Graphic Packaging Holding Company (GPK) Earnings Call Transcript & Summary

All right. Thank you and good afternoon, everyone. We're glad to continue our Goldman Sachs Industrials and Materials Conference with Graphic Packaging. I'm very pleased today to have Steve Scherger, the -- Graphic's CFO here today. Melanie Skijus, who helps head their Investor Relations effort, is also on the line. I just want to remind the audience, there is a webcast. There is a question box in your webcast window. So please do send in your questions. We're going to get to those later. But we will -- we have been soliciting questions from the audience. They've been great. Keep them coming, and we're going to get to those in a little bit. But we're going to really just dive into Q&A, Steve.

So maybe to start, just -- you just came out of the first quarter. Can you talk about the current business environment? A lot of cross-currents between normalizing kind of economy post-COVID price cost. There's a lot of dynamics on people's minds. Maybe let's just start on the volume side and think about what you're seeing in your volumes by end market, by grade, whether it's year-on-year or versus 2019, whatever you think is the most relevant comparison. Just help us think about how you're seeing -- how the volume trends look in the business.

I'll be glad to, Adam. And good afternoon, everybody. I appreciate the opportunity to spend a little time together. Now you touched on it well into the first quarter and into the second. There's a lot going on. And overall, net favorable and positive, but we are managing through some unique times as well that I'll touch on. But on the volume front, overall supply/demand and volume dynamic for -- across our 3 substrates, and as such, across our integrated platform, are quite favorable. Overall, volume was up again in the quarter. We were up on a -- 2% on a 7% comp from a year ago, up 3% on an LTM basis. So we feel very good about the positive momentum of the business, sustainability supported and fiber-based packaging-driven, as you know. And it applies across really all 3 substrates. Our CRB substrate, the overall demand profile there, very good, operating rates and backlogs extended. And as such, we'll talk about the inflationary environment in a moment. But overall demand for recycled products has been quite favorable. You've seen some real growth across the CUK platform for beverage packaging and other strength packaging solutions. We feel very positive about the demand profile there. Again, a global growing substrate, particularly around the beverage platforms with growth around the world driven out of Europe with solutions like the KeelClip. And then SBS has also seen positive in terms of the demand profile. Yes, some real difficult challenges last year with foodservice volume being down in the COVID environment. But as we came out of Q1, we were pleased to see the foodservice business moving into flat in March and is up here, as we mentioned on the call in April. And that's a good inflection, an important one to see. We obviously have to earn on that as well as our foodservice applications come in. And overall, the execution across our new product development initiatives and the innovative products that we're bringing is on track and consistent with, actually for us, having the confidence that we'll be at the high end of our organic sales growth expectations for the year. And one of the things that we're monitoring quite a bit is, as we do see some return into the work environment, how many of the trends that -- very real trends around at-home consumption, working from home, delivery to home, delivery of foodservice to home and there's for longer-term benefit relative to our organic sales growth aspiration. So off to a good start. That being said, as you probably will pivot to, it's certainly been a unique time as inflation came back into the business, we can talk about separately as you kind of work through the questions.

Yes. Maybe let's go there because I think it is something that's very much on people's minds and probably one of the most common questions I get from investors since I've assumed coverage of Graphic. You pretty meaningfully took up your inflation outlook for the year, what -- in your cost basket on your first quarter earnings. Can you talk about the key drivers there kind of the comfort level you have that you've properly kind of ring-fenced kind of the costs that you think you're going to be experiencing this year on the pricing side?

