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

Welcome back, everyone. Gabe Hajde here, Wells Fargo's packaging analyst, joined by my colleague, Zach. And our first presentation today is from Graphic Packaging. Representing the company is the CFO, Steve Scherger, I'm sure you guys are familiar with; and Melanie Skijus, Vice President of Investor Relations. Welcome to the 2 of you. Thank you.

So first, I wanted to kind of start with a high-level question, we were kind of talking about this beforehand. But I think the pandemic was kind of perceived as a net positive, at least from a volume perspective, across the board for maybe consumer packaging. But GPK, foodservice, obviously, which is about 20% of your business, was negatively impacted. But the offset, obviously, through the grocery channel was pretty notable. I think results over the past 2 to 3 quarters, quite frankly, would suggest there's some normalization effect but that things are holding in there pretty well. So perhaps work from home and, we know, learning are contributing to that. But can you talk about the efforts of your customers perhaps reformulating their products for health and wellness or convenience that keep these volumes kind of sticky?

Yes. I'll be glad to, Gabe. And again, thanks for having us. Glad to be here. Good to spend some time here with other folks as well, and thanks for those that joined us. I think you were touching on some important aspects of our business. If we look back over the last really 2.5 years, as we pivoted towards the ability to grow organically, to have an innovation engine driven by a very large addressable market for fiber-based sustainable packaging, recyclable, renewable, the consumer has done a very nice job of pivoting towards some natural biases, some preferences for fiber-based solutions. As such, our customers, the CPGs, have been on a journey for finding opportunities to make conversions that make sense relative to the product, relative to the functionality where our solutions can be a preferred solution. And we've seen over the last couple of years very real identifiable positive momentum, whether it's plastic replacement, whether it's strength packaging, whether it's microwave or cooking solutions or conversions into cups. We've seen very real movement, positive movement that's resulted in the 2% to 3% organic sales growth that we've seen. And you said it well. We had to work through and we've been in truly unprecedented times geopolitically, inflation, obviously, the pandemic, where we had to weather through, yes, some at-home consumption improvements, but foodservice down. But when you kind of look through it all, the net has been organically favorable. And as we move towards more mobility and people being out and about more, and we're seeing that as we're spending time together here today, we -- as we look through that, their -- the realities of a new flexible work environment, an evolving flexible work environment, actually, I think, works as a net more permanent positive because of more at-home consumption and just the realities of more flexible work, more on-the-go work-from-home perspective. And even interestingly, and I apologize for the length of the answer, but even in our foodservice business, the drive-through has become -- in QSR as the majority of our foodservice business, the drive-through has become the place as opposed to the end of store. That actually works favorably relative to our products and our consumption patterns. So you add it all up, we've now got 2.5 years of 2% to 3% organic sales growth and a pipeline of innovation activities that gives us the confidence that we can continue to grow organically as we have been.

Yes. No, I think the foodservice and the fast casual has certainly changed things over the past 5 to 10 years in terms of just consumption patterns overall.

I agree.

Also, kind of a high-level question, but something that I'm sure on investors' minds, one of the perceptions is that, again, packaging companies tend to be fairly defensive in periods of economic uncertainty or a recession. So I think in your Q1 earnings deck, you gave us some key differences between today and 2008, 2009 time frame and that recession. I would kind of like your perspective on how the company is positioned should there be sort of a recession? And then maybe product lines or geographies that stand out as more susceptible? Again, we even talk about QSR, but I almost feel like that's a staple for folks and a reasonable -- it's an economic way to get calories. And I guess the one thing that comes to mind and we're a little less familiar with is AR Packaging, just sort of your early read and maybe what can happen there.

