weeks of supply inventory. I'll now turn it over to Tom, who will provide further details on containerboard sales and the corrugated business.

Tom Hassfurther, Executive Vice President

Thanks, Mark. Domestic containerboard and corrugated products prices and mix were $0.64 per share above the first quarter of 2022 and were down $0.50 per share compared to the fourth quarter of 2022. Export containerboard prices were down $0.06 per share versus last year's first quarter and down $0.04 per share compared to the fourth quarter of 2022. Corrugated product shipments were down 12.7% in total and per workday compared to last year's first quarter. Outside sales volume of containerboard was 69,000 tons below last year's first quarter and 33,000 tons above the fourth quarter of 2022. With the first quarter of 2022 setting a shipments per workday record as well as being our all-time record for total shipments, we knew this would be a tough comparison period. However, that being said, 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. As we mentioned on last quarter's earnings call, it was difficult to predict the demand curve given the numerous variables with varying degrees of impact. As noted in our earnings release yesterday, the shift of consumer buying preferences more towards service-oriented spending, persistent inflation and higher interest rates continue to negatively impact consumers' purchases of both durable and nondurable goods. In addition, there is a varying degree of inventory destocking across our customer bases, both in boxes and our customers' products. The inventory destocking situation has been a longer-term issue than we originally anticipated. The manufacturing index has remained in contraction territory for several months now. And as you know, we have a large presence in the ag business in the Pacific Northwest and also down in Florida, where both of these regions have been dealing with significant weather events. As we look to the second quarter, we expect the inventory destocking of both customer product and boxes to be near completion. We expect to see recovery in our ag business and we have received some positive feedback from our customers regarding improvements in their business. Our April volume, as we see it today supports that position. I'd also like to point out that the capital spending and optimization strategy within our box plant system that we have been focused on over the last few years continues to remain one of our top priorities. The current demand trends will not cause us to lose our focus in this area. The investments from this strategy provide the products and service needs that our customers desire and allow them to grow while focusing on the mix of customers from which we want to profitably grow our revenues. I'll now turn it back to Mark.

Mark Kowlzan, Chairman and CEO

Thanks, Tom. Looking at our Paper segment, EBITDA, excluding special items in the first quarter was $41 million with sales of $151 million or a 27.2% margin, compared to the first quarter of 2022 EBITDA of $29 million and sales of $153 million or an 18.9% margin. Paper prices and mix were 18% higher than last year's first quarter and about 3% above for the fourth quarter of 2022. Sales volume was about 17% below last year's first quarter which included some of the inventory that had been sold from our Jackson Alabama mill and just over 4.5% below the fourth quarter of 2022. The efforts of our employees to optimize the cost structure inventory and product mix in our paper business helped minimize the inflationary cost increases compared to last year and delivered solid returns for the quarter. I'll now turn it over to Bob.

Bob Mundy, Chief Financial Officer

Thanks, Mark. For the first quarter, we generated cash from operations of $280 million and free cash flow of $168 million. Free cash payments during the quarter included capital expenditures of $112 million and common stock dividends of $112 million. We ended the quarter with $520 million of cash on hand, including marketable securities. I want to update you on a revision to the scheduled mill maintenance outage guidance we provided on last quarter's call. Current plans and the scope of work for the scheduled maintenance outages at our containerboard mills have changed, resulting in a revised total company estimated cost impact for the year of $0.75 per share versus the $0.67 per share we mentioned previously. The actual impact in the first quarter was $0.13 per share. And the revised estimate impact by quarter for the remainder of the year is now $0.18 per share in the second quarter, $0.24 in the third and $0.20 per share in the fourth quarter. I'll now turn it back over to Mark.

Mark Kowlzan, Chairman and CEO

Thanks, Bob. Looking ahead, as we move from the first into the second quarter, although there is one less shipping day for the corrugated business, we expect improved volume in our Packaging segment. However, prices will be lower as a result of the previously published domestic containerboard price decreases along with lower export prices. Sales volume as well as prices and mix in the Paper segment are assumed to be slightly lower based on lower demand. Although we do look for most operating costs to trend lower, our converting costs, scheduled maintenance outage expense and depreciation expense will be higher, primarily due to recent increases in contract rail rates at most of our mills. We expect higher freight and logistics expenses compared to the first quarter. Considering these items, we expect second quarter earnings of $1.96 per share. With that, we'd 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 the annual report on Form 10-K on file with the SEC. The actual results could differ materially from those expressed in these forward-looking statements. And with that, Jamie, I'd like to open the call up for questions, please.

