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

All right. Well, good afternoon, everyone. My name is Adam Samuelson. I'm the agribusiness and packaging analyst here at Goldman Sachs. We're thrilled to continue our Industrials & Materials Conference today with Graphic Packaging. We're thrilled to have Mike Doss, who is Graphic's CEO here with us today. I want to remind the audience before we get into Q&A that we are going to -- yes, we do really welcome and love the questions from the audience. There's a box in your webcast windows. Please do send those in. We love the audience participation. I'm going to get dive right into questions with Mike, but if there's questions from the audience, please do send them our way, and I will get to those as the session continues. But Mike, thank you so much for taking the time today and joining us.

Thank you, Adam. Great to be here, and I welcome everybody on the call. I really appreciate the interest in Graphic Packaging.

So great. Well, maybe just to set the stage, you reported earnings about 2 weeks ago. Pretty constructive first quarter and start to the year. Maybe just to level set, just help us think about what you're seeing in the market today on the demand side? And kind of how that's informing your view of how, both what you've seen this year and how you think the rest of the year can play out, more on the demand side, then we'll get into the price cost questions in a little bit.

Sure. Yes. So listen, it was a good start to the year for us, particularly when you think about the Omicron variant in January really kind of being a challenge in terms of getting people and personnel back into our facilities to operate them efficiently. That impacted us a little bit and our customers as well in January and early February. But that pretty quickly washed through by mid-February. We executed well in February and in March. Really pleased to see 3.3% year-on-year organic growth, very solid growth in our foodservice business as mobility started to improve again. We saw that business up on a volume basis, low double digits, with all the pricing was actually up almost 30%. And as I mentioned on the call, that business now is actually ahead of pre-pandemic levels in terms of where we saw volume. So that was an important milestone for us, and we continue to build on that momentum. A lot of our initiatives around plastic replacement and the strategic priorities we've talked about in terms of our new product development. We profiled a number of those at our February investor meeting for investors to see. And we continue to see traction along those lines. Maybe, Adam, the other thing I'll say is that our 2 strategic imperatives that we had announced over the last couple of years, one being the Kalamazoo CRB paper machine. We started that up in the middle of February, ramped up through March. We averaged almost 800 tons a day in March, and that number has continued to improve since then. Very high-quality material, qualifications have gone well. Overall, feedback from the marketplace has been great. And then in Europe, we've been busy integrating our AR Packaging acquisition that we made, and I'm happy to go into detail wherever you want to go and talk about on that. But we saw volumes even in a pretty uncertain macro with all the things that are going on from a geopolitical standpoint. Solid on our AR Packaging business as well as our legacy European business, and it performed very well in the quarter from a volume standpoint. So we think all those things kind of come together and inform our opinion that we can be towards the high end once again. For now, it would be the fourth year in a row of closer to our high end of our target of 100 to 200 basis points of organic growth year-on-year. And by way of reminder, over the last 3 years, we've actually averaged around 300 bps. So pretty solid momentum there. And that's a real strategic priority for us in terms of how we're building the business. And it's nice to see those results showing up here in Q1.

All right. No, that's really helpful. So maybe we can -- your business and the grades of paperboard that you supplied, it's very stable, nondiscretionary categories. But can you just remind us, and as you look at the market today, kind of where you're seeing backlogs, inventories, end customers? And I think that would be an important point to inform kind of confidence on that growth outlook for the balance of the year, just where -- how you're seeing kind of the tightness in the market today and that plays into pricing?

