Domtar Corporation
Q2 2018 Earnings Call Transcript

Published: 2 Aug 2018

[Operator:]

Please standby. Good day, ladies and gentlemen, and welcome to the Domtar Corporation Q2 2018 Earnings Conference Call with Financial Analysts. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. As a reminder, this call is being recorded. Today is August 1, 2018. At this time, I'd like turn the meeting over to Nicholas Estrela. Please go ahead, sir.

[Nicholas Estrela:]

Thank you, Jim. Good morning, and welcome to our second quarter 2018 earnings call. Our speakers today will be John Williams, President and Chief Executive Officer; and Daniel Buron, Senior Vice President and Chief Financial Officer. They will be supported by Michael Garcia from our Pulp and Paper division; and Michael Fagan, from the Personal Care division. John and Daniel will begin with prepared remarks, after which they will take questions. During the call, references will be made to supporting slides, and you can find this presentation in the Investors section of the websites. As a reminder, all statements made during the call that are not based on historical facts are forward-looking statements subject to a number of risks and uncertainties, many of which are outside our control. I invite you to review Domtar's filings with the Securities Commissions for a listing of those. Finally, certain non-U.S. GAAP financial measures will be presented and discussed, and you can find the reconciliation to the closest GAAP measures in the Appendix of this morning's release, as well as on our website. So, with that, I'll turn it over to John.

[John David Williams:]

Thank you, Nick, and good morning, everyone. This morning, we reported EBITDA before items of $143 million in a heavy maintenance quarter. Our businesses generated strong operating cash flow, over $175 million in the quarter, and our year-to-date free cash flow is tracking well. Market conditions and order books continue to be favorable for both Pulp and Paper. Both of these businesses are providing us with good sales momentum and cash flow, and we're building on several important initiatives. In Paper, the business is delivering steady results. Our volumes trended above forecast driven by higher demand and lower imports as we further position our volume to capitalize on opportunities in our key markets. We're making progress with announced price increases across several uncoated freesheet grades. Our paper price realization should improve further over the next couple of months as the recent increases take hold. In Pulp, prices trended higher following the increases announced this year, while demand held steady. Quarter two was also our peak outage quarter this year with planned maintenance spending up $38 million from the first quarter. This increased activity represented approximately 16,000 tons of paper and 42,000 metric tons of pulp maintenance downtime. Although maintenance costs remain relatively in line with our guidance the elevated level of outages impacted fixed cost absorption and productivity. In addition, cost headwinds continued as we experienced higher chemical and freight costs at several locations. As expected, Personal Care results were impacted by volume reduction and commodity inflation. This was partially offset by strong cost savings, reduced overhead spending, and early results from our customer portfolio transition efforts. These measures will help us compete more effectively in an environment that's become more challenging over the last few years. In addition, we expect to see margin improvement towards the end of the year as the benefits of new customer wins flow through. Overall, I'm pleased with our results during an exceptionally busy maintenance quarter. Aside from the additional central and maintenance cost, results were in line with our expectations, and I look forward to the momentum we've built into the second half of the year. With that, let me turn the call over to Daniel for the financial review before making further comments on our second quarter performance and our outlook. Daniel?

[Daniel Buron:]

Thank you, John. And good morning, everyone. Let's start by going over the financial highlights of the quarter on slide 4. We reported this morning, net earnings of $0.68 per share for the second quarter compared to net earnings of $0.86 per share for the first quarter of 2018. Adjusting for items, our earnings were $0.65 per share in the second quarter compared to earnings of $0.87 per share for the prior quarter. EBITDA before items amounted to $143 million compared to $161 million in the first quarter. Turning to the sequential variation and earnings on slide 5. Consolidated sales were $8 million higher than the first quarter due to higher prices in our Pulp and Paper businesses, partially offset by lower paper volume and lower sales in our Personal Care business. Depreciation and amortization was set at $79 million, while SG&A was $8 million higher than the first quarter largely due to higher mark-to-market of stock-based compensation. The second quarter results included a gain on disposal of property, plant and equipment of $3 million. In the second quarter, we recorded an income tax expense of $8 million or 16%, slightly lower than our expected tax rate due to enacted tax rate changes in Sweden. Now, turning to the cash flow statement on slide 6. Cash flows from operating activities amounted to $177 million, while capital expenditures amounted to $37 million. This resulted in free cash flow of $140 million in the second quarter. Turning to the quarterly waterfall on slide 7. When compared to the first quarter, EBITDA before items decreased by $18 million, due to higher maintenance costs for $38 million, higher SG&A for $9 million, higher fixed costs and other of $7 million, lower volume and mix for $6 million, lower overall productivity of $4 million, and higher freight cost of $2 million. These were partially offset by higher selling prices for $36 million, and lower energy and fiber cost for $12 million. Now, the review, our business segment starting on slide 8. In the Pulp and Paper segment, sales were 2% higher when compared to the first quarter and 12% higher when compared to the same period last year. EBITDA before items was $143 million compared to $140 million in the first quarter of 2018. Our Paper business on slide 9. Sales increased 1% versus last quarter and were 11% higher versus the same quarter last year, while estimated EBITDA before items was $98 million. Manufactured paper shipment were 2% lower compared to Q1 and 8% higher versus the same period last year. Average transaction prices for all our paper grades were $34 per ton higher than the first quarter. Let's turn to our Pulp business on slide 10. Sales increased 4% versus the last quarter and were 16% higher versus the same quarter last year. Estimated EBITDA before items was $45 million. Pulp shipment were 1% higher versus the first quarter and down 2% when compared to the same period last year. Average pulp prices increased $29 per metric ton versus the first quarter. Our Paper inventories decreased by 15,000 tons when compared to the last quarter, while our Pulp inventories decreased by 26,000 metric tons. Our Personal Care business on slide 12. Sales decreased 6% when compared to the last quarter and were 4% higher versus the same period last year. EBITDA before item was $20 million, $6 million lower than the first quarter. Turning to slide 13, as you can see, the third quarter will see lower major maintenance activities. We expect to spend approximately $11 million less than what we spent in the second quarter, and this decrease should largely impact our Pulp business. So, this concludes my financial review, and with that, I will turn the call back to John.

