Sylvamo Corp Q3 FY2022 Earnings Call

Good morning and thank you for standing by. Welcome to Sylvamo's Third Quarter 2022 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, we will have an opportunity to ask questions. And as a reminder your conference is being recorded. I would now like to turn the conference over to Hans Bjorkman Vice President of Investor Relations. Sir the floor is yours.

Thanks Lorris. Good morning and thank you for joining our call today. Our speakers this morning are Jean-Michel Ribiéras, Chairman and Chief Executive Officer; and John Sims Senior Vice President and Chief Financial Officer. Slides 2 and 3 contain important information including certain legal disclaimers. For example, during this call we will make forward-looking statements that are subject to risks and uncertainties. We will also present certain non-US GAAP financial information. Reconciliations of those figures to US GAAP financial measures are available in the appendix. Our website also contains copies of the third quarter earnings press release as well as today's presentation. I would now like to turn the call over to Jean-Michel.

Thanks, Hans. Good morning, and thank you for joining our call. I'll begin my comments on Slide 4. On October 1, we completed our first year as a public company. Our first year was one of significant achievements. As we build the world's paper company, we generated strong earnings per share and free cash flow, which we used to reduce debt, begin returning cash to shareholders, and reinvest in our business. We agreed to acquire the Nymolla mill in Sweden and divested our Russian business. Then we repaid our Term Loan B and achieved our gross debt target of $1 billion. We have also exited our transition services agreement. I'm proud of our teams and accomplishments over the last year. More importantly, I'm pleased that we are well positioned to navigate any macroeconomic headwinds and resulting industry challenges. Slide 5 highlights our third quarter results. Our three-point strategy of commercial excellence, operational excellence, and financial discipline was the foundation of our success. On a quarter-over-quarter basis, we increased adjusted EBITDA by 14% to $216 million and we grew our margin by 160 basis points. We increased adjusted earnings per share by 24% to $2.51 per share. We generated $114 million in free cash flow and repaid $88 million of debt in the quarter. These results were above the high end of our guidance. Our continued strong performance reflects our talented teams, our iconic brands, and our low-cost mills, all of which enable us to remain the supplier of choice for our customers. Slide 6 highlights our key performance metrics compared to the second quarter and to last year's third quarter. We increased net sales by 6% to $968 million. Our adjusted EBITDA of $216 million represents a margin of 22.3%, the highest margin level we have achieved. We generated $114 million in free cash flow, which was an increase due to higher earnings, less capital spending, and a reduction in working capital. These strong performances demonstrate our ability to continue to deliver on our investment thesis. Our teams performed well, creating value for all our stakeholders. Now John Sims will discuss our third quarter performance in more detail. John?

Thanks, Jean-Michel. Good morning, everyone. Let's turn to slide 7 please. As Jean-Michel said earlier, we earned $216 million in adjusted EBITDA in the third quarter. This is a 160 basis point improvement and was driven by $60 million in price and mix improvements, as realization of price increases exceeded our outlook and we continue to drive mix optimization. Volume increased slightly by $3 million with stronger shipments in Latin America and North America. Our order backlogs were strong in all regions in the quarter. We also had a slight increase in operations and costs, which increased by $3 million. We spent $14 million less on outages than in the second quarter, and we successfully conducted the planned maintenance outage at the Mogi Guacu mill. Input and transportation costs increased by $46 million as costs for energy, fiber, and chemicals continue to increase. Let's take a look at our regional results on slide 8. Each region continues to perform very well, demonstrating the strength and resilience of our talented teams, iconic brands, and low-cost mills, as well as favorable industry conditions. Each region benefited from utilizing price increases, which offset escalating costs and inflation. Our volumes remain strong in all regions and we continue to outperform the industry shipments. We operated well in all three regions. Input costs and transportation availability remained under pressure, and we have seen some relief truck availability in North America, but obtaining adequate rail service continues to be a challenge. The appendix contains additional details on our regional performance. So, let's turn to slide 9. In the third quarter, uncoated freesheet industry fundamentals remain favorable across our regions. Demand in Latin America and North America continued to rebound from pandemic levels while demand in Western Europe declined by 2%, which in part was driven by the lack of supply in Europe. Relative to 2019, 2022 year-to-date imports were about flat in Western Europe and down about 20% in each of the Americas. And as the bottom really shows, capacity is down 10% to 20% in our regions relative to pre-pandemic levels. The cost curve in Europe remains quite steep with more than 25% of the capacity being non-interest and generating 85%. Not only do we operate in the most attractive regions, but we continue to win with key customers. We also continue to optimize our product mix and increase our positions in high-margin segments. We are growing with key customers. For example, we expect to increase our Chamex volume with a strategic retail customer in Latin America by 25%. And in all regions, we'll continue to focus on the evolving needs of end users. We are optimizing our mix. For example, in Europe, we will increase our brand mix to 50% in 2022 versus 30% in 2021. In North America, we are optimizing our portfolio to ensure it aligns well with our channel partners and consumer trends. Furthermore, we are updating our business practices so that we are adequately paid for the value-added services we provide and we are segmenting our service levels and growing in high-margin segments. For example, we continue to expand our e-commerce presence in North America. Our commercial efforts driven by commercial excellence efforts drove higher volumes and margins, increased customer loyalty, and allowed us to outperform industry demand. Now, back to Jean-Michel for a discussion of our recent moves in Europe.

