Chesapeake Corporation (CSK)

Q2 2008 Earnings Call Transcript

August 1, 2008 11:00 am ET

Executives

Joel Mostrom – EVP and CFO

Andy Kohut – President and CEO

Analysts

Rob Magnuson – Goldman Sachs

Patrick Moore – Deutsche Bank

Kunal Shah – Trafalgar Asset Management

Tim Burns – Cranial Capital

Karlin [ph] with Blue Bank [ph]

Presentation

Operator

Good day and welcome everyone to this Chesapeake Corporation second quarter 2008 earnings conference call. Today's call is being recorded. At this time, I would like to turn the call over to the Executive Vice President and Chief Financial Officer, Mr. Joel Mostrom. Please go ahead, sir.

Joel Mostrom

Good morning and welcome to Chesapeake Corporation's second quarter conference call. I am Joel Mostrom, and joining me today is Andy Kohut, our President and Chief Executive Officer.

Andy will begin with some overall comments on our business. I will then provide a financial review of the results for the second quarter. After that, we'll be available for questions.

Before we get started, I want to advise all participants that this call is being recorded by Chesapeake Corporation and is copyrighted material. It cannot be recorded or rebroadcast without Chesapeake's express permission.

Furthermore, the comments on this call may include forward-looking statements as defined in the Private Securities Litigation Reform Act. The accuracy of such forward-looking statements is subject to a number of risks, uncertainties and assumptions that may cause Chesapeake's actual results to differ materially from those expressed in the forward-looking statements.

Certain of those risks, uncertainties and assumptions are set forth in the summary of this conference call, which will be posted on the company's website at the conclusion of this call.

Additionally, during this call there may be references to certain non-GAAP financial information. This information has been reconciled to GAAP in the company's earnings release, and will also be posted on the company's website.

Now, I'll turn the call over to Andy.

Andy Kohut

Thanks Joel and good morning. While the operating results for the second quarter were disappointing, we have improved over the first quarter results and we expect to improvement to continue into the third and fourth quarters of the year. We are approaching the seasonal peak in many of our businesses and in addition we should start to realize the benefits of significant new business wins in the second half of the year. We have also made good progress in rolling out a comprehensive process improvement program from which we expect to begin to realize benefits in the second half of the year.

In addition to significant new business and process improvement initiatives, we recently announced a general price increase of approximately 10% to recover rising raw material and energy-related cost. We remain committed to meeting our customers needs and in order to provide the level of service they expect, it is no longer possible for us to absorb rising input cost and maintain an innovative service oriented business.

This has been a difficult period for us as unexpected issues have caused delays in the refinancing of our senior credit facility. Today we announced a comprehensive refinancing plan to provide us with the necessary financial flexibility to meet our business needs. Just as we have successfully reached agreement with our largest pension group in the UK and settled an unexpected lawsuit from Philip Morris, I am confident we will be successful in this more comprehensive approach to our refinancing needs.

While we continue to work on the sale of non-core assets, we are increasingly concerned that in the current credit market we may not be able to achieve reasonable value through the assets today. If we conclude reasonable values cannot be achieved, we will delay the sale of these non core assets until such time that we can complete our refinancing and the broader credit markets improve and buyers are willing to pay reasonable prices for these assets.

We remain confident the second half of the year will continue to show improving trends in the operating performance of our business, however, we are very much aware of the current headwinds facing the economies around the world and expect improvement in our full year operating results over last year’s to be challenging. Although we expect the general economic conditions will remain difficult, we continue to believe that our primary end use markets pharmaceutical and healthcare, agrochemicals, and alcoholic drinks will be more resilient than many other markets during these unsettled economic times.

I will now turn the call back over to Joel.

Joel Mostrom

Thanks, Andy. This morning we reported a second quarter net loss from continuing operations of $227.7 million compared to a net loss from continuing operations of $10.6 million for the second quarter of 2007.