[John David Williams:]

Thank you, Daniel. In Paper, we are maintaining our strong volume performance in a favorable market environment. North American uncoated freesheet demand rose 1.5% in quarter two and is down 1.2% year-to-date, compared with an average decline of 4% over the past two years. As a result of this better demand, our year-to-date shipments continue to improve and are up 6% versus last year, with all of our Paper sales channels performing at or ahead of plans. We've seen particularly strong growth in the specialty paper grades, up 12% year-over-year. We ran our paper machines at full capacity outside of the maintenance downtime and shifted 102% of production in order to meet customer demand. This improved performance comes at a time when several U.S. capacity shuts have occurred, and this has allowed us to further improve our market share. We are fully committed to remaining the partner of choice as the leading North American uncoated freesheet producer. Given the freight and logistical challenges in the North American market, we're also geographically well-positioned to support our customers' demand. Average paper prices were up $34 per ton versus quarter one as we saw increases across all grades and channels. The May price increase has been successfully negotiated and will be phased in throughout the third quarter as we expect a fuller and faster realization. These price increases helped offset higher maintenance and inflation on some raw material and freight costs in the quarter. Given that some of these costs are expected to remain at elevated levels for the remainder of the year, we announced yesterday evening, an additional $50 per ton price increase across all our commodity grades. In Pulp, our customer demand across regions and grades remained positive. Our shipments were slightly lower than our usual run rate, driven by the planned outages and low inventory levels from the weather related issues in the first quarter. Our average prices were $29 per metric ton higher than in the first quarter. Although we expect some seasonal weakness in Chinese paper and pulp (00

[Nicholas Estrela:]

Thank you, John. So, both John and Daniel will be available for questions. I'd ask our participants to ask a few questions at a time and return to the queue for follow-ups as we want to get as many people as possible. Jim, you can open the lines for questions.

[Operator:]

Certainly. We'll take our first question from Gail Glazerman from Roe Equity Research.

[Gail Glazerman:]

Hi. Good morning.

[John David Williams:]

Yeah. Good morning.

[Daniel Buron:]

Good morning.

[Gail Glazerman:]

John, can you give a little bit more insight into where you stand on the asset repurposing outlook? You're talking adding maybe a little bit more in Pulp proactively than you have in the last couple of quarters. And if your thinking has been influenced by any of the recent investment news we've seen in kraftliner globally over the last couple of months?

[John David Williams:]

Yeah, certainly. So, and I think the way we see it, if we look at our pulp mills, as you may know, historically, I think we've sort of done pulp when we couldn't think of anything else to do. We're now running that business on a much more focused basis. We put one of our very best people, Steve Makris, in charge of it, reporting into Mike Garcia. And we now have a very clear plan of investment in the current asset base, just to be clear, to ensure that we get everything we can out of it, both from reducing cost and also from increasing productivity in those mills. So, we have about probably a three-year plan in order to really drive ourselves to the kind of position that we think will make us even more competitive than we already are. So, that's where we see the world in Pulp, focusing, as ever, really on fluff pulp and NBSK and SBSK as the grades that we really want to focus on. Makes sense?

[Gail Glazerman:]

Yeah. I'm just thinking more in terms of repurposing, is Pulp maybe more attractive now than it might have been when you first started talking about your next repurposing relative to last year?

[John David Williams:]

I see what you're – right. I understand what you mean. Well, so I think in terms of that, we think we have a lot of opportunity around kraftliner. We continue to do the work. As we said earlier that the engineering study was pretty positive, we think there are probably three, maybe four assets where we can do that over time. We're doing a lot of work around the market. As you know, there are some divergent opinions on whether or not one has to also own corrugated box plants. We're open to all choices, and we're doing that work and engaging with our board as to the when and the where of that in the next few months.

[Gail Glazerman:]

Okay. And just switching gears for the last question, the modest growth that you saw on uncoated freesheet in the quarter, is that being driven by macro trends? I mean, I guess, you mentioned the specialty where that's kind of standing out. Like is this a new kind of sustainable change or do you think it's maybe positioning ahead of the price increases and other elements driving it?

[John David Williams:]

Yeah. So, that's a great question. So we haven't seen what I would call a dramatic buy-in against price increase. Maybe some small buy-in, but, quite frankly, we haven't had the inventory to really allow people to make buys against forthcoming price increase. I think obviously, white collar employment, a economy that's as strong as our economy right now is going to drive uncoated freesheet usage. People are going to advertise more, obviously, that helps direct mail, which is very important to us all on cut size white collar employment, as we said earlier, in offices, makes a little bit of a difference. I think for us, where you see us growing faster than market, that's about industry capacity having been reduced, and we become sort of a very serious – an even more serious player in the marketplace. I also think on the packaging side, there's a lot of negativity around towards plastic these days. So, I think you're beginning to see companies make choices about trying to find paper substrate solutions, whereas perhaps, once upon a time, they have instantly thought of plastic. So I think that underpins some of that packaging growth you see there.