So I know there's a lot of questions out there around our customers' inventories, and are they building inventories? What I can tell you is that we are actually still constrained in terms of what we're able to sell them. As we talked about on our Q1 call, we're running wide open on all 3 of our substrates, so CRB, SBS and CUK. As a matter of fact, our backlogs are a little longer than we'd like them to be at 10 weeks plus. We'd like to see those more 7, 8 weeks. We're able to service our customers a bit better in that kind of an environment. So very healthy backlogs don't believe there's much, if any, inventory building going on in the system. Obviously, we'll continue to watch for that. But based on what we're seeing from new orders and new order requests and people looking for tons, that business continues to be very busy. In terms of which grades are probably the strongest? I mean, look, as I said, all 3 of them are up around 10 weeks. But I think I'd point to CUK, if I had to single one out in terms of a substrate that just has a lot of demand based on functional characteristics, kind of the price value. We're selling strength and care there, Adam. As you know, we make a lot of beverage cartons and pizza boxes, so things that need tear and strength in the overall food distribution channel. And the demand for that has grown over the last 15 years. And Melanie had a slide in one of our presentations at a 3% CAGR. So really great grade for us. We've actually had pushed some CUK business into SBS. And now with our new CRB platform starting up and the quality we see coming off of that machine, we'll actually be able to take around the margin, some additional growth in share that historically would have wound up in CUK, but now we can make it in CRB. So we're looking at all those things and that really is how we fund the paperboard to drive that 200 bps growth that we want to achieve this year.

Can I just ask, have you asked your team on your side, just going to check the sound, Mike. It faded out there a little bit as you were speaking.

All right. I see some hands going up there. Hopefully, they're able to make the progress [indiscernible]

There we go. That sounds much better. No, that color is really appreciated. So I guess it's a really good segue into kind of this discussion and this key kind of investor point on price cost. Often as many of the -- drives many of the inbound questions that I get from investors about Graphic, and I'd love to just maybe approach it from the -- maybe start to look back and help frame how the company's approach to pricing has changed in this cycle versus the past? And kind of how that -- apart from just the market backdrop, how that's informing how you are going to market today? So I think it's very different than in prior cycles, and I think it's really worth to emphasize that point.

Well, look, when you've got 1-week backlog, that gives you a fair amount of leverage, right? And if you look at what we've been able to do in terms of some of the announcements we've made and the increases that we've pushed through. Admittedly in 2021, last year, the inflation came at us fast after winter storm Uri. It took us about 6 months to kind of get that momentum really going. Once we did, though, just on a high level, we took $330 million of inflation last year. We offset that with $150 million worth of price. And then rolling into this year, we put a range out there of inflation, which we just recently moved up to 450 to 500 -- or excuse me, $650 million, but we also upped our pricing to really a target of $850 million, meaning we'll make up the price cost spread that we drug into this year as well as have -- we're out in front of what we see happening now. And we're still seeing sequential inflation, albeit at a slower pace in certain categories, and I'm happy to go into details on that once we're done answering this question. But things we've done is shortened up our lags. It used to be 9 months, now they're 6, you see it flowing through the P&L. We break it out for you in our waterfall so that you can clearly see what's happening there. We think that's important. We think it's important to show investors a multiyear look at what our pricing is doing given that lag. So as we said on our first quarter call at the end of our second quarter, we'll update that with a preliminary view of what we see for '23 pricing. We sell to big multinational customers, and they do expect there to be some shock absorber that we've got there. And so we've gotten pretty comfortable with that 6-month lag, meaning we get 2 movements a year. But what we've also done, Adam, is really worked hard on what I'll call the terms and conditions of the Ts and Cs. So tightening up the openers, tightening up some of the noncontract bids, tightening up some of the rules of engagement. How much inventory do we store? Where is the freight going to be counted for? Storage costs, obsolete inventory, all those types of things that actually have a margin impact. So those are things you don't necessarily see because it's not raw pricing. But when you're in a good market like we're in right now, you need to take advantage of that, and that's in fact what we're doing. So a lot of momentum on the pricing side. It's starting to flow through the margins. You'll see, we had $222 million of pricing in Q1, where we're pointing to $850 million for the year. And that doesn't include the most recent round of $50 a ton increases that we have out on all 3 of the substrates. So it's going to be another big year for price, that's for sure.

So that's really helpful. So maybe just first, taking that last point, as you think about taking -- another try to take the $50 across all 3 substrates. Any part of that, any one of those maybe that you're seeing even more acceptance or you're more or less concerned about than the others?

We're pushing them all in unison. And again, I got 10-week backlogs here at Graphic. So our conviction level is high.

Okay. And then you alluded to what you're seeing on the inflation side, still sequential increases, but maybe not as steep and as universal. Can you maybe disaggregate that? And where are you being still most surprised on cost inflation? And maybe where are you seeing, if not relief, then moderation?

