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

Good afternoon. Thanks for being here. My name is Kyle White, the lead analyst of Packaging & Environmental Services here at Deutsche Bank. We're very happy to have Steve Scherger here, Executive Vice President and CFO of Graphic Packaging. Really appreciate Graphic Packaging's participation here at our conference. Thank you for being here.

No, good to be here, Kyle. I appreciate you giving us the opportunity to do so, and congratulations on the good conference. Feedback's been good from our dialogue so far this morning.

Sounds good. If anyone from the audience would like to ask a question, feel free to just raise your hand anytime throughout the presentation. There is a mic that will get around to you, so just wait for the mic before you ask a question so that everyone can hear and for the webcast as well. But with that, we'll start off with the fireside here.

I guess just kind of kicking it off, maybe kind of current update on demand -- or people that are maybe newer to the story, from a high level, what you saw from a demand standpoint throughout the pandemic on your volumes? And then why have volumes even now that we're past the pandemic kind of stayed robust still?

Yes. No, great place to start. And I think if you look back over what's now the last 3 years for us as we kind of brought Vision 2025 to life in September of 2019, we've seen steady 2% to 3% real organic sales growth in our Consumer Packaging business, which is entirely fiber-based. And so if you look at the product categories that we participate in, the market categories, food, beverage, foodservice, consumer, kind of throughout the pandemic, yes, we saw some pockets where there was a little bit of accelerated, At-home growth, for example. Foodservice coming under a little bit of pressure. But if you kind of stand back from it all, overall consumption patterns for the consumer and a bias towards fiber-based solutions really has supported what's been a consistent 2% to 3%, 200 to 300 basis point growth over the last 3 years. And we saw that again in Q1, even though there was some appropriate return to mobility as folks, all of us, kind of getting out more for us, overall demand profile for our solutions with the innovative products that we've been bringing, things like KeelClip and PaperSeal and others that are growth into food and beverage and foodservice markets. Kind of regardless of the mobility and how things have been, we've had a good, consistent and steady growth profile. We saw that in Q1. We're seeing that in Q2. So it gives us confidence that our organic sales growth, really kind of consumer-driven sustainability-driven, innovation-driven has the kind of sustainability to it that we're seeing here again in 2022.

Yes. Sounds good. A lot of focus more recently has been on price elasticity of demand, especially given the inflationary environment we're in. If I think about that from your perspective and your mix, I think the most risk might be on foodservice. Is there -- have you seen any kind of weakness there with the potential softening of the consumer on the foodservice demand side?

Yes. And thanks for that. I mean our foodservice business, which is about 20% of the company, so a $9 billion total top line, about 20% of it is in foodservice, it's very heavily weighted towards QSR. So think about that as the Chick-fil-A's and Dunkin' Donuts and on-the-go consumption. And what's been interesting over the last couple of years particularly is the drive-through is winning. And so we participate very actively in the drive-through with the cups and the bowls and the plates, et cetera and the on-the-go consumption that is there. And so to date, we've actually seen a return to kind of pre-pandemic demand levels for foodservice, and then the growth in our foodservice business has been heavily driven by conversions of cups primarily into paper-based, fiber-based cups from other alternatives. And so really, foodservice has kind of done a nice job of returning back to pre-pandemic levels, and then now we're seeing growth with it given some of the conversions we've seen from other alternatives.

Backlogs were 10-plus at the end of last quarter for across the grades. Is that still the case today? And then what would you characterize as kind of a more normalized environment of where backlog should be? And then is there any kind of paper grade that is seen a little bit better or longer backlog?

Yes. No, you said it well. I mean, at the end of the first quarter, we talked about 10-plus being week backlogs really across all 3 of our paperboard substrates. That continues to be the case. I think if you kind of look at it, historically, you would say 8-plus-week backlogs would be conducive to the realities of taking price where necessary to offset commodity input cost inflation. So we're in a very strong demand environment. That has stayed that way just given the realities of what we just talked about, which is a good demand profile for consumer fiber-based packaging. Overall supply pretty steady net-net. Imports of some products, paperboard products that compete in our markets like FBB have kind of more stabilized. And so the net of that, in terms of industry structure and the supply/demand, have kind of resulted in that. And it's really across all 3 substrates. And I know one of the things you've seen us do is we're really thinking about the paperboard that we produce, the 4 million tons or so that we produce, 73% of which ends up in an end product that we, as a consumer, take off the shelf. We're really treating that as a true portfolio of paperboard solutions, and we've been moving between and among where necessary to really meet customer demand, but also then that results in kind of pretty consistent backlogs across all 3 categories of substrates.