Thanks John. I'm now on slide 11. First, some perspective on the recent divestiture of our Russian business. After the invasion of Ukraine, we made a principled decision to exit Russia. In October, we sold the business and received $390 million in net proceeds. The divestiture of our Russian business allowed us to avoid a $220 million recovery point of projects, reduced our exposure to the most cyclical market pulp segment by 30%, and significantly decreased our geopolitical risk and uncertainty. Completing this deal also eliminated a major distraction for our management team, which is now focused on our core business. Let's move to slide 12. We are taking a proactive approach that would be mostly completed before we take ownership of the mill. As you might imagine, we are excited to add this mill to our European business in the first quarter. Slide 13 please. The Nymolla mill is one of the largest integrated uncoated freesheet mills in Europe. It is 85% energy self-sufficient and has strong environmental practices. The mill produces multiple grades for sized business forms, digital papers, and asset papers. It produces iconic brands that fit well with our strategy. Let's move to slide 14. The Nymolla mill is an excellent fit with our three-pronged strategy of commercial excellence, operational excellence, and financial discipline. In addition to the complementary uncoated product mix and iconic brands, the mill maintains strategic channel partnerships and a complementary geographical mix. It also has a customer-focused culture and shared values with our company. The mill is low cost and in an attractive location. It fits well within our portfolio and strategy. This purchase price represents an attractive price, and we expect more than $20 million in synergies and an internal rate of return greater than 25%, and it will be immediately accretive to our earnings per share and free cash flow. Let's turn to Slide 15. Using the last 12 months of adjusted EBITDA as of the end of June, the transaction multiple is 2.5x and is expected to be below 2x after $20 million in synergies, including the pulp mill project previously mentioned. We estimate $15 million one-time cost and capital to achieve the synergies and $14 million in information technology, transition services, and other integration costs. We look forward to closing as soon as we receive the required regulatory approvals and to welcoming new colleagues to Sylvamo as soon as possible. Now back to John for a discussion of our fourth quarter outlook and revised investment thesis.

Thanks, Jean-Michel. I'm now on Slide 16. In the fourth quarter, we project price and mix to improve by $30 million to $35 million as we continue to realize prior price increases in all three regions. We expect volume to be flat to decrease by $0 million to $5 million with seasonally weaker volume in Europe and North America. We project operations and costs to increase by $35 million to $40 million driven by seasonally higher costs in Europe and North America, foreign exchange impacts in Brazil, and an increase in incentive compensation accruals. We expect input and transportation costs to be flat or increase by $0 million to $5 million largely due to higher energy and input cost inflation. Maintenance outage expenses are projected to increase by $21 million as we conduct two planned maintenance outages. This will be our heaviest planned maintenance outage quarter of the year. All in, we expect to deliver fourth quarter adjusted EBITDA of $180 million to $190 million, which would put us slightly below the low-end of our full year guidance of $740 million to $780 million. This change is largely driven by the increase in foreign exchange impact on our Brazilian earnings and compensation accruals, which were not included in our previous guidance. We expect fourth quarter earnings per share of $2.05 to $2.25. And we expect free cash flow of more than $25 million for the quarter, which increases our full year outlook to greater than $210 million. The appendix contains additional information on fourth quarter outlook. Also, appendix Slide 37 shows that we have reduced our outlook for our 2022 capital expenses by $20 million to $155 million. We will be unable to complete certain projects in 2022 due to supply chain constraints and contractor delays. We project spending this $20 million in 2023. Slide 17 shows the three pillars of our capital allocation framework. This is how we think about allocating cash to create shareholder value. At the time of the spin-off, we prioritized debt reduction and returning capital spending to the levels necessary to maintain our mills. Now that we reached our $1 billion gross debt target, we are putting greater emphasis on returning cash to shareholders. We remain a cash flow story. We will leverage our streams to drive high returns on invested capital and generate free cash flow, and we'll use that cash to increase shareholder value by maintaining a strong financial position, returning more cash to shareholders, and reinvesting in high return projects in our business. Let's move to slide 18 to review our fortified financial position. Since the spin-off, we've reduced debt by more than $560 million. We repaid the initial amount drawn from the revolving credit facility and have entirely repaid our Term Loan B. Also, we renegotiated our credit agreement to raise the limits on restricted payments prior to the final settlement of the Brazil tax dispute, so that we now match the terms of our bond agreement. Under the revised agreement, our annual restricted payment limit was increased to $90 million from $75 million as long as our gross debt is less than two times our adjusted EBITDA. Currently, that ratio is less than 1.5 times. Appendix slide 35 provides more details. As a result of reducing our debt, our annualized interest expense will decline by more than $20 million at the current interest rates. Note also that our pension fund remains well funded at more than 95%. So as you can see, we head into the second year with a strong financial position. Back to you Jean-Michel.