A couple of things, and these are public, so you can kind of get a frame for what we're seeing. Nat gas is an example, Adam. It's something that is inflated since the beginning of the year, really principally driven by this conflict, just tragic conflict that is happening in the Ukraine right now. And if you look at what's happened for nat gas, we see prices on an MMBtu basis that are in the mid-7s. We buy 22 million MMBtus of natural gas every year. A year ago, that time -- or this time, that number was closer to $3 an MMBtu. So that's still something that's out there. Of course, the price of diesel, it's well chronicled, it's up. Having said that, we do see things like line haul rates, particularly spot freight rates that for the last 10 weeks have actually moved down a little bit, and that will start rolling into our contracted rates here as we renegotiate those contracts here on a quarterly basis. So there'll be some positives there. There'll be a few positives on OCC. You've seen that go down roughly $50 a ton since October. On the other side of that, some of the high grades that we use in CRB manufacturing have moved up as the tissue manufacturers continue to run pretty strong. It's things like happened this morning, publicly, Celanese announced force majeure situation on a number of their commodities, specifically VAM, vinyl acrylate monomer. And that's a building block for a lot of adhesives and latexes. And so that will pressure some of those things that we buy. So it's inflation that kind of pops up in pockets like that we have to respond to. You put it all together, it's still inflating. But like I said, at a slower rate than it was certainly a year ago this time.

And maybe the decline more recently in OCC, is that a signal of logistics and exports to China? Is that maybe a bit of a canary on recycled paper demand or supply domestically? Just how do you look at that and interpret that?

Yes. I'd have to say I don't really know for sure. I mean, I think some of the historical things that we used to gauge that stuff are probably not as relevant just given the disruption in the supply chain. It's not hard to see the argument that you just made that because of the inability to ship some of that material in the export markets, it's backing up a little bit here in the U.S. So that's certainly a plausible explanation.

Okay. All right. So that's really helpful. So maybe -- if we maybe -- you brought this up earlier, but last year was a pretty active year on the M&A front and a pretty significant one that you did in Europe in AR Packaging. And I'd love to just -- we're now nearly 6 months into the transaction. Just help us think about what you're seeing in the business? And especially since Russia invaded Ukraine, and as you've seen that business see a pretty upended market environment in Europe, how do you feel that, that organization is responding and kind of maybe what you're learning about the real caliber of what you bought?

Yes. So it's a great question. And what I'll tell you is we got what we thought we were going to buy, which is an important thing, right? Because sometimes you buy something and it's not exactly like you thought it was going to be. This one is -- as a matter of fact, I'd actually say it's better than what we originally had thought it would be, meaning that our team that we've been able to put together and the talent we got with AR Packaging and the combined leadership team that we've built along with one of our expats, a gentleman by the name of Joe Yost, who was in Europe until about 5 years ago, came back, ran our Americas businesses. Now we've [ expat-ed ] him back there, so he knows that market good, have really come together. They're gelling well, a lot of positive energy. Markets have remained solid. We're steady. We're busy. I mean, in many cases, Adam, it's around our ability to buy paperboard as opposed to not have enough demand. Because as you've read, I mean some of the paperboard markets in Europe have been a little bit dislocated here with some of the challenges that the mills have been having there. But look, Joe and his team locked down a lot of those tons in the fall of last year. We're servicing our strategic customers well. We've got a high degree of conviction and confidence in our $40 million of synergies we put out there. Admittedly, this year won't be a lot just given the inflation that's coming, but next year will be a sizable number towards that $40 million, and then we'll get the balance of it in '24, as we outlined when we announced the deal. So Look, I like the deal. We'll get the 2 turns of synergies we looked for. But more importantly than that, we've entered some really great markets that we were underclubbed in, and we're learning a lot. So that would be like health and beauty, pharmaceutical, those types of things, high-end cosmetics that Graphic historically did not participate in anywhere in the globe. And now we have plants that are dedicated to doing that kind of work. We've got management talent that knows how to manage those operations and commercial expertise that we can now build upon as we look to continue to drive our growth ambitions over the next few years, as part of our Vision 2025.

And do you see -- where you didn't participate in some of those types of customers and products in the past, is that something you see an opportunity to bring back stateside and find new -- leverage those same relationships or the similar ones in the U.S.? And then does that -- how much capital do you think that would -- a capital question, just putting the capability in place?

