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

Everybody, thanks for joining us. My name is Ghansham Panjabi. I'm the packaging and coatings equity research analyst at Baird. Next on the lineup is going to be Graphic Packaging. And from Graphic Packaging, we have Mr. Mike Doss. Mike joined -- I make sure this is correct, Mike joined Graphic Packaging in 1990, 10 years old or so at that time, right?

Which makes me old.

Yes. And he was Chief Operating Officer for several years, and he's been CEO since 2016. We also have Melanie Skijus, who is Vice President of Investor Relations, a great resource for the street, and Melanie joined in 2019. So welcome to you both.

And thank you for everybody for coming today and your interest in Graphic Packaging. Great to be here.

Thank you again, Mike. And just for logistics, no one ever sends any questions in, but [email protected], or you could simply raise your hands later. And with that, why don't I turn it over to Mike and Mike, we ask all for companies to sort of start with a high-level introduction of the company just to baseline everybody.

Yes. So Graphic Packaging is a consumer fiber-based packaging company. This year, we'll approach $10 billion in revenue. If you look at our overall makeup of that revenue, about 75% of that is in North America, 25% of that comes outside of North America, obviously, and then the vast majority of that is in a well-capitalized European business that we have.

So Mike, last year at this conference, I hosted Steve, the CFO. And it was pretty obvious as to what the theme was going to be. It was massive price cost. The debate was how much would actually hit your P&L and so on and so forth. And objectively, as we think about next year, and you're not the only one, but it's less clear as to what the fundamentals look like. So maybe we could just start off, open ended at that point, and then we'll build off of that.

Yes. Look, I think the macro is a little bit more uncertain as we head into '24 than it certainly was into 2023. For us, our focus is really all around returning to our organic growth and getting back to our 100 to 200 basis points cadence of organic growth, driven largely by our innovation pipelines and substitution out of home and in plastic into paperboard. And so that's really where our focus is. We're in the middle of a big investment cycle. As you know, Ghansham, where next year will be a high watermark for our company in terms of CapEx as we build out our new mill in Waco, Texas. And then as we exit '24 and '25, you'll see that start to ramp down. That mill is scheduled to start commissioning around midyear 2025, and we'll be making paper by January 1, 2026, is that time line that we put out there. And then at that point in time, what you see for Graphic is a regression of the amount of CapEx, we're spending more towards the 5% of sales or below. And our debt, as we end up this year, as you know, winds up somewhere around 2.6x, 2.7x. So we've got a lot of optionality relative to our balance sheet as well.

How would you -- as we sort of step back, right, the industry went through a whole bunch of chaos through COVID, inflation, just step function higher significance. You counted that as an industry with price increases, maybe dimensionalize how much in pricing across the different grades over the time line, sort of from the starting point to the peak? And then what's happened since then with pricing?

If you look at over that period of time, it's anywhere depending on the grade, and there's really 4 grades paperboard. There's coated recycled paperboard. There's uncoated craft, which is we call it a CUK or our trademark name, SUS, which is primarily in beverage packaging. There's coated SBS, which is more high-end packaging and then uncoated SBS, which is largely cupstock. And so we manufacture all 4 of those grades. And if you take a look at over that time period, really going back to kind of the start of the pandemic in March 2020, we saw pricing that increased anywhere between $350 and $500 a ton depending on the substrate. Now there's been a little bit of a give back around the margin here in 2023, $20 a ton on CUK and CRB and a little more almost $80 on coated SBS, which is the least consolidated substrate that we run and also the least integrated that we run at Graphic Packaging. And so if you look at the 3 primary grades that are making up our highly integrated platform, those have been very snug in our operating rates, even with the market-related downtime we've taken this year to match our supply and our demand have been in the 90s, low 90s here in the third quarter. The one outlier for that is our coated SBS and that's been around 70%. And that's also where we've taken the disproportionate amount of the downtime.

How much does that cost you roughly, Mike, this year?

