Packaging Corp of America: Form 10-Q for the period ended Jun 30, 2010

Overview

Packaging Corporation of America, or PCA, is the fifth largest producer of containerboard and corrugated products in the United States, based on production capacity. We produce a wide variety of corrugated products ranging from basic corrugated shipping containers to specialized packaging, such as wax-coated boxes for the agriculture industry. We also have multi-color printing capabilities to make high-impact graphics boxes and displays that offer our customers more attractive packaging. Our operating facilities and customers are located primarily in the United States.

In analyzing our operating performance, we focus on the following factors that affect our business and are important to consider when reviewing our financial and operating results:

• containerboard and corrugated products demand;
• corrugated products and containerboard pricing and mix;
• cost trends and volatility for our major costs, including wood and recycled fiber, purchased fuels, electricity, labor and fringe benefits, and transportation costs; and
• cash flow from operations and capital expenditures.

The cost to manufacture containerboard is dependent, in large part, on the costs of wood fiber, recycled fiber, purchased fuels, electricity and labor and fringe benefits. Excluding the cost of containerboard, labor and benefits costs make up the largest component of corrugated products’ manufactured costs.

The market for containerboard is generally subject to changes in the U.S. economy. Historically, supply and demand, as well as industry-wide inventory levels, have influenced prices of containerboard and corrugated products. In addition to U.S. shipments, approximately 10% of domestically produced containerboard has been exported annually for use in other countries.

Industry Conditions

Market conditions for containerboard and corrugated products continued to improve in the second quarter of 2010. As reported by the Fibre Box Association, industry-wide shipments of corrugated products increased 4.6% for the three months ended June 30, 2010 compared to the same period in 2009, and second quarter 2010 industry containerboard production increased 8.2% from the second quarter of 2009. Industry containerboard export shipments also increased 5.6% over the same timeframe. Industry published prices for containerboard increased $60 per ton in April after having increased $50 per ton in January. Reported industry containerboard inventories at the end of the second quarter 2010 were at their lowest June ending level in 30 years, at approximately 1,999,000 tons, or 246,000 tons below June 2009.

PCA Operations Summary

During the second quarter of 2010, we produced approximately 589,000 tons of containerboard at our mills after taking a total of 35,000 tons of downtime due to maintenance outages at our Valdosta, Georgia, Tomahawk Wisconsin and Filer City, Michigan mills. Our maintenance outage at Valdosta was an extended outage of fifteen days in order to complete major improvements on the paper machine while the other two outages were routine, lasting five days each.

Our corrugated products manufacturing plants sold about 7.9 billion square feet (“bsf”) of corrugated products during the second quarter of 2010. Our corrugated products shipments were up 8.0% compared to the second quarter of 2009 and essentially equalled our pre-recession corrugated products volume achieved in the second quarter of 2008. Containerboard volume sold to domestic and export customers increased 11.9% for the three months ended June 30, 2010 compared to the same period in 2009. Sales prices of containerboard and corrugated products were higher than the second quarter of 2009 as a result of the January and April containerboard price increases and the pass-through of those price increases to corrugated products. Recycled fiber prices remained at high levels during the quarter, dropping just $5 per ton from the first quarter average price. Wood fiber costs were lower in the second quarter compared to the first quarter of 2010 as weather and logging conditions improved, especially around our Counce, Tennessee linerboard mill which had been significantly impacted by bad weather in the first quarter of

2010, making wood procurement difficult. Purchased energy costs were lower than last year’s second quarter and the first quarter of 2010 with prices paid for fuels decreasing by approximately 15% compared to the prior year and approximately 8% compared to the first quarter.

In a memorandum dated June 28, 2010, the IRS concluded that black liquor qualifies for the taxable cellulosic bio-fuel producer credit of $1.01 per gallon of bio-fuel produced in 2009. PCA filed an application in July 2010 to receive the required registration code to become a registered cellulosic bio-fuel producer, and we expect this registration will be received during the third quarter. PCA has not filed a claim for any black liquor tax credits earned in 2009 since our 2009 tax return is not due until September 15, 2010. The total alternative fuel mixture credits earned by PCA in 2008 and 2009 were $185.4 million. Through June 30, 2010, the total credits applied against federal cash tax payments were $89.4 million, resulting in a receivable of $96.0 million for the remaining balance of the alternative fuel mixture tax credits earned through December 31, 2009. Based upon both the memorandum and IRS guidance regarding the cellulosic bio-fuel credit, PCA is analyzing the additional potential benefits from claiming the cellulosic bio-fuel producer credit for 2009 instead of the alternative fuel mixture credit, or claiming a combination of the two credits for 2009. The amount of credits that the Company can apply against future federal taxes owed will be dependent upon the timing and amount of PCA’s future taxable income. See Note 15 to the condensed consolidated financial statements included in this report for a description of the alternative fuel mixture tax credits and the cellulosic bio-fuel producer credit.

