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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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The following discussion of historical results of operations and financial condition should be read in conjunction with the audited financial statements and the notes thereto which appear elsewhere in this report.
Overview
PCA is the fourth largest producer of containerboard in the United States, based on production capacity. We operate four containerboard mills and 71 corrugated products manufacturing plants throughout the United States. Approximately 83% of the containerboard tons produced at our mills is consumed in our corrugated products manufacturing plants. The remaining 17% is sold to domestic customers or the export market. 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.
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; |
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| • | corrugated products and containerboard pricing and mix; |
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| • | cost trends and volatility for our major costs, including wood and recycled fiber, purchased fuels, electricity, labor and fringe benefits and transportation costs; and |
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| • | cash flow from operations and capital expenditures. |
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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 for use in other countries.
The market for containerboard and corrugated products is generally subject to changes in the U.S. economy. The U.S. economy improved modestly in 2012 as real GDP increased 2.2% compared to a 1.8% increase in 2011 as reported by the U. S. Department of Commerce. Trade publications reported that industry-wide corrugated products shipments increased 0.2% in 2012 compared to 2011 and containerboard production was 0.6% higher than in 2011. PCA benefitted from improved demand that exceeded the industry average, as well as the acquisition of four corrugated products plants made during 2011 and 2012, and for the year, our corrugated products shipments were up 6.6% compared to 2011. PCA also set a new record for annual production at its mills, with containerboard production increasing by 4.0%, from 2,499,000 tons in 2011 to 2,600,000 tons in 2012. Trade publications reported that industry containerboard inventories at the end of December 2012 were 2.18 million tons, the second lowest year-ending level since 1980.
Average prices for containerboard and corrugated products were higher during 2012 compared to 2011. Published containerboard prices increased by $50 per ton in September 2012.
Increased pricing and higher demand along with lower costs for energy and recycled fiber improved PCA’s 2012 earnings compared to 2011. However, these positive factors were partially offset by higher costs for labor and benefits, transportation, depreciation and interest expense. Energy costs were lower, reflecting the benefits of our completed major energy projects as well as lower prices paid for purchased fuels and electricity which decreased approximately 10% in 2012 compared to the 2011 average. Published recycled fiber costs decreased in 2012, on average, approximately 30% compared to 2011. Wood fiber costs in 2012 were essentially unchanged from 2011 levels. Transportation costs increased 3% from prior year levels as average diesel prices, as reported by the U.S. Department of Energy, increased 3% from the 2011 average price. Labor related costs increased reflecting annual merit increases and higher costs for medical insurance, pensions and incentives.
Special items impacting 2012 earnings included (a) net charges of $19.6 million, or $0.21 per share, relating to alternative energy tax credits described in Note 15 to the consolidated financial statements, (b) charges of $16.0 million, or $0.16 per share, from the Company’s debt refinancing completed in July 2012, and (c) charges of $1.4 million, or $0.01 per share, from plant closures. Excluding these special items, PCA earned net income of $200.7 million ($2.06 per diluted share) for the full year 2012. This compares with $161.8 million ($1.61 per diluted share) for 2011, which excludes charges of $4.8 million, or $0.05 per share, from asset disposals related to major energy projects and $1.0 million of income, or $0.01 per share, from an adjustment related to medical benefits reserves. Management excludes these special items and uses non-GAAP measures to focus on PCA’s on-going operations and assess its operating performance and believes that it is useful to investors because it enables them to perform meaningful comparisons of past and present operating results. Reconciliations of non-GAAP measures used in this Item 7 to the most comparable measure reported in accordance with GAAP are included elsewhere in Item 7 under “Reconciliations of Non-GAAP Financial Measures to Reported Amounts.”
In the first quarter of 2013, our containerboard production should be lower and operating costs higher compared to the fourth quarter with two less mill production days and mill annual maintenance downtime. We also expect higher energy costs with colder weather, and a pattern of extremely wet weather put pressure on wood costs and availability in the U.S. South during January. Corrugated products volume will be seasonally lower, and we expect higher costs for recycled fiber and labor and benefits. These items will be partially offset
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by higher average corrugated products prices with a full quarter’s realization of fourth quarter price increases. Considering all of these items, we expect first quarter earnings to be lower than fourth quarter 2012 earnings, excluding special items, of $0.61 per diluted share.