Yes. No, thank you. I'll try to hit both of them. Obviously, you said it well. We had, going into the year, expectations of inflation that would be in the mid-$30 million range on a $2.5 billion commodity input cost spend. And coming out of the quarter, we saw over 5% inflation across that basket of spend. And so we've taken our full year expectations up into the 4% to 5% range. And it's pretty specific around several of the commodities. Obviously, OCC has moved up. We've seen resin-based commodities move up. We've seen some, obviously, around logistics, particularly, and then impacted and influenced by some unique storm-related activities in the -- particularly in the South and in Texas that impacted some supply chain. So we were very pleased to be able to keep our customers in product, but some of that inflation did flow through the business in Q1, and we're seeing it continue in Q2 as we share. Nothing has really kind of stepped back from that. So certainly, the inflation that we've seen in Q1 is continuing here into Q2, as we mentioned on our Q1 call. As such, we've been very definitive and action-oriented on taking the price actions that are necessary to offset that commodity input cost inflation. So whether it's a series of price increase announcements across the 3 substrates or executing on increases with our cost models or taking new actions with noncontract customers or changing terms for things like freight and elsewhere. We also have line of sight this year to increased pricing around $90 million for the year based upon all known and executed price actions that we've taken. But we have over $200 million of price activity in motion that would come in over the '21-'22 time horizon, the $90 million being in the $200 million. And so yes, we have seen inflation come back into the business. We're pleased to see our ability to move that pricing through to our customers in a way that keeps any dislocations short and shallow. That's really important to us, as you know, and important to the value proposition for our business in terms of stakeholder value creation. So more moving parts there than we had seen in a couple of years in what was a pretty benign inflationary environment in kind of end of '19 and '20, changed in '21. It's a good test for our model, and we're pleased with how we're executing on it as we move price through to our customers given the inflation.

So maybe that's a good point to reflect. In 2016 kind of through '18, the company experienced some pretty significant raw material inflation. The pricing didn't really come through. You gave a whole list of kind of initiatives that you have in place to get the price this year. What were the learnings from prior inflationary periods? What have you changed in terms of how you go to market with customers, how the mix of the -- of your cost-based models versus things that are tied to RISI? Just help us think about why this isn't like last cycle. I do think there are lots of...

Yes. No, it's the right question and the right one to ask with memories tend to be long on these kind of things. And I think you have to put it into multiple buckets. One, was industry structure. The structure of the industry broadly across the 3 substrates is more consolidated today than it was at that time. And so there's a structural component to this that's of relevance. That kind of feeds into -- at the end of the day, as you know, pricing is all about supply/demand. And as such, the supply-demand environment today is in a place where when inflation does move through when you look at operating rates, when you look at inventory levels, when you look at the backlogs, those metrics, which are critical to enabling price to move through to our customers when we do see inflation come through the business are in a place where we're able to execute. And that's really probably the catalyst that's different from several years ago when you had a supply-demand environment heavily around CRB that wasn't conducive to passing pricing through when you had a dislocation in cost. And so those are really important. And then in addition, we've had numerous actions to compress the legs, move pricing through to customers in a faster and more efficient way. And the first half of this year is a great example of that. We've had literally $90 million of pricing that we have line of sight to that when we announced earnings on Q4 call, we expect it to be in the 30s. And that just speaks to the ability to take action and do so in such a way that as inflation begins to move, we move. We are certainly also more forward-facing on this topic than we would have been in '16, '17, meaning the moment we're seeing inflation come into the business, we're taking action because you don't know where it's going to go. And as such, we've been very assertive on getting out in front of these actions as we started to see inflation come into the business at the end of last year and into the beginning of this year. So it's kind of 4-pronged in the answer, so apologies for the length of it. But it has both industry supply/demand, structural as well as terms and conditions, components to it that has allowed it to happen in a way that keeps the legs shorter and more compressed, as I mentioned.

That's actually helpful. And you brought up operating rates in that discussion. Maybe that's a good opportunity to just review kind of where we are across CRB, CUK, SBS from an operating rates perspective, from a backlog perspective to help think about that backdrop for pricing.