Yes, and thanks. And we did, coming out of Q1 earnings, put a little bit of a from-to as a reminder of back in the '08-'09 time frame, we were a $4 billion top line business, very food- and beverage-oriented, and we were defensive then. But we had a lot of leverage, and we were a very different corporation than the one that we are today at nearly double the size and also very much more distributed today from a market and geographic perspective. So if we have to weather through a recessionary environment similar to '08, '09, we actually believe that we're better positioned today with a stronger balance sheet, probably a better overall supply/demand environment and improved industry structure, wider geographic distribution and more distributed, to your point, around food, beverage, which is now 56% of the company; plus foodservice at 20%, plus a much larger consumer packaging business and a much larger footprint in Europe. And you add all that up -- and yes, if we have to go through a recessionary environment, we'd likely see some slowdown. We will. But the realities of our participation in branded as well as private label is consistent with the realities of how we consume. And so if there's movements in and out, we expect that we will be able to weather through that actually quite effectively. So what is really kind of unique about the business we are today is that we can be on the offensive when we've got growth that can be captured, like we were just talking about, but we also have a defensive posture that still has the ability to generate very significant cash flows. And in '08, '09, we actually expanded margins because you saw a step back on the realities of commodity input costs. And as long as the supply/demand environment stays in appropriate balance through a recessionary environment, which it can, you actually could even see margin expansion in that environment. Maybe.

Okay. Sticking with demand, I guess. Backlogs, I think your latest touch point was greater than 10 weeks across the board. Can you tell us the last time that you kind of saw backlogs at that level and maybe how long it took you to work through that? Again, maybe just describe for us the environment.

We've seen pockets. Typical backlogs kind of what I'd characterize as strong customer service, strong ability to service our customers, appropriate backlogs relative to the supply-demand environment tend to be in the 6- to 8-week level. And so 10 weeks is extended. We've actually never seen it across the entire infrastructure of all of our substrates because all 3 of our major substrates, SBS, CUK and CRB are all at greater than 10 weeks. It's actually longer than we would prefer because we're not servicing our customers as effectively as we want to. We're actually doing a very fine job given the supply chain dislocations, but not at the kind of premium levels that we want to service our customers relative to on time and in full and efficiencies, et cetera. And it will take -- I think what we're seeing is, I think we'll probably work through that here as we bring Kalamazoo to life and bring some of the investments we've made there, which we can talk about separately. But I think you'll see over the next several quarters, probably a move back to some semblance of what I'd characterize as a good, strong set of backlogs that are value-creating relative to ability to manage price/cost. But I think we'll probably weather through that over the next few quarters.

Okay. And I guess maybe one of the concerns that investors might have, and I think this is true for a lot of industries, is given a lot of these supply chain disruptions, customers may be placing orders across multiple suppliers to ensure that they have product availability. In the event a supplier comes -- delivers on time and in full, then they're okay carrying, what I'll call, some safety stock, given, again, kind of a lot of the uncertainty. Is there any way for you to gauge that at the customer level, or again, just maybe up through the commercial channels, their perception on how far ahead maybe customers are ordering?

Yes. And it's a great question. And frankly, we see none. And it's almost a function of that 10 weeks is that's as soon as we can get you product. And so there is really no preordering or ability to buy ahead. If you kind of step back from it in a unique way as a packaging company, we're almost a $9 billion corporation. About $8 billion of it is almost the job shop. It's literally make something for somebody. And as such, there really isn't an order-ahead pattern that can happen. We also have very deep-rooted relationships with our customers, with our CPGs so that we're servicing them in the exceptional capacity that we work to do so, doing it extremely well. But I don't really see any scenarios around where there's been buy ahead or kind of pull forward. We're all operating with less inventory than we would prefer. And over time, I think that, that will normalize, but I don't see any evidence at all, actually, based upon our engagement with customers that we're in a buy forward-type environment. Great question, by the way.

All right. And then foodservice has obviously been on a recovery path. We touched on a little bit there. And I think you said on your Q1 call, it was actually above prepandemic levels. I'm assuming that's volumes. But can you lay out for us kind of how you see that business evolving over the next 2 to 3 years. Asking for 2 reasons: one, because I know you have some new products and innovation there; and two, SBS tends to be one of the more fragmented markets. I know cupstock is a little bit insulated, if you will, from some of these other Bristols and other markets. But...

No, you asked it well, and you summarized it kind of where we are. We obviously saw almost 20%, 25% volume decline in kind of the deepest parts of the pandemic. We, over the last several quarters, have seen a renewal back to volume levels consistent with prepandemic, and the pipeline of growth inside of that business, inside of our foodservice business is actually quite material. We continue to see opportunities for conversions from other alternatives into our fiber-based solutions. We've got several things in motion that we feel very good about. And so our foodservice business consistently growing kind of at or above the 100 to 200 basis points that we've identified for the corporation, we feel real -- very good about that. I think our innovation teams are doing a nice job of bringing the products themselves to market. Not everything goes exactly as you expect, but overall, the actual volume trends in that business are quite favorable.