Results of Operations
Year Ended December 31, 2012 Compared to Year Ended December 31, 2011
The historical results of operations of PCA for the years ended December 31, 2012 and 2011 are set forth below:
| For the Year Ended December 31, | ||||||||||||
| 2012 | 2011 | Change | ||||||||||
| (In millions) | ||||||||||||
| Net sales | $ | 2,843.9 | $ | 2,620.1 | $ | 223.8 | ||||||
| Income from operations | $ | 443.4 | $ | 272.7 | $ | 170.7 | ||||||
| Interest expense, net | (62.9 | ) | (29.2 | ) | (33.7 | ) | ||||||
| Income before taxes | 380.5 | 243.5 | 137.0 | |||||||||
| Provision for income taxes | (216.7 | ) | (85.5 | ) | (131.2 | ) | ||||||
| Net income | $ | 163.8 | $ | 158.0 | $ | 5.8 | ||||||
Net Sales
Net sales increased by $223.8 million, or 8.5%, for the year ended December 31, 2012 from the year ended December 31, 2011. Net sales increased primarily as a result of increased sales volumes ($214.8 million) and higher sales prices of corrugated products and containerboard ($9.0 million).
Total corrugated products volume sold increased 6.6% to 34.7 billion square feet in 2012 compared to 32.5 billion square feet in 2011. On a comparable shipment-per-workday basis, corrugated products sales volume also increased 6.6% in 2012 versus 2011. Shipments-per-workday is calculated by dividing our total corrugated products volume during the year by the number of workdays within the year. Both 2012 and 2011 contained 251 workdays, those days not falling on a weekend or holiday. Containerboard sales volume to external domestic and export customers decreased 6.0% to 482,000 tons for the year ended December 31, 2012 from 513,000 tons in 2011.
Income from Operations
Income from operations increased by $170.7 million, or 62.6%, for the year ended December 31, 2012 compared to 2011. As noted in Note 15 — Alternative Energy Tax Credits to the “Notes to Consolidated Financial Statements,” PCA amended its 2009 federal income tax return to reallocate gallons from the cellulosic biofuel producer credits to the alternative fuel mixture credits. As a result, income from operations was increased by $95.5 million in 2012 with an offsetting amount recorded in tax expense of $118.5 million. Excluding special items (as detailed below under “Reconciliations of Non-GAAP Financial Measures to Reported Amounts”), income from operations increased $71.4 million for full year 2012. This increase was primarily attributable to increased sales volumes ($50.7 million), higher sales prices ($9.0 million) and lower costs for energy ($26.5 million), recycled fiber ($18.6 million) and chemicals ($7.5 million). These improvements were partially offset by increased costs for fringe benefits ($11.9 million), depreciation ($11.5 million), labor ($11.2 million), and transportation ($7.3 million).
Gross profit increased $97.7 million, or 18.0%, for the year ended December 31, 2012 from the year ended December 31, 2011. Gross profit as a percentage of net sales increased from 20.7% of net sales in the year ended
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December 31, 2011 to 22.5% of net sales in the year ended December 31, 2012 primarily due to increased volume and prices and reduced costs described above.
Selling and administrative expenses increased $16.8 million, or 8.7%, for the year ended December 31, 2012 from the year ended December 31, 2011, primarily as a result of increased costs for salaries ($8.3 million), depreciation ($3.3 million), fringe benefits ($3.0 million), and incentive compensation ($2.5 million).
Corporate overhead for the year ended December 31, 2012 increased $4.6 million, or 7.1%, from the year ended December 31, 2011. The increase was primarily attributable to increased salary and fringe benefits expense ($3.8 million) and higher depreciation ($0.6 million).
Other expense, net, increased $1.1 million, or 9.9% for the year ended December 31, 2012 compared to the year ended December 31, 2011. The increase was primarily due to increased fixed asset disposal costs ($1.1 million).
Interest Expense, Net and Income Taxes
Net interest expense increased $33.7 million, or 115.4%, for the year ended December 31, 2012 compared to the year ended December 31, 2011. The higher interest expense included a $21.3 million premium paid as part of the July 2012 redemption of the Company’s 5.75% notes due in 2013 (see Note 8—Debt contained in the “Notes to Consolidated Financial Statements”) and a $3.4 million charge from settling the Company’s 2011 treasury lock prior to its maturity (see Note 9—Derivative Instruments and Hedging Activities contained in the “Notes to Consolidated Financial Statements”). The remaining $9.0 million increase in interest expense was primarily a result of lower capitalized interest ($6.3 million) related primarily to the Counce, Tennessee linerboard mill and Valdosta, Georgia linerboard mill major energy projects and additional interest expense ($2.1 million) related to PCA’s term loan of $150.0 million borrowed in October 2011.
