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

I think we'll kind of keep this on schedule. Thank you, everybody, for joining us today. My name is Adam Samuelson. I'm the agribusiness and packaging analyst here at Goldman. We're going to continue our Industrials and Materials Conference today with Graphic Packaging. We're very pleased to have the President and Chief Executive Officer, Mike Doss, here to join us. We're going to do this in a fireside chat format. Happy to take questions from the audience. There will be microphones, and happy to open that up as we go on through the session. But Mike, thank you for joining us here today.

I think we'll just jump right in, and you guys reported earnings last week. I think top of people's minds at this conference across the industrials and materials landscape is the demand environment and volumes, and what you're seeing from your customers, obviously, much more consumer-facing. But can you talk about demand across your customer -- your product categories, how it's tracked through the year into April and into May, and kind of what you're seeing, especially with the destocking that's been happening kind of through all our supply chains?

Yes, I'm happy to do that. First off, thanks for the invitation. It's nice to be here, and thanks for your interest in Graphic in coming to the fireside chat that we're having here today. Look, our demand held up pretty good in the first quarter as we reported last Tuesday, our first quarter demand was up almost 1% in real volume. It was pretty broad-based. Europe and foodservice kind of led the way on that with North America being down just slightly. But the overall aggregate was very positive. And I think that's really a testament to the work we've done over the last, really, 10 years to build out our customer portfolio in a way that is very defensive in nature. And we've got a very large foodservice business now. I think back to 2008, 2009, we didn't have that. We've got a very large presence in store brand and private label. Roughly 20% of everything we make falls in that category. About 10 years ago, we were all branded. And so when you look at how the portfolio performs with our customer participation strategies, it's been very purposeful in what we've done. And that, I think, is really helped us to be able to outperform in this kind of market.

Got it. That's really helpful. And so is there -- I mean, if you think about your key substrates in the paperboard space, is there any noticeable differences that you're seeing in terms of lead times, inventories, kind of customer inbounds that would kind of be a signal of changes in the demand today?

Yes. So by way of reminder, there are 3 principal substrates that we use in North America. SBS, solid bleached sulfate; CUK, which is coated unbleached kraft; and in CRB, which is coated recycled paperboard. And ultimately, we use all of those to service our customers and have a unique ability to be able to kind of push them around based on what customers' needs are as well as what our own internal needs are in terms of balancing out the mills. And as we reported on our Q1 call, our overall demand -- our backlogs have gone down a bit from where they were a year ago this time, which, as I pointed out then were too high. I mean we're in the 9- to 10-week range. We were not doing a great job servicing our customers. And if you look at historically somewhere in the 6 to 8 time -- 6 to 8 weeks has been a really solid backlog that's allowed us to be able to do a good job servicing our customers. And -- we haven't really seen any material differences along those lines. We drive our integration rates up quite a bit, as you know. Since 2018, we're 62% integrated. Now we're on high 70s on our way to hopefully break 80 by the end of the year, a combination of organic and M&A that's allowed us to do that. So nice balance there.

No, that's really helpful. And I think it speaks to some of the pricing resilience you're seeing in your grades, which I think are pretty unique amongst the broader paperboard products market, box markets these days that pricing hasn't gone down at all despite some cheaper inputs on the gas, on recycled fiber, most notably. So as you think about that price cost environment, which gives you some pretty good visibility over -- into the year, talk about kind of the confidence level that you have in price cost this year and recouping kind of cumulative inflation that you've had the last few years?

So I mean, at a very high level, if you think about 2021 when we saw the inflation really start to run, we draw the $180 million of price -- negative price cost into '22, and we recovered all of that, and they went positive by the end of the year. We're positive right now. But there's a cycle that you kind of go through with input costs and pricing for sure. We think it's going to be a lot tighter range than it's been in the past. Again, we've manufactured all 3 substrates. We've got good visibility over that. We grew our volumes in Q1, which means we needed more paperboard internally than we did the prior year, which is a good way to continue to keep pressure on those backlogs and operating rates, as I said. And I think our input costs, at least what we've seen so far this year, a few of them are up, like purchase paperboard in Europe is still up. Some of the chemicals are still up pretty dramatically. I cover some of those companies. So you're well aware of that. But we have seen things like secondary fiber and nat gas a little bit of transportation that have more moderated, and in some cases, actually gone down a little bit. So that's a little bit of a tailwind for us now.