Okay. And then competitive landscape, either maybe by product line, CUK, CRB, SBS or market, we know kind of direct exposure to the Ukraine or Russian conflict is limited within your organization. But can you give us an update on your operations kind of within Europe and potential for ripple effect? Just sort of maybe the tone or feedback that you're getting from your European team.

No, absolutely. And you mentioned AR Packaging earlier. So I'll touch on that as well from an integration perspective. I mean, first and foremost, our thoughts are with the horrific situation in Ukraine and Ukrainian people. As you mentioned, our actual exposure to Ukraine, we have no operations in the Ukraine. We do have 2 facilities in Russia. It represents about 1% of our top line and a little less than 1% of our EBITDA, so small on a relative basis. And we've got a team of folks there that are continuing to operate the business to the best of our abilities to do so within the context of full adherence to the sanctions and both U.S. and EU-based. And as we mentioned on our Q1 call, we're going to continue to actively explore options for that business as we look forward, and it's small. Overall, the integration of AR Packaging, which we acquired back in November, is really meeting and exceeding expectations. The team has come together very, very well. The leadership team is an outstanding combination of leaders from Graphic Packaging before the acquisition and leaders from AR Packaging. The interest in being a part of that team has been extremely high. Our integration full-time team has identified at or above the synergies that we've committed to, the $40 million over a couple of years, and the business is off to a very good start. Sales and EBITDA, we saw growth in Q1 in our legacy business. And then AR Packaging and EBITDA expectations met our expectations. So we're off to a great start there. And the actual implications kind of Pan-European for us are -- of this crisis are kind of probably flat to actually very modestly positive, unfortunately, because some of our competitors have had impact from assets that they've had in Ukraine that may not be operating, or in Russia that were for export. So we're actually assisting in some ways. And so we're seeing some very modest positive from that, fortunately. But that's kind of the realities of the market dynamic.

Okay. And given AR is kind of a new addition to the platform, and there's a lot going on, obviously, as it relates to trade flows with paper, have you seen any disruption to date on paper supply? Obviously not operating any mills over there. And does it put extra -- either does it present extra opportunity here in the U.S. or put extra strain maybe on your domestic system.

Yes. Our team upfront did a fantastic job of kind of seeing almost 6, 9 months ago that the supply/demand environment for paperboard in Europe was very tight on a relative basis. And so we've secured the appropriate paperboard for that, which we acquired that -- which we buy, which is a very significant amount of paperboard. And we put ourselves in a position to send over the 250,000-plus tons that we send from the U.S. CUK to ourselves. And so overall, we've been meeting customer demand pretty effectively actually and have secured the paperboard. That realities of that market, and while there's been some capacity additions that will come on board here, '23, '24, '25 in Europe, the reality is that the demand profile in Europe for sustainable fiber-based packaging is quite high. Growth is very good. And as such, there's actually been fewer exports from Europe to the United States of a couple of substrates, particularly FBB, which kind of competes with SBS. So in some ways, there had been some favorability on a U.S. basis from a supply/demand perspective because of the strong demand for sustainable solutions in Europe, and Europe has kind of led the way on that, as you know. And so overall, that dynamic has been probably net modestly favorable.

Okay. Sorry, I feel like I'm going to go off script here for just a second. But have you had any, again, feedback from your team over there in terms of mills having to make choices of operating or nonoperating because of cost of energy and/or availability, I guess, at that point?

There are some examples where those tend to be to date with what you're referencing is an explosion in energy costs, nat gas, particularly some oil-based. And there have been examples primarily on what would be our definition of CRB, the coated recycled board, they referred to it as the white line chip board, where if you're not an energy producer, so if you don't have the ability to produce energy, both mill, et cetera, and you're a net buyer, you actually have had to make trade-off decisions about runability versus the like. And we've seen some examples of that. It tends to be in third and fourth quartile mills that run more of on a nonintegrated basis, but it's something to be monitored and mindful of. And I think that with the long term in mind, if you have kind of a visual around energy costs being longer for higher -- higher for longer, if you will, I think that some of that is going to play out. It certainly has an impact on keeping paperboard more local and European, if you will, particularly for the lowest cost producers who are competing in that market.