PCA’s effective tax rate was 57.0% for the year ended December 31, 2012, which included a 22.5% higher rate from amending our 2009 tax return in 2012 related to alternative energy tax credits as described in Note 15 of the consolidated financial statements. Excluding the amendment, the 2012 effective tax rate would have been 34.5% for the year ended December 31, 2012, compared to 35.1% for the year ended December 31, 2011. The effective tax rate varies from the U.S. federal statutory tax rate of 35.0% principally due to the impact of the alternative energy tax credits in 2012, state and local income taxes and the domestic manufacturers’ deduction. PCA had no material changes to its reserve for unrecognized tax benefits under ASC 740, “Income Taxes,” during 2012 but does expect a significant change within the next twelve months as described in Note 14 to the consolidated financial statements.
Year Ended December 31, 2011 Compared to Year Ended December 31, 2010
The historical results of operations of PCA for the years ended December 31, 2011 and 2010 are set forth below:
| For the Year Ended December 31, | ||||||||||||
| 2011 | 2010 | Change | ||||||||||
| (In millions) | ||||||||||||
| Net sales | $ | 2,620.1 | $ | 2,435.6 | $ | 184.5 | ||||||
| Income from operations | $ | 272.7 | $ | 185.4 | $ | 87.3 | ||||||
| Interest expense, net | (29.2 | ) | (32.3 | ) | 3.1 | |||||||
| Income before taxes | 243.5 | 153.1 | 90.4 | |||||||||
| (Provision) benefit for income taxes | (85.5 | ) | 52.3 | (137.8 | ) | |||||||
| Net income | $ | 158.0 | $ | 205.4 | $ | (47.4 | ) | |||||
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Net Sales
Net sales increased by $184.5 million, or 7.6%, for the year ended December 31, 2011 from the year ended December 31, 2010. Net sales increased primarily as a result of increased sales volumes of corrugated products and containerboard ($122.6 million) and higher sales prices of corrugated products and containerboard ($61.9 million).
Total corrugated products volume sold increased 5.0% to 32.5 billion square feet in 2011 compared to 31.0 billion square feet in 2010. On a comparable shipment-per-workday basis, corrugated products sales volume also increased 5.0% in 2011 versus 2010. Shipments-per-workday is calculated by dividing our total corrugated products volume during the year by the number of workdays within the year. Both 2011 and 2010 contained 251 workdays, those days not falling on a weekend or holiday. Containerboard sales volume to external domestic and export customers increased 1.2% to 513,000 tons for the year ended December 31, 2011 from 507,000 tons in 2010.
Income from Operations
Income from operations increased by $87.3 million, or 47.1%, for the year ended December 31, 2011 compared to 2010. As noted in Note 15 to the consolidated financial statements, our 2010 income from operations was reduced primarily due to reversing a portion of our 2009 alternative fuel mixture credits out of income from operations ($96.0 million) in order to claim cellulosic biofuel credits which were recorded in the provision for income taxes ($135.5 million) in 2010. In addition, income from operations included alternative fuel mixture credits in the amount of $9.2 million in 2010. Excluding special items (as detailed below under “Reconciliations of Non-GAAP Financial Measures to Reported Amounts”), income from operations decreased $6.8 million for full year 2011. This decrease was primarily attributable to increased costs for transportation ($20.5 million), chemicals ($16.7 million), labor ($13.4 million), recycled fiber ($10.0 million), medical and workers’ compensation ($8.9 million), depreciation ($8.1 million), energy ($4.8 million), the impact of severe winter weather in first quarter 2011 ($3.5 million), legal services ($2.3 million), travel, entertainment and meetings ($1.9 million), warehousing requirements ($1.7 million), building repairs ($1.5 million), environmental expenses ($1.4 million) and other fringe benefits ($1.2 million). These increases were partially offset by increased sales prices of corrugated products and containerboard ($61.9 million) and higher sales volume ($29.4 million).
Gross profit increased $9.7 million, or 1.8%, for the year ended December 31, 2011 from the year ended December 31, 2010. Gross profit as a percentage of net sales decreased from 21.9% of net sales in the year ended December 31, 2010 to 20.7% of net sales in the year ended December 31, 2011 primarily due to cost increases on a per unit basis described above.
Selling and administrative expenses increased $11.5 million, or 6.3%, for the year ended December 31, 2011 from the year ended December 31, 2010, primarily as a result of increased salary expense ($4.3 million) reflecting annual merit increases, fringe benefits ($1.3 million), warehouse costs related to customer requirements ($1.7 million), travel and meeting costs ($1.6 million) and other increased costs which were individually insignificant.