About $100 million all in. And so what that manifests itself in is under absorbed fixed costs because the mills tend to have the labor and the cost structure associated with that. But we feel that's an important strategy for us to protect our pricing and make sure that, ultimately, we're only making tons that we have sold.

Does that imply that more consolidation is needed in SBS?

I think on a global basis, the FBB and SBS is the most global of all the substrates and the most exported depending on what geography you're talking about. And so and there's been investments there. There's been conversions out of printing and writing mills and into SBS paperboard. There's also been some closures that have occurred. So there's a dynamic that's going on there. But of all 4 of the grades, that's the probably has the lowest operating rate on a global basis. So I would expect over time that you'll see more closures occur.

So let's build on that. So during the good old days of low cost of capital, which is -- 2 years ago...

For a long time.

For a long time. It just seemed like there was a lot of stuff in terms of capacity that hit the market, not just in the paperboard but metal beverage cans and other industries, et cetera. And it seems like we're on the flip side of that, whereby things are just getting a little bit tighter in terms of shutdowns and stuff like that. So if we sort of step back because a year ago, there was a lot of concern about new capacity announcements in paperboard specific to the U.S., including European imports into the U.S. What's happened since then?

Yes. So if you really look at what's happened, a couple of those announcements have gotten kicked down the road, meaning that they're not taking place now as they were originally planned to buy a couple of European producers, in particular. And then there's also been a pretty significant closure. One of our competitors shut a mill down earlier this year that was quite old. It was over a century old. And our theory of the case is that's kind of what ends up happening there. You've got supply and demand balance and low-cost wins in commodity markets and paperboard falls in that category, not packaging, but paperboard does, and we'd expect that to continue to be the case. The other thing that I think has happened and you see this, if you go back and look at the European producers' cost profile, is that it's changed pretty dramatically as a result of the sanctions that have gone in place relative to the war between Russia and Ukraine specifically, and of course, natural gas is well chronicled, it's about 5x more expensive in Europe than it is in the U.S. But what sometimes goes a little underreported is the impact on fiber. So if you look at all the Nordic suppliers and look through the last couple of quarters of what they pointed to, there's a structural increase in the cost of their fiber almost 25%. So when you think about -- that's the from a variable cost standpoint, the largest variable cost in making paperboard, it actually shows you from a trade flow dynamic standpoint, it's going to pressure their ability to export that into a market like the U.S. where we've got a lower cost structure, particularly where you're competing with people like Graphic, where we've got an integrated converting system that's well capitalized and very geographically dispersed.

Great. In terms of demand, as you kind of think about your verticals of exposure, packaged food, beverage, food service, just take us through what's been happening there.

Yes. So why don't we talk about the third quarter from a revenue standpoint, foodservice was up about 8% year-on-year. Beverage, food and consumer is down 6%. If you look at the volumetric impact of the quarter is around 4.65 -- 4.6% if I adjust for day on day, quarter-to-quarter, which was consistent with what we thought we'd see in the third quarter, pretty much on top of the second quarter. And for us, and you and I have talked a lot about this. I mean the destocking phenomenon if you look at '21 and '22 volumes and kind of look at what our customers said they did versus what we sold, there was probably close to 4% more that we sold than they sold during that period of time. So the destocking event is probably around 4%. It's kind of played through our system. And so now, as I said on our last call, destocking is really in our rear view mirror and any volume shortfalls that would happen by customers would be a function of elasticities as opposed to adjusting supply chain. I think they've got those pretty well nailed, right now. And we gave a pretty wide range for volumes in our fourth quarter between minus 2% and plus 2%, and that's a good number still to have out there because there's just uncertainty around what customers end up doing. And we've had some customers talk about elongated recoveries. We've had some customers say, no, we're back to positive growth, and we're promoting. I'd like to see a little bit more green shoots around that, but my confidence level is relatively high as we go into 2024 for the 3 reasons I outlined in the call, that we can return to that growth in those 3 reasons really being -- the comps get a lot easier coming off of this year. Our innovation pipeline is very robust. We've got a long list of things that we're working on. We profiled some of those on the call, whether it's cup of noodles or the Chick-fil-A conversions, some of the other things that we're working on are Rainier paperboard that we had our first sale in the quarter. And then the third point of that is the CPGs have just -- they've been taking a fair amount of hits. If you look at their index, it's one of the worst performing indexes because they haven't had volumetric growth, and they're going to work to fix that. So you put that all together, I think we can return to a modest amount of growth next year. And if we do, if you look at the last 3 years coming into this year, we've grown 3% each one of those years, 10% on a 3-year stack. Let's say, we go backwards 2%, 2.5% this year, look at a 4-year stack. We're still at 2%. I was getting asked by a lot of analysts, not you, others, why don't you raise your number when we were growing 3%, we said consistently, we're outperforming what we believe is the right number for us. And I remain convinced that the 100 to 200 basis points is the right target for us, and I'm confident we can return to that over the medium to long term.