Thanks, John. Slide 19, please. We are well positioned to create value for shareholders. We have reduced total debt significantly and $128 million in 2022 spin-off related payments will not recur next year. Returning cash to shareholders is a core component of our investment thesis. We started by paying $10 million in dividends this year and by establishing the authorization to repurchase up to $150 million of shares. I'm pleased that today our Board has approved an increase that more than doubled our quarterly dividend to $0.25 per share effective in the first quarter of 2023. As John discussed, we will continue to reinvest in our business to increase returns on capital and generate free cash flow. This includes our investment in the Nymolla mill and our return capital project. We are investing in our business to increase our cost competitiveness and to remain the supplier of choice. I'm grateful for our talented and engaged colleagues and their dedication to working safely, delivering on our promises to customers and for creating value for shareholders. We remain committed to creating value for all of our stakeholders and are confident in our ability to achieve our vision of being the employer, supplier, and investment of choice. With that, I'll turn the call back over to Hans.

Thanks, Jean-Michel and thank you John. Okay. Lois, we're now ready to take any questions.

Thank you. And we have a question from Ed Brucker from Barclays. Please go ahead.

Thank you for taking the call and congratulations on this quarter. I have a couple of questions. First, could you comment on the lower end of the original guidance? The quarter was strong, and it seems like the fourth quarter might be even stronger. Are you being a bit conservative considering the current environment? Additionally, with the uncertainty, what are your expectations for the outlook of your market credit facility?

Yes, this is John Sims. As we mentioned, our guidance places us at the lower end of our full-year forecast, mainly due to the impact of foreign exchange rates while we’re also seeing strengthening in that area. This situation is somewhat uncertain. Additionally, we've had to increase our accrual for our incentive plan. I want to remind everyone that our incentive plans are aligned with our shareholders' interests and are based on EBITDA margins and free cash flow. The rise in incentive compensation reflects the strong cash flow we are generating this year, which demonstrates our commitment to free cash flow. However, in terms of being cautious, everything else is essentially in line with what we anticipated for the fourth quarter. The price increases we've implemented have more than offset input costs, which appear to be stabilizing across all regions. While input costs remain elevated, we are uncertain about what 2023 will hold due to various uncertainties. Nevertheless, we are confident in our position, particularly our exit rate, our balance sheet with $1 billion in debt, as well as our margins, earnings, order backlog, and the strong relationships we have with our customers in all our markets.

Got it. It's helpful. Yes. I mean it's testament how well you've done with the balance sheet. I guess next question is about that, just if you are thinking about a potential leverage target through the cycle or if I guess a max leverage you'd be willing to take it out given your capital allocation priorities have shifted a bit given that you have paid down so much debt. Just want to get your thoughts on where leverage kind of fits in is in there?

Well, we said that the $1 billion target because we felt that that would allow us to continue to invest through the cycle in high-return projects into the business and it continue to improve our business and also, return cash back to our shareholders. Now, we'll continue to have to pay down some debt because we have amortization requirements for the term loan that we do. So, in terms of your question is with the math that we go, I think we're comfortable in saving where we want to be is at that $1 billion or slightly less. And we think that's a very good position for us to be in and to be able to execute the rest of our strategy.

Okay. Thanks for the time.

Thank you. And we'll move to the line of Ron. Please go ahead.

Thank you. Last year in the fourth quarter, you anticipated operations reaching $15 million due to typical seasonality. Can I assume that, while energy expenses have increased compared to last year, the guided range of 35 to 40 in the fourth quarter is approximately split between normal seasonality and the incentive accrual?

Ron, this is John. Yes, the incentive you're right, but it's also the FX. So we add the FX with the incentive accrual and you're close to that 50% of that cost is driven by those two items.

Okay. So going to the next quarter, whatever is the incentive accrual, let's assume are they roughly equal? Because whatever the incentive accrual ought to go back to some normal level I realize you were under looking earlier in the year. But the extra accrual are to go back. And I guess the FX we just hope to be flat. But roughly the incentive accrual would it be in the $10 million range?