Yes. That was one of my questions that you're on, but we'll touch on now. Texarkana mill, where you're having this flexibility to kind of meet demand and change over to whatever paperboard grade is necessary or seeing growth. Curious where you're at with that right now in that investment. I think you're still producing SBS, just given how strong SBS is going. And then do you have other opportunities in your mill system to make kind of similar investments and add that flexibility?

Yes, and thank you for that. We did announce that roughly $100 million investment a little while back to have one of the paperboard machines be capable of making both CUK and SBS. We've held off on doing it because of the demand profile. And so it's still a good project. It's on hold. We won't do it here in '22. We'll assess in '23, can we afford the downtime necessary to actually make the investment because we want to keep our customers in product. And as I mentioned before, we've actually converted some products over to SBS, and they're kind of staying there a little more permanently in that case. So we've got great flexibility there. It's a good example of a project that increases flexibility across the whole platform. We'll do it when we can. And as we've talked before, there are other options for investments that we can continue to make in the platform. We've talked about the optionality at our Augusta mill to actually make potentially an FBB-type grade. That's a good example of a project. We have not made that decision as we talked at our first quarter earnings. But we like the optionality that we have, and it's all in the context of how we would allocate capital broadly in terms of our capital allocation strategies. And so right now, the primary emphasis is bring Kalamazoo to life. We can talk about that separately, have that be the fantastic investment that it was meant to be with the world's lowest-cost, highest-quality CRB. As we then dial that in and see those economics come to life, then we can assess other investments.

Yes, sounds good. Let's go straight to Kalamazoo. I think based on some of the industry reports that we saw, it seemed like it was a little bit delayed and which is understandable. We're seeing that with other companies in terms of the supply chain, yet your target in terms of the benefit you expect for this year is to remain constant throughout. Just curious, is that -- was that some conservatism in the target? Or is it just kind of -- was it in line with your scheduled time line?

Yes. No, I'm glad you raised it like you did. When we first announced the $600 million investment, we thought it would come to life in Q1 of this year. We then were on track to actually go faster, talked about that, said we could do it in Q4, and then it ended up still being in Q1. So the good news is it's on the original time line, which gives us confidence that the $50 million of EBITDA improvement this year is there to be had. I can't applaud our teams enough in Kalamazoo and broadly the teams that have supported the project. They're bringing it to life as we speak. We were running very effectively. Right now, the paperboard is very high quality, appreciated by our customers and are converting facilities that actually make the products. And so our confidence in that $50 million in the second half of the year and $130 million over a 3-year time horizon is intact and we feel really good about it.

What's the pipeline in terms of capital allocation and CapEx for similar-sized projects like Kalamazoo to drive that kind of productivity and savings benefit? Is it -- do you have similar projects on the mill side? Or is it stuff you can do on the converting side as well, probably more sizable on the mill input?

Yes, the larger-scale investments, like you said, would tend to be more mill-based. This particular investment was pretty unique because we could invest in existing facility in Kalamazoo and close other higher-cost facilities, which we've just completed the closure of our Battle Creek, Michigan facility team there did a great job of managing through an eventual shutdown and thank them for that. But those are unique to have something that's of that size. They tend to be smaller in terms of the size of the capital investment. As we've talked before, we're kind of in a constant 5-year capital planning process for the capital spending. And we've got a good long list of projects that make sense, and then we literally allocate them in the context of how does it fit into our broader capital allocation strategies relative to M&A and putting money back into the business. So that one was pretty unique in terms of its size and scale, things like we were just talking about, Texarkana and Augusta are materially smaller, just given the uniqueness of Kalamazoo.

And then to go back to backlog a little bit, a lot of concern right now from investors and some headlines are seen as related to inventories. You've also seen customers trying to make sure they have security of supply. So I guess the question is, have you seen any kind of double ordering or any kind of un-normal kind of order patterns?