Building off the upside in foodservice in terms of growth what do you attribute that towards?

Mobility. I mean you got 3.9% unemployment. So -- if you want a job, you can have a job in this environment. People like going through the drive-through. They like the convenience. 80% of our cups as they are coming through the drive-through. So in the U.S., in particular, it's different in Europe, but in the U.S., it's all about mobility and convenience for the consumer.

And Rainier, what is so unique about that product?

Well, you've got on that particular sheet of paperboard, it's 100% recycled and you've got brightness and smoothness, capabilities and specifications that rival coated SBS. And so you're able to take on kind of that premium sheet or high-end cosmetics, confectionery different types of packages that historically would have been in coated SBS and now can be in our CRP sheet.

Okay. All right. In terms of customer priorities, it seems like the initial phase of destocking was just purely having too much in the channel, right? But now it seems like your customers, just like everybody else, including yourselves, are torquing on inventory to reduce working capital right? Where -- has that been impacting you in significance?

Well, I think they talked to us about the fact on a macro basis, they probably went from like pre-pandemic was around 6 weeks. The overall supply chain, they went up to 8 weeks, maybe even 9 weeks and now they've kind of gone back to more historical level around 6 weeks. That's the kind of blow-through on the supply chain that we've dealt with. There's some variation there depending on the customer. But I think that's a pretty good algorithm to think about it.

Sure. Okay. All right. Do you sense that your customers are going to have even less inventory than pre-COVID?

No. I think, maybe some. But I think in general, they really were sensitized to supply chains that are robust enough to handle different types of shocks that could happen. And if anything, security supply remains a key consideration in the C-suite when they're thinking about their supply base.

Sure. Okay. Right. In terms of CPG, there's been this characterization of at some point, our customers will promote increased promotional spending and so on, right? But if you actually listen to them and look at their cost baskets, labor is pretty big and distribution and so on and so forth. And labor is only inflating. We see all the strikes in the U.S. over the last few months, et cetera. I'm sure there'll be more. And the unions are winning every single one with higher wages. So as you directly talk to your customers. Yes, what is the tenor out of -- what do they need to see before they start to actually truly start promoting more?

Look, I think like many industries, our customers have -- they really worked hard to get the pricing up and pricing has been difficult for them for years, as you know, to take price in that kind of environment. So they're very reticent to take any actions that would degradate the pricing they fought hard to get. Having said that, they've got to grow their volumes, too. I think they'll be cautious. I think they'll be thoughtful. I don't think it's going to be a massive wave of things that you see about 100 to 200 basis points coming off of, that's not exactly 5% or something like that. I think if I said something like that, you should look at me like, yes, that doesn't make sense. But with the fiber substitution into out of plastic and foam. That's our tailwind there. So we're not seeing big elasticity problems, we should be able to get that kind of growth. Now we, like them, are taking the labor situation [ built ] seriously. And so when you look at what we're doing, we're investing heavily both in our mills and our converting plans to eliminate unskilled and semi-skilled roles because we can't get them and they're inflating. And the technology is actually available to really automate a lot of those functions, and that's what we're doing. I expect our customers to do the same thing.