George Staphos, Analyst

Thanks for the details. Mark, a question for you. Normally 2Q is up sequentially from 1Q. And when we look back historically over time, the only time that we saw a down 2Q, if we're correct, was the COVID second quarter. Even if we went back to the great recession in '08 and '09, you had up 2Q versus 1Q. As you sit here today and if you're in our seat, what is the biggest driver of the drop off 2Q versus 1Q? Is it the timing effect on the pricing and just how that's flowing through? Or is it the demand effect, the continued demand effect being worse than expected? If you could give us some qualitative comments on that, that would be helpful. And then a couple of follow-ons.

Mark Kowlzan, Chairman and CEO

Yes, George, let me start that out. I think, again, if you look at the November, December and February price decreases, and how they've rolled in. I think in the past 20-plus years, we only had 1 or 2 incidents of this kind of timing of price decreases. But Bob can give you some real detailed color on how that's impacting, but that's pretty much what's happening.

Robert Mundy, Chief Financial Officer

You're right, Mark. The $70 drop, George, in terms of timing between the first and second quarters is unprecedented in the company's history. We noted in last quarter's call that the majority of those price declines would appear in the second quarter, and that's exactly what is occurring. The unusual timing of the published decreases is driving this significant price drop. That's essentially the situation.

George Staphos, Analyst

Understood. And I appreciate the color there. Could you give us a sense for how much demand might have been off relative to your prior expectations and what the bookings and billings look like early in 2Q?

Mark Kowlzan, Chairman and CEO

Yes. Tom, why don't you go ahead and take a...

Tom Hassfurther, Executive Vice President

Yes, George. I’d like to provide some additional context on that. If you remember from our call last quarter, we started January with good bookings. However, as the quarter progressed, we experienced a slight decline each month, which was disappointing. I mentioned then that it was difficult to forecast the effects of destocking and the state of consumer demand. The indicators, including consumer demand and the manufacturing index, became increasingly negative as the months went by, closely aligning with the volume trends. The positive news is that there has been a significant turnaround starting in April. After 13 days into the month, our bookings are up 11% compared to March and 10% compared to the first quarter. Although they are still down 6% compared to April of '22, that month was our highest on record. To put this in perspective, we saw a substantial volume increase due to COVID until April, after which it began to decline. We still face challenging comparisons for April, but the fact that we are seeing double-digit improvements over March is encouraging and applies across all sectors. While there are still some weaker areas, such as home improvement and home building, we also suffered setbacks in our ag business during the first quarter due to hurricanes in Florida, significant rain and flooding in Northern California, and cold weather in the Pacific Northwest. However, those areas are recovering as well. I believe we are nearing the end of those significant challenges concerning the volume.

George Staphos, Analyst

Last quick one, I'll turn it over. Just from an operations standpoint. Can you talk a little bit about the facility closures, kind of what they're allowing or optimizing for PCA? And given the shift in recycled cost versus virgin cost, this question comes up periodically on your calls. How are you flexing your system relative to lower-cost recycled and lower-cost recycled board, recognizing your customers ultimately dictate what kind of box they want that ultimately dictates the Board. I'll let it go there.

Tom Hassfurther, Executive Vice President

Okay. Thanks, George. Yes, relative to the plant and the design center closure that we announced in the first quarter, that is typical of the evaluation that we do of our footprint at all times, and it's part of our capital planning process. So these are not knee-jerk reactions to let's just say, volume demand change or anything like that. These are all part of our capital planning process where we're trying to optimize our system. Of course, we've made acquisitions over the years and other things like that. So we do have some duplicity in some of the markets that we want to fix. And so it's been a continuous process that we've been doing this. Relative to the recycled versus virgin, what PCA has been, and I've said this before, what we have been focused on for years now in our mill system is to be able to match the just the right amount of fiber to the performance that's necessary in the marketplace. And some of those proprietary products and some of the things that we've done in our mill system have served us incredibly well in the marketplace and are ultimately even more competitive than recycled in most of those markets. So I'm very, very pleased with what we've been able to do in the mill system. It's been an outstanding performance by all of our people. And we've talked about our engineering expertise. We've talked about our paper tech expertise, and that's provided us. And of course, the flexibility we have in these mills, and we will flex back and forth, obviously, with OCC to the degree we can when the prices of a nature that make the most sense.