Corporate overhead for the year ended December 31, 2011 increased $6.4 million, or 11.1%, from the year ended December 31, 2010. The increase was primarily attributable to increased salary and fringe benefit expenses ($4.0 million) and increased costs for professional services related to legal matters ($2.3 million).
Other expense, net, decreased $9.2 million, or 46.3% for the year ended December 31, 2011 compared to the year ended December 31, 2010. The decrease was primarily due to closure costs at two facilities ($4.2 million) and costs related to the write-off of paper machine assets at Tomahawk ($2.8 million) in 2010 in addition to reduced fixed asset disposal costs ($1.6 million).
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Interest Expense, Net and Income Taxes
Net interest expense decreased by $3.1 million, or 9.6%, for the year ended December 31, 2011 compared to the year ended December 31, 2010, primarily as a result of higher capitalized interest ($2.2 million) related to the Counce and Valdosta major energy projects.
PCA’s effective tax rate was 35.1% for the year ended December 31, 2011 compared to (34.2)% for the year ended December 31, 2010. The effective tax rate varies from the U.S. federal statutory tax rate of 35.0% principally due to the impact of the alternative energy tax credits in 2010, state and local income taxes and the domestic manufacturers’ deduction. PCA recorded a material change in its reserve for unrecognized tax benefits under ASC 740, “Income Taxes,” of $102.0 million in the fourth quarter of 2010 due to the amendment of the 2009 federal income tax return to claim gallons of alternative fuels produced at the Filer City, Michigan mill. Due to the proprietary nature of the biofuel process at the Filer City mill, uncertainty as to total fuel gallons qualifying for the credit exists, which caused the additional reserve.
Liquidity and Capital Resources
| For the Year Ended December 31, | ||||||||||||
| 2012 | 2011 | 2010 | ||||||||||
| (In millions) | ||||||||||||
| Net cash provided by (used for): | ||||||||||||
| Operating activities | $ | 404.2 | $ | 345.5 | $ | 349.9 | ||||||
| Investing activities | (107.5 | ) | (350.1 | ) | (321.3 | ) | ||||||
| Financing activities | (245.6 | ) | (35.6 | ) | (92.8 | ) | ||||||
| Net increase (decrease) in cash | $ | 51.1 | $ | (40.2 | ) | $ | (64.2 | ) | ||||
Operating Activities
Net cash provided by operating activities for the year ended December 31, 2012 was $404.2 million compared to $345.5 million for the year ended December 31, 2011, an increase of $58.7 million, or 17.0%. Cash provided by operating activities before changes in operating assets and liabilities was $485.0 million for 2012 compared to $366.1 million for 2011, an increase of $118.9 million that was driven by the stronger operations in 2012 as previously discussed and an additional $29.5 million of alternative energy tax credits used to reduce federal income tax payments during 2012 compared to 2011. Cash used for operating assets and liabilities totaled $80.8 million in 2012 compared to $20.5 million in 2011, an increase of $60.3 million. The additional requirements for operating assets and liabilities in 2012 were driven by reduced accounts payable levels in 2012 and higher levels of accounts receivable from higher sales volumes in 2012. Cash requirements for operating activities are subject to PCA’s operating needs and the timing of collection of receivables and payments of payables and expenses.
Net cash provided by operating activities for the year ended December 31, 2011 was $345.5 million compared to $349.9 million for the year ended December 31, 2010, a decrease of $4.4 million, or 1.3%. Cash provided by operating activities before changes in operating assets and liabilities was $366.1 million for 2011 compared to $395.9 million for 2010, a decrease of $29.8 million that was driven by $32.7 million in fewer alternative energy tax credits used to reduce federal income tax payments during 2011 compared to 2010. Cash used for operating assets and liabilities totaled $20.5 million in 2011 compared to $45.9 million in 2010, a decrease of $25.4 million. The lower requirements for operating assets and liabilities in 2011 were driven by an improvement in accounts receivable resulting from price increases in 2010 and favorable changes in inventory in 2011 compared to 2010 due to a 2010 build in inventory in anticipation of the downtime related to the major energy project work completed in 2011, partially offset by unfavorable changes in accounts payable.