Okay, I do want to build off with that in a minute. But in terms of Europe, the demand dynamics there, a lot of companies have talked about pronounced weakness in Europe. It's starting to hit everything that they went through last year with inflation and energy and so on and so forth. What are you seeing in terms of demand?

Certainly, higher levels of inflation on the consumer. We're seeing more trade down in that market than we are in this market for store brand items. But some of those geographies like the U.K. store brands are already a big part of the overall sales basket mix. It's been interesting, Ghansham, for us. We were asked early on when we got bigger in Europe, you have to have a mill in Europe, and we said it's not a mandate. It would be something we consider like any other investment we have. But what's been actually need to see is how well our business has held up on the packaging side, even in a tough macro over there. Our overall demand profile has really modeled what we're seeing here in the U.S. and we've got a lot less invested capital driving the revenue line. So when you think about that, the return on invested capital in that market approaches what we've got in this market differently. And so is management thinks about as I think about it, Steve and I, in particular, and our Board, one size doesn't necessarily have to fit all. So I think that's been a positive thing for us to really kind of see too.

Okay. Let me just stop there and see if there's any questions in the audience. If not, we can keep going, Automation, you mentioned that you've been very public with your large projects as you would expect, given the carriers requirements. Maybe you could disaggregate what's been happening in terms of an update in Waco and also what you're doing on the downstream converting side?

Yes. So what we've really been doing -- and I'll take a step back to 2019 with Kalamazoo and Waco is between those 2 projects, we'll invest roughly $1.7 billion and completely recapitalize our entire coated recycled paperboard platform. Kalamazoo is done. For those of you who may not be aware, it's been operating for almost 2 years now. It's been a huge home run for us. We're delivering about $130 million of savings on that investment. And now Waco is in the process of being built. As I mentioned earlier, we'll be finishing that up in the summer of 2025 and have paper on the reel by the end of that year. And we said that you can model about $160 million for that a combination of cost reduction, where we're going to shut down the remaining high-cost mills and machines that we have and then some growth roughly 200,000 tons, that's going to be this high-quality CRB that I spoke about earlier for the other [ $16 million], should model that about [ $80 million ] and [ $80 million ] in '26 and '27. Those are good enough numbers for now. So what I like about where we are is as we ramp down into '25 and had certainly in the '26 and capital reverts back to more of a lower number, call it, 5% of sales, which is still very healthy. We could run the -- operate the company on a maintenance capital basis only below $300 million. Our team wouldn't like it very much because they like working on projects that drive value for customers, but we could definitely do it. You can see the cash flow power that we'll have coming out of that. And our balance sheet is actually as good a spot now as it's been since I've been CEO on a much bigger company. Like I said, we finished the year at 2.6x, 2.7x levered. So we've got good optionality there. But there's also an uncertain macro. So as we look at next year, we've got heavy CapEx next year. We'll generate a little bit of cash flow for debt reduction. If we go a little bit below the low end of our range for a while, that's okay. Because I know we'll always be able to find good ways to create shareholder value. And our track record is really good at having a balanced capital allocation approach.

On Kalamazoo, you mentioned it was a home run. Where was the upside in terms of specifics?

