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

Wrapping up our morning session. We saved the best for last. Joining me is Mike Doss, CEO; Steve Scherger, CFO of Graphic Packaging; also Melanie Skijus from IR. Mike, team, thank you for joining us. Mike, Steve, I think I'll turn it over for you, maybe give a kind of a brief introduction, and then we'll just jump right into questions and have some time for questions [ from audience ] if there are.

Yes. No, listen, thanks. I appreciate everybody's interest in spending some time with us. We're thrilled to be here, like you said, live, been a while since 2019. And so -- for those not as close to the story, if you stand back and look at Graphic Packaging today, roughly a $10 billion business from a top line perspective. We are a -- we're an integrated fiber-based packaging company. Almost entirely focused on us is consumers, and we operate in really markets focused around day-to-day consumption, food, beverages, consumer packaging, foodservice packaging. Our footprint is heavily North America and European based. It's expanded significantly over the last several years through a series of acquisitions. We've been deploying capital very significantly, both in terms of M&A activity over the last decade, particularly over the last 5, 6 years, that Mike and I have had the honor of meeting in our roles as well as deploying capital in significant ways with the great example being the Kalamazoo, Michigan coated recycled paperboard investment that we've made over the last couple of years. That's come to life as we speak. We'll talk about that a little bit in the Q&A. But no, listen, we're thrilled to be here. We operate in an environment that's a very steady business. We've been growing 3% organically for about the last 3 years, very innovation-driven through conversions into fiber-based, recyclable, renewable solutions, other alternatives and a big important part of the trajectory of the business as well as earning on that organically and the margin improvements that we've seen play out over the last -- particularly over the last 24 months.

And maybe just kicking it off. I mean, we're coming to the end of the year and looking at the year, I mean, you guys have really surprised to the upside, being raised a number of times. Broadly, like what has -- what parts of the business have surprised you? What's allowed you to do that as you look back on the year, we're not finished yet, but what has kind of worked better than you expected?

Yes, I'll start and then Mike can, of course, add on. But I think we're very pleased with the broad-based nature of our execution this year. So if you pick off the key components, we've been very successful in executing on pricing in what has been an unprecedented inflationary environment. So we've successfully offset all of the inflation that's occurred over the last 2 years with pricing initiatives that we've executed on successfully. We're earning on their 3% organic sales growth. That's important to not only just grow but to earn on it. And we're seeing very real productivity and early returns on our productivity investments, particularly around Kalamazoo investment, which has come to life really well, probably in some ways more recently, that's exceeding and playing to the upside. Having 3% organic sales growth outruns our 100 to 200 basis point goal, again. So those have been positive relative to execution. And I think overall, broadly speaking, our teams have been executing in a very tough environment, supply chain disruptions and the like. And then probably the final point would be the acquisition of AR Packaging has really performed at exceptional levels, particularly given the geopolitical and the inflationary environment throughout Europe, when teams come together and has really shown us they've got an innovation engine that can really be supportive of the growth, not only in Europe but really globally. That's an important part of how we see things going forward.

And maybe just kind of digging deeper on some of those. On price cost, can you remind us kind of assumptions for price cost in 4Q and then maybe the carryover through '23 and kind of current price cost trends, maybe mark-to-market where some of your major cost...

Yes. I mean Q4 is still as we have articulated coming out of our Q3 messaging. So it will be positive price cost, which will get us into the cumulative 2-year positive price cost in the $300 million range. I think to your question, really no change from what we articulated at the end of Q3. We still have a very good line of sight to [ $175 million, $245 million ] of price next year, all based upon known initiatives, things we've already executed on. And of course, we take into consideration cost models and how costs are moving. And while quite volatile, our inflationary early look mark-to-market is still in the kind of range that we talked about. So we've still got good positive line of sight. Obviously, we'll provide guidance in February on the specifics, but there's really been no change to the ranges around price and cost as we kind of look out from where we are today. Things are moving inside of it. It's the volatility in Europe and some things moving a little more favorable like OCC, some things still staying elevated. But I think our visibility into '23 is getting sharper. And we'll, obviously, put a fine-tune on that -- fine point on that in February. I don't know if you've got anything to add to that, Mike?

No. Yes, I think that's precise.

Can you remind us on the lag of the price increases that you pushed through kind of on a blended basis, how many orders it takes?