[Gail Glazerman:]

Okay. That's great. Thank you.

[John David Williams:]

You're welcome.

[Operator:]

Moving on, we'll take our next question from George Staphos from Bank of America Merrill Lynch.

[George Leon Staphos:]

Hi, everyone. Good morning. Thanks for all the details.

[John David Williams:]

George, good morning.

[George Leon Staphos:]

How's it going? I guess, the first question will be around pricing within uncoated freesheet. John or Daniel, could you tell us where exit rates are relative to average pricing, 3Q versus 2Q? And if I heard you correctly, the May increase which has been negotiated, can you suggest to us or give us some direction of what incremental that might be beyond, obviously, what you announced yesterday?

[Daniel Buron:]

I think we're seeing a quick implementation of the May increase, quicker than what we've seen in the last few increases. We still believe it's going to be done over three, four months' period. So we should see a large portion of the benefit in the third quarter and the remainder of that in the fourth quarter. And to your first question, I don't have with me, so I'm sorry. I think it's around $10 or $12 more in terms of exit price on uncoated freesheet versus the average of the quarter. But don't quote me on that because I'll need to check.

[George Leon Staphos:]

Okay, no worries. And could you give us also the exit rate on Pulp versus the average in the quarter? That'd be helpful, too, if you could.

[John David Williams:]

Well, I think on that one, George, you're probably looking – I think the way to see it would be the price increases we've announced in the quarter assume a sort of 30- to 60-day lag on some of it because of contracts in the U.S., and then work the pricing out from there. I don't have the exact number with me, but that's the way we would look at it. So, it's probably versus the average sort of $15 to $20 a ton.

[George Leon Staphos:]

Okay.

[John David Williams:]

Okay?

[George Leon Staphos:]

That helps. Thanks, John. And then second question I had with pricing to side (00

[John David Williams:]

Yeah, it's a great question. So, really, it's about when we take – we're now on an 18-month shutdown cycle. So that has meant in a couple of instances, when we actually take the shot, there are things we're discovering that we weren't aware of, so maybe there are some cracks here and there or whatever it may be. And that's just causing us to spend a little bit more money around maintenance as we fix those things because obviously, what we don't want to do is limp along for 18 months. So, that's really what's driven some of that. I think as we settle down into this 18-month cycle over the next few years, I would imagine that, that will reduce almost a little bit, but that's what driven that number.

[George Leon Staphos:]

Okay. And my last one and maybe a different take on Gail's question, given the fact that you've seen certainly improved pricing and margin and better than market growth in uncoated freesheet, does that change your view relative to what you would have thought or discussed, say, at the beginning of the year about uncoated freesheet relative to the repurposing alternatives that you have, whether it's in containerboard or pulp? Thank you.

[John David Williams:]

Sure. So, I think any repurposing we do, we have to remind ourselves, we're taking a 30- to 40-year view on the future of that mill and that asset. And no doubt, one has to be careful around the decline level of uncoated freesheet. But really, to be frank, in the end, one's going to make an economic decision, which is where are the long-term earnings stronger for this company based on the choices we make. So, to my mind, that's what's going to drive us. And we just have to see where that lands.

[George Leon Staphos:]

And so, over six months, that hasn't changed then, you'd say?

[John David Williams:]

No, not really.

[George Leon Staphos:]

Okay. Thank you, guys.

[Operator:]

Moving on, we'll take our next question from Brian Maguire from Goldman Sachs.

[Brian Maguire:]

Hey. Good morning.

[John David Williams:]

Brian, morning.

[Brian Maguire:]

Just a question on the cost inflation you're seeing. If I strip the maintenance change year-over-year out of the Pulp and Paper segment, it looks like the costs were up around 10%. I'm guessing some of that was maybe just some elevated fixed costs, but variable, you mentioned have been up. Just wondered if that kind of 10% inflation rate is sort of what you're seeing and expecting going forward, or within the chemicals and freight basket, obviously, some are probably running a little bit higher than that. But are there any offsets to that? Just kind of general comments on inflation, if you could.

[Daniel Buron:]

I think if you look at our inflation, we've seen freight going up versus last year significantly, and our view is it is where it is and it should remain more or less at this level. So, when you're going to compare quarter-quarter, you should then see further freight inflation. But when you're going to compare to last year, you're going to see freight inflation. We've also seen some inflation in chemical costs. There, it's more difficult to forecast what's going to happen for the rest of the year, where we do believe we'll see a little bit more increase in the next six months. And again, if you compare to last year, it's going to be a bigger inflation because last year cost, I mean we're just exiting actually kind of a low raw material environment and entering into some sort of a more inflationary environment for raw material, and that's one of the reasons supporting our price increases in both Pulp and Paper. But our view is if you look at our thoughts for the next six months, you'll see moderate inflation. So, just a little bit more than what we've seen in the past for the next six months.

[Brian Maguire:]

Okay. And just a question on Personal Care, it's kind of a two-part question. One, I think last quarter, you talked about maybe the full year margin just peaking into the double digits. It seems like there's been some incremental headwinds, freight and other things. Just wondering if you could kind of update us on that and the longer term outlook I think you had talked about $150 million of EBITDA out of the business, just wondering if anything's changed, that would cause you to change that.

