PKG

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended September 30, 1999, for Packaging Corporation of America (PCA). The company was formed on April 12, 1999, following the sale of Tenneco Packaging Inc.'s (TPI) containerboard and corrugated packaging business (the "Group") to PCA for approximately $2.2 billion. The transaction involved $246.5 million in cash, the assumption of $1.8 billion in debt, and a 45% equity interest retained by TPI, with the remaining 55% acquired by PCA Holdings (Madison Dearborn Partners). Financial results for the nine months ended September 30, 1999, include pro forma results for the Group prior to the transaction closing.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 8.9% ($36.4 million) in the third quarter and 5.5% ($65.6 million) on a pro forma nine-month basis compared to 1998. This was driven by higher containerboard prices (up 16.2% in Q3) and increased sales volumes.
• Profitability: Operating income surged 105.8% in Q3 and 42.4% on a pro forma nine-month basis. Gross margins improved from 18.2% to 22.5% in Q3 due to price increases and volume growth.
• Interest Expense: Interest expense increased dramatically (8,368% in Q3) due to the $1.8 billion debt incurred to finance the April 1999 transaction. This includes $550 million in senior subordinated notes and term loans.
• Debt Reduction: Despite high leverage, PCA made significant voluntary prepayments on term loans totaling over $332 million between May and October 1999, deferring quarterly installments until December 2001.
• Impairment: The prior year (1998) results included a $230.1 million impairment loss related to the sale of the Group, which is not present in the 1999 results.

Outlook, Risks, and Management Commentary

• Market Conditions: The containerboard market remains cyclical. While supply/demand balance has improved and prices have risen ~25% since January 1999, industry oversupply or economic deterioration could negatively impact future results.
• Liquidity and Capital: PCA expects operating cash flow and its $250 million revolving credit facility to fund debt service and capital expenditures. The company has committed to $75.5 million in capital expenditures.
• Timberland Sales: PCA is selling approximately 405,000 acres of timberland. Proceeds are being used to reduce debt. Excess proceeds over $500 million may be used to redeem notes or preferred stock.
• Year 2000 Compliance: PCA is 98% complete with IT remediation and expects full compliance by year-end. Estimated total costs are $5.3 million, with $4.5 million already incurred.
• Legal Proceedings: PCA is a defendant in a class-action antitrust lawsuit regarding linerboard pricing (1993-1995). Management believes the allegations lack merit and the outcome will not be materially adverse.
• Environmental Risks: Compliance with new EPA "Cluster Rules" will require future capital spending. TPI retained liability for pre-closing environmental issues.

Investor Verification Checklist

• Debt Service Capacity: Verify the ability to service $1.66 billion in debt given the high interest rates (weighted average ~8.5% on term loans) and cyclical nature of the industry.
• Timberland Sale Proceeds: Confirm the timing and net proceeds of the remaining timberland sales to assess debt reduction capabilities.
• Interest Rate Exposure: Review the effectiveness of the $720 million interest rate collar agreements in mitigating rising LIBOR rates.
• Year 2000 Contingencies: Monitor for any operational disruptions or supply chain issues arising from the remaining 2% of IT remediation or third-party supplier failures.
• Antitrust Litigation: Track developments in the Winoff Industries, Inc. v. Stone Container Corp. case for potential liability exposure.