Yes. It's still a couple of quarters. I think what you've seen us do a lot of over the last couple of years is really attack pricing on multiple terms and conditions, multiple fronts. So yes, it's still -- there's still a lag, but you've seen us be much more attentive to inflation and acting early when we see inflation, which keeps the lags tight because as we see inflation, we've taken the price actions. We've changed a lot of terms and conditions. Things like no longer really providing delivered freight, as an example. We now have freight that's really at the customer's cost. We have priced from our facility and they pay for it to them, meaning it's in their pricing, but it's no longer a variable for us. And so a lot of those tightening of conditions have really tightened up that visibility to price and as we talked in other conversations. What we really encourage the investor community to do is every quarter ask us where are we on pricing because there's a lot of moving parts. It's not really just a -- what's the market model saying or what's the cost model because we've got renegotiations that we're doing with our customers every 2 to 4 years. So we always have things in motion, which is why that visibility into pricing is something that is really kind of an accumulation of a lot of work.

And hopefully, what you've seen too, Anthony, is we're trying to be pretty transparent in terms of giving a little guidance 6 months out, just given the nature of some of those agreements. And that's been conscious on Steve and our financial team standpoint to make sure that our investors kind of get a look at what that's developing like.

And then on the demand side, if you think about the kind of 3%, 4% volume growth, can you talk about the drivers of that, maybe the end markets that have been stronger or weaker? And then as you talk about plastic substitution, maybe what is driving? What component of that is being driven by plastic substitution?

Yes, I think a couple of things there and it's the right question to ask. If you kind of look across this year's, it's up to 3% in the last couple and [indiscernible] positive this year, 3% it's very broad-based. So we look inside of our beverage packaging markets, we're seeing growth of elimination of plastic rings or resin-based wraps with our KeelClip solution or other fiber-based solutions. If you look into our foodservice business, we're seeing real conversions from foam and plastic cups into our fiber-based solutions. If you look at food, we've got growth happening on the perimeter of the store, with meats and cheeses and fruits and vegetables that we've never participated. And then in consumer packaging, we've got new market opportunities. Our filter frame business continues to grow materially. We're winning in places like batteries and pet food and detergent, really in categories where historically we didn't have an active participation strategy. And all of that is in the context of a $12.5 billion addressable market for growth that for us is a very identifiable market. It's very known areas where we can win. And $11 billion of that is plastic replacement. So it is absolutely the majority, and it's played an important role in that 3% a year for the last several.

And do you increase your TAM estimate for plastic substitution in terms of what gave you confidence to do that? I mean is it conversations with customers or orders or?

Yes, I'd say and Mike add on, but there are probably 3 things there. One is AR Packaging. So we acquired AR Packaging a year ago and it gave us line of sight to new market opportunities and new innovation capabilities. So that was important. And then really, it's just being able to identify through our innovation efforts. You know what, there's a phone tray or there's a category where we know we can actually win. So our new product development teams are quite specific in the monthly report outs that we do around -- it's these categories with these -- this billion of products that we can actually convert so that we're not talking conceptually, but we're actually talking about markets that we can action.

I think maybe just to put a little finer point on that, too, Anthony, in terms of the proof of how that's resonating with the end use consumer. If you really look at the overall category and category spends, we get asked a lot, even though elasticities have stayed pretty good, the categories and most are major items are down 1%, 2%. Yes, we're up 3%. And so with a 40% market share for folding carton in North America, we would get beta, right? If you think about it the ways we're generating alpha, I guess, to put it in terms of your conference here. And really, that's coming at the -- because of plastic replacement, that's really what is enabling us to outperform the market. So I know we've had -- you've allowed me the opportunity this morning to listen in on a couple of other presentations and everybody's work on the sustainability side of it, that's awesome. But for us, I think the proof point now 3 years in a row, we've outperformed our kind of medium- to long-term goal of 100 to 200 basis points and that story around plastic replacement on the margin, and we've identified where those things are, and I think Melanie has done a really nice job in our decks kind of showing the types of products that we're replacing with paperboard and the investment we're making in Kalamazoo on the recycling side of things, should give some proof points that on a 3-year stack, we're over 10% organic volumes. So yes, there was some stuff with COVID that really helped us, pantry loading and then the supply chain piece of it, but this year is pretty normal in terms of all that stuff. And yes, we grew over two, three quarters 4% and if you look at the midpoint of our guide, as Steve said, will be right around 3%. It's kind of what we're anticipating. We'll grow in Q4, but not quite at the same rate. So all enabled by that.