Mark Weintraub, Analyst

Good to hear that demand looking better in April, but I did want to follow up a little bit on George's question, and I realize it's a bit of an overlap. But in the third quarter and the fourth quarter as well, your year-over-year box shipments were a bit below the industry. And we don't have the industry data yet, we'll get that, I guess, on Friday. But certainly, the 12.7% was a surprise to us to the downside and you guys as well. If you look back over the last 6 months or so, any thoughts as to why you might have been showing reduced market share, recognizing that over time, you've actually outgrown the industry very substantially and very profitably? And whether it's this ag business? Or what are you coming up with in terms of what might have been going on with your book of business?

Mark Kowlzan, Chairman and CEO

Yes. Mark, just remember back in 2008 into the 2009 period, we saw a more rapid downturn in volume than our competitors. And then when we started seeing the improvement in the spring, we came back stronger and faster than our competitors. And I believe most of that has to do with the predominantly local book specialized local accounts, smaller local account business that we have. These accounts are much more tuned into what's happening with their own business. They can move very quickly. They're very nimble. But I'm going to let Tom elaborate on that because, again, it's not as simple as it seems.

Tom Hassfurther, Executive Vice President

Yes, Mark. One of the important points is that we haven't lost any volume, meaning we're not losing any market share. This is not happening. If you consider what we've discussed often and take pride in, it's the diverse range of business sectors we operate in. During COVID, some of these sectors experienced growth as high as 200%. Once COVID ended, those sectors naturally declined significantly. It varies by sector, which is why we're taking a bit longer than anticipated to address the volume situation. Many sectors have seen sharp declines, some have remained steady, and a few have slightly increased. This is the primary factor. Additionally, during COVID, we had to manage a lot of business that we typically would have sourced externally, and we have now shifted that business back out. While we maintain our revenue and income, it does impact our volume negatively. This is somewhat of a peculiar situation based on how it is reported to the FBA, but it is another factor affecting us. Does that help?

Mark Weintraub, Analyst

It does. Just two quick follow-ups. One is you mentioned not losing volume; were you suggesting that you haven't lost customers, even though your volumes are down?

Tom Hassfurther, Executive Vice President

We haven't lost any customers in terms of what you would call market share in terms of customers or things like that. Obviously, our volume is down. But it's down. We haven't lost any share within those accounts or anything like that. It's just that some of that broad-based business, some of those sectors are down significantly. And as I mentioned, we've never had a period where we got hit with ag getting hit like it did in the regions where we have big footprints all at the same time.

Mark Weintraub, Analyst

I need some clarification on why, despite the weak demand and your ability to fulfill needs internally, you are still relying on external fulfillment. It seems a little puzzling to me, as I would think you have ample capability to meet those needs within the company.

Tom Hassfurther, Executive Vice President

The reason is that producing this internally costs us significantly more than outsourcing it. Therefore, it doesn't make practical sense for us to handle it ourselves. However, to ensure we meet our customers' needs, we've chosen to proceed with the higher-cost option. Additionally, we aim to operate our plants as efficiently as possible, which is why this decision is cost-effective from our perspective.

Unidentified Analyst, Analyst

This is John on for Phil. Appreciate all the details. And I want to first start off asking how much economic downtime you guys took in 1Q given the last couple of quarters, you've called that out, and it's been a bit outsized. Is that something you can quantify? And maybe how can we think about trends for that in 2Q with some of the demand starting to normalize?

Robert Mundy, Chief Financial Officer

Yes. It was about 110,000 tons in the first quarter.

Unidentified Analyst, Analyst

Okay. And any insights on how to think about 2Q?