Yes. And I think I'll focus on several of the key metrics that are -- certainly, that we monitor and that we work to effect in that regard. And you touched on them. I mean the operating rates -- and with operating rates, you have to really make sure that you're looking through multiple months or quarters and that you're conscientious of downtime that occurs to ourselves or to others because of weather or things that get in the way or known maintenance or material downtime. So you kind of have to take a mid- to longer-term view of operating rates, 95-plus being important relative to the ability to have price actions where they're needed. Backlogs kind of feed from that, which is what are the operating rates and backlogs? And are they moving at 5-plus weeks, 6-plus weeks? Which again are conducive to taking the actions that are necessary around pricing where that's required to do so. Those are at 6 to 8 weeks, almost across the entire enterprise. Operating rates are at 95-plus when you look through the disruptions, and I'd say that, meaning look through some of the downtime and some of the weather disruptions that caused some production challenges. And inventory levels, our own and the industry's, are down pretty materially on a year-over-year basis. And as such, there really isn't available inventories. We talked on our call, we're actually in a position where we're actually having to allocate product to our customers in a way that keeps them in product, but is pretty detailed on making sure that we keep our customers in product but are recognizing that there really isn't inventory in the system necessarily that you can rely on. So it creates a tight supply chain. And so we're working very tirelessly to keep our customers fully in product, which we've been doing successfully. But those are the kind of by substrate metrics that we're certainly monitoring, and all of them are conducive to the need to pass pricing through because of the reality of inflation. Because over time, as we've talked, we're really -- we want pricing to offset commodity input cost inflation over time. It's not a margin-enhancing component to how we operate the business.

And just on that -- on the one thing you just mentioned there on customers being on allocation. Is that across all 3 grades? Or is there a specific product line or substrate in a specific geography where that's a bit more of...

Yes. It's not across all 3. It's in some targeted situations where we have particularly tight supply lines and are working with customers to make sure that we've got line of sight to their order patterns for the next, let's call it, month or 2 and -- so that we can make sure we allocate to them appropriately to keep them in product. So it's not a -- I wouldn't -- it's not more like a commodity approach where, to your point, that everything is just being allocated. But it's a term that applies to just a very tight connection with our customers' demand, needs and our ability to produce product for them effectively.

So I want to take that -- I want to switch to some of the longer-term discussion. But given that tight supply environment that we're in, maybe it's a segue. The K2 investment is intended to be capacity-neutral. You're expanding the facility in Kalamazoo. You're closing some other mills. Would you actually consider delaying some of those shutdowns if the demand environment stays this strong into the back half of the year? Or the K2, that's where -- we're set on what we're doing, and that's it?

Well, we built the investment around the variable and fixed cost reductions, and that's how we absolutely built the investment and the $100 million of EBITDA improvement over the '22-'23 time horizon. What we won't do is let any capacity move into the business unnecessarily associated just relative to that supply-demand environment. But we'll monitor it and keep our eyes on it, but it's our intent to close facilities associated with what we conveyed originally. But we, of course, will always look at what's the true demand profile for CRB and are we seeing applications where it could be applied in ways that maybe it hasn't historically. But our plans are our plans, and we'll continue to execute on them. The good news is, as we have levers to pull, as we do across the totality of the platform to make sure that overall supply/demand for our business on a highly integrated basis, is in balance. And so really, we don't have change to our plans because we'd like the plans that we see. We can continue to see the variable and the fixed cost reductions associated with it. But we also -- when we made the investment, even the tailwinds on CRB were a little more neutral than they are today, which is a good thing. It's a favorable thing. And obviously, we'll -- the good news is we've got a world-class asset that we should be able to also grow within itself over time in terms of its own production given the high quality of the asset we're putting into the ground.

Okay. No, that's really helpful. So maybe let's just take a step back, and you've laid out a long-term kind of program. You call it Vision 2025, and there's a growth component and there's a margin component to it. They're interrelated, but let's start on the growth side. And maybe -- can you outline kind of the key growth platforms that you've been targeting, incremental opportunities for fiber-based packaging? Kind of maybe rank order the ones where you're most excited as we just help think about focusing on what's really going to move the needle at the corporate level.