Looking ahead to the third quarter of 2010, our earnings are expected to be significantly higher than the second quarter of 2010 from a full quarter’s benefit of the second quarter corrugated products price increase, higher sales volumes and increased mill production. In addition, lower costs for recycled fiber, wood fiber and purchased fuels are expected to improve earnings.

Results of Operations

Three Months Ended June 30, 2010 Compared to Three Months Ended June 30, 2009

The historical results of operations of PCA for the three months ended June 30, 2010 and 2009 are set forth below:

(In thousands)

Net Sales

Net sales increased by $66.1 million, or 12.0%, for the three months ended June 30, 2010 from the comparable period in 2009, primarily as a result of increased sales volume ($47.2 million) and higher prices ($18.9 million) of corrugated products and containerboard to third parties.

Corrugated products shipments for the second quarter increased 8.0% compared to the second quarter of 2009 both on a total basis and a shipments-per-workday basis. Total corrugated products volume sold for the three months ended June 30, 2010 increased 0.6 billion square feet (“bsf”) to 7.9 bsf compared to 7.3 bsf in the second quarter of 2009. The second quarter of 2010 and 2009 both contained 63 workdays, those days not falling on a weekend or holiday. Containerboard volume sold to domestic and export customers increased 11.9% for the three months ended June 30, 2010 compared to the three months ended June 30, 2009. Containerboard mill production for the three months ended June 30, 2010 was 589,000 tons compared to 555,000 tons during the same period in 2009. During the second quarter 2010 we took approximately 35,000 tons of downtime for annual mill maintenance outages at three of our containerboard mills.

Income from Operations

Income from operations decreased by $68.0 million, or 50.1%, for the three months ended June 30, 2010 compared to the three months ended June 30, 2009, primarily due to alternative fuel mixture tax credits in 2009 ($79.7 million), which was not available in 2010. Excluding the alternative fuel mixture tax credits and 2010 energy project related asset disposals ($1.7 million), income from operations increased $13.4 million, or 23.9% compared to second quarter 2009. Such increase primarily resulted from increased sales prices ($18.9 million) and volume ($13.6 million), and lower energy costs ($3.0 million) partially offset by higher costs for recycled fiber ($10.4 million), wood fiber ($5.1 million), transportation ($3.4 million) and maintenance and building repairs ($2.4 million).

Gross profit increased $14.5 million, or 12.2%, for the three months ended June 30, 2010 from the comparable period in 2009, excluding energy project related asset disposals, primarily due to the sales price and volume increases described above. Gross profit as a percentage of net sales was 21.6% of net sales for both the second quarter 2009 and second quarter 2010.

Selling and administrative expenses increased $1.9 million, or 4.4%, for the three months ended June 30, 2010 compared to the same period in 2009, as a result of increased expenses for travel, entertainment and meetings ($0.8 million), salaried merit increases ($0.7 million), and related fringe benefits ($0.2 million).

Corporate overhead decreased $0.1 million, or 0.4%, for the three months ended June 30, 2010 compared to the same period in 2009.

Other expense for the three months ended June 30, 2010 decreased $0.4 million or 9.0% compared to the second quarter of 2009, primarily due to a decrease in legal expenses ($0.4 million).

Interest Expense, Net and Income Taxes

Net interest expense decreased $0.7 million, or 8.3%, for the three months ended June 30, 2010 from the three months ended June 30, 2009, primarily as a result of higher capitalized interest ($0.6 million) being recorded related to the Counce and Valdosta energy optimization projects during the three months ended June 30, 2010 compared to the same period in 2009.

PCA’s effective tax rate was 36.2% for the three months ended June 30, 2010 and 14.2% for the comparable period in 2009. The effective tax rate varies from the U.S. federal statutory tax rate of 35% principally due to the impact of state and local income taxes and the domestic manufacturers’ deduction. Additionally, the 2009 effective tax rate was impacted by the alternative fuel mixture tax credit.

Six Months Ended June 30, 2010 Compared to Six Months Ended June 30, 2009

The historical results of operations of PCA for the six months ended June 30, 2010 and 2009 are set forth below:

(In thousands)

20

Net Sales

Net sales increased by $104.4 million, or 9.8%, for the six months ended June 30, 2010 from the comparable period in 2009 primarily as a result of increased sales volume of corrugated products and containerboard to third parties ($128.1 million), partially offset by lower average prices for the first half of 2010 ($23.7 million) compared to the first half of 2009.