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Investing Activities
Net cash used for investing activities for the year ended December 31, 2012 decreased $242.7 million, or 69.3%, to $107.5 million, compared to the year ended December 31, 2011. The decrease was related to lower additions to property, plant and equipment of $151.7 million as our major energy projects were completed in 2011, the receipt of $57.4 million in grant proceeds from the U.S. Treasury in 2012 (see Note 19 — U.S. Treasury Grant in the “Notes to Consolidated Financial Statements”), and lower cost of acquisitions of $21.9 million and lower additions to long term assets of $12.0 million during 2012 compared to 2011.
Net cash used for investing activities for the year ended December 31, 2011 was $350.1 million, an increase of $28.8 million, or 9.0%, compared to the year ended December 31, 2010. The increase was primarily related to $57.3 million in corrugated products business acquisitions completed in 2011 and higher additions to other long-term assets of $10.4 million in 2011 compared to 2010. This was partially offset by lower additions to property, plant and equipment of $40.0 million during the year ended December 31, 2011 compared to the same period in 2010, primarily due to reduced spending ($55.9 million) on the major energy projects.
As of December 31, 2012, PCA had commitments for general purpose capital expenditures of $27.0 million. PCA believes that cash-on-hand combined with cash flow from operations will be sufficient to fund these commitments.
Financing Activities
Net cash used for financing activities totaled $245.6 million for the year ended December 31, 2012 compared to $35.6 million for the same period in 2011, an increase of $210.0 million. Payments on long-term debt, net of proceeds received, were a use of cash of $40.1 million in 2012 compared to a source of cash of $149.3 million in 2011, or a difference of $189.4 million (as discussed in more detail below). Please see Note 8 — Debt in the “Notes to Consolidated Financial Statements” for a discussion of debt refinancing activities in 2011 and 2012. Additionally, PCA paid an additional $75.4 million to settle treasury locks in 2012 compared to 2011 (please see Note 9 – Derivative Instruments and Hedging Activities in the “Notes to Consolidated Financial Statements” for additional information). Also in 2012, the Company paid higher dividends of $41.8 million (including the $24.5 million of dividends that would have been paid in January of 2013 but were accelerated to December of 2012). This was partially offset by lower repurchases of PCA common stock of $79.9 million and higher proceeds received from stock option exercises of $15.7 million during 2012 compared to 2011.
Net cash used for financing activities for the year ended December 31, 2011 was $35.6 million compared to $92.8 million for the year ended December 31, 2010, a decrease of $57.2 million, or 61.6%. During 2011, PCA repurchased an additional $86.1 million of its common stock and paid an additional $14.2 million in dividends than it did in 2010. This was more than offset by $150.0 million in proceeds received from borrowing under a new term loan in 2011 and $9.9 million in proceeds received from settling treasury locks in February 2011.
On November 29, 2000, PCA established an on-balance sheet securitization program for its trade accounts receivable with a $150.0 million receivables-backed revolving credit facility. On October 11, 2011, PCA amended the receivables credit facility agreement to extend the termination date to October 11, 2014 and increase the borrowing capacity from $150.0 million to $200.0 million. As of December 31, 2012, PCA had $91.0 million in additional borrowing capacity available under this facility and $109.0 million of borrowings was outstanding.
On October 11, 2011, PCA replaced its senior credit facility that was scheduled to terminate in April 2013 with a new senior credit facility that provides a $150.0 million term loan facility, which PCA fully borrowed, and a $250.0 million revolving credit facility, including a $50.0 million subfacility for letters of credit. Borrowings may be used for general corporate purposes and bear interest at LIBOR plus a margin that is determined based upon PCA’s credit ratings. PCA is required to make quarterly principal payments on the term loan of $3.8 million beginning March 31, 2012 through September 30, 2016, with the balance due at maturity. The new senior
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credit facility will terminate on October 11, 2016. PCA had no borrowings and $13.7 million of outstanding letters of credit under the revolving credit facility, resulting in $236.3 million in unused borrowing capacity as of December 31, 2012.
On June 26, 2012, PCA issued $400.0 million of 3.90% senior notes due June 15, 2022 through a registered public offering. PCA used the proceeds from the offering, together with cash on hand, to redeem its $400.0 million of 5.75% senior notes due August 1, 2013 on July 26, 2012. In connection with the redemption, PCA paid a redemption premium of $21.3 million and $11.2 million of accrued and unpaid interest.
Off-Balance Sheet Arrangements
The Company does not have any off-balance sheet arrangements as of December 31, 2012 that would require disclosure under SEC FR-67, “Disclosure in Management’s Discussion and Analysis About Off-Balance Sheet Arrangements and Aggregate Contractual Obligations.”