Yes. I think the big thing for us on that, first off, we tend to run our business centrally. And so while we have distributed management responsibility on a geography basis, at our core, we're a pretty tight company in terms of what we do. I mean we've got one principal market, it's folding cartons. And so when we find a business or buy a business or enter a market through new product development, we look to learn quickly about what we have there. And sometimes it's better to buy the talent and buy the capabilities then to try to build them yourself. And we try to make those decisions along the line. I'll get compare and contrast. So making KeelClip rings, that's something that we do for our beverage business. So it made perfect sense for us to just do new product development. It's a new product. We can do that all ourselves. When you look at pharmaceutical or health and beauty, there's some specific good manufacturing practices and the way you operate those facilities and how you go to market and commercial pricing strategies that if you're not participating in those markets with talent, it's tough to do that kind of as a build-out. So we like doing that, and we do think there are opportunities for us to learn in Europe. And we've demonstrated that before. If you look at the business we bought in 2015, that was called Benson Box. Their principal market was convenience business, where they sold to all the supermarket stores there in the U.K., and they sold service. And high touch, really, really fast turnarounds, and we learned a ton on that business, and we've been able to bring that back to the U.S. and then scale up how we do that here with some of the retailers here with a great deal of success. So that's how we do it. And you can expect that we'll look to do more of that here. And in terms of the CapEx requirements of doing that, it's all within that 5% to 7% max CapEx as a percentage of sales number we rolled out at our Investor Day. That's plenty for us to do. We can improve the company quite well with that and drive our growth ambitions.

Okay. Well, I'd love to talk a little bit more about those growth ambitions. And I guess, I mean you brought up -- you talked about some of these AR applications that you've now brought some capabilities in, and you talked about another in KeelClip and what you're doing on the beverage packaging side as areas where you see real growth. I mean, can you talk about the level of customer engagement that you have in the pipeline of new business that you're building. Are you seeing that conversion time shorten? Extend? Europe has often been a leader in the switch to fiber-based packaging. Are you seeing that same momentum domestically? And how do you just prioritize the opportunity set in front of you?

No, you're right. I mean the trends for packaging, all types of packaging usually start in Europe. And that's one of the main reasons we wanted to get bigger in Europe and pursued AR Packaging aggressively and built out now, which is the largest consumer fiber-based business in Europe that we're operating around 22% market share.

Mike, can you -- I think your volume is fading out there again. Can you just get your team to try to...

They're adjusting it. How is that?

A little more.

How about now?

Much better.

All right. Great. So as I was saying there, Adam, we've got 22% market share there. And so we anticipate that those trends will continue to occur in Europe and those trends are usually anywhere between 18 to 24 months ahead of what we see here in North America, so we're learning. We can kind of rapidly scale things here to drive those opportunities. We've restructured our business a little bit in terms of how we're managing our new product development process. A little over a year ago, we shifted the leader of that department to work directly for me. So Ricardo De Genova, who's our Senior Vice President of New Product Design and Development, he works as part of my staff. And so what that allows me to do is really stay close to what is happening from a trend standpoint, remove those barriers organizationally that may get in the way from time to time, to move quick and make decisions to allow us to capture market share quickly. And so -- and certainly capitalize on those new trends that are out there. So again, it's a combination of being in the right spots, having the right structure and really being nimble and being able to execute quickly. And I think we've demonstrated our ability to do that, and that's why we've seen now over 3 years, 300 basis points of new product growth every year.

Got it. And as you are -- as you're pushing with -- as you're continuing to work with our both existing customers and prospective customers, where do you still see the biggest barrier to accelerating that adoption? Because obviously, growing that downstream demand is how you achieve that Vision 2025 goal, rise the -- better margins on the paper -- paperboard, more integration. Where is the gating factor that you -- is there capabilities that you could still benefit from internally? Or is it just time and effort with the customer set?