I think just how fast the machine ramped and how well the new equipment runs with operators that have only -- almost everybody we hired onto that machine was new and didn't have papermaking experience. We augmented it a little bit with some of our team in Kalamazoo. But the digital controls and the way that machine is set up and the operating system on it, it came up incredibly smooth and the quality, we thought it'd be good, exceeded my expectations, and they were high. So we had basically a 1-year ramp on a big investment like that where we are actually above where we said we were going to be and quality higher than we thought it was going to be. And if you go back in history, in our industry, usually, these startups are kind of messy. They take longer, they cost more, the overruns are significant. And you don't always get what you say you're going to get. So that's what really emboldened myself and the Board to press our muscle memory we developed in that process and take out the rest of the remaining high-cost mills because to the point earlier around labor we're having a big reduction. We've got -- many of those people were kind of getting senior and aged, they we're working in those mills. And let's face it. You come into a small mill that's undercapitalized as an engineer graduating from a good school. That's a tough sale. You come into Kalamazoo, you come into Waco, where it's a $1 billion asset -- you look at our control rooms, I joke and we talk about the fact that we're teaching young people who are playing Call of Duty on their parents couch 5 or 6 years ago. Now they're running our paper machine. And they're very comfortable with that kind of an environment. They're not going to turn valves or be out there on the paper machine like we have in some of our older smaller mills. So we're kind of building the jobs for what I believe the future will be, and I think that will position Graphic's for incredible success for years to come.

And Waco in terms of status, great state of Texas, any issues so far or...

Yes, I would just have to say this that -- but Texas doesn't give you a huge amount of incentives to come into Texas. What they do is go out of their way to make it a business-friendly environment. And anything we've asked or wanted for permitting or different things that we've needed. It's gone incredibly smooth. We're really happy to be there. And it's an area you live there. So in that Texas Triangle, you're adding people every day and when you're making recycled paperboard, that's a good thing because that's -- that generation more fiber that we can clean up.

In terms of on iterative projects because, obviously, Kalamazoo is huge. Waco is massive as well. What does it look like 3 years out? Are there -- those sizable projects? Are there going to be more discrete in terms of automation that you would expect just based on trying to hit your productivity targets?

Great question. I think, look, we're going to come out of this with 6 incredibly well capitalized mills, 2 on the SBS side, 2 on the CUK side and 2 making coated and uncoated SBS. They're all well capitalized. There'll be some discrete projects that come with returns, but nothing like what we did in Waco and Kalamazoo, we just don't need to do it. And so when you take a look at our free cash flow and what we'll be able to do is we -- if we do spend more money than the maintenance CapEx, it will be returning savings and productivity for our shareholders, and we'll drive that stuff down and eliminate labor and continue to automate our platform. And the neat thing about Waco and Kalamazoo too, Ghansham, that I think goes a little misunderstood is for the first 10 or 15 years, the CapEx requirements in those 2 locations are almost nothing. So a little bit of infant mortality, things that may go bump or maybe a project we find that would add value. But these are measured in $40 million, $50 million projects. They're not hundreds of millions of dollars.

Inflation, CC has ticked up a little bit. Energy has bounced around. But yes, just where are we on the raw material cost inflation?

Yes. Well, right now, we're in a pretty benign inflationary environment. But I say that as of October 31, as I jokingly point to. It can change in a hurry. I mean there's a lot of geopolitical things that are out there. And could we see some disruption that occurs and see some reinflation? Yes, I can certainly see that. I don't necessarily believe that we'll see significant reductions beyond where we're at based on where we're -- what we're seeing, what our supply base is telling us because everybody is trying to hold on to their price too. So I think right now, it's probably as good a guide as I can give you.

And on 2024, you don't have perfect line of sight, no one does, but you do on certain items, right, cost inflation and so just kind of state what you've talked about -- I think you called out an $80 million headwind for pricing, right?

Yes. $80 million headwind offset partially by the Bell EBITDA that we acquired and synergies that will come in there, which is roughly $30 million. A better year of productivity, if we drive 100 to 200 basis points because we don't have as much underabsorbed fixed costs. So that will be a positive pickup there, which has historically been for Graphic and then we'll earn on the growth. And so if you put that all together, I think the analysts have it pretty right. It's a flat to slightly down year as we kind of sit here right now but that's okay because we saw a huge pickup in EBITDA over that period of time. Remember, we made $1.70 billion in '21. And so that ramp has been pretty significant. We're holding it around the 20% EBITDA margin. We're going to throw off a lot of cash. We'll invest it wisely in Waco. And our balance sheet is at a good spot. As we come out of that, we're well positioned to have a lot of optionality.