Contractual Obligations
The following table summarizes PCA’s contractual obligations at December 31, 2012:
| Payments Due by Period | ||||||||||||||||||||
| Total | Less Than 1 Year | 1-3 Years | 3-5 Years | More Than 5 Years | ||||||||||||||||
| (In thousands) | ||||||||||||||||||||
| Receivables credit facility (due October 11, 2014) | $ | 109,000 | $ | — | $ | 109,000 | $ | — | $ | — | ||||||||||
| Senior credit facility — term loan (due October 11, 2016) | 135,000 | 15,000 | 30,000 | 90,000 | — | |||||||||||||||
| 6.50% senior notes (due March 15, 2018) | 150,000 | — | — | 150,000 | ||||||||||||||||
| 3.90% senior notes (due June 15, 2022) | 400,000 | — | — | — | 400,000 | |||||||||||||||
| Total short-term and long-term debt | 794,000 | 15,000 | 139,000 | 90,000 | 550,000 | |||||||||||||||
| Capital lease obligations | 41,798 | 2,654 | 5,308 | 5,308 | 28,528 | |||||||||||||||
| Operating leases | 178,377 | 33,888 | 52,837 | 25,572 | 66,080 | |||||||||||||||
| Capital commitments | 27,046 | 27,046 | — | — | — | |||||||||||||||
| Purchase commitments | 31,301 | 5,960 | 6,389 | 2,972 | 15,980 | |||||||||||||||
| Letters of credit | 13,709 | 13,709 | — | — | — | |||||||||||||||
| Total contractual obligations | $ | 1,086,231 | $ | 98,257 | $ | 203,534 | $ | 123,852 | $ | 660,588 | ||||||||||
The above table excludes interest payments on debt outstanding. Based on interest rates in effect and long-term debt balances outstanding as of December 31, 2012, projected contractual interest payments would be approximately $28.8 million in 2013 and for each future year. For the purpose of this disclosure, we have assumed that PCA’s variable and fixed rate long-term debt would be replaced at maturity with similar long-term debt and similar interest rates. This disclosure does not attempt to predict changes in interest rates. See Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” for the impact of changes in interest rates on PCA’s future cash flows.
The operating lease commitments, capital commitments, purchase commitments and letters of credit are not reflected on PCA’s consolidated balance sheet as of December 31, 2012. See Note 8 — Debt and Note 12 — Commitments and Contingencies in the “Notes to Consolidated Financial Statements” for additional information. PCA is not required to make any pension plan contributions in 2013 under the “Moving Ahead for Progress in the 21st Century Act” that was enacted in 2012 which, among other items, provided companies with some
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pension funding relief. PCA currently does not have any projections for future pension contributions beyond 2013. See Note 6 — Employee Benefit Plans and Other Postretirement Benefits in the “Notes to Consolidated Financial Statements” for additional information.
As of December 31, 2012, PCA had $111.3 million of obligations for gross unrecognized tax benefits and an additional $2.6 million for gross interest and penalties classified as noncurrent liabilities. At this time, PCA is unable to make a reasonably reliable estimate of the timing of payments in individual years in connection with these tax liabilities; therefore, such amounts are not included in the above contractual obligations table. See Note 14 — Income Taxes in the “Notes to Consolidated Financial Statements” for additional information.
PCA’s primary sources of liquidity are net cash provided by operating activities, available borrowing capacity under PCA’s revolving credit facility and additional borrowings under PCA’s receivables credit facility. As of December 31, 2012, PCA had $327.3 million in unused borrowing capacity under its existing credit facilities, net of the impact on this borrowing capacity of $13.7 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, excluding unamortized debt discount, and the weighted average interest rates as of December 31, 2012 for PCA’s senior credit facility, the receivables credit facility and the senior notes:
| Borrowing Arrangement | Balance at December 31, 2012 | Weighted Average Interest Rate | Projected Annual Cash Interest Payments | |||||||||
| (Dollars in thousands) | ||||||||||||
| Revolving Credit Facility | $ | — | N/A | N/A | ||||||||
| Term Loan | 135,000 | 1.71 | % | $ | 2,311 | |||||||
| Receivables Credit Facility | 109,000 | 1.06 | 1,154 | |||||||||
| 6.50% Senior Notes (due March 15, 2018) | 150,000 | 6.50 | 9,750 | |||||||||
| 3.90% Senior Notes (due June 15, 2022) | 400,000 | 3.90 | 15,600 | |||||||||
| Total | $ | 794,000 | 3.63 | % | $ | 28,815 | ||||||
The above table excludes the annual non-cash interest expense of $5.7 million from the amortization of the treasury locks over the terms for both the 6.50% senior notes due in 2018 and the 3.90% senior notes due in 2022.