We incurred charges for special items in both of these periods, including a goodwill impairment charge of $215.5 million in the Paperboard Packaging segment in the second quarter of 2008.

Special items include goodwill impairments, restructuring expenses, asset impairments, and gains or losses related to divestitures.

Our operating income, exclusive of special items, for the second quarter of 2008 was $3.3 million compared to $9.8 million for the second quarter of 2007. Changes in foreign currency exchange rates increased operating income exclusive of special items approximately $900,000 for the second quarter of 2008 when compared to the second quarter of 2007.

Also during the quarter, we changed our accounting policy to record pension expense using the actual fair market value of pension assets in our actuarial calculations, which is a preferred method of accounting for pension expense. The change in accounting decreased pension expense before the effect of income taxes for the second quarter of 2008 by $.1.3 million and decreased pension expense for the second quarter of 2007 by $.1.5 million.

During the second quarter we recorded a $33 million loss in discontinued operations following the settlement of a lawsuit from Philip Morris. The loss related to a lower cap be in place on the environmental indemnification we are entitled to related to the Fox River environmental liability. This resulted in a reduction in the previously recorded receivables from Philip Morris USA related to the Fox River liability.

I'll now review our operating results starting with the Paperboard Packaging segment. My discussion of segment operating income excludes the effects of special items. Second quarter net sales of $205 million for the Paperboard Packaging segment were down 1% compared to net sales for the second quarter of 2007.

Excluding changes in foreign currency exchange rates, net sales were down 6% for the quarter. Sales in both branded products and pharmaceutical and healthcare packaging were down in the second quarter of 2008.

Excluding changes in foreign currency exchange rates, sales of branded products packaging were down about 9% for the second quarter. The decline was due to a 46% decline in tobacco packaging sales partially offset by 14% increase in alcoholic drinks packaging and German confectionary packaging.

Excluding changes in foreign currency exchange rates, sales of pharmaceutical and healthcare packaging were down about 5% for the second quarter. The decline in sales was primarily the result of lower customer demand and a competitive price environment. We expect our sales volumes to improve in the second half of 2008 based on new business we have secured in this area.

The Paperboard Packaging segment's operating income for the second quarter of 2008 was $4.2 million, which was a decrease of $4.2 million compared to the second quarter of 2007.

Changes in foreign currency exchange rates increased segment-operating income by $300,000 for the quarter. The decrease in operating income for the second quarter was largely due to the decreased sales of tobacco packaging that accounted for over 50% of the operating income decline for the quarter. The remaining decline was primarily due to expenses related to multi-shaped tubes production for alcoholic drinks packaging, cost associated with recent process improvement initiatives, and increased energy and transport cost as well as the decreased sales of pharmaceutical and healthcare packaging.

The Plastic Packaging segment had sales of $46 million in the second quarter of 2008, up 6% from the second quarter of 2007. Excluding changes in foreign currency exchange rates, net sales were down 2% for the quarter. The decrease in net sales for the second quarter was primarily due to decreased volume of food and beverage packaging in South Africa partially offset by increased sales of specialty chemical packaging in the UK and Hungary.

The Plastic Packaging segment's operating income was $3.4 million for the second quarter of 2008, a decrease of $2.6 million from the second quarter of 2007.

Changes in foreign currency exchange rates increased segment operating income $600,000 for the quarter. The decrease in operating income for the second quarter was primarily due to competitive market conditions and increased raw material costs throughout the segment. Increased transportation and energy costs accounted for about 30% of the decline for the quarter.

Turning back now to our consolidated results. Net cash used in operating activities was $28.8 million for the first six months of 2008 compared to net cash provided by operating activities of $15.4 million for the first six months of 2007. The decrease in operating cash flow was primarily due to the decrease in operating income in 2008 and increased working capital requirements.

Total debt at the end of the second quarter of 2008 was $574 million compared to $515 million at the end of 2007. Changes in foreign currency exchange rates increased total debt by approximately $11.6 million at the end of the first six months of 2008 compared to the end of 2007.