Yes. No. And it's a little bit interesting because we read the same things that you do relative to some of the retailers' inventory levels and the like. It's -- we're a little bit unique in that we're literally a $9 billion job shop. You order our products, we send you the products. And so the amount of inventory building in our business is very small. We do a little bit of inventory building in our beverage packaging business to support summer seasons for soft drink and beer consumption as an example, but it's really not an environment -- we haven't seen any examples of, what, ordering ahead or double ordering, mostly heavily influenced by the backlogs. There really isn't an opportunity to do so. And so we're obviously want to support our customers exceptionally well, and most of that is just getting them on time what they need for now. And our customers really would build carton inventory, if you will, in terms of our products. So we haven't seen that really across our business.

Yes. I mean to touch on it, it might be hard to see, but like you said, some of the retailers have talked about inventory builds and trying to wane off of that. Do you -- are you concerned at all that, that might have an effect on you 6 months from now, 3 months from now?

Yes. I think if you look under the recent news, particularly with the big retailers, Walmart, Target, I think what was there in detail was that the inventory build was more in durables, larger-scale items, the television, the appliance, the deck you're going to build or whatever it may be. It's really -- in many ways, I think they're clearing room for food and beverages. Because at the end of the day, we all have to eat and drink. It's something that is at the core of how we sustain ourselves. And so I don't think the inventory build conversation is necessarily targeted where we live, but that doesn't mean that there won't be any of it. But I think, that particular issue, I think, is a little more focused on other categories.

Yes. I want to take a pause and see if anyone from the audience has a question that they'd like to ask. Sounds good. We'll go into everyone's favorite topic, price cost with Graphic Packaging. We'll start with the prices...

That took you longer than most.

You had some other -- you led me to some other topics that I had to address, but you can't miss price, that's why I got to go back to it. So for pricing, you're targeting $850 million this year. You're out with another price increase that we'll know how successful that is in the coming 2 weeks or so, but that likely doesn't flow through until next year just given timing and everything. Not really a question, but just wanted to phrase that and see if you had any updates on it, but also curious on moving contracts to more cost-based models versus list-based? It's something you guys were doing a few years back. It seems like the narrative on that kind of paused a little bit, but is that something you're still looking to do?

Yes. Now let me touch on kind of all the components you were just -- that you were just talking about. As we talked at the end of the first quarter, clear line of sight to $850 million of price that we're executing on this year. Those are known price increases where we have and are executing on an additional price action here in May and June that we're executing on with our open market customers. And as you said that there will be some benefit this year, but more likely out into 2023. And the market will opine on that here in a couple of weeks, as you said. But keep in mind, we are executing on those price increases because we've announced them and are executing on them. You touched on the cost models. You're right, I mean, we go back 5 to 7 years really started to attack broadly the terms and conditions we have with our 2- to 4-year contracts with our customers and began the process of migrating customers over to a variety of models, cost models. And yes, some market-based models. We've had a lot of success in doing that, kind of got to that 50% level. And then to your point, that paused a little bit. And we've really been focused on other terms and condition changes as well to continue to match price and inflation, things like eliminating delivered freight as an example. That's been a big move where you take the variability of freight off the table in terms of that cost not being a delivered cost, but one that's from our facility to them as an example. So we've been active doing those -- making those kind of moves. We've tended to run into more competitive roadblocks in the past relative to risky versus other alternative cost models. If there's some momentum towards alternatives being more pervasive from an industry perspective, then our customers will be more open to it. I have no doubt relative to that. At the end of the day, what we've got to continue to do extremely well is have pricing mechanisms that are in place with our customers that allow for a prudent and timely pass-through of inflation when we see it. And so that's really for us, what we've been very intensive about so that when we have line of sight towards the possibility of inflation, we're taking appropriate price actions and keeping any lags and dislocations, small and modest in duration. And that's really what we've been executing on here and 2022 coming out of when inflation started to hit as hard in '21.

Is this something to where you think you can move the models from 6 months to 3 months? Or...