Yes. And to that end, in the first quarter, you pretty meaningfully exceeded your own expectations on price/cost that you've given back in February. And we've gotten a lot of questions on that gap from investors. And I'd love to just be elaborate on kind of some of the sources of that, both in terms of top line cost as well as geography for where that really was?

Yes. Geography, the vast majority of that was in the U.S. market, and it was around the price/cost spread. We had, what I'll call, excellent commercial performance that really allowed us to reset a number of contracts that were open, and we did that, and they actually ended up with really good end results. And then ultimately, we saw a little less inflation than we thought we would when we gave the guidance in February.

That's really helpful.

We expect that to continue, as you know, in the second quarter, and then start to moderate as we go through the rest of the year.

Yes. And the guidance for the balance of the year really doesn't much incremental pricing from what's already in the marketplace.

That's right. I think second quarter was $115 million as a guide on the price/cost.

Right. So maybe that's a good segue on to the maybe a more medium-term kind of discussion, start on the demand side. As you talk about rising integration rates and rising demand, which again is increasingly unique amongst kind of a lot of paperboards products these days. There is a -- does seem to be a real sustainability-driven shifts into boxboard from plastic, from glass and other substrates. Kind of talk about the opportunity that you see today and the confidence and really what inning we're in right now?

Yes. What I'm really excited about is our TAM, our total addressable market is in our materials there is now $12.5 billion, with the vast majority of that being plastic replacement. And that is around things that we've pointed to like KeelClip and fully enclosed cards replacing shrink wrap film, plastic rings in the beverage side. It's PaperSeal replacing polystyrene foams with paperboard trays, still a plastic but have a lot less and are easily recycled. In some cases, it's just taking cartons that were in rigid plastic and putting it in paperboard. And you put that all together, there's a lot for us to. I'd say we're in the early to mid-innings on a number of those things, but we're really busy on a number of those initiatives. Our backlogs are solid with our customers who want to continue to find new products that help them position their products in the marketplace with consumers, well, that really resonates. And a lot of that movement, Adam, has really been driven by the end-use consumer. They're basically supporting brands that are doing what they believe are the best decisions for the planet. They're using their purchasing dollars to help drive some of that. They've got a lot of our customers attention and ultimately create some real opportunities for us.

To that end, I think with earnings last week, we saw Chick-fil-A announce they're going to go double-walled paper cup.

On a trial -- of course, on trial.

On a cost-to-cost trial, which is interesting in the beverage cup space because you -- in QSRs in particular, polypropylene still does have a real share. Talk about the opportunity and what that could represent for you guys growing that business?

Yes. So we're really excited about this trial, as you can imagine. We were thrilled that we're able to partner with an existing customer like Chick-fil-A that just is a phenomenal run in terms of their overall performance in the marketplace. Excellent product. And they want to trial this in coast-to-coast stores, and in some cases, some universities and airports. It's a unique proprietary paper cup. It's different than anyone we've built in the past. It's got bigger air gaps between the 2 layers of paperboard that ultimately provide thermodynamic capabilities, particularly for cold beverages, so they don't sweat as much. And that was really the goal. If you think about some of those stores in the southern part of the U.S. Some of those sweet teas tend to be pretty good size, as you know. And some of the other products they sell as well. So it's really filling that niche. And the early reads look really positive, and we're quite encouraged by it. But you're right, there's still other things we compete against. I've always said we're not going to win every jump ball. But we've been winning more than our fair share, which is really -- we can control the things, we can control the innovation, we have out there is something that seems to be resonating with customers.

And that's maybe that kind of demand growth is knock-on notice in the marketplace. There's been a number of announcements both in North America and Europe on new capacity in this industry, including yourselves, not necessarily, but for you but others, it is. How do you see that kind of competitive environment kind of changing and the cost curve changing as some of this capacity might actually happen?