Likewise, foreign exchange rates increased interest expense approximately $300,000 for the second quarter of 2008 when compared to 2007. Before we open the call up for questions, I would like to expand on a few points that Andy mentioned in his opening remarks.

On July 15, 2008, one of our UK subsidiaries agreed with the trustee of its defined benefit pension plan on an amended recovery plan. Under the terms of the amended recovery plan the trustee agreed to accept annual supplemental payments of 6 million pounds sterling over those needed to cover benefits in expenses until the earlier of 2021 with the plan obtaining 100% funding after 2014 and has waived the requirement for the additional cash payment due on July 15, 2008, to achieve an interim funding level of 90%. The UK subsidiary has also agreed to grant to the pension plan fixed and floating charges on assets of the UK subsidiary in the UK and Ireland securing an amount not to exceed the pension plan funding deficit. The security granted will be subordinated to the security provided to the lenders under the company’s senior revolving credit facility.

Also on July 15, 2008, the company obtained an agreement from a majority of the lenders under the senior revolving credit facility to increase the total leverage and senior leverage ratios and provide for an intercreditor agreement among the senior revolving credit facility lenders, the company, and the trustee of the UK pension plan.

Today, we announced a comprehensive refinancing plan to address our upcoming debt maturities and general liquidity needs. We expect that upon completion this proposed refinancing plan will address our short and long-term capital needs. The proposed refinancing plan is expected to include new senior secured credit facilities to be used to fully repay the company’s existing $250 million senior secured credit facility and provide incremental liquidity and an offer to exchange the company’s outstanding 10.375 sterling denominated senior subordinated notes due in 2011 and the 7% Euro-denominated senior subordinated notes due in 2014 for new debt and equity securities.

We expect to continue to work with GE Commercial Finance Limited and General Electric Capital Corporation to participate in elements of the new senior secured credit facilities. We anticipate commencing the exchange offer and marketing for the new senior secured credit facilities in September 2008.

Furthermore, we have engaged Alvarez and Marsal to provide consulting services including evaluating the company’s business plan.

Now at this time we will be happy to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We'll go to Rob Magnuson, Goldman Sachs.

Rob Magnuson – Goldman Sachs

Hi, I was wondering if you could speak to where you think you are in terms of market share in each of the segments, is it some of this volume decline, is it purely demand or do you think you have lost any share?

Andy Kohut

We don’t believe that we have lost any share an actually the additions to the customer business that we spoke about the new business wins actually suggest that we have increased position. There is a timing element of when that business is transferred to us but in some cases our customers had lower demand and that resulted in us having less than expected shipments in particularly the first half of the year.

Rob Magnuson – Goldman Sachs

And just in terms of second half performance, if I am understanding it correctly it will not only be a sequential increase going forward in the second half but also year-over-year increase in EBIT, adjusted EBIT, I guess?

Joel Mostrom

What we said is we expected to be a sequential improvement over the first half of the year. We said that year-on-year improvement for the entire year would be more challenging.

Rob Magnuson – Goldman Sachs

Right, but I guess the first half of the year is down materially. So would that imply second half ’08 is stronger than second half ’07?

Joel Mostrom

We really didn’t provide that other than that we expected in improving position with the business going into the second half, but then we just gave an annual view that it would be more challenging to have year-on-year improvement.

Rob Magnuson – Goldman Sachs

Okay, and the new business that has been won but doesn’t come online until the second half, have you given a total revenue number for that or does that – I guess does that fully offset the BAT business?

Joel Mostrom

It certainly helps us at the BAT business, but what is particularly good about it is it is across really all our divisions and pharmaceutical and healthcare are the branded products as well as in our plastics division we have seen wins across the board.

Rob Magnuson – Goldman Sachs

Okay that is good for me. Thank you.

Operator

(Operator instructions) We will go to Patrick Moore, Deutsche Bank.