Yes. Thanks for that, Adam. And you said it well. When we brought Vision 2025 to life, we put a stake in the ground over in 100 to 200 basis points of organic sales growth. And so we believe that we could organically grow consistently over a 5-, 6-year time horizon. Been executing on that well over the last 1.5 years. Where we see positives is that the addressable market for our fiber-based packaging at the time of Vision 2025 at the end of September 2019, we viewed it as about a $5 billion addressable market. I think today, we believe it's $7.5 billion-plus. So it's expanded, and that's good because it's grown in areas, food and beverage and consumer-oriented, into areas like meats and cheeses and more perimeter of the store and fruits and vegetables. So we like the potential for that organic sales growth engine. And we have very specific innovation platforms that we are pursuing around plastic substitution, options like KeelClip, for example, like our fiber-based cups replacing foam or other solutions. We also have our cooking solutions, which are outstanding for using fiber-based packaging, and then our strength packaging, which is oftentimes used in e-commerce or club-store-type environments, as an example. And so while all of them tend to be a series of singles and doubles in terms of baseball term, there's -- they all unearth value up $10 million to $20 million to $100 million at a time as these platforms kind of gain value. So beverage packaging is a great example, the KeelClip solution, fiber-based packaging growing globally. We like the decisions that the consumer and our customers and our customers' retailers have made to move to more fiber-based packaging for multiple packaging of beverages is a good example. Foodservice took a little bit of a hit in COVID, but it's coming back. We like what we see with cup conversions, as an example. PaperSeal, a great example that's been a real winner for us. Probably bigger than we thought around moving into some of the categories I was just mentioning where retailers, particularly in Europe, have made decisions to move away from alternatives and move towards more of a fiber-based solution with some additional resins in it still, but a more sustainable and fiber-based solution. So the pipeline is good. We haven't seen anybody move away from their sustainability commitments or the desire to do so. The consumer has certainly moved that direction. So overall, that momentum is good on the volume front. We have to earn on it, which is critical. And we hold ourselves to a high bar, as you know, on our economic waterfalls to make sure that not only does it come in the top line, but unearths value and benefit through the EBITDA and cash flow.

And to the point on the customers, how do we think about the -- where the pull is coming from? Is it purely on the part of your CPG customers and the retailers who are trying to hit their own sustainability and ESG commitments? Are those companies finding actual share gains for products where the packaging form changes? I'm just trying to think about how -- where the real kind of pull is coming from here.

It's -- and again, it's a very good question. I think in many ways, the real pull is from the consumer. I think that the consumers' bias towards doing what's right for the planet to having a preference for environmentally friendly, more circular products, a desire to do more of what is right for planet that we're all a part of. So in many ways, the consumer is the ultimate vote. And as such, then through the retailer, through our customers, through us, is where then the work is to, well, what kind of solutions are those? And fiber-based solutions fit certain applications, not every, and we never try to articulate it that way. But they're -- there's a fit for purpose oftentimes that really works well, both in the eyes of the consumer and the eyes of the retailer and in terms of their preference and then with the CPG relative to their ability to either retain existing customers or attract new. And we find ourselves in conversations with them about both in terms of the products that they're contemplating, whether it's to meet the needs of an existing consumer preference or bias or as a way to differentiate a product for gaining position.

Okay. And you brought up one example of something that maybe exceeded your expectations, which is PaperSeal, which again is a bit more, one, that I think a lot of people, myself included, wouldn't always think of as fiber being well suited for given it's mostly for fresh and perishable items. Talk about -- is that, a, it's still mostly a European dynamic less U.S. to this point, the ability to actually take out the plastic? Or how much incremental resin and barrier films and for quality and freshness do you still need? Just how do we think about growing that?

Yes. No, you summarized it well. It's a little more European-focused today, a little more Asian-focused today in terms of the early adoption. You've said it well. It's a perceived better solution but not an optimal solution. So it has less plastic and resin in it but not entirely free. And as such, I think as it continues and we continue to evolve the product categories, we'll continue to be investing behind it for more circularity, more recyclability, more biodegradability. So I think I would characterize it as on that journey. The cup is a good example. We're working hard to develop and commercialize and scale cup solutions that move further away from resin-based coatings in them. And so I would -- like you just were doing, I would characterize many of the products we're talking about as better than the incumbent, but there's always more to do. And you can't rest on your innovation efforts to continue to drive towards even more sustainable solutions relative to how they can be reused or become circular in their utilization.

And then on that point, how do you think about the key challenges in terms of commercializing some of these new products? And help us think about maybe the relative unit economics for a fiber versus a resin-based solution.