First half 2010 corrugated products shipments increased 11.0%, or 1.5 bsf to 15.6 bsf compared to 14.0 bsf in the first half of 2009. On a shipments-per-workday basis, corrugated products volume increased 10.1% in the first half of 2010 compared to the first half of 2009. The percentage increase, on a shipments-per-workday basis, was lower than on a total basis due to one more workday in the first six months of 2010 (126 days), those days not falling on a weekend or holiday, than the first half of 2009 (125 days). Containerboard volume sold to domestic and export customers increased 28.2% for the six months ended June 30, 2010 compared to the six months ended June 30, 2009. Containerboard mill production during the first half of 2010 was approximately 1,158,000 tons compared to 1,070,000 tons produced in the first half of 2009.

Income from Operations

Income from operations decreased by $84.0 million, or 45.3%, for the six months ended June 30, 2010 compared to the six months ended June 30, 2009, primarily attributable to the alternative fuel mixture tax credits of $79.7 million described previously which was recorded in the second quarter of 2009 partially offset by an additional $9.2 million recorded in the first quarter 2010. Excluding the alternative fuel mixture tax credits, energy project related asset disposals ($3.6 million) in 2010 and costs related to the closure of the Ackerman Mississippi sawmill ($2.0 million) in 2010, income from operations decreased $7.9 million for the six months ended June 30, 2010 compared to the six months ended June 30, 2009. Such decrease was primarily attributable to increased costs for fiber ($31.2 million) and lower average sales prices ($23.7 million), partially offset by increased sales volume ($39.7 million) and lower energy costs ($9.7 million).

Gross profit decreased $7.1 million, or 3.1%, for the six months ended June 30, 2010 from the comparable period in 2009 excluding energy project related asset disposals. Gross profit as a percentage of net sales decreased from 21.5% of net sales in the six months ended June 30, 2009 to 19.0% of net sales in the first half of 2010 due primarily to the cost increases and lower average prices previously described.

Selling and administrative expenses increased $2.9 million, or 3.3%, for the six months ended June 30, 2010 compared to the same period in 2009, primarily as a result of higher expenses for salaries ($0.8 million), related fringe benefits ($0.6 million), travel, entertainment and meetings ($0.8 million), and broker commissions ($0.5 million).

Corporate overhead for the first half of 2010 decreased $0.9 million or 3.0% compared to the same period in 2009, primarily due to decreased incentive expense ($1.4 million), partially offset by increased travel, entertainment and meeting expenses ($0.5 million).

Other expense for the six months ended June 30, 2010 increased $1.5 million or 18.5% above other expense for the first half of 2009, primarily due to costs to close the Ackerman, Mississippi sawmill in the first quarter of 2010 ($2.0 million) and higher expenses related to tax matters ($0.2 million), partially offset by lower legal costs ($0.8 million).

Interest Expense, Net and Income Taxes

Net interest expense decreased $0.8 million, or 4.3%, for the six months ended June 30, 2010 from the six months ended June 30, 2009, primarily as a result of higher capitalized interest ($0.7 million) being recorded related to the Counce and Valdosta energy optimization projects during the six months ended June 30, 2010 compared to the same period in 2009.

PCA’s effective tax rate was 32.3% for the six months ended June 30, 2010 and 19.8% for the comparable period in 2009. The effective tax rate varies from the U.S. federal statutory tax rate of 35% principally due to the impact of the alternative fuel mixture tax credit, state and local income taxes, and the domestic manufacturers’ deduction. The Company had no material changes impacting FIN No. 48 during the first half of 2010.

Liquidity and Capital Resources

The following table presents a summary of our cash flows for the periods presented:

(In thousands)

Operating Activities

Net cash provided by operating activities for the six months ended June 30, 2010 was $108.6 million compared to $141.2 million for the six months ended June 30, 2009, a decrease of $32.7 million, or 23.1%. Net income, excluding the income from the alternative fuel mixture tax credits (described in Note 15 to the financial statements included in this report) of $9.2 million in 2010 and $80.2 million in 2009, was $48.0 million and $54.3 million, respectively, for the first six months of 2010 and 2009, a decrease of $6.3 million that reduced net cash provided by operating activities. Additionally, the deferred tax provision in 2010 was lower by $10.1 million and requirements for operating assets and liabilities were higher by $41.6 million during the first six months of 2010 compared to the same period in 2009. This was primarily due to higher accounts receivable levels in 2010 of $57.2 million as a result of both higher sales prices and increased sales volumes previously described. These decreases in net cash provided by operating activities were partially offset by an additional $22.3 million of alternative fuel mixture tax credits used to reduce federal tax payments during the first six months of 2010 compared to the same period in 2009. Cash requirements for operating activities are subject to PCA’s operating needs, the timing of collection of receivables and payments of payables and expenses, and seasonal fluctuations in the Company’s operations.