I think it's time and effort. I mean there's wood that's got to be chopped in order to kind of develop this stuff and make sure that it works for them. But we also need to make sure we've got the paperboard and it's available to service their business the way that they want to be serviced. And one of the things I'm really excited about, Adam, is in North America, for the next probably 2 to 3 years with our ramp-up in Kalamazoo and us continuing to run our Middletown mill, we're going to have high-quality, low-cost CRB tons. And we'll be able to take advantage of that substrate and move things around the margin out of our other grades to make sure that we've got that paperboard to drive that top line growth profitably that we've been talking about. So I think it's time and effort and work with customers as well as making sure you've got the paperboard to supply them consistently because they need to know their supply chains are going to work. They got a lot of stresses right now. They can't afford stock outs. They can't afford having to pay slotting fees for material that isn't on the shelf. So our ability to respond quickly is a key part of that. And I'm just thrilled about our new machine in Kalamazoo and what that's going to mean for us over the next couple of years.

Yes. No, obviously, maybe is a good -- something I was going to ask about. And you talked about maybe not shutting down the Middletown facility kind of initially, which has been part of the original plan. Help us understand how that -- how you came to that kind of commercial decision? How that impacts the project returns? And maybe as you think about where -- what it can enable further down the road? Just where -- how that decision has evolved?

Yes. So maybe if we go back to the summer of 2019 when we announced the project, we basically said we were going to build a state-of-the-art 500,000 ton CRB machine in Kalamazoo, and we're going to shut down 4 older machines, and it was going to be capacity neutral. We're going to spend $600 million to do it. We're going to deliver $100 million of EBITDA. So wind the clocks forward here through the pandemic, which we didn't even know what COVID-19 was at that time. Our overall demand has continued to grow. I've hit it a couple of times here, but it's real, and that our tonnage requirements are driven by that growth that I'm talking about and the acquisitions that we've done as we integrate those up through our business. And so we just need more CRB to operate our business and to grow it profitably. We're very sensitive to the supply and demand dynamics. I think we've demonstrated that with how we've actively managed our capacity over the last decade. But right now, we need every ton that we can make. And so we're shutting down our Battle Creek facility because our start-up in Kalamazoo is actually a little ahead of schedule where I thought it'd be even when we were together in February. So we're taking that line down. We have roughly 60 operators that are transferring from our Battle Creek facility, which is 16 miles away from Kalamazoo. So it's a good story there, too. We get talented individuals and people get to keep doing what they love to do, which is make paper. We upped our savings as a result of running the Middletown mill, and it's not thinking about it. We said our plan is to continue to operate that mill. So you can write down those 180,000 tons that come with that. And what that means is that there's another $30 million of overall contribution that was going to go away that will not go away now. So the project will return $130 million. You get about $50 million of that this year and then another $50 million the following year and then the balance in '24.

Okay. And maybe that's a good segue because we get this -- you think about how AR is now in -- is now part of the organization and where that has changed the integration kind of component. I mean how do you think about sourcing, supplying that business and that downstream demand moving forward? And do you -- could there be a need for more capacity in the North America system? I would think that's cheaper than producing in Europe down the road, but how do you approach that?

Yes. So it's a great question. And so you're right, we buy globally, including what we buy in North America around some supply agreements, excuse me, about 1 million tons of various grades of paper. And so the opportunity here for us to drive our integration up and obviously, profitability, too, is to make those tons over time, probably not all of them, but a lot of them. You're right, North America is, from a cost curve standpoint, particularly when you look at nat gas, I'm complaining about $7 an MMBtu natural gas, the equivalent for that in Europe right now is $35. So it's a big delta the CRB manufacturers in Europe as well as anybody who's buying natural gas. And so yes, we're looking at that. Obviously, that may not stay that way forever, but right now, there's a big bias from a cost standpoint. The North American producers are, by far the lowest cost producers of paperboard in the world. And we do have a lot of experience shipping our paper to Europe. This year, we'll ship over 250,000 short tons of our CUK or SUS material to Europe, in the PacRim and Australia and New Zealand. Those markets will -- to our own converting facilities. We're not selling it on the open market. That's going downstream into our own converting facilities. And so we have the experience. We're going to watch the cost curves, and we're going to be smart about how we allocate the capital to stand up low-cost capacity. But again, as we talk about the low-cost capacity, think about that in the context of 5% to 7% of CapEx per sales, and then a commitment that Steve and I outlined of that $10 billion plus and 20% EBITDA margin. So they all go hand in hand. If we spend that kind of capital, you can expect that our margins will continue to go -- to increase as a result of the integration and the savings, the cash savings for making our own paperboard.