Yes. Thank you. The -- it's critical that, yes, while the consumer has a bias or a preference for certain products and certain characteristics, you have to be able to still produce at scale and on a cost-effective basis. So while there can be some premiums, and we've seen examples of modest premiums for alternatives to replace other substrates, it still does have to meet the overall business case for our customer, meaning they're making some investment. It's incremental. It may be small in the scheme of the overall COGS, but it's still an increased cost in the package itself oftentimes. And as such, those premiums, we work hard to make them modest and receptive to being executed on and that we can make the products in scale, at scale. Because often, as you know, we're in the business of making millions and billions of things, typically, in terms of the quantities. And so it's important that we can scale them and make them cost effectively. So there are going to be some premiums, but they need to be rational in your expectations, other than in truly niche scenarios where the price of it is less relevant, but those tend to be small.

Okay. And so maybe the other part of Vision 2025 is around kind of EBITDA and margins. And so remind us -- again, there's the price/cost dynamic this year that we're all watching very closely. But there's a lot of capital that's being committed today that should have some benefits in '22 and beyond, whether we're talking about K2, we're talking about the swing machine in Texarkana, the supply agreement that you got with the Greif asset. Can you remind us just things that you already have line of sight to that you hit the base investment plan, there's EBITDA growth and margin that's kind of really built into the outlook already?

Yes. No, you were touching on in several of them. And if you kind of talk about moving from, I'll call it, the 16s on an EBITDA basis up towards our vision of the 18 to 20s, you were just touching on it. So organic sales growth of 100 to 200 basis points, erring on the high side of that unearths both EBITDA dollar growth, and over time, help support margin growth because of the innovative nature of the product. So that's one avenue for margin expansion. Our traditional productivity initiatives, $50 million to $70 million a year, more than offsetting labor and benefits inflation unearths some margin benefit over time. And then you've got your larger-scale investments because capital has been escalated and high over the last couple of years, which will come down to more normalized levels. But earning on those investments, that $100 million on Kalamazoo, getting the economics out of the swing machine in Texarkana, those are margin-enhancing investments. And then just our ongoing capital, as I mentioned, in places like Monroe and the facility here, world-class converting facility, curtain coaters, investing in places like Sneek into -- in the Netherlands for incremental enhanced converting capability. So it's -- you said it, it's a bit of and all here. So it's that combination of organic sales and our productivity initiatives, and we're looking forward to generating the cash flow from that next year. We're levered up a little higher than we have been historically. And so it's important for us to begin to see that value creation to in terms of generating, not only margin enhancement but moving real cash flow through the balance sheet and allowing us to be back in that 2.5 to 3x leverage over time.

That's maybe a perfect segue then to my next topic, which is capital allocation. So you talked about taking the leverage down. I think you want to be about 3.5 by the end of the year. How do we -- does Graphic actually want to be investment-grade, maybe if the metrics there? Do you actually care from a cost of capital perspective? Does it make a difference?

Yes. On a Vision 2025-type conversation, we've definitely put investment-grade into that dialogue. So when you take a multiyear view out into the end of that time horizon at $10 billion-plus and leverage in -- at the lower end of that range conceivably, yes, that might be the time and place. So is it in the horizon? It's plausible. Do we like the flexibility we have today to lever up like we're doing when we need to and we're borrowing very effectively? We're in a bit of a sweet spot today for being able to borrow very effectively yet give ourselves the flexibility to do what you just articulated, which is a good balanced approach to capital allocation. We're working through a 2-year window on CapEx being higher than what would be the norm going forward. That will subside coming out of this year and our cash flow benefits next year. We want to have M&A as a possibility. We've been very clear, M&A plays a role. You've seen us continue to be acquisitive and would expect us to continue to be going forward. So we have to have the balance sheet flexibility to do so. But we'll only lever up if we've got clear line of sight to levering down. And then we've been very aggressive over the last several years in buying back the company, both in the form of the International Paper monetization that's taking place as well as buying back the company when we had high confidence that the inherent value was higher than where we were trading. And so those have been the big ones. I don't really put the dividend increase high on the short-term list, long term potentially, but not in the short term because we've got plenty in front of us in kind of those other major categories of capital deployment, certainly as we come out of '21 and look into '22.