[John David Williams:]

Sure. Yeah. That's a great question. So certainly, we think sort of quarter two, quarter three are going to look fairly similar. We're expecting improvement in quarter four and sort of moving forward then as these major account wins come in. Are we going to see the top line move. The top line is actually not that unhealthy at the minute, given the fact we had this customer switch out. However, I think the only thing that still concerns me or one of the things that concerns me is raw material inflation. Obviously SAP, and obviously pulp. When you look at other consumer goods companies, you see most of them out there discussing the fact in the tissues space and in the personal care space, that pulp is the reason they're moving prices. That's obviously an issue for us. So, we are largely either a retail private label business or an institutional business. We have a few little brands here and there. We're trying to move those – we're moving those prices. But our ability to get those costs back in the short term is fairly limited, given the way the business is organized around contracts for large – either large retailers or large healthcare authorities. So that's our struggle at the minute. So my view is this is still a healthy business. It's got a good top line growth. The market is very strong. These products are being adopted by more and more consumers. Two things have happened. There's a lot of capacity in that business that wasn't there before. There's been a massive diaper war between the two main incumbents that's caused margins to suppress on the baby business. The adult business is actually still pretty healthy and growing. So, I think over time, that's going to show through. But at the minute, there's no question and you can see the numbers, it would be foolish to pretend otherwise, we're battling hard.

[Brian Maguire:]

And just on that last point on the diaper war, P&G said some comments yesterday around trying to pivot maybe a little bit more toward a price first instead of volume approach. Do you think you would expect to follow that and push price to kind of offset some of this raw inflation in this environment?

[John David Williams:]

I mean, the answer is absolutely, if we can. No question. But I think one – the only caveat I give to that is that in baby diapers, there is a lot of capacity out there in the manufacturing side. So that is the other thing that tempers the opportunity, to be frank. But, of course, we look to move price and margin every day we can.

[Brian Maguire:]

Okay, thanks very much.

[John David Williams:]

You're welcome.

[Operator:]

Moving on, we'll take our next question from Adam Josephson from KeyBanc.

[Adam Jesse Josephson:]

John, Daniel, Nick, good morning.

[John David Williams:]

Adam, good morning.

[Adam Jesse Josephson:]

Good morning, John. One more on the repurposing situation, if you don't mind. John, you started talking about this a year ago, potentially repurposing to containerboard, of course. And obviously, since then, there have been a number of announcements, there have been three conversions. So just trying to understand, I guess, why this review is taking you as long as it is just given the speed with which some others have already converted machines in recent months, and again, how these recent announcements/conversions are affecting your thought process if at all.

[John David Williams:]

I think that's a great question. So two reasons, one is to make certain that the asset base that we're looking at can be cost effective and to understand the cost of those conversions over time, maybe over five to seven years across a number of mills. So, to us, the issue here is the entering a market question, rather than just, look, we've got a mill, we could make containerboard, let's give it a go, right?

[Adam Jesse Josephson:]

Yeah.

[John David Williams:]

Because as we see it, this is a serious, meaningful, strategic decision really about the future of the corporation. It's not about, well, let's just make some stuff because we can make it. As I think you and I both know, the paper industry is riddled with assets where they've had a kind of build it and they will come approach, and have paid the price accordingly. So we're doing a lot of work around the marketplace. We're doing a lot of work around the grades, we'd be thinking of manufacturing. We're obviously doing a lot of work around how we'd enter that market; do we partner, what do we need to do? That's been an iterative process both for the management and, of course, for the board because our approach here will be to build a business over time as distinct from just sort of converting an asset or two. So I think that's why we've been very careful about it, and we remain careful about it because our core business now is showing very strong signs, probably the strongest signs I've seen since I've been doing this job for the last nine years in terms of both opportunity for margin and opportunity for volume. Having said that, however, as I said earlier, this is a 30- to 40-year choice we're going to make for these assets. So, I'm not overly concerned about other people opening containerboard assets. If I'm being truthful, most of them are opening them to get the growth they need to run their integrated model. Patently, we're thinking slightly differently around that. So, that's not necessarily impacting us because you can get the timing right or wrong and it just is what it is, quite frankly, because obviously, you're investing for the long haul. So that's why we might look like we're agonizing a bit, but we're just being very thoughtful because this is about us entering and building a business for the long term, not just a down and dirty conversion because we could sell some product. Does that make sense?

[Adam Jesse Josephson:]

Absolutely. And just one related question on that, John.

[John David Williams:]

Sure.

[Adam Jesse Josephson:]

The Chinese situation, it seems likely they're going to just outright ban mix – solid waste imports, including recovered paper, by the beginning of 2020. The Chinese companies are scouring the globe for pulp and paper assets. How does that situation affect your thought process along the lines of the potential conversion of containerboard?

[John David Williams:]

Well, I think probably, not enormously on the first one because we think that's going to be, over time, domestically orientated; although, to be frank, we'll do some export. I don't like the idea of selling an asset or two here or there because, to be frank, if this is compelling enough, we're selling the future of the business. So, we're not going to, here's a mill for conversion. I struggle to see how anyone's going to give me true value for that. Does that make sense?

[Adam Jesse Josephson:]

Sure.

[John David Williams:]

So, I think the Chinese situation says, well, if the world is – if they're scouring the world for linerboard. What I'm hearing, and it's only anecdotal, is actually, the major players in linerboard in China, obviously, they're making different – they're going to place assets in different geography. But actually, they're finding recovered paper from the domestic collection system. The people who are really suffering are the kind of second, third tier containerboard producers. So, I think part of this is also a big shakeout...

[Adam Jesse Josephson:]

Yeah.

[John David Williams:]

...trying to make sure efficient modern capacity stays alive and the sort of polluting older capacity doesn't. I think, overall, it just gives a little bit more tailwind to containerboard, and therefore, a little bit more tailwind to our thinking.