Mark Kowlzan, Chairman and CEO

No. As we have always done, we will continue to respond to demand and do what is necessary to satisfy our customer base. If you look back at the first quarter during January, we anticipated that volume would begin to stabilize and improve. We expected to go through our winter and spring annual shutdowns which would increase demand. Therefore, our plan was to build a bit more inventory. In fact, we increased inventory by about 30,000 tons in the first quarter compared to the end of last year. However, as we observed a decline in volume, particularly in February and March, we realized that we did not need that extra inventory. As a result, we reduced our production and ended up with only 6,000 tons at the end of the first quarter, rather than the higher amount we had anticipated. We will continue to operate according to demand.

Unidentified Analyst, Analyst

Okay. That's helpful. And then I just wanted to pivot over to the cost side. You guys have done a very good job taking out costs in the system. But in terms of the guidance, just a couple of questions. First, I want to get a better understanding of what's driving the higher converting costs. Is that maybe more on the labor side? And then on the rail rate increases. Is that something that you can maybe give us a little bit better understanding of the structure of those contracts? Like how long those rates will kind of be in place when they get renegotiated? How much maybe it was weighing on 1Q and going into 2Q? Just to give us some better tools to forecast the models have.

Robert Mundy, Chief Financial Officer

Yes, John, it's Bob. Regarding the rail rate increases, much of it occurred in the first quarter, and some started at the beginning of the second. This results in a significant impact as we transition from the first to the second quarter, as nearly all of those rates will be higher as we begin the second quarter. That's what's driving the increase in freight costs. I'm sorry, what was your first question?

Unidentified Analyst, Analyst

I guess, just to stay on that for a second, are those contracted rates for the next year, the next couple of years?

Robert Mundy, Chief Financial Officer

Yes, typically. Typically, that's probably a good way to think about it.

Unidentified Analyst, Analyst

And the first question was around the converting costs and what's driving higher converting costs.

Robert Mundy, Chief Financial Officer

Yes, labor benefits are certainly a part of it. The other significant factor is the starch prices, which have increased considerably this year. As we anticipate improvements in volume at the box plants, we're also using more of those materials. This trend is contributing to rising labor costs and some of the material expenses reflected in the converting costs.

Unidentified Analyst, Analyst

Is the starch starting to turn over? Or is it still..

Robert Mundy, Chief Financial Officer

No. No, it's not.

Mark Kowlzan, Chairman and CEO

Thank you. Next question.

Anthony Pettinari, Analyst

Kraft liner prices have been stable for a couple of months now. And understanding you don't sell much board in the open market, and I'm not asking about forward pricing. But I'm just wondering if you had any thoughts about kind of where containerboard markets kind of feel like they are right now. I mean, you've seen a number of cycles maybe some of these capacity projects have started up and maybe are being sort of absorbed. I just wanted to get your sense of containerboard markets versus maybe where we were a few months ago?

Tom Hassfurther, Executive Vice President

Yes, prices have stabilized, and there hasn't been much activity related to price recently. I'm not predicting future prices, but I believe the outlook is more positive. The industry has significantly adjusted to demand, and the open market is quite limited at this time. Companies with excess capacity are either reducing downtime or trying to explore export markets, which are also facing challenges. Overall, the current market is different from the past due to its limited size, which suggests greater stability moving forward.

Anthony Pettinari, Analyst

Got it. That's helpful. Could you discuss, considering your balance sheet flexibility, your approach to capital allocation? From a capital return perspective, you're currently offering an attractive dividend. Can you talk about any potential for share repurchases? Additionally, as you're coming off a significant CapEx cycle with numerous internal projects, I'm curious about where you see opportunities in capital allocation and capital return this year.

Mark Kowlzan, Chairman and CEO

Yes, nothing's changed. As we've talked about for the last year, our plans were to bring capital down this year, and we're in that $400 million range. And I would anticipate that working through into next year. Also, we've done most of the big projects that we could foresee in the mills, and we're just going to continue with the box plant optimization. As far as utilization of cash in terms of other opportunities like dividends, share repurchases, acquisitions. We'll remain flexible on any and all opportunities in that regard as we go forward. As we've done for many, many years now, we've got that flexibility to take advantage of all of these opportunities as they present themselves. And that's how we look at it day to day.

George Staphos, Analyst

Actually, Anthony took my next question. So I will turn it over to the next person.