I don't know that we'll get all the way down to 3 months. I think it's the line of sight to the inflation and a modest lag. 4 to 6 months is something that, I think, is tolerable relative to the fact that, keep in mind, unlike some other pass-through businesses that buy known raw materials that are commodities and they can pass that through in very short order, we produce that raw material. And so there has to be a little bit of some time in order for us to absorb that cost and then have it actually be passed through because we're an integrated company. We make the raw materials in addition. But listen, we have an enormous amount of confidence in the price that we're executing on, the guidance that we provided for the year is the right guidance. We'll continue to narrow up the range in July around that, but pricing is critical, as you know, particularly given in this pretty unprecedented inflationary environment.

Yes. And then shifting to the other side on cost. You pointed to the $450 million to $650 million range from commodity cost inflation this year. I think last quarter you mark-to-market around $475 million. Is that still the right kind of target that investors should put into their models? Or where is that today?

I don't want to necessarily have a mark-to-market conversation every time we talk publicly.

I got to try.

I appreciate your attempt. But because we do that very quarterly, we do it very methodically and, as you know, we do it very transparently, and so we'll do that again here in July. What I will tell you is that, as I mentioned just a moment ago, confidence in our guide extremely high. Confidence in our volumes, the productivity, very high in a very good way. And as such, we're continuing to take price because we have seen -- I think what is interesting since our first quarter nat gas, albeit up pretty materially, obviously, gas and diesel up. And that's, hence, the pricing that we continue to move into the marketplace. Because as we've talked a lot, the minute we see the essence of that inflation, we'll continue to take the price actions that are necessary to have that price/cost relationship even this year, particularly be very, very favorable, which it will be.

Yes. Sounds good. On AR Packaging, just kind of the update there. How is that integration going relative to your expectations so far?

It is going extremely well. Net is probably exceeding our expectations, mostly because the -- the leadership team has come together very, very well with the cross-section of existing leaders from our legacy and core business prior as well as our packaging team. Retention has been outstanding. We've completed the full work around synergy capture. That work was done from November into the first quarter. So our line of sight to $40-plus million of synergy capture is clear. We know where it will come from. And probably the exceeding expectations is the growth orientation of the business. I think what we're finding is that, by combining efforts not only regionally in Europe where we now can, from a market perspective, more actively participate in some countries, primarily Eastern regionally moving east, where there's growth potential for us that we couldn't capture before, beverage packaging, as an example, we didn't have facilities as we moved further east, now we do. And then we're seeing some good advancements in global conversations with customers that on the health and beauty side, for example, where there's potential for growth in the U.S. that we didn't have necessarily the dialogue with those customers before. So that's where it's net favorable is more probably on the growth side. And relative to the team and the synergy capture, it's definitely meeting our expectations, and Q1 was very good.

What's the kind of the long-term strategy for Europe in terms of vertical integration? Right now, you're exporting over some paperboard from the U.S. as well as buying paperboard there. Would you look to potentially a few years from now acquire a mill?

It's plausible long term, but not required. And I think it's important here over the next 12 to 24 months particularly, we've got a great converting platform that we're building here. There's additional consolidation that can take place there on the converting side, non-mill-based side. We're not going to acquire a fixer upper, which means that there are a limited number of alternatives. And so it's not really a requirement for us. We're a very large good buyer of paperboard. As you mentioned, we shipped to ourselves materially, 200-plus -- 250,000-plus tons of CUK. That works for us very well in terms of servicing ourselves. So not really required from a capital allocation prioritization perspective here in the short to medium term given other priorities.

Yes. And then on the paperboard side, the paperboard that you purchased from external players over in Europe, given that you're short there, this year, I think is a little bit different given the inflationary environment that we're seeing. As I understand it, you're kind of having direct pass-throughs of whatever price increases are made on the paperboard, whereas traditionally, as far as I understand, you do kind of annual resets for the paperboard. Going forward, will we see these kind of direct pass-throughs?

Yes, I think -- it's interesting. I think you raised a very good question. And you -- just to play it back to you what you said, we've seen unprecedented inflation for all items, energy and others, and it flows through in the form of accelerated paperboard pricing for that we acquire. As such, we've literally moved to monthly and quarterly conversations with our customers around pricing. That's certainly the environment we're in today because of the unprecedented inflation. I think it will be interesting to see as things -- when things kind of settle back down from an inflationary perspective, do we continue with some of the realities of some of the goodness both sides that comes from more quarterly resets? I could see it being 2 to 4 times a year potentially as where it settles in rather than the annual because the annual was a little bit behind, if you will, where we've been trying to take the markets here in North America as an example. So I do think it probably opens the door for more and, I guess, more occasional price movement as we -- even as we kind of get into an environment where the inflationary pressures start to subside.