[Adam Jesse Josephson:]

Sure. No, it makes complete sense. And just one on freesheet. You talked about how good conditions are, obviously. If you compare today to 2014, obviously, at the end of 2013, there was a huge capacity closure. It was followed by two price increases right before prices started backsliding in late 2014. This time around, there were obviously significant capacity closures announced toward the end of last year, that's been followed by two price increases, just as was the case four years ago. Now, you've announced the third. How would you compare today to what you saw in 2014, when you had the two successful increases, only to be followed by prices eroding soon thereafter?

[John David Williams:]

That's a great question. So, I think one thing is different, which is because of the phasing of some of those closures, which the customer, whilst thinking uncoated freesheet is not thinking uncoated freesheet is not gettable, I must scour the world to get it. In addition, of course, we have some duties on. So, some of the usual suspects who would have come in can't come in competitively. But I think it's – what we see in our supply and demand network is it's very clear, our job here is to stay loyal to those customers who stay loyal to us, and continue to make sure we ship them good strong product, and then I think this is sustainable. If suddenly, there's this huge shortage and no one can get paper, then I think we run the risk that we ran the last time. Does that help?

[Adam Jesse Josephson:]

Okay. Yeah. Absolutely. Thank you, John.

[John David Williams:]

Thank you.

[Operator:]

Moving on, we'll take our next question from Anthony Pettinari from Citi.

[Anthony Pettinari:]

Good morning.

[John David Williams:]

Anthony, good morning.

[Anthony Pettinari:]

I was wondering if you could talk a little bit about what you're seeing in the Chinese pulp market currently. I guess, typically, seasonally, you see a little bit of softness in the end of the summer. Are you seeing anything kind of more positive or negative than that with buyer sentiment? And then, we've heard about some Chinese buyers maybe being a little hesitant to buy from U.S. producers in anticipation of some kind of duties or tariffs. Have you seen any of that? And then you have some mills in the U.S., you have some mills in Canada. If there were to be escalation of trade tensions, how could that impact you?

[John David Williams:]

Sure. So, it's kind of odd. So, I would have expected if they were expecting duties, they'd buy like crazy, not the other way around, because obviously, trying to supplant those American volumes will be staggeringly difficult. I mean take, for example, fluff pulp, which is really a southeast United States game apart from sort of Klabin and Suzano. You would imagine if they're worried about duties, they're going to be – the opposite will happen. They'll be buying – they'll be trying to get other supply chains, but they'll be buying very heavily. We haven't seen that. On pricing, it looks reasonably flat in China for sort of what we're settling in August, maybe a few dollars here and there. But one should remember, Chinese pricing is higher than U.S. pricing today. And overall, pulp pricing, I think we should just keep reminding ourselves, is only slightly above trend. It's not like we're at some major choppy price in terms of a cyclical commodity. So to my mind is there's still runway. On the duty side, our Kamloops facility is largely exporting, so if there's duty, it would continue to do that. And Plymouth in the U.S., which is pure fluff pulp, the issue there I think is where are those Chinese producers are going to find fluff pulp. The answer is they're probably not, in fact, they're almost certainly not, insufficient quantities. And therefore, if a duty goes on, I think we would think of we'd have – the opportunity would have to be that we just move the prices to the duty and that's the end of that. Does that help?

[Anthony Pettinari:]

Yeah. No. That's very helpful. And then just switching gears on the capital structure, your net debt to cap is 25%. It's come down pretty steadily over the last few years. You haven't bought back much stock during that period. Is the right way to think about that, that you're keeping your powder dry for the next repurposing or big capital project, or could you be getting to a point now where you could potentially do both in terms of maybe buying back a bit of stock, but also having the flexibility to do some of these projects?

[Daniel Buron:]

We'll continue to have kind of a balanced approach with our capital allocation. I think you'll see in the next few years, probably a little bit more investment in our own assets, so probably more CapEx. I think John alluded in the speech to some opportunities we have in our Pulp business, and we all know Paper is declining, so there's a repurposing at some point also in the future, and we're making sure that we have the financial flexibility to do all of that. And let's be honest, I mean, we need to keep some financial flexibility if something comes on the horizon in terms of M&A. So, we're happy where our balance sheet is. We know it could be more efficient, but the best way to create value for our shareholder long-term is to invest that cash in our own assets.

[Anthony Pettinari:]

Okay. That's helpful. I'll turn it over.

[John David Williams:]

Thank you.

[Operator:]

Moving on, we'll take our next question from Chip Dillon from Vertical Research.

[Chip Dillon:]

Yes. Hi. Good morning, and thanks for all the comments.

[John David Williams:]

Good morning.

[Chip Dillon:]

One question about the repurposing alternatives as you think about fluff versus containerboard. Obviously, you've mentioned, John, very clearly laid out that going into containerboard is a business decision, to do something multi-year, multi-asset, whereas you're already in the fluff business. And just sort of looking at the global marketplace for fluff and, of course, you yourselves just took down some capacity at Plymouth. Is there a chance that maybe you move on that front before you decide to – or before we see something in containerboard? Is that something that could look more likely now versus maybe where it was six months ago?

[John David Williams:]

I think to be honest, Chip, we'll balance all alternatives and see where it leads us, and that'll be based on what we think is for the better long term future of the business. But to your point, I mean, we do have opportunities on fluff pulp. So, it may not be an either or, but it might be as well as.