Patrick Moore – Deutsche Bank

Hello, my question is from the bondholder side. I would assume – I am not sure how much you can say prior to the discussions in September, but the bondholders and equity holders for that matter could have been more focused on who is going to have a claim on the company and how you plan to restructure it. So can you comment at all, I am assuming once the new debt to be – obviously to have a longer term than 2011 and 2014, and what – would you be looking for a haircut on the current outstanding level and how much equity to the equity holders, you know, you know the offer someone – were you planning to offer the bondholders to restructure the debt is really the question?

Joel Mostrom

Patrick those are all great questions but obviously we can’t provide any of those details in the public arena at this time.

Operator

We will take our next question from Kunal Shah, Trafalgar Asset Management.

Kunal Shah – Trafalgar Asset Management

We were actually going to ask exactly the same question. When are you going to present the details of the offer to bondholders, can you at least tell us what the timing is, because –

Joel Mostrom

We said we would commence the offering in September; obviously there will be discussions prior to that.

Kunal Shah – Trafalgar Asset Management

It just seems little strange the stock should be trading at this time with such uncertainty about you know what the offer will be to bondholders. I would have thought you would have had a faster [ph] timetable?

Joel Mostrom

Again, I can’t comment on that. We are certainly working on it and it will happen and discussions will begin very shortly.

Operator

(Operator instructions) And we have a followup question from Rob Magnuson, Goldman Sachs.

Rob Magnuson – Goldman Sachs

Hi, just in regards to the senior credit facility $250 million. It sounds from the press release and your comments that GE will either not be the sole lender or may not be the majority lender. I guess is that true and what conditions or precedents are in place for that other than obviously the restructuring with the bondholders?

Andy Kohut

Rob, the only thing we could say at this stage is that we are still talking to GE. We had the dialog going with them earlier in the year and we do still see very much them playing in a role in a component of the restructuring debt plan.

Rob Magnuson – Goldman Sachs

Okay, and I will maybe try a question somewhere in the last too, what is the appropriate leverage for Chesapeake Packaging in the current environment?

Joel Mostrom

We obviously can’t give that other than to say that we are uncomfortable with our current debt level and we are through asset sales, through improved operating cash flow, and through the refinancing. We are looking at getting the capital structure aligned with both our short and long-term needs.

Rob Magnuson – Goldman Sachs

All right, I tried [ph] thanks.

Operator

We will go next to Tim Burns, Cranial Capital.

Tim Burns – Cranial Capital

Andy and Joel how are you guys doing?

Andy Kohut

All right.

Joel Mostrom

All right.

Tim Burns – Cranial Capital

A lot of companies this quarter have been talking about you know putting in place price increases to cover the cost inflation components. Are yours going to enough to be caught up by year-end or let’s say that everything stays stable from here out, it looks like we were having a major change in the cost of almost all commodities. Do you guys catch up by year-end or what are your thoughts on this 10% price increase?

Joel Mostrom

Tim, it is a practical matter and I think we said this before. Some of our contracts have built in pass-through with lag. So, in part we would be looking to recover under some existing contracts under the current indexing provision. Other contracts throughout the business do not provide or afford us that option. None of our contracts per se have any indexing or pass through for energy and freight and some of those things that are very significant to most companies today and I think most companies in fact have said that in part what they are trying to do is recover those types of items. So, my answer would be we are going to go out. We have just implemented it. We are working closely with all of our customers from both a sales and operations side and we are going to take it customer by customer in terms of what we can accomplish in terms of this ask for a general across the board increase.

Andy Kohut

In the items such as resin and board typically have a 30 to 90 day lag depending on the index that is being used.

Tim Burns – Cranial Capital

Got you, and with your impairment charge and restructuring the return on that is – what kind of time frame again?

Joel Mostrom

I am not sure. The return on the – the impairment charge you are talking about the goodwill impairment charge Tim or –

Tim Burns – Cranial Capital

Yes.

Joel Mostrom

Return on that.