Okay. I guess I'll stop there and ask if there's any questions from the audience. I don't -- typically, there are not. The obligatory -- and you can jump over the chair, if you want. I think since you guys reported earnings, there was a price announcement that RISI had picked up. So as of, again, kind of last update, you were pursuing or implementing $1 billion. I think $150 million was achieved last year, $850 million this year, and that was to be expected kind of Q2 to Q4. So with this incremental $50, again, back of the envelope math says maybe $35 to $40, if it gets recognized, let's say, in June, just the way contracts work and RISI functions, you might get a little bit of that in the fourth quarter and then it really is a 2023 kind of event, if you will.

Yes. No, that's well summarized. Going into earnings, the $850 million of pricing for this year, $150 million from last year was all as recognized with our market-based models, our cost-based models, our renegotiations with our customers, tightening up terms, et cetera. So that was very clear. Following earnings, you're correct, we did announce another $50 per ton price increase across all 3 substrates, and you summarized it well. Assuming that's recognized on the time line that we're executing on it, the majority of that impact is in 2023. There will be some modest impact in 2022. And it's a recognition of -- or really a continuation of this inflationary environment that we're in. We haven't seen any natural abatement yet, and it's pretty unprecedented that what everybody is enduring and what we're absorbing, which is also in the context of the $330 million from that last year of real commodity input cost inflation and another $450 million to $650 million this year.

Yes. I think the only thing I would say is on the OCC front, that's -- I'm sure your customers say, well, but that with the exception of, I think, the knock-on effect and kind of the second, third derivatives. What I'm hearing on the chemical side is that you've got a lot of inflation there, and obviously, truck transport, et cetera. So it's working its way through the system.

I would agree with you completely. And even OCC is a good example. OCC at the raw material level has seen some movement down, but at the logistics level, to move the OCC, it's still on a total basis is up. And so it's -- you kind of have to look through that. You just touched on it. Nat gas moving around here in the U.S. quite a bit here recently, diesel moving around, which is why we're still a bit of a wide range. We had a -- just repeating from Q1 to kind of line of sight to the first $475 million of inflation for the year. It's kind of where things were mark to market. And to your point, things are moving around, but all those things hold together actually quite well relative to where we were, consistent with Q1.

So you brought up the guidance, and I think I may have been the one that asked about it and why the range was so wide. And it would be that, if I were in your shoes, it would be that wide, by the way. So don't take that the wrong way. But as we take all these things into account and thinking through kind of your line of sight, again, I would think to myself, well, maybe they've got a shot to be at the midpoint or above. So I'll take the different angle. What would have to happen for you to kind of hit the low end of the range, do you think? Is it more volume? Is it inflation? Is it price is not flowing through as you expect? Or I'm sure it's a combination, but...

Yes. I think -- obviously, to your point, we have a lot of confidence in the midpoint of our EBITDA guide. And to your point, there's some opportunity for upside inside of that, and that's inherent in the guide, in the numbers that we provide. If you kind of look at it on the downside, there'd probably be a couple of things. One, if there was just some very unusual acceleration in inflation, something truly happened that just caused a bit of mayhem, and you were just touching on it, in chemicals and something that really would move the commodity input cost to the high end of the range, we don't see that today, but that's the potential dislocation. And then we're constantly focused on our controllables. And if we didn't perform as expected, Kalamazoo, AR Packaging, it's plausible, which is why the range is there, but our confidence in the start-up at Kalamazoo with the world's lowest cost, highest quality CRB mill is really on track, and we can talk about that here in a moment. And as I mentioned, the AR Packaging integration in a very good spot. And so as we also mentioned on the call, we'll definitely narrow the range here in July after we report Q2, and it will be the right time to do it. Our line of sight to inflation at that point, I expect, to be pretty high in terms of line of sight to where it's likely to be.

Well, that's where I was going next was -- I appreciate the response there, Steve. The Kalamazoo. So obviously, it's kind of been in the works now for a few years, and you guys are now being able to kind of cultivate or -- these returns from the project and showcase for folks what you're doing. Just in terms of your confidence level in the $130 million and kind of the different levers or the, I'll call it, the stage gate of how that progresses, can you walk us through that?