[Chip Dillon:]

Got you. That's clear. And one business you've mentioned in the past given your pulp capability has been tissue, and, of course, it has gotten to be quite a competitive marketplace, to say the least, which, to your credit, it has been good that you've stayed out. Of course, we saw some signaling, as was mentioned earlier, by some of the big players that they're starting to focus on price and not so much on volume. And there are some assets out there that seem to be cheaper than we've seen in a long time. Is that a direction that you would still consider as well or not as likely?

[John David Williams:]

Well, I think it's a very interesting question. I mean, the headline when the major players says, we're going to focus on margin, we're not going to focus on volume. But to be frank, when you run converting lines, overhead recovery and absorption is still important. So, you can't make a fantastic margin on half the volume. It just can't be done because you need that overhead recovery and you need that critical mass. So, in my mind, it's easy to say, but it's pretty difficult to do, especially with the customer base. Retailers are fighting each other tooth and nail. So, if you look at our opportunities, we've obviously, as you say, look to this a lot over the years. What I really come away with is there is a lot of capacity in private label tissue if I separate that from the brand. So if I just say, those are people competing for that type of business as distinct from branded business, that capacity seems to drive pricing more than the opportunity does if the larger player decides they're going to go and move their price. And one of the reasons is, I think, that the retailer is seeing that as an opportunity to actually drive the price differential on private label versus brand. So, I'm not sure in and of itself that tells me that private label tissue gets pricing power from activity that a Procter & Gamble or a Kimberly-Clark might put together. I could make a strong argument, it makes not that much difference.

[Chip Dillon:]

Okay. Okay. Got you. And then this last question in terms of looking at the broader containerboard question. When you, again, think about your options, does doing some kind of what I'll call a partnership arrangement, and that could even be just where you have one or two customers that you sign up to take all your board for, let's say, in the first conversion, for 10 or 20, 30 years, whatever, in addition to just having a possible equity partner helping to do the conversion, would either of those sort of long-term partnerships, we'll call them, interfere with the goal of getting into the business sort of on your own, as you've expressed?

[John David Williams:]

I don't think so. I mean, to be honest, I think that's doable, particularly on a long-term supply agreement. We'd be open to that, we're open to partnership. So we're open to whatever options there are. And again, I think, Chip, the question is around earnings and risk, right? The more partnership, the less of the earnings you're necessarily going to have, but you're going to minimize your risk. So our debate is always going to be around that element of any partnership or supply agreement.

[Chip Dillon:]

Terrific. Thank you.

[John David Williams:]

Thank you.

[Operator:]

Moving on, we'll take our next question from Mark Connelly from Stephens.

[Mark Connelly:]

John, just two questions. What is the...

[John David Williams:]

Mark, good morning.

[Mark Connelly:]

What is the required CapEx spend in Personal Care to keep that business stable? And how much more are you spending beyond that to get to the improvement plans and targets that you've set out?

[John David Williams:]

So, I would say sustainable 3% to 5% of sales if I'm buying sort of one or two machines a year, Mark, to keep me able to go for the growth, and a little bit more than that if I'm repurposing or restructuring. So we, of course, have been well over those numbers when you look back because we've essentially built a new machine platform across, really, our AI product base. Not our baby base, but our AI base. Now, that's largely complete. So, right now, if we're buying machines, we're buying machines for the fact that we have to support growth, particularly in our European business on pull-ups, but that's about it.

[Mark Connelly:]

Okay. That's helpful. One more and that's it. Can you help me understand the impact that mix is having in white paper? First quarter had some negative mix, I assume it was better this quarter, but can you give me a sense of whether these capacity closures are affecting what's going to be normal mix for you going forward?

[John David Williams:]

I couldn't give you the detail. I could give you, I think, the way we look at it. So, when you look at some of the work we are typically going to do or have done historically in sort of fourth quarter, so some of the tablet, all that kind of stuff, which is sort of lower priced work. Our approach there is to move that price dramatically. I think in our most recent price increases, we said $80 a ton on that kind of work. So, even the bottom end of the mix comes up quite a way. One of the issues for us is that cut size used to be sort of kind of top of the mix. It's moved down a little bit to the middle of the mix. So we have a job to do, I think, to move our cut size business back to the levels it used to be. So that's really how we're looking at the mix. So, I think you know the rising tide will lift all boats, but right now, certainly at the bottom end of the mix, those customers who perhaps haven't been with us for a while and are now calling us to say, you're our new best friend, will pay higher prices than they have historically.

[Mark Connelly:]

Is there a shift in your specialty versus commodity grade mix that's being affected by these closures?

[John David Williams:]

Not really. I mean, the specialty grades are – I mean, certainly, one of our strong pieces of business this year is our relationship with Appvion on the thermal paper. And that actually has been very strong this year. So, some things are driving it. I mean the packaging grades, there's a bit more R&D going on, we're a little bit more full around those grades in terms of substitution from plastic and people looking for other alternatives. So, I think that's what's driving some of it.

[Mark Connelly:]

Super. Thank you.

[John David Williams:]

You're welcome.

[Operator:]

Moving on, we'll take our next question from Hamir Patel from CIBC Capital Markets

[Hamir Patel:]

Hi. Good morning.

[John David Williams:]

Good morning.

[Hamir Patel:]

John, I just want to follow up on the trade question. I appreciate, I think, what 90% of global fluff comes out of the U.S., but there is that new eucalyptus product that's been in the market now for a couple of years.

[John David Williams:]

Yeah.

[Hamir Patel:]

So, just curious what's been the reception to that...

[John David Williams:]

Yeah.

[Hamir Patel:]

...by the customer base and do you think that could be a threat.