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, |
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| • | incur liens, |
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| • | incur indebtedness at the subsidiary level, |
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| • | enter into certain transactions with affiliates, or |
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| • | merge or consolidate with any other person or sell or otherwise dispose of all or substantially all of the assets of PCA. |
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These limitations could limit corporate and operating activities.
In addition, PCA must maintain a minimum interest coverage ratio and a maximum leverage ratio under its senior credit facility. A failure to comply with the restrictions contained in the senior credit facility could lead to an event of default, which could result in an acceleration of any outstanding indebtedness and/or prohibit PCA
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from drawing on its senior credit facility. Such acceleration may also constitute events of default under the senior notes indentures and the receivables credit facility. At December 31, 2012, PCA was in compliance with these covenants.
PCA currently expects to incur normal capital expenditures of about $125.0 million in 2013, primarily for maintenance capital, cost reduction, business growth and environmental compliance, plus $50.0 million for either box plant acquisitions or strategic investments in our existing box plants.
PCA believes that net cash generated from operating activities, cash on hand, 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. Its ability to do so will be subject to future economic conditions and financial, business and other factors, many of which are beyond PCA’s control.
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); |
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| • | Clean Water Act (CWA); |
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| • | Clean Air Act (CAA); |
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| • | The Emergency Planning and Community Right-to-Know-Act (EPCRA); |
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| • | Toxic Substance Control Act (TSCA); and |
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| • | Safe Drinking Water Act (SDWA). |
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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. The Company 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. For the years ended December 31, 2012, 2011 and 2010, we spent $25.8 million, $26.0 million and $24.6 million, respectively, to comply with the requirements of these and other environmental laws.
As is the case with any industrial operation, PCA has, in the past, incurred costs associated with the remediation of soil or groundwater contamination, as required by the federal Comprehensive Environmental Response, Compensation and Liability Act, commonly known as the federal “Superfund” law, and analogous state laws. Cleanup requirements arise with respect to properties the Company currently owns or operates, former facilities and off-site facilities where the Company has disposed of hazardous substances. As part of the sale to PCA of the containerboard and corrugated products business of Pactiv Corporation in April 1999, Pactiv agreed to retain all liability for all former facilities and all sites associated with pre-closing off-site waste disposal. Pactiv also retained environmentally impaired real property in Filer City, Michigan unrelated to current mill operations.
In 2004, the U.S. Environmental Protection Agency (the “EPA”) published the Boiler MACT regulations, establishing air emissions standards and certain other requirements for industrial boilers. These regulations were vacated and remanded by the U.S. Court of Appeals for the D.C. Circuit in 2007. The EPA proposed final regulations in March 2011, and concurrently announced its intent to reconsider certain provisions of the final rule. In December 2011, the EPA published proposed rules containing changes to the March 2011 rules and
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requested public comment on several of the rule revisions. After reviewing public comments, the EPA published a revised final rule in January 2013. The January 2013 rule establishes a three year deadline for compliance which states are authorized to extend by an additional year if they so elect. PCA is currently assessing the impact of these regulations, which are expected to require modifications to or replacement of certain of PCA’s boilers. PCA currently estimates that compliance with the final rule will require capital expenditures between $45.0 million and $55.0 million over the next three years. Due to the complexity of these regulations, and the potential for additional future regulatory or judicial modification to these regulations, this estimate is subject to further revisions. We currently estimate capital expenditures to comply with Boiler MACT regulations in 2013 of up to $10.0 million and expect other environmental capital expenditures of about $2.0 million in 2013. Total capital expenditures for environmental matters were $1.8 million, $2.8 million and $1.1 million for 2012, 2011 and 2010, respectively.
Because liability for remediation costs under environmental laws is strict, meaning that liability is imposed without fault, joint and several, meaning that liability is imposed on each party without regard to contribution, and retroactive, PCA could receive notifications of cleanup liability in the future and this liability could be material. From 1994 through 2012, remediation costs at PCA’s mills and corrugated plants totaled approximately $3.2 million. As of December 31, 2012, PCA maintained an environmental reserve of $11.7 million relating to on-site landfills and surface impoundments as well as ongoing and anticipated remedial projects. As of this filing, the Company believes that it is not reasonably possible that future environmental expenses above the $11.7 million accrued as of December 31, 2012 will have a material impact on its financial condition, results of operations and cash flows.