Yes. No, I'll be glad to, and I appreciate you raising it because -- and we've talked about this a fair amount. When we took the decision to do this back in 2019, it requires some patience, obviously, from an investor perspective when you put that much capital to work over a multiyear time horizon. And at that time, we expected $100 million of EBITDA improvement from the investment. And at that time, we didn't -- we had no growth assumed in that. It was purely like-for-like cost, like-for-like capacity. We're more excited about the investment today even than we were then because we now have line of sight to both a world-class cost structure and the confidence that we have in the start-up. We've informed our teams at Battle Creek, Michigan we'll be closing that CRB mill, consistent with our original expectations. But we now have line of sight to actual organic sales growth, which has us maintaining for now our Middletown, Ohio mill to support the demand profile we have, because we now have 3 components to the return profile. We have fixed cost reduction from closing facilities. We have variable cost reduction from using less water, less energy, and we have organic sales growth, which moved our return profile from $100 million to $130 million over really a 3-year time horizon. And as we mentioned on the call, the start-up is going absolutely as we expected it to. And so our confidence in the first $50 million this year is high. The value of that will start to benefit probably more Q3, Q4, but we'll get a little bit here in Q2. And the teams in Kalamazoo are just frankly doing a masterful job of dialing in the machine, ramping up the production day in and day out, and we're at or above where we expected to be as of now, which has been outstanding outcome to date.

I was going to say, you must sleep well.

I sleep on occasion.

We mentioned at the Investor Day -- no I just -- I'd say that it sounds like a lot of things are going right at the moment. So the 90-plus percent integration target, you guys have taken a little bit of a different strategy than one of your peers, which I think is proving to be the right one. But this 90% vertical integration rate by 2025, it's kind of coming from 3 different buckets. We touched on the organic growth, internalizing some tons. And then the third part was acquisitions. So I'm assuming you got better line of sight into -- first one we've talked about a lot. The second one, internalizing tons. So can you share with us kind of, again, maybe just time frame associated with that or investments that might be required? I know you haven't announced anything formally, but just conceptually.

Yes. No, and I appreciate you bringing it up for the reminder. We're currently -- we exited the year about 2% integrated, meaning 72% of all the paperboard we produce, we turn into a packaged product that we, as a consumer, will take off the shelf or utilize, and that's been a huge part of our strategy. That number back in 2019 was in the 60s. And so we've made good, strong progress. And you've said it in February with our latest Vision 2025 update, we took an 80% to 90% original vision and said we actually can see 90%. And 100 to 200 basis points of organic growth drives 72 up into the high 70s just on organic growth. And we purchased 1 million tons of paperboard. So we produced about 4 million, but we purchased 1 million tons. Those represent integration opportunities for us. And not all of them can be managed, but some of them can. We buy quite a bit of CRB in the United States and Mexico. We buy a lot of CUK-type equivalents in places like Europe and Brazil and Australia and New Zealand. And so those represent probably the path into the low to mid-80s in terms of integration and then the path to 90% that goes out to Vision 2025 would come from probably from integration of additional M&A. Now this year, our capital allocation strategies are very clear around debt reduction. So M&A is not as critical from a capital allocation perspective. But when the balance sheet gets into the scenario that it will, as we exit out of '22 and '23 back into that 2.5 to 3x leverage range, then we -- the doors open up quite nicely to additional capital allocation priorities to drive integration rates higher.

I know it's challenging in a format like this, but I mean is there a list as -- when you go back to your desk of things, of opportunities that you see like, hey, if this comes up for sale, I'd like to take?

We do. We do. And just to give you a little insight, and we've talked about it before, we kind of take what I'd characterize as an always strategy mode with our Board. And we're always in conversations around our swim lanes, if you will, of what are the acquisition options that exist, what's the actionability, can they be actioned, what's our point of view on likelihood of something coming available. So we always have line of sight to small, medium and large scale M&A in terms of what we think is possible, both geographically and as well as within market. And then, of course, we've got long-term views around our capital investments. So we do 5-year capital planning. So we're in an always mode there of what investments are plausible. What are the return expectations? What do we believe can be done, small, medium and large there? And then we always talk about those and share those with our investors as we make those decisions. So when it comes to those 2 big buckets of our capital allocation strategies, we all -- even today, when we're in very much a debt paydown, it doesn't stop us from doing the work because you don't know when things will become available. And you've seen us be pretty balanced in our capital allocation priorities over the last 5 years, lots of M&A, big capital investments that make sense, buy back 20% of the company as we exited out of the IP transaction, which returned value to shareholders. And then we, of course, got the dividend as well.