Investing Activities

Net cash used for investing activities for the six months ended June 30, 2010 increased $104.9 million, or 201.5%, to $157.0 million, compared to the six months ended June 30, 2009. The increase was primarily related to higher additions to property, plant and equipment of $105.1 million, which included $89.2 million for the major energy optimization projects, during the six months ended June 30, 2010 compared to the same period in 2009.

Financing Activities

Net cash used for financing activities totaled $30.8 million for the six months ended June 30, 2010, a difference of $14.8 million, or 32.4%, compared to the same period in 2009. The difference was primarily attributable to lower common stock dividends paid of $15.2 million and higher proceeds from the exercise of stock options of $2.2 million during the first six months of 2010 compared to the same period in 2009, partially offset by repurchases of PCA common stock of $3.1 million during the first six months of 2010.

PCA’s primary sources of liquidity are net cash provided by operating activities, borrowings under PCA’s revolving credit facility, and additional borrowings under PCA’s receivables credit facility. As of June 30, 2010, PCA had $172.2 million in unused borrowing capacity under its existing credit agreements, net of the impact on this borrowing capacity of $18.8 million of outstanding letters of credit. Currently, PCA’s primary uses of cash are for operations, capital expenditures, debt service and declared common stock dividends, which it expects to be able to fund from these sources.

The following table provides the outstanding balances and the weighted average interest rates as of June 30, 2010 for PCA’s revolving credit facility, the receivables credit facility, and the senior notes:

(In thousands)

The above table excludes unamortized debt discount of $1.1 million at June 30, 2010. It also excludes from the projected annual cash interest payments, the non-cash income from the annual amortization of the $22.8 million received in July 2003 and the non-cash expense from the annual amortization of the $4.4 million paid in March 2008 to settle the treasury locks related to the 53/4% senior notes due 2013 and 61/2% senior notes due 2018. The amortization is being recognized over the terms of the 53/4% senior notes due 2013 and 61/2% senior notes due 2018 and is included in interest expense, net.

On April 14, 2010, PCA extended its $150.0 million receivables-backed credit facility through March 1, 2011.

The instruments governing PCA’s indebtedness contain financial and other covenants that limit, among other things, the ability of PCA and its subsidiaries to:

• enter into sale and leaseback transactions,
• incur liens,
• incur indebtedness at the subsidiary level,
• enter into certain transactions with affiliates, or
• merge or consolidate with any other person or sell or otherwise dispose of all or substantially all of the assets of PCA.

These limitations could limit corporate and operating activities.

In addition, PCA must maintain minimum net worth and maximum debt to total capitalization and minimum interest coverage ratios under the revolving credit facility. A failure to comply with the restrictions contained in the revolving credit facility could lead to an event of default, which could result in an acceleration of any outstanding indebtedness and/or prohibit PCA from drawing on the revolving credit facility. Such an acceleration may also constitute an event of default under the senior notes indentures and the receivables credit facility. As of June 30, 2010, PCA was in compliance with these covenants.

PCA currently expects to incur capital expenditures of about $300.0 million in 2010, including up to $180.0 million for major energy optimization projects at its Counce and Valdosta mills. The remaining $120.0 million in expenditures will be used primarily for maintenance capital, cost reduction, business growth and environmental compliance. As of June 30, 2010, PCA spent $155.3 million for capital expenditures and had committed to spend an additional $214.5 million in the remainder of 2010 and beyond.

PCA believes that net cash generated from operating activities, available cash reserves, alternative fuel mixture tax credit receivable, available borrowings under its committed credit facilities and available capital through access to capital markets will be adequate to meet its liquidity and capital requirements, including payments of any declared common stock dividends, for the foreseeable future. As its debt or credit facilities become due, PCA will need to repay, extend or replace such facilities, which will be subject to future economic conditions and financial, business and other factors, many of which are beyond PCA’s control.

Market Risk and Risk Management Policies

PCA is exposed to the impact of interest rate changes and changes in the market value of its financial instruments. PCA periodically enters into derivatives in order to minimize these risks, but not for trading purposes. For a discussion of derivatives and hedging activities, see Note 10 to PCA’s condensed consolidated financial statement included elsewhere in this report.