And then moving to plastic replacement, a pretty compelling story for you, an opportunity for you. You guys target the 100 to 200 basis points of organic growth every year. How much of this is being driven by plastic replacement and new product innovation that you have? And kind of what's the opportunity here long term?

Yes. No, you're right. When we look at our -- we've kind of gotten pretty definitive around the $9 billion addressable market for growth with our fiber-based consumer solutions. And if you step back from that, $7.5 billion of that $9 billion is plastic replacement. And so it's material. It's very relevant. The positive is that it's multimarket. And so if you look at the $9 billion and the $7.5 billion for plastic replacement, it applies to beverage packaging, food, foodservice, consumer packaging. And what it's resulted in is a nice cross-section of a portfolio of solutions that's a lot of singles and doubles in a baseball term that allows us to win in multiple places. And so that's been a really critical part. If you look underneath our 200 to 300 basis points of growth, plastic replacement would be a material part of that, in addition to strength packaging and the cooking solutions that are also net favorable, but we like the runway for that growth. And I think we -- Europe continues to lead the way broadly in terms of the decision-making as well as some of the regulatory environment. They're supporting some of the movement towards fiber-based solutions, but we like the momentum that we're seeing in Europe and then as decisions are being made particularly here in North America.

Yes. And then lastly, on capital allocation, just maybe refresh the priorities there. I mean, near term, obviously, debt you're leveraging post AR Packaging. But going forward, how should we think about your organic growth story? What are you targeting? What markets, geographic regions? And just kind of thought process on share purchases.

No, you summarized it well. I mean coming out of AR Packaging, we were pro forma probably 4.5x levered. We'd like to be 2.5 to 3x. We'll end the year in the low 3s. And so we will make a very big move relative to debt reduction this year. It's a priority. As we kind of round out of '22, we'll have line of sight into that 2.5x to 3x, which then opens up the optionality around some of the M&A that we've talked about historically that would drive integration now that you've seen us do quite a bit of that door would open back up. It's going to be more probably North America, European-based just broadly because there's still work to do in terms of what's possible on that front. It will most likely be consumer-based just in terms of kind of who we are and what we do when you talk about us as Graphic Packaging today. And so North American European-based, consumer-oriented, fiber-based, and it will be a combination of the M&A and putting capital to work that either supports our growth or drive significant productivity because that $50 million to $70 million a year productivity is critical to the engine of the business. And all of those decisions will be in the context of kind of what we've laid out for the goals for Vision 2025. And those -- what's good is back in February we enhanced some of those goals that we established back in September 2019 and can see the path to the $10 billion-plus top line and 20% type EBITDA margins, the cash flow generation that comes along with that and, obviously, the value creation for our shareholders.

Yes. The productivity is something you guys have been hitting on quite recently pretty well. I'm curious about the runway you have for that $50 million to $70 million over the next 5 years or so.

Yes. It goes back to a little bit what we talked about a couple of minutes ago. I mean having a constant rhythm of kind of a 5-year window of capital investments that we're looking at gives us confidence that there's still runway to generate day-to-day improvement to our normal lean and other processes, but also returns on the capital and kind of in that 5% to 7% of sales range. And so the runway is good for productivity. What we like about probably more today than even a few years ago is that we're actually making capital investment decisions that are a combination of traditional productivity cost takeout and supporting our growth, which is, as we've seen the 200 to 300 basis points of growth, some of these are not huge investments, but investments in cup-making capabilities and the like. And so those tend to be $10 million to $50 million investments that are kind of in the context of our overall spend, but we've got a good combination of productivity-driven investments and supporting the growth engine of the company, which is a nice thing to see have itself play out here over the last few years.

Sounds good. Anybody from the audience? I think we'll just end early here.

All right. I appreciate it, Kyle. Thanks for the time. Good to talk to you, and good to see everybody. Yes. Thank you. Take care.

Appreciate it.