[John David Williams:]

Well, that's an interesting question. So I have a view – probably they'll announce new capacity the day I say this. I had a view, if it was really taking the world by storm, new capacity would have been announced. They say very clearly in their own literature that they see it as a blend. So, in fact, euca pulp is blended with loblolly pine fluff probably at about a 30% drop through rate. Now, that has complexity if you're a manufacturer of adult incontinence and baby diapers because, of course, at the hammer mill that you then have to blend, you have to make sure that you can cope with those two grades going through. So, I don't think it's a slam dunk, to be honest. Now, there may be people who just say, well, I want to make a less absorbent sort of lower-end baby diaper or whatever it may be, and maybe fem high (00

[Hamir Patel:]

It does. Thanks for that. That's actually all I had. I'll turn over. Thanks, John.

[John David Williams:]

All right. Thanks.

[Operator:]

Moving on, we'll take our next question from Steve Chercover from Davidson.

[Steven Pierre Chercover:]

Thanks. Good morning, everyone.

[John David Williams:]

Steve, good morning.

[Steven Pierre Chercover:]

First question is on pulp. So, we've seen an unprecedented sequence of price hikes, but the second component to get to mill met (00

[John David Williams:]

Right. So, I mean that's a great question. So, obviously, you've seen over the last few years how – really, this is a United States question – how in the U.S., the net from discount has moved – sort of the net back from the supposed price has increased. If I'm being truthful, I think that's also so purchasing agents can feel they're sort of beating an index because really, in the end, people are buying pulp on a net price and that's what counts. So, I'm not really particularly thoughtful around that level of discount. And certainly, I think, over time, if people were just buying against net price, I think that will be a healthier way to do it, but that's just my personal opinion.

[Steven Pierre Chercover:]

Okay. Thanks. And then the second question revolves around wood fiber. In the regions where you're using softwood chips, are you seeing the prices come down due to sawmill activity? And where you're using hardwood, what's going on in the hardwood baskets?

[John David Williams:]

So, the answer is yes, most certainly, we're saying softwood chips where we use them come down. And in hardwood, we're seeing pretty level pricing. So we don't see any issues in terms of acquiring. As you may know, what you're trying to do, of course, is really harvest wood within 50 miles of the mill. You don't really want to go that much further. Occasionally, when we have bad weather and flooding, we have to go further for our wood, but we're not seeing any issues.

[Steven Pierre Chercover:]

Great. Thank you.

[John David Williams:]

Thank you.

[Operator:]

Moving on, we'll take our next question from Andrew Keches from Barclays.

[Andrew Keches:]

Hey, good morning.

[John David Williams:]

Hi. Good morning.

[Andrew Keches:]

Just two questions from me.

[John David Williams:]

Sure.

[Andrew Keches:]

First, on the M&A front. I mean, you clearly appear focused on the organic opportunities and asset optimization. But how would you describe what you're seeing in the M&A environment and perhaps the opportunities that you see out there in terms of inorganic growth?

[John David Williams:]

Well, I mean I think we'd look at it as we'd always looked at it. Does it help us build on a business we already have? Are the synergies compelling? And, quite frankly, is it good value for money? And looking around, businesses are transacting, I think, at very high prices currently. So, unless it's extremely compelling, right now, our focus is really drive organic growth and productivity in our Pulp business, drive our Personal Care business, and repurpose our assets. And, of course, maintaining a strong dividend. So, I think that's how we're going to focus. Since 2011, we've returned, I think, about 69% of free cash flow to shareholders, about $1.5 billion, and that still remains a priority for us.

[Andrew Keches:]

Okay. That's helpful. And then the second piece, with respect to the balance sheet, perhaps more generally, how important are the investment grade ratings of your business from a strategic standpoint? And then with that, I just, I guess, ask, is there a specific leverage level that you're targeting? And I'm asking this just as cash flow is clearly improving and leverage on, at least on a net basis, continues to decline. So I'm just sort of trying to frame up how you think about both those items.

[Daniel Buron:]

Sure. We've been careful never to commit to investment grade because the credit agencies have a negative view on our business mix and quite fishy (00

[Andrew Keches:]

That's very helpful. Thank you.

[John David Williams:]

Thank you.

[Operator:]

Moving on, we'll take our next question from Paul Quinn, RBC Capital Markets.

[Paul Quinn:]

Yeah, thanks very much. Just one easy question. Five or six years ago, you started investing in some smaller projects, innovative stuff around...

[John David Williams:]

Yeah.

[Paul Quinn:]

...lignin. I think you've done some stuff on fibers and turpentine. I'm just wondering what the state of the playing field is on those and what looks like (00

[John David Williams:]

Right. So, as we've said before, Paul, it's a sort of series of experiments. You have to kiss a few frogs and maybe one will turn into a prince. So, as you know, we have our CelluForce, our JV up here in Windsor. Right now, we're rebuilding some of the production equipment. We've got some great partnerships with Schlumberger and a number of other people. There are definitely product opportunities, so I think that one will fire into life. On lignin out of Plymouth, we're selling every ton we can manufacture. And the Prisma approach is really to take that lignin, and with a partner who has a relationship with a large car parts manufacturer, can we drop lignin into ABS, maybe 20% to 30%, to create a sort of more environmentally-friendly product that actually enhances some of its qualities. So, it's a very long-term game. If you take where we're also selling products we used to consider to be waste like tall oil, turpentine, these kind of things, if I gave you a number, we probably got on there, $35 million, $40 million worth of sales in that space. We make a little bit of money. And really, these experiments are to try and build that out over the years into something more meaningful. So, that's what we continue to do. Does that help?