$10 million, that's correct, and about $5 million or so for the FX.

You're going to have significantly less leverage by the end of next year. I understand there is $150 million coming out, but you're generating substantial free cash. Is there a consideration to renegotiate the terms of the agreement, or are you planning to deploy the cash and see if you can achieve more?

Ron, we are currently exploring options regarding the bond perspective to create more flexibility with the restricted payment terms. Additionally, I want to reiterate that the acquisition is not central to our strategy, as we have stated before. However, we are open to considering acquisitions that align strategically with our goals, which was the case with the Nymolla perspective.

I would like to add a point here. We have achieved our $1 billion debt target. As John mentioned, the Nymolla opportunity was quite unique and not central to our strategy. However, returning cash to shareholders is essential to us and has become an even higher priority for our capital allocation. This is why we increased dividends, more than doubling them. At the current share price, repurchasing shares is very appealing. You might wonder why we didn't do this sooner. In the third quarter, we were in a blackout period due to material nonpublic information related to Russia, Nymolla, and the third quarter earnings. So, focusing on cash returns to shareholders is a top priority for us right now.

Can I follow-up one quick one on that. So the $90 million a year you haven't done any this year, could you sort of reach forward in the fourth quarter, because the $90 million starts again for 2023?

We've done $10 million in dividends out of the $90 million for this year. And then it started again $90 million, January 1st.

So you have lots of room to do it in the fourth quarter this year.

We do.

You're welcome.

The next question is from Paul Quinn from RBC Capital Markets. Please go ahead.

Yeah, thanks very much. Good morning, guys. Just on the increased brands in Europe from 30% to 50%, what's the margin impact on that? And then what happens with the addition of the Sweden mill?

We don't want to provide specific details about the margin differences between the brands. There is indeed a margin increase in the premium areas as we pursue it, but there are also additional advantages. Primarily, you can consider how brands become more appealing to customers, creating barriers to imports and competition. Thus, there are other benefits associated with enhancing our brands that we can leverage across all regions.

And concerning Nymolla, they have also a strong brand, which is called Munsi Copy. On the cut size side of the business, it's going to continue to be Sylvamo's strong brands approach.

And the other thing that Nymolla brings to us that we didn't really have with the Saillat mill is strong brands in their commercial printing and forms business. So that's actually an increased market segment for us and an opportunity for us to really leverage that.

Okay. And then just maybe you could give us a little bit more color on this $40 million pulp mill upgrade at Nymolla, as well as when are you taking maintenance at Saillat?

I'll address your second question. Saillat is just 18 months old, so we won't have any maintenance, but we plan to have an annual outage this year, likely around April next year. As for Nymolla, the mill modernization project has mostly been completed this year. We will start seeing the benefits next year when we take ownership of the mill. They have upgraded the back end of the mill, specifically in two areas: a new digest to enhance the production of softwood pulp, which will increase capacity, and liquefaction, which will help reduce costs. The mill operates under a different sulfide process compared to our other mills, and the increase in softwood pulp consumption and production is a positive outcome of this mill upgrade.

Okay. So just lastly does that upgrade affect the production capacity of the mill at 500,000 tons?

No. What it does increase is the pulping capacity. This means we will need to purchase less from the open market. It doesn't significantly increase the market pulp for the product grade. This upgrade allows us to substitute hardwood pulp with softwood that we can source in the region.

All right. Thanks so much. Best of luck.

Thank you. The next question is from Adam Ritzer, Private Investor. Sir, please go ahead.

Hi. Thanks for taking my call. I just had one quick question. You guys gave kind of a pro forma debt number after the Russia sale of what $957 million, I think it is. How much cash are you going to have on a pro forma basis after the sale?

After the sale, I need to reflect on it. We will likely be in the $100 million range. We'll update you on that.

So what you had $390 million in proceeds from the sale and you paid down about $270 million of debt. So is that difference, add to the cash you had at the end of Q3? Is that the right way to look at it?

That's the right way to look at it.

Okay. I will talk about with you that later. Okay. That's what I want to ask. Thanks very much.

We're using cash to pay for the Nymölla mill.

Right. But that's not going to be till Q1 right?

Yes, the number I provided accounts for the payment for the Nymölla mill, as we expect to complete that early in the first quarter.

Right. Okay. Right. So you take that cash minus the $150 million assuming that plus whatever free cash should generate in Q4. Okay. Understood. Thanks very much.

Thank you. I will now turn the call back over to Hans Bjorkman for closing comments.

Thank you everyone for joining our call today. We appreciate your interest in Sylvamo and we look forward to continued conversations in the coming days, weeks and months ahead. Have a great rest of your day and a great week.

Once again, we would like to thank you for participating in Sylvamo's Third Quarter 2022 Earnings Call. You may now disconnect.