And you talked about the volume growth that you're seeing being pretty broad-based. And during the pandemic, you talked about the teeter-totter where the consumer went up and the foodservice dropped and reversed coming out. So should we think of that as just completely sort of in equilibrium now? Are they're both growing? And then sort of a mix and margin perspective, how do you think about those two businesses?

I think I'll take that one. Steve's never really liked that term that was kind of mine, but it actually helped people, I think, visualize what was happening from a [ economic ] standpoint. But I mean, I think the clearest point we can make on that is if you look at our volumes on our foodservice business against 2019, we're actually above those now. And that's really driven by polystyrene replacement and overall growth in QSR. And if you think about the dynamic there, which is interesting around what's going on in our economy, we still have under 5% unemployment. So there's a lot of mobility still for end use consumer, and we're over-indexed to the large QSRs. And so these are the folks that are redoing their stores. They want smaller dining rooms. They want not one, but two drive-thrus and that really fits what we're doing well. So they've got the money to invest behind their franchises, and that's in fact, they're doing, and we're benefiting from that mobility trend on the end use consumer. So we're kind of getting it on both sides right now as opposed to having it kind of teeter-totter out. We'll eliminate that vernacular now here going forward, but it was somewhat helpful during the pandemic.

Mike makes it a really important point there around the drive-thru because we get the question a lot about definitely recession, what will we see at the consumer level? And if you went back to '08, '09, foodservice took a pretty good hit back then. And what feels like it could be a little different dynamic here as we see some slowing in the economy is the QSR and the drive-thru is actually winning. And so as you're seeing the consumer move away from maybe the dine-out experience, they wanted to have Applebee's or [indiscernible] pickup, faster casual type environment. They're actually going through the Chipotle. And that's a place where we -- a vast majority of our cup business actually resides and really kind of seeing the QSRs grocery channels competing for the consumer, but both of those places are places that we are. And I think also back to kind of the '08, '09 recession, if you look at the company that we are today, we're also much more balanced around branded, nonbranded, small, medium, large customers, no longer a customer that's 5% of the company. So that distributed nature of what we've been able to create over the last several years, I think, also is well prepared to weather through the realities of the consumer, then absolutely [indiscernible] (00:15:21) is coming under pressure in this inflationary environment. I think unemployment and employment will be a very important part of the dynamic role into '23.

Maybe just circling back to plastic substitution. Obviously, you have a lot of products, you have a lot of customers, but from your customers' perspective, do they kind of view this as brand building packaging or this is driving sales at the shelf? And from a cost perspective, is this maybe adding a penny to a package? Or is it sort of cost neutral? Or just how do you think about it?

So I think when you talk about it is literally measured in fractions of pennies per package. So it's somewhat a de minimis impact on overall COGS. Obviously, any number becomes a big number is a big number. So when they look at it on a roll-up, it's not insignificant, but relative to the actual COGS price, it is. From that standpoint, as we think about the plastic substitution here and kind of what those opportunities are, really all comes down to our ability to help our customers drive lift and help them build their brands. You've got a crowded marketplace. They're competing for rent and the average consumer goes to the marketplace and they're buying three or four things. They know they're going to buy. They're going to buy milk, bread and eggs. And then beyond that, it's kind of an invention. So does it catch their eye, does it resonate with them? So when you think about things like KeelClip or the sack to cube that we've given examples on, the merchandising capabilities of paperboard are pretty significant there. And that actually is somewhat eye appealing and machines index those cans so that their brand is pointed out in every one of them. We think we're helping that process. But I think the other part of that, they really have to take a step back where a lot of this is being driven by the end-use consumer who really has decided that paperboard is more recyclable than plastic. It's just that simple. They know the reclamation rates are much higher for paper and paperboard. If you look at it in the United States last year, it approached 70% where plastics was low teens. And not only is the reclamation rate, but it turns around and goes back into primary package. So it starts as a cake carton, the next time you see it's a serial carton, the next time you see it's a carrier carton. It's not going downstream into some planking or park bench or something like that. And I think they appreciate that. And so they're supporting the brands that they feel are doing those things. And so there's some agitation by the end-use consumer on our customer to say, look, I want to support brands that are doing the right thing from an ESG standpoint and ultimately plan it. And of course, many of our big brands have pretty significant commitments they've made out there around greenhouse gas reduction, other things and our products help them accomplish some of those objectives they've put out there over time. So it's kind of a holistic aspect of it.