Mark Weintraub, Analyst

I was reflecting on how your volumes ended up being down about twice what you had expected back in January. You mentioned aiming for flat average daily volumes, which would have meant a decline of around 6% or 7%, but you actually saw a drop of 12.7%. Is it reasonable to say that the negative year-over-year impact on volumes was about $0.95? If we take half of that, was that the additional negative effect from the demand weakness you encountered? If the volumes had met your expectations, theoretically, you could have been closer to $2.70, especially considering the $20 price reduction in February, which likely had a small impact. If that's accurate, it represents a significant difference from the $2.23, presumably stemming from the operational adjustments you made. I'm trying to understand if those adjustments were necessary due to the business situation, or if they were measures to delay certain types of spending. Essentially, I'm looking to gauge the underlying earning potential in a future environment.

Robert Mundy, Chief Financial Officer

Yes. Mark, this is Bob. So there's a lot going on there. If you're saying if our volumes were higher, it were closer to what we had anticipated, you're looking at that $0.95 being something a lot larger?

Mark Weintraub, Analyst

I believe you mentioned during the January call that you expected average daily box shipments to be flat sequentially, which would suggest a decline of about 6.5% instead of the reported decline of 12.7%. So, essentially, I'm asking if this implies that the negative impact would have been around $0.47 instead of $0.95.

Robert Mundy, Chief Financial Officer

That volume includes not only box shipments, but also export volume, trade, and domestic outside volume. Therefore, looking at it that way wouldn’t be accurate. However, in general terms, yes, it would be a higher number. Additionally, you would likely have better costs within your system since your mills and box plants would be operating at higher capacities. Consequently, your converting costs and direct variable costs would be lower, meaning your unabsorbed costs wouldn't be as high and would more than offset any additional decline you might see in price variance due to increased volumes.

Mark Weintraub, Analyst

It does, but it sort of comes back to the point that you're only $0.03 off what your guidance had been.

Robert Mundy, Chief Financial Officer

Yes. To put it simply, the published price decreased by $20 a ton after we provided our guidance. If you calculate that, as we mentioned earlier, when the published price falls, it immediately affects our outside containerboard without any delay. Thus, from that price drop that occurred after our guidance, there is approximately $0.03 impact.

Mark Weintraub, Analyst

What I'm trying to convey is that if we experience a rebound in demand, the recovery in earnings could be quite significant compared to the $2.23 run rate that was mentioned during a downturn.

Mark Kowlzan, Chairman and CEO

Absolutely, Mark. Absolutely. That's what we would anticipate.

Mark Weintraub, Analyst

Okay. I apologize for the fairly convoluted questioning here. But thank you.

Unidentified Analyst, Analyst

This is John again. I appreciate you taking the follow-up. I just wanted to quickly shift over to the paper segment. Demand was a bit lower than we had expected. Just kind of looking to get some insights on how the paper segment volumes are trending. It looks like maybe this next quarter where we should see another down double-digit type of volume year-over-year. Just kind of what's going on and maybe what are the main factors impacting demand on the paper side.

Mark Kowlzan, Chairman and CEO

Again, as we spoke last year, our paper business now has become just the International Falls mill up in Minnesota, and that mill is capable of a little over 500,000 tons a year. And that's pretty much what we're selling too. We're down slightly off of that peak capability. But what that allows us to do really is just run and optimize the market and where we choose to sell and where we want to sell to maximize profit. So we really have the luxury of being the fourth largest player and we don't have to do anything. I say we're in a real sweet spot right now, down just a few thousand tons off of where we were last year. Any other questions, please?

Operator, Operator

And our final question comes from George Staphos. Once again, a follow-up from Bank of America Securities. George?

George Staphos, Analyst

Sorry, there seems to be a technical issue here. I just want to reaffirm that the guidance for the paper segment indicates a slight sequential decrease in both pricing and volume. Was that the comment, Mark? And Tom and Bob? Thank you very much and good luck this quarter.

Robert Mundy, Chief Financial Officer

Yes, George. That's correct.

George Staphos, Analyst

Excellent, thanks guys, good luck in the quarter.

Mark Kowlzan, Chairman and CEO

Thank you, George. Operator: Thank you, everybody, for joining us on the call today, and appreciate your time, and we look forward to talking with you in July and covering the second quarter earnings results. Have a nice day. Thank you.

Operator, Operator

And ladies and gentlemen, that will conclude today's conference call and presentation. We do thank you for joining. You may now disconnect your lines.