Okay. And I want to be mindful of time so there are a couple of questions that come in from the audience. So there's one here. The investor is asking about the typical lead times on orders from your food and beverage customers. And I think they're trying to get a sense of your visibility on volumes as you move through the year. Like at what point do you actually know kind of we know what the volumes are going to be, assuming we operate?

Yes. Great question. On a day-to-day order basis, our customers have good line of sight to what's around the corner. But we also are very engaged with them on what their expectations are for the year, what do they expect relative to their order patterns. And nobody has perfect line of sight or vision, but we had enough of it coming out of Q1, for example to be able to see through the next 3 quarters to be able to say, "We're pretty confident we'll be at the high end of our range." So there's enough visibility on real execution of new product development activities, secured customer contracts that we have with them and what those expectations are to give us confidence that we kind of have a good sight into what the remaining year looks like. Not perfect, but pretty good visibility. Now things can move and change if truly there's a disruption economically or if something really goes off the rails in terms of how the economy is functioning. But given kind of the flow of at-home and away-from-home consumption patterns and new product development initiatives, we have good enough line of sight to have confidence in where the full year will be on an organic sales basis.

Okay. That's helpful. So maybe coming back to the capital allocation question. Maybe just help me think about rank ordering kind of the priorities uses of cash. And clearly, CapEx is coming down. But between bolt-on M&A, bigger M&A, kind of share repurchase or IP unit reduction, same difference really, how do we think about the priorities for those? You did the Americraft Carton deal recently. But bigger M&A in particular, just what is there kind of likelihood that actually come to pass?

Yes. No. And I think probably rather than rank ordering because at any point in time, we take a very balanced approach to capital allocation, and M&A is one of those where you don't know when it's coming, right? So Americraft, we were absolutely thrilled when the Johnson family indicated that, that was something that they were interested in pursuing with us. And so it comes along when it comes along. And so whether it's that size M&A or the shortlist of potential larger, they kind of happen when they happen. And so we won, I want to make sure we've got a balance sheet that can execute on M&A when we believe that there's significant value creation from it. And so we'll keep that powder dry for potential M&A on an ongoing basis. But then we'll continue to put capital to work, but we put a lot of capital to work. So we're actually looking forward to taking that number down, and we've already kind of forwarded into taking that number down materially next year in our current form from $700 million down into the $400 million range. And so that's a real shift, and as such, a real generation of capital. And then with International Paper, I think both parties, and it's been a fantastic partnership, are seeing the path towards full monetization. And I think you'd expect us to continue to move down that path, but we have a lot of flexibility on how we do it. But we'll do it with the balance sheet in mind because we are a bit above our range, as I mentioned, probably ending the year closer to 3.5x.

Okay. And then maybe final one me touches on that being ready for M&A. Remind us your return on invested capital or accretion hurdles as you're approaching a target transaction.

Yes. Talking about it in a couple of different ways. Obviously, you know where our cost of capital is. It's probably in the 6, 7, 8 range, depending upon how short, medium or long term you kind of look through that. But we certainly want to generate returns well above that, and those are our aspirations. We've tended to buy businesses, certainly over the last couple of years, in the 8 to 9x EBITDA range. We've got clear line of sight to take 2, 3 turns out of that consistently. That's how we think about it to get to above cost of capital returns. We have to see that cash flow come to unearth positive benefit to us. And then we'll keep that bar appropriately high for what kind of return expectations we believe are capable of any M&A that we do. And also, we are very accountable internally for holding ourselves responsible for those returns. So we track against them and measure against them to ensure that we're on track to achieving those and track them all for multiple years to make sure that we actually do create that value.

Great. Well, look, I think we're just about bumped up against the scheduled time. So maybe we'll leave it there. Steve, thank you very much. Thanks so much. Everyone, thanks for joining. I hope everybody has a great rest of their day. Thank you so much.

Yes. Thanks, Adam. Thanks for the opportunity. Thanks for everybody that joined. Take care.