The interest rates on approximately 84% of PCA’s debt are fixed. A one percent increase in interest rates related to variable rate debt would have resulted in an increase in interest expense and a corresponding decrease in income before taxes of $1.1 million annually. In the event of a change in interest rates, management could take actions to mitigate its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no changes in PCA’s financial structure.

Environmental Matters

PCA is subject to, and must comply with, a variety of federal, state and local environmental laws, particularly those relating to air and water quality, waste disposal and the cleanup of contaminated soil and groundwater. The most significant of these laws affecting the Company are:

• Resource Conservation and Recovery Act (RCRA);
• Clean Water Act (CWA);
• Clean Air Act (CAA);
• The Emergency Planning and Community Right-to-Know-Act (EPCRA);
• Toxic Substance Control Act (TSCA); and
• Safe Drinking Water Act (SDWA).

PCA believes that it is currently in material compliance with these and all applicable environmental rules and regulations. Because environmental regulations are constantly evolving, the Company has incurred, and will continue to incur, costs to maintain compliance with these and other environmental laws. PCA works diligently to anticipate and budget for the impact of applicable environmental regulations, and does not currently expect that future environmental compliance obligations will materially affect its business or financial condition.

Impact of Inflation

PCA does not believe that inflation has had a material impact on its financial position or results of operations during the three- and six-month periods ending June 30, 2010 and 2009.

Off-Balance Sheet Arrangements

PCA does not have any off-balance sheet arrangements as of June 30, 2010 that would require disclosure under SEC FR-67, “Disclosure in Management’s Discussion and Analysis About Off-Balance Sheet Arrangement and Aggregate Contractual Obligations.”

Critical Accounting Policies and Estimates

Management’s discussion and analysis of PCA’s financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, PCA evaluates its estimates, including those related to bad debts, inventories, intangible assets, pensions and other postretirement benefits, income taxes, contingencies and litigation. PCA bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

PCA has included in its Annual Report on Form 10-K for the year ended December 31, 2009, a discussion of its critical accounting policies which it believes affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. PCA has not made any changes in any of these critical accounting policies during the first six months of 2010.

Forward-Looking Statements

Some of the statements in this Quarterly Report on Form 10-Q, and in particular, statements found in Management’s Discussion and Analysis of Financial Condition and Results of Operations, that are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are often identified by the words “will,” “should,” “anticipate,” “believe,” “expect,” “intend,” “estimate,” “hope,” or similar expressions. These statements reflect management’s current views with respect to future events and are subject to risks and uncertainties. There are important factors that could cause actual results to differ materially from those in forward-looking statements, many of which are beyond our control. These factors, risks and uncertainties include the following:

• the impact of general economic conditions;
• containerboard and corrugated products general industry conditions, including competition, product demand and product pricing;
• fluctuations in wood fiber and recycled fiber costs;
• fluctuations in purchased energy costs;
• the possibility of unplanned outages or interruptions at our principal facilities; and
• legislative or regulatory actions or requirements, particularly concerning environmental or tax matters.

Our actual results, performance or achievement could differ materially from those expressed in, or implied by, these forward-looking statements, and accordingly, we can give no assurances that any of the events anticipated by the forward-looking statements will transpire or occur, or if any of them do occur, what impact they will have on our results of operations or financial condition. In view of these uncertainties, investors are cautioned not to place undue reliance on these forward-looking statements. We expressly disclaim any obligation to publicly revise any forward-looking statements that have been made to reflect the occurrence of events after the date hereof. For a discussion of other factors, risks and uncertainties that may affect our business, see Item 1A. Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2009.

For a discussion of market risks related to PCA, see Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Risk and Risk Management Policies” in this Quarterly Report on Form 10-Q.

PCA maintains disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934) that are designed to provide reasonable assurance that information required to be disclosed in PCA’s filings under the Securities Exchange Act is recorded, processed, summarized and reported within the periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to PCA’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Prior to filing this report, PCA completed an evaluation under the supervision and with the participation of PCA’s management, including PCA’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of PCA’s disclosure controls and procedures as of June 30, 2010. The evaluation of PCA’s disclosure controls and procedures included a review of the controls’ objectives and design, PCA’s implementation of the controls and the effect of the controls on the information generated for use in this report. Based on this evaluation, PCA’s Chief Executive Officer and Chief Financial Officer concluded that PCA’s disclosure controls and procedures were effective at the reasonable assurance level as of June 30, 2010.

During the quarter ended June 30, 2010, there were no changes in internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, PCA’s internal control over financial reporting.

PART II

OTHER INFORMATION

There have been no material changes to the risk factors disclosed in Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2009.