Okay, that's helpful. And maybe just in that context, and we've now had a few months post the Russian invasion of Ukraine, and energy markets remain very volatile in Europe. Are you seeing any evidence of more -- less production in Europe, more imports out of North America that might be even more supportive to your base business here? Just what -- is there any evidence of that in the marketplace yet?

Well, I think right now, what we've seen over the last year is less imports into the U.S. market, and that's backed up by the U.S. Census data. We can track it and see it. Through the first quarter of this year, imports were down high single digits year-on-year. It's just hard to ship things right now internationally. There aren't enough containers. It's expensive. Then once you land it, you got to truck it or rail it to wherever it's got to go. It's just a really long supply chain. So I don't expect that to get materially better in '22 just given the shutdowns in China in the ports and the kind of dislocation of containers globally. I mean you read about all that, too, and see the challenges associated with that. But what we're seeing in Europe is actually more of those tons staying in Europe. They're having good growth. They need them -- those tons in Europe right now to service the demand that's there. There's a little bit of extra material. You've heard some of the producers over there talk about that was going to Russia now is available for kind of Mainland Europe, a couple of hundred thousand tons maybe annually. So that's a pretty small number given how many tons are converted there, which is almost 10 million tons annually. So I think that -- [ more of ] that will end up staying there in '22. As you go into '23, maybe these supply chains open up a little bit more, maybe they're a little more efficient. Time will tell. But either way, we've got 1 million tons that we buy. We're going to leverage that buy very smartly and strategically in terms of how we do it. And then we've got the opportunity to invest for high-return projects that could allow us to make some of our own paperboard going forward. So I love our optionality here, Adam. It's just we're in a really great spot. You want to build that converting out first, which is what we always do and then invest behind it, and it's a great story. And we do see a path to 90% integration by 2025, and that really derisked the corporation dramatically.

Okay. And maybe on the point on investment, just a couple of quick ones on the capital allocation front. Obviously, you did the AR Packaging acquisition at the end of last year. In the near term, deleveraging is a higher priority use of capital. But how do we think about the comfort with leverage? And is investment grade a priority? Is it a potential? Is it -- or where -- how -- as we -- where are you comfortable on the leverage point before capital return can maybe come back into the discussion?

Well, so maybe a few numbers that I'll put it into context. And I know the computer algorithms here drive a lot of this on stock trading. And right now, there's kind of a risk off kind of the mentality with a lot of good reasons, right? Given the uncertainty on the economy. So what you have seen is a bit of a challenge. But if you really think about it for Graphic, even though we're in the low 4s right now, pointing to by year-end being somewhere between 3.0 and 3.5x levered, driven by a combination of EBITDA growth at our midpoint and then obviously using that free cash flow that you correctly will go towards debt reduction in 2022. Our cash interest cost this year is around $170 million on $1 billion -- $1.5 billion of EBITDA. So really good interest coverage there. And a lot of that is fixed debt. Now I think by the end of the year, we'll approach 70% of our debt stacks will be fixed. Just how we've -- our treasury group has done an excellent job kind of building that in over the next 3 to 4 years. But beyond that, as we kind of [ drive ] down to our ratio that we've committed to for '23, which is somewhere between 2.5 and 3x for debt, we will take a look at investment grade as a strategic option there, maybe a little longer money. Up to this point, there hasn't been a lot of value in it in terms of interest rate coverage or interest rate reductions. As you know, you can get a little longer money, and sometimes that's helpful. But when you look at our average interest cost, it's in the mid-3s. And so we're borrowing very effectively, and most of that's fixed here over the next few years, and we're going to generate a lot of cash flow, as you know. So we're quite comfortable with the capital structure of the organization.

Great. Well, I think maybe -- I think that's where we're going to have leave it. We're just up against our scheduled time. Mike, I want to thank you so much for taking the time today joining us. Thanks, everybody, on the webcast for listening in, and hope everybody has a great rest of their day.

Adam, great to see you, and thanks for having me.

Thank you.