Okay. I want to switch gears a little bit to sustainability. And I mean I think you guys have a pretty good story to tell. But we've been reading kind of a decent amount in the press about extended producer responsibility. And I think the paper trade groups, at least as I've seen, have kind of been pushing back on that pretty hard to say, "Hey, look, collection rates, recycle rates are pretty good for paper." So what are some of the other considerations, if you will, that municipalities that should be taking into account when they think about kind of the broader -- because this is a multidimensional problem, right? We have to convince consumers to do the right thing. We have to educate folks, et cetera, et cetera, and have the infrastructure in place. So just your perspective on that.

Yes. No, thank you for asking that, and you were touching on some critical things. Certainly, one of the very positives about fiber is that it has, on a relative basis, a high recycling and reclamation rate, so 65-plus-or-minus-percent. So there's a very good, strong infrastructure that exists, both at the consumer level and industrial level to bring the fiber back and produce the OCC that we then can make fiber-based solutions 6 or 8 more times after making it the first time with the virgin paperboard. We have to continue to encourage the recycling rates to move up and so to help municipalities realize that cups can be brought back into the recycling stream and we have the ability to take them. And so working with, whether it's consumers, around what's possible around what can be, in fact, recycled when you put it into recycling bin, or working with CPGs to encourage the products be not just disposed of in the normal waste stream. So there's no singular answer there, but we firmly believe that what is a very good recycling rate today can be better. And there are great examples, certainly, in some medium- and large-sized communities, where that education process and the like is, I think, going to have an impact as we look out over the next 3 to 5 years. And that keeps it on the mind of the consumer, too, in terms of, yes, this product can be recycled multiple times, and I should take the steps necessary to be helpful in that way.

Sure. One interesting thing, and this is sort of trying to think about, again, derivative impacts. But Weyerhaeuser, I think, bought some timberlands recently, and the price is probably a little bit higher than what most folks would associate with timberland. I think part of that was sequestration opportunity for selling emissions and stuff like that recapture. Does that -- how does that play into maybe the medium-term thought process around the cost of virgin fiber?

Yes, a very good question, by the way. I think to date, what we would say is that in very strong wood baskets with strong growth patterns, particularly -- and we'll speak specifically to where we acquire most of our wood, the Southern United States, I think that the value of the land will stay consistent with the value of the harvesting, the ability for the land to produce and produce again and again. I think where you're finding some of what you just described would be on lands where growth patterns aren't nearly as substantial. It's longer growth, yet there now is value that can be created through some of the credits and some of the things you're articulating, which has taken land that may not have been as valuable for the purposes of growing and harvesting and regrowing trees to actually having some greater value for alternative uses. We don't see anything today that would indicate that, that will impact our wood baskets around our virgin mills. Could it collectively have a modest increase if you kind of take a U.S. or North American-based? I think it's plausible, but I think in our wood baskets, just because of the highly productive nature of those wood baskets, I don't think that it's likely to see that as much of an impact.

Okay. We're coming close on time here. One question that I always like to try to give you the opportunity is, what is -- what do you think the investment community is not understanding well or maybe a misperception that might be out there of Graphic?

I think we're on a journey to earning the right to be valued as the packaging company that we are. We are a highly integrated packaging company. That's what we do. We're not a producer of raw materials. 70% of everything we do, and 85% of our top line is a packaging company. Our margin profile fits it, our return profile fits it. And the last 2.5 years of 2.5% to 3% -- 2% to 3% organic sales growth are the proof points that there's a growth engine here. And I think we recognize you got to earn that right. When you live in a neighborhood that sometimes has earned that right in the past, you've got to show that you've got -- that you're in the right ZIP code, if you will. And we're earning that. And I think that's ours to do. We take that as our responsibility to let the facts and the metrics and the returns speak for themselves. But I think that's the thing that really is the -- if you're looking at should I be investing in this business, the reality is the metrics associated with at our packaging company. And I think that's what we've got to continue to show.

Great. Well, I think that's it. Thank you for your time.

Yes. Thanks, everybody. Appreciate it.