And when you think about demand in your consumer and foodservice categories, I mean one of the big themes from the conference and from talking to other management teams is just inventories, people have too much inventories going into next year, they're trying to get those recalibrated. Can you talk about sort of your inventory situation and maybe customers' inventory situation? I'm hearing some maybe faster-moving channels [indiscernible] to you as much as...

Yes, it's absolutely the right question to be asking. And for our business, specifically, the really -- we're, in many ways, very, very large [indiscernible] (00:18:50). But that's majority of what we do is make the order a little bit [indiscernible] (00:20:57) it's very little. It's de minimis, actually. It's a little bit on the beverage side. So generally speaking, our customers are not in the business of building our inventories. Now we did talk coming out of Q3 that supply chains kind of stabilized a little bit in Q3, and we do see our customers kind of manage it through their own year-end working capital and inventory, which is why we think will be 100 to 200 basis points this quarter rather than kind of 3-plus. But this is -- really our segment is not one where there's a lot of activity on the inventory build front, including our own. I mean, we produced paperboard in order to roll through our integrated platform, keep our operating rates high, our backlogs high. But at the customer level, kind of not in at that spot where the inventory build correction, if you will, is of substance. For us, it's a little bit of it, as we talked in Q3 that we're going to see here in Q4, but it's still we expect to grow inside of it.

We actually need our operating rates, our backlogs to come down a little bit as we talked about on the third quarter call because we weren't able to service our customers the way we wanted to service for the past 1.5 years because of just the tightness in the overall market on paperboard. So while that's creating [indiscernible] balance and obviously, the pricing components of it, we still have to be able to help them in their supply chains. So we think we're going to be in a really good spot here as we round the turn into '23 to be able to really be responsive. So even if they come down a little bit, that's actually not a bad thing for us.

That maybe kind of links into next question just about kind of market conditions and demand for the three paperboard grades that you participate in. I don't know if you can make a few -- kind of draw some finer points between SBS and CUK and CRB and just kind of the level of demand. And then also if you could touch maybe on the kind of the global trade flows, which I think were disrupted by the pandemic and they are sort of, I don't know if it normalize at all, but just where those stand.

Yes, I'll start, and then we'll both tag team here. But I think similar to the broad-based discussion earlier about the innovation, the backlogs and really operating rates and the demand profile of all 3 substrates remain very good. We're really pleased with our CRB has kind of evolved from a pretty flat demand environment. If you went 5 to 10 years back, the one that actually has a growth profile, it's one of the reasons we kept one of our mills open for now to support the actual demand for some of the conversions, sack to cube and other things that we've been talking about. So CRB demand very stable and good. CUK is such a strong global substrate, a highly consolidated market. Demand profile there -- we're oversold by some of our needs around the world. And so the growth there, very strong and steady. And then SBS, which has really benefited from really foodservice conversions, whether it's cups that we make or plate, which we don't make plates, but we produce the paperboard for some very large plate producers. Their demand is very, very strong. And so that [indiscernible] of SBS. So really, the good news is it's broad-based. Trade flow wise, obviously, the cost to move things has been up materially. When you hear about ocean rates coming down, it tends to be more China, Asia-based. The actual movement between Europe and the U.S. is still up, which is where the trade flows are and as such, actual exports from Europe into the United States for FBB, which is the primary paperboard that makes its way into the -- into North America has kind of been flattish, even down a little bit with the primary competitor that's been moving paperboard here. So that hasn't really been a source of volume or supply that's been coming here really in '23 -- or excuse me, '22. Probably doesn't change much in '23, given that there's really no capacity coming into this market in '23, a little bit in '24 with the primary competitor that's got the one mill that they're expanding upon. And then obviously, there's some potential that we can talk about out in '25 and '26. But trade flow wise, not a lot of activity up or down, in fact, it's been modestly down here over the last year.