And the $100 million headwind from under-absorption presumably would be...

Yes. If we drive 100 to 200 basis, we're going to naturally need more paperboard [ things ] to run the mills more.

Which would hold pricing as well.

Correct. Yes. It really is all interconnected.

In terms of new products at the trade show in September you have a lot of stuff for replacing plastics, including what product applications like berries and containers or berries and stuff like that. What's been the receptivity of that?

It's been high. Look, I think some of these things are difficult to do. You mentioned berries. Berries aren't easy because they're packed in the field. But the people that are making those are very focused on trying to find an alternative solution to rigid plastic, which is not something they want to use for the foreseeable future. But what we've really tried to do is give some good insights into kind of the base hits we're getting. Look at cup noodles. Cup noodles is 15,000 tons. It's an incredibly sticky transition when it goes out of home and into paper. Chick-fil-A has been kind enough to let us talk about our trial we've been running with them. It's gone well. That's a very big one. And if they go, ultimately, there'll be others that will have to be fast followers. And so when you think about our total addressable market there, we call it about $12.5 billion. The biggest chunk of that is cups and containers and just overall plastic replacement behind that. And we've got a steady list of projects that we're working on with customers, and that really informs our 100 to 200 basis points of growth.

Balance sheet going to be the best since 2016 based on our math on significant optionality, as you pointed to. Where do you see -- in context of the world also having changed for you, right? The interest rates higher so on. Take us through why 2.5-ish is sort of the right terminal leverage, why not lower? And then how should we expect cash flow to be allocated next year?

Well, being lower in '24 and '25 won't bother us, just given the uncertainty of the macro that I mentioned earlier, so I'll start with that. But look, I think the neat thing is for us is our major investment cycle in our recycled platform will be behind us. So that won't repeat. And that the cash flow gives us a lot of optionality to look at smart M&A, and I think our track record has been pretty good there. We've done some tuck-unders like we did this year with Bell and some larger ones like we did with ANR. All of them come in somewhere in that 8 to 9x range. Maybe that gets a little more pressured with interest rates going up, but they were never had double digits on them. And we've done a nice job finding synergies that come in behind the operational leverage of driving those tons through our own mills behind that. And so those are things that we look at. CapEx is probably pretty good around 5%. So that leaves some additional money that we can look at returning for shareholders via dividend increases and/or share buybacks, all of which we have done.

Okay. All right. In terms of M&A, most of it has been done on the downstream side. Is that what we should expect?

Yes. Yes.

Yes. Just to boost your integration rate?

Correct. Yes. And again, we're a packaging company. And so for us, it all starts with a cup or a carton. And so that's our -- that's at the very top of the wheel, if you will. Our focus is on growing our volumes because when our volumes grow, everything else kind of takes care of itself. And we choose to make the paperboard where we can make our shareholders a great return but we grow the packaging side of the business because that's the kind of the wheel of the engine.

Okay. All right. In an L-shape world, maybe you can close this out, Mike. Just give us a pitch as to L-shape recovery, I should say from [indiscernible] and assuming that's the case hopefully, it's not. How does the Graphic -- why should investors consider Graphic Packaging?

Well, I think in an uncertain macro company like Graphic with broad-based exposure to both the big CPGs and a large foodservice business gives you the optionality to play in a number of different ways. If the economy is a little better, you're going to see the foodservice business continue to grow. The economy is a little worse and unemployment goes higher, you're going to see people eat more at home. And we've got high market share in that kind of environment as well. Very stable and predictable volumes. As we talked about, I mean, our volumes are down 4.6%, but that's a fraction compared to what many people have dealt within the packaging space. And it's all tied to the fact that 95% of what we do is consumer nondiscretionary. And we've really been purposeful on how we built that our market participation strategies out. So I think in an L-shaped world, we play pretty well in that environment.

We will cap it there in the interest of time. Mike, thank you for your time.

Always a pleasure.

Melanie, thanks for joining us and the next...

Thank you for your interest in Graphic.