Yes. So maybe I'll break it down between imports, which sometimes I get questions about and some of the announced investments that at least are being contemplated here in the U.S. So on the import side, I mean I always go back and I take a look at the variable cost. If you think about our industry, and it's no different than most. I mean low cost tends to win over time, high cost loses. If you look at most of the imports are coming from Scandinavian countries and 4 principal inputs, transportation, natural gas or energy, fiber and labor. With the exception of maybe labor, given some of the scale of some of the facilities that they're building, the North American producers have a cost advantage against them before they even get a ton to the United States. So it's not a low-cost country sourcing strategy to buy from Scandinavia. There will be some imports around the margin that ultimately make it in, for sure. But I think the -- it's just tough to compete when you're 5,000 miles away shipping paperboard. I've talked a lot about being a Midwestern business. You draw 600-mile radius around St. Louis, you've got 90% of all our ship-to locations. Our customers run just-in-time type manufacturing processes because they have to be responsive to what customers are buying and consumers are buying in the marketplace. So I like how we can compete in that kind of environment. We make all 3 substrates at Graphic. We have no plans to toll for anybody in the North American market. Why would we, we make all our own material already. So that's a little bit how I think about the imports. Ultimately, some of the bigger investments that are being contemplated, which are conversions out of primarily printing and writing machines into paperboard. People who are contemplating doing that have no downstream converting. We do. We've got 70 facilities across the U.S., and it's a pretty big country. And so you've got to have downstream converting that ultimately allows you to respond to customers' needs, where they need to make it. They're not buying paperboard. They're buying cartons. And we've got the ability to make those for them.

So that point on integration, maybe there's a distinction in terms of European production to Europe versus European into North America, and new North America into North America. But talk about the importance of that converting capacity and kind of maybe differences in market concentration there that would be a real barrier to some of that new capacity really kind of muscling in.

Yes. So if you think about North America, it's a fairly constructive rivalry in terms of the competitors and how it shakes out. We're the largest in North America. The second largest is fairly decent sized as well. And so -- and then there's a pretty long tail of smaller converters out there. And over time, there's been a bit of a roll up in that space as you've seen. And I expect the same thing eventually will happen in Europe. We've been participating in that. If you look at our market share a decade ago, it was less than 5%, today it will approach 20%. We're the #2 producer in Europe. The #1 producer has about 1% more market share than we do. And then it's a very fragmented market. And we don't have any mill assets in Europe. We only -- we have converting, which has been our strategy to grow converting first. And then ultimately, you've got the optionality, not a mandate, as I've said, but the optionality to backward integrate behind it. If you find a way to do that, that creates value for shareholders and customers.

Yes. And part of that, again, coming back to North America, you're also putting money behind that effort. So you announced -- you did first the Kalamazoo mill which opened 2 years ago, which was the first new-build in North America in decades. You now announced in February, you're doing another one in Waco, Texas for a little over $1 billion. Talk about the investment economics on that and kind of why that's the right use of capital for Graphic at this point in time?

Yes. Thank you for that. So in the summer, August, specifically, in 2019, we announced that we were going to spend a little over $600 million to build a new paper machine in Kalamazoo, Michigan, and we were going to retire a bunch of old smaller machines that were kind of at end of life. We ended up spending around $700 million in total doing that. And with the original commitment, we said it was going to be $100 million of EBITDA improvement. This turned out to be north of $130 million. The ramp-up has gone extremely well. It's faster than what we thought. We figured it would be a 3-year ramp. We have fully there in to, so we'll deliver the $130 million this year. We focused all our communication on cost and not on capability until this last earnings year. We always thought that we'd have a higher-quality sheet because we're buying modern technology for formation, calendaring and ultimately coating as well. And in fact, when we look at the quality, we're able to get on a grade that we're calling [ veneer ], it'll rival SBS paperboard in terms of its appearance characteristics. We're really excited about that because we believe that 200,000 tons of additional tonnage between Waco and Kalamazoo we're going to generate, we'll be able to position, and right now is largely an SBS or an FPP-type applications. So we're really excited about what that innovation can bring for us as well. We announced Waco in February of this year, probably a little sooner than what most people would have thought. And the thought process behind that actually turned out to be pretty straightforward with the Board and with myself. Our success in Kalamazoo emboldened us. And ultimately, we wanted to press our competitive advantage that we have and we're building an identical paper machine for the one we built in Kalamazoo. There'll be some new things like we have to build a wastewater treatment plant, a little bit more on the stock-prep side. We're going to have some additional capabilities there that's going to allow us to process up to 15 million paper cups a day and sort of back into high-quality material. We're going to make all our own electricity because it's a greenfield facility, so we'll put a gas turbine generator in place to allow us to do that. But the overall paper machine, identical. So engineering is all done. The engineers who did that project, the folks who did the training, those are skills that if you don't use them, they atrophy in a hurry. And so we talked about it as a Board and ultimately decided, let's press that advantage, keep going to replace the rest of these old mills that we've got. And our confidence level is high. We can bring it up on time, which we said we'll be commissioning it in the fourth quarter of '25 and fully operational in '26. Over a 2-year period of time, we'll deliver $160 million in EBITDA. And given our track record in Kalamazoo, I'm quite confident we'll be able to do that. And that's the thought process behind it.