And the ocean rates from China and the U.S. falling do not -- I mean, there's maybe some white top that they send there, but does not really...

It's literally almost not.

Yes. When you look at the import data, there's virtually no [indiscernible] import coming into the United States.

And then maybe just kind of thinking about Europe separately, like you had a big business in Europe before AR Packaging and you got bigger with AR Packaging. Can you talk about sky-high energy costs, consumer demand, maybe competitive dynamics in terms of competitors of that mills or just sort of what's happening in Europe and how is that business performing?

Yes. Thanks, Steve. I think, look, if you look at energy for a minute, just in terms of the exposure for Graphic Packaging, we're somewhere between 23 million and 24 million MMBtus in natural gas. We buy less than one of those in Europe because we're converting only. So our exposure to overall energy there is we've got electricity rates and things like that, the rise in inflation rates, but it's not like it would be if we were buying that kind of a gas pipe here in Europe. So we don't have that exposure. So that's a good thing for us. In terms of the dynamics over there, I mean it's kind of interesting, if you think about, again, the markets that we're in, even with the diversification Steve has talked about, we're pretty heavily indexed to food and beverage. And even in the economy and the macro like they have, being a physiological need they have to eat and drink and the question is what are they going to consume and what types of products are going to kind of help them consume that? And so when you look at our business over there, overall demand's held up really well. We have one category there that we're excited about for the medium- to long-term health and beauty that you could certainly see probably a little under pressure in this kind of an environment. But it's less than 4% of our overall sales as a corporation. So it's pretty de minimis in terms of what it looks like. Should we see more at-home consumption on things like beverage as some of the pricing rolls through and you're paying GBP 15 for a pint of beer at a restaurant. It's not difficult to see why you probably see more of that consumed at home in that kind of environment. I think the bigger challenge in Europe won't be this winter, depending on what happens with the overall weather. I think it will be a little more concerning around how do they refill those reserves without any Russian gas through the summer of next year and into next winter. December 5 is a big date with the embargo and what ends up happening. So we're watching all of those types of things. But overall, our demand profile in Europe is quite -- well, it's been quite resilient, frankly, in terms of what this all looks like.

And to Mike's point about nat gas and MMBtus, we're a small consumer in Europe that we don't produce -- we're not a mill producer, we don't have mills. But it's a very unique time in Europe as a paperboard producer because if you're a producer of FBB and you make your own energy, you actually are a cost advantage today versus a non-energy producer like most whiteline chip or recycled paperboard producers. So you have probably one of the those unique environments ever where the cost to produce is almost inverted. Some of that's moving around as nat gas moves around, but it's a very interesting time, and we're a very good and large buyer of paperboard. We don't need to be an owner of paperboard in Europe any time over the near term at all, given we've got a large platform now in Europe with a couple of billion dollars that's competing only, which is actually proven to be the right place to be in this environment. And yes, it's a little bit of a hand-to-hand combat on pricing because of all the inflation and team's done a great job of managing through that in this environment. But the paperboard side of it relative to global trade and where paperboard goes, there's a lot there that's happening. It's frankly never happened before, given what's going on, on the energy dislocation.

To put a little finer point on that because you asked about the trade flows here. It's not difficult to see how some of these large-scale projects that have been announced, concern is, of course, all of that [indiscernible]. There have been a lot of small, non-integrated in energy and fiber mills in Europe and it's not difficult to see the cost advantage of the [ cap ] over them. And so I think it would be interesting to see that develop over the next couple of years as that capacity comes on in 2025. Our theory of the case is a lot of it ends up getting in Europe. And it's not hard to see why that would be the case.

For the couple of projects that have been announced for 2025 in the U.S. I mean, I'm not asking you to comment on anything specifically, but just as you think about the opportunities or the obstacles for somebody to kind of put a big boxboard mill in the U.S., other than technical challenges, commercial challenges, is there any way that you can frame that and how you could get to play out?