Tim Burns – Cranial Capital

No, no. I thought that the impairment charge was related to a plant restructuring but that has already happened.

Joel Mostrom

The $215 million charge is a write-off of goodwill associated with the goodwill on our Paperboard Packaging segment and it was a consequence of – we have three year process – annual process where we update our outlook into the future and as a consequence of accelerating that outlook is part of this refinancing activity concluded that we needed to take the impairment charge in the Paperboard Packaging segment this quarter.

Tim Burns – Cranial Capital

(inaudible) Are the people that you are dealing with across the board slowing down in terms of their thoughts of innovation. I mean is just down the brass tacks we got to reduce costs and we don’t new ideas or I mean what you guys see out there?

Joel Mostrom

No. Actually Tim the – across the board we have investments going into strong demand in Germany for our confectionary business, very high-end confectionary packaging. Our agrochemical business is with the agrochemical moves around the world is doing very well. Pharmaceutical and healthcare, a variety of moves and significant wins on customers. We have put in an innovation team in place across the company that works with clients. We are not seeing that at all. Now pharmaceutical and healthcare like everything, the effects of generics you know, where those products are actually produced does impact the overall demand for some of the more exotic packaging products that we have, but we are going into the third quarter with a pretty robust business right now.

Tim Burns – Cranial Capital

Got you, and the comment you have made about not a good time to sell non core assets, if the market recovered both from a finance and evaluation situation, I mean it just – it continues to be the I guess unanswerable question in that sellers want prices or values from 18 months ago and buyers want post subprime crisis valuation but I mean if resin and other costs go down over the second half, does the valuation for the assets pick up and potentially get done?

Joel Mostrom

I can’t speculate on that but one thing I can say Tim is we are not going to give away good businesses at distress levels.

Tim Burns – Cranial Capital

Got you and any changes in Capex moving forward is my last question?

Joel Mostrom

We were still guiding down to 10 something that is in and around the $40 million range. So, I think it pretty comfortable that is going to be certainly be in that. A lot of the investment we have made year-to-date was some carry-over from investment that we made in our new operation in China from last year. So, some of that was still of the capital investment going in that facility, but as you would expect we are trying to manage that very closely.

Tim Burns – Cranial Capital

Got you. While hang on guys.

Joel Mostrom

Thank you.

Andy Kohut

Thank you.

Operator

We will go next to Karlin [ph] with Blue Bank [ph].

Karlin – Blue Bank

Hi, I have about three questions. The first one on the UK pension scheme, could you quantify the amount, which will be secured on the UK assets, the amount of the deficit, I think you said?

Joel Mostrom

What I can tell you is this. We have agreed that the second line [ph] would be equal to the amount the 100% of the amount of the deficit. The last published figure we had provided which was as of April ’08 of the deficit was 58.9 million pounds. Since that time we have made a scheduled payment in July of 6 million pounds Sterling and that is the agreed to supplemental payment amount that we will be making in each of the ensuing years. So that would be the current roughly speaking point of deficit without regard for changes in asset movement or anything else in the interim.

Karlin – Blue Bank

Okay, and could you give some idea of the amount of the UK assets?

Joel Mostrom

No, I don’t think I would be comfortable disclosing this (inaudible) the amount of deficit, which I just gave you.

Karlin – Blue Bank

Okay, and finally just on the proposed senior secured facilities. Could you give us some indication of what margin you would expect to pay on those facilities?

Joel Mostrom

Not in a position to discuss that at this point.

Karlin – Blue Bank

Okay, thanks.

Operator

It does appear that are no further questions at this time. Mr. Mostrom, I would like to turn the conference back over to you for additional or closing remarks.

Joel Mostrom

Thank you. I just like to remind everyone today’s call will be available for replay on our website chesapeakecorp.com or it can be accessed by calling 888-203-1112 or you can also dial 719-457-0820. The access code is 7909848. This concludes today’s call and thank you for participating.

Operator

That does conclude today’s conference. Thank you for your participation. You may disconnect at this time.

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