PKG

Business Context and Reporting Period

Company: Packaging Corporation of America (PCA)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2009
Business Overview: PCA is the fifth largest producer of containerboard and corrugated products in the United States. The company operates integrated mills and corrugated plants, producing packaging materials for industrial and consumer markets. Operations are primarily located in the U.S.

Key Financial Metrics

All figures in thousands, except per share data.

Key Balance Sheet Items (Sep 30, 2009):

• Total Assets: $2,111,501
• Total Liabilities: $1,259,185
• Stockholders' Equity: $852,316
• Alternative Fuel Mixture Tax Credits Receivable: $106,381

Material Changes vs. Prior Period

Three Months Ended Sep 30, 2009 vs. 2008:

• Net Sales: Decreased 10.8% ($67.2 million) due to lower sales volume (-$35.0 million) and decreased sales prices (-$32.2 million). Industry prices fell due to economic weakness.
• Net Income: Increased 90.7% ($34.6 million) to $72.7 million. This increase was primarily driven by a one-time Alternative Fuel Mixture Tax Credit of $47.1 million.
• Operating Income: Increased 40.2% to $96.3 million. Excluding the tax credit, operating income would have been $19.5 million lower than the prior year due to price and volume declines.
• Gross Margin: Decreased from 21.3% to 20.0% of net sales.

Nine Months Ended Sep 30, 2009 vs. 2008:

• Net Sales: Decreased 11.0% ($199.1 million) driven by volume declines (-$185.6 million) and lower prices (-$13.5 million).
• Net Income: Increased 96.6% ($101.8 million) to $207.2 million, largely attributable to $126.8 million in Alternative Fuel Mixture Tax Credits.
• Operating Income: Increased 48.2% to $281.7 million. Excluding the tax credit, operating income decreased $35.2 million due to lower volume and prices, partially offset by reduced costs for recycled fiber, transportation, and energy.
• Cash Flow: Operating cash flow increased 14.9% to $209.3 million, aided by reduced federal tax payments resulting from the tax credits.

Guidance, Outlook, and Risks

Management Commentary and Outlook:

• Q4 2009 Expectations: Management expects fourth-quarter earnings to be lower than the third quarter. Factors include three fewer shipping days, normal seasonality, lower prices, and increased wood and energy costs due to colder weather.
• Capital Projects: In October 2009, the Board approved a $295 million energy optimization project at Counce and Valdosta mills, to be funded by existing cash and operating cash flow over two years.
• Dividends: The quarterly dividend was reduced from $0.30 to $0.15 per share in February 2009.
• Stock Repurchases: No shares were repurchased in the first nine months of 2009. $65.0 million remains available under the $150.0 million authorization.

Risks and Contingencies:

• Tax Credit Expiration: The Alternative Fuel Mixture Tax Credit is scheduled to expire on December 31, 2009, unless legislation extends it. This credit significantly boosted 2009 earnings.
• Market Conditions: The company faces risks from general economic downturns, fluctuations in wood fiber and recycled fiber costs, and energy price volatility.
• Environmental: An environmental reserve of $8.9 million is maintained for remediation projects. Management does not expect future expenditures to materially impact financial condition.
• Liquidity: PCA maintains $172.2 million in unused borrowing capacity under credit agreements. The company is in compliance with all debt covenants.

Investor Verification Checklist

• Tax Credit Sustainability: Verify the status of the Alternative Fuel Mixture Tax Credit legislation and its potential expiration on Dec 31, 2009, as it accounts for a significant portion of 2009 net income.
• Core Operating Performance: Analyze operating income and margins excluding the tax credit to assess the underlying business health amidst declining sales volumes and prices.
• Capital Expenditure Commitments: Review the funding plan for the new $295 million energy optimization project and its impact on future cash flows.
• Debt Covenants: Confirm continued compliance with debt covenants, particularly interest coverage and debt-to-capitalization ratios, given the economic environment.
• Inventory Valuation: Note that interim LIFO calculations are estimates; verify final year-end LIFO valuation impact on cost of sales.