I'll take that. I think, look, from that standpoint, one has formally been announced in kind of with project specifics. The other is kind of pending more details. And I guess latest that's out on that is it will be out by some time midyear next year. So we'll have to wait and see kind of what ends happening there. Neither of those producers are vertically integrated downstream. So meaning they don't have any converting operations. So when you look at a company like Graphic Packaging, that really, as Steve says, an integrated packaging provider. Our end-use customers aren't buying paperboard. They're buying packages. And so that intimate knowledge that we have and the supply chain we provide and all the different benefits that we put together for our customers are all part of our value proposition that we provide those customers that we have the honor to serve. We're going to continue to drive our integration rates up over the next couple of years, particularly with the types of the growth we've been talking about here. You've seen our aspirational goal is part of Vision 2025, and we're bumping up against a number of those goals we put out in 2019. It might add next year. And so our confidence level is high that we can do that. I think, look, if you look at those projects, it probably costs more and take longer than what are currently being talked about. I mean that's been the experience with the one competitor that just announced the most recent one. The last one they significantly overspent. They spent several years earning single-digit EBITDA numbers and then same capacity was removed and the pandemic hit, and it worked out okay, I guess, now for them. And that one probably surprised Steve and I a little bit, to be honest with you because of the phenomenon I just described. But when you're looking at graphic paper versus maybe packaging paper, it all comes down to the assumptions that you consider in the boardroom. And you can convert any paper machine to do just about anything you want. The question is where you're going to be on the cost curve, how much it's going to cost and who you're going to sell the material to? You better have answers for all three of those things. And in our case, and that particular one that was just discussed, when it's done, it will be cost advantage on electricity, natural gas, freight, fiber and integrated when they're done. So we like our odds to be able to compete against that. It will be something we have to deal with in 2025. We'll see what ends up happening with the other producer and what they actually end up doing. Time will tell. I mean they'll know it's that, but it's not hard to see how someone's got to remain making coated freesheet and ultimately, some of that capacity that might now be slated to be converted to packaging lines of staying in its current format. We'll see. Either way, our integration rates will go up. And as Steve has outlined to you, our overall balance sheet is going to be in a really great spot. By 2025, we'll be able to respond to those types of things. The industry has had a pretty good track record of maintaining capacity that's high cost over time. And I don't expect that this will be anything different, but that capacity won't be Graphics because it will be integrated and low cost.

You bring up a great point about cash. And so you bought AR and then you had the Kalamazoo project, which consumed a lot of cash. Can you talk about, I think, the end of this year, lower 3s, close to 3? Can you talk about the cash generation that you see next year and opportunities to return that or other investments, M&A?

Just to kind of -- as a reminder, I mean, our primary capital allocation priorities are very, very known and clear. I mean we want to have a balance sheet in the 2.5x to 3x leverage range with capital [indiscernible], so we can drive real value creation of both the maintenance capital, we do M&A where it makes sense to do. And then obviously, we return it directly to shareholders in the form of dividends and share repurchases. Share repurchases is on a basis only when we see a real dislocation. We've been pretty balanced on those over a long period of time. In the current environment that we're in, we're going to be weighted a little more heavily towards let's get the balance sheet into a great spot. We're going to be probably 3.2x levered at year-end coming off of mid-4s a year ago. We'll get into those 2s. We can get there and have line of sight to significant cash flow generation. We like the optionality we have with capital to work, like we've done over the last couple of years. It's high-return oriented, low cost, high quality. We'll keep looking at those. Those aren't leveraging events. Those are just good thoughtful return and as such, we'll be more conservative on the M&A front. It's a higher cost environment to finance deals. Leverage in this environment is not as -- is conducive or is cost effective as it was. It doesn't mean that it's an absolute no, but it says [indiscernible], we're going to be more conservative, probably lean more heavily on the other two in that particular case around leverage and [ any thoughtful ] CapEx back into the business. So we'll always have all of them available, but this is an environment where we're leaning a little more heavily towards balance sheet and just putting lots of capital back into the business.

Moat, we can build around the business over the next couple of years, it's pretty substantial type of cash that we're going to generate. As Steve said, we're not going to overinvest in the business, but we've got some really good self-help things that we can do with the M&A we've done and the platform we've built that will make it difficult for everybody to penetrate our overall revenue streams, and that's where we're going to spend our time.

I think we're coming up on time. I don't know if there's any questions in the room. But if not, Mike, Steve, thank you so much, and great to hear this update.

No, glad we can do it. Thanks, everybody, for taking the time. Good rest of your weekend. Thank you.

Thank you, Anthony.