[Paul Quinn:]

Yeah. It's pretty good. Thanks very much. Best of luck.

[John David Williams:]

You're welcome. Thank you.

[Operator:]

Moving on, we'll take our next question from John Tumazos from John Tumazos Very Independent Research.

[John C. Tumazos:]

Thank you very much.

[John David Williams:]

John, good morning.

[John C. Tumazos:]

In terms of a containerboard project, it would seem like there is ways to do it without spending any money or having a distribution system, such as JV-ing with the Chinese where they put up money and you'd export liner to China, or JV-ing with an existing producer that has a distribution system, or letting a customer like Procter & Gamble or Unilever JV with you. And they have contacts with box makers and could arrange the conversion. I'm sort of at a loss. It's not obvious to me that the project would require much capital or marketing, or a JV could define your marketing strategy. What am I missing?

[John David Williams:]

Well, I think you make a point for a conversion. The issue is if we consider this to be a business over time, this will be one of maybe three or four to actually build out a business. And probably – and again, this is the debate, so this is why it's taking us a bit of time – that model might not hold for – right away through that. But that's a seven-, nine-year program. So, actually, with the first conversion, to your point, I think everything you outline, we're discussing with people, both a partnership, a JV, a customer leverage game, i.e., they buy the containerboard, they find the network to convert it. So, all of those are under consideration. And if I felt or we feel that, that doesn't kind of prevent us from building out the business over time, we'd do it. Does that help?

[John C. Tumazos:]

Thank you. Thank you.

[John David Williams:]

You're welcome.

[Operator:]

And moving on, we'll take our final question from George Staphos from Bank of America Merrill Lynch.

[George Leon Staphos:]

Hi. Thanks for taking my follow-ons, guys, late in the call. I had two or three questions here. I'll try to make it quick. Near-term, when we look at fluff over softwood spreads, they're pretty compressed, John.

[John David Williams:]

Yeah.

[George Leon Staphos:]

When do you think – or what would be required to try to open them up to more historical levels? And is – and I'm overstating it obviously, but is everyone's conversions to fluff basically compressing the spread, and therefore, how to get around that? That's question number one. Question number two for you – why don't you take that one first?

[John David Williams:]

Let me answer them one by one or I'll never remember all three.

[George Leon Staphos:]

Well, that's the strategy, John, right? Okay. Anyway.

[John David Williams:]

I know what you're trying to do and I admire you for it, but let me answer that one first. So, in all seriousness, I think what has actually happened, it's more about SBSK. I mean, we look at it in terms of – yeah, of the softwood, obviously, not in terms of northern softwood, but southern softwood bales because that's the alternative for most producers. What has actually happened is the demand on that has grown, and that, to some extent, has closed the gap as distinct from fluff closing the gap. Does make sense? So, that's...

[George Leon Staphos:]

Yeah. I guess so.

[John David Williams:]

And fluff has not gone up proportionately. Now, I do think that opportunity exists. I mean, we are anything but the majority player in that game. So, I think you have to see people getting more confidence around opening that gap up. But you're exactly right, it's a frustration to me.

[George Leon Staphos:]

I mean, this is more a comment than question, but given the incremental cost, you wonder whether some of these conversions maybe go back to commodity. But maybe we'll pick that up on the next call.

[John David Williams:]

Okay.

[George Leon Staphos:]

The next question I had for you and for Mike, when I look at Domtar's margins in Pulp and Paper versus peers regionally, certainly, you mentioned you have, I think, a three-year program with Steve Makris that you're going to work on to try to improve returns. But nonetheless, I generally find that Domtar's generating margins flat or below a lot of the other companies that are in the pulp and paper space. Would you generally agree with that? And what do you think are the one or two action items that would allow you to get more comparable margins? And then the last question, flogging containerboard one more time, given what's been happening with National Sword and the Chinese likely manned (01

[John David Williams:]

All right. So let's answer the second question, I guess. So I think on Pulp, we have a plan in place to ensure that we build our margins, both driven by productivity, and therefore, by better absorb cost across more volume, and I'm confident that, that will see us right. In a couple of places, we've made mill choices. I think particularly of Ashdown, actually, where if I look at the paper from that mill, we're not making the margins that we could make if it were somewhere else, but we haven't got room for it anywhere else. So I think part of our product mix in the tail given our volume versus competitors suggests that our margins are worse at the bottom end, and we've got to do the job of raising that mix, which is exactly what we're doing in this price increase. And quite frankly, historically on paper, I think we've had pretty strong margins. On – and I've forgotten the third question. I mean, I think on the containerboard...

[George Leon Staphos:]

Containerboard and export.

[John David Williams:]

Yeah, there's no doubt that we – part of any kind of marketing plan for the beginning of selling that containerboard is export driven. As you may know, actually, we have our own organization in Hong Kong. So, we don't sell through Asians into that geography. We sell through our own people. My view is that if we wanted to put containerboard into that space, we have pretty good relationships already where we could do that. So, that may be a little bit more than we imagined, but I still think it's important over time, we build a decent sized domestic business. All right.

[George Leon Staphos:]

Thank you, John.

[John David Williams:]

Thank you.

[Operator:]

And at this time, I'd like to turn the conference back over to our speakers for any additional or closing remarks.

[Nicholas Estrela:]

Thank you, Jim. We will release our third quarter 2018 results on Thursday, November 1, 2018. Thank you for listening and have a great day.

[Operator:]

And that will conclude today's conference. We do thank you for your participation. You may now disconnect.