While legislation regarding the regulation of greenhouse gas emissions has been proposed at the federal level, it is uncertain whether such legislation will be passed and, if so, what the breadth and scope of such legislation will be. The result of the regulation of greenhouse gas emissions could be an increase in our future environmental compliance costs, through caps, taxes or additional capital expenditures to modify facilities, which may be material. However, climate change legislation and the resulting future energy policy could also provide us with opportunities if the use of renewable energy is encouraged. We currently generate a significant portion of our power requirements for our mills using bark, black liquor and biomass as fuel, which are derived from renewable resources. While we believe we are well-positioned to take advantage of any renewable energy incentives, it is uncertain what the ultimate costs and opportunities of any climate change legislation will be and how our business and industry will be affected.
Critical Accounting Policies
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, goodwill and intangible assets, pensions and other postretirement benefits, income taxes, environmental liabilities, stock based compensation, and 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 believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. For a further discussion on the application of these and other accounting policies, see Note 2 — Summary of Significant Accounting Policies in the “Notes to Consolidated Financial Statements” included elsewhere in this report.
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Accounts Receivable — Allowance for Doubtful Accounts and Customer Deductions
PCA evaluates the collectibility of its accounts receivable based upon a combination of factors. In circumstances where the Company is aware of a specific customer’s inability to meet its financial obligations (e.g., bankruptcy filings, substantial downgrading of credit sources), PCA records a specific reserve for bad debts against amounts due to reduce the net recorded receivable to the amount the Company reasonably believes will be collected. For all other customers, the Company recognizes reserves for bad debts based on its historical collection experience. If the Company’s collection experience deteriorates (i.e., higher than expected defaults or an unexpected material adverse change in a major customer’s ability to meet its financial obligations), PCA’s estimates of the recoverability of amounts due could be reduced by a material amount.
The customer deductions reserve represents the estimated amount required for customer returns, allowances and earned discounts. Based on PCA’s experience, customer returns, allowances and earned discounts have averaged 1.0% of its gross selling price. Accordingly, the Company reserves 1.0% of its open customer accounts receivable balance for these items.
As of December 31, 2012, the balance in the allowance for doubtful accounts reserve was $1.9 million, which was unchanged compared to the December 31, 2011 reserve. For the year ended December 31, 2012, the Company recorded expense related to doubtful accounts of $1.0 million compared to expense of $0.1 million recorded during the year ended December 31, 2011. The increase in bad debt expense of $0.9 million was due to expense from customers who had filed for bankruptcy or had liquidated. For the year ended December 31, 2011, the Company recorded expense of $0.1 million related to doubtful accounts compared to income of $0.9 million in 2010. The income in 2010 of $0.9 million was primarily due to a $1.0 million reduction in the allowance for doubtful accounts reserve to reflect the low level of actual losses over the previous three years.
Inventories
PCA records its inventories at the lower of cost or market and includes all costs directly associated with manufacturing products: materials, labor and manufacturing overhead. The estimated market value is based on assumptions for future demand and related pricing. If actual market conditions are less favorable than those projected by management, reductions in the carrying value of inventories may be required. Raw materials, work in process and finished goods valued using the last-in, first-out (“LIFO”) cost method comprised 58% and 61% of inventories at current cost at December 31, 2012 and 2011, respectively. Supplies and materials inventories are valued using a moving average cost.
Pension and Postretirement Benefits
The Company accounts for defined benefit pension plans and postretirement plans in accordance with Accounting Standards Codification (“ASC”) 715, “Compensation — Retirement Benefits.”
One of the principal assumptions used to calculate net periodic pension cost is the expected long-term rate of return on plan assets. The expected long-term rate of return on plan assets may result in recognized returns that are greater or less than the actual returns on those plan assets in any given year. Over time, however, the expected long-term rate of return on plan assets is designed to approximate the actual long term returns.
The discount rate assumptions used to calculate net periodic pension and postretirement costs reflect the rates available on high-quality, fixed-income debt instruments on December 31. The rate of compensation increase is another significant assumption used to calculate net periodic pension cost and is determined by PCA based upon annual reviews.
For postretirement health care plan accounting, PCA reviews external data and its own historical trends for health care costs to determine the health care cost trend rate assumption.
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Environmental Liabilities
PCA accounts for its retirement obligations related to its landfills under ASC 410, “Asset Retirement and Environmental Obligations,” which requires legal obligations associated with the retirement of long-lived assets to be recognized at their fair value at the time that the obligations are incurred. Upon initial recognition of a liability, that cost is capitalized as part of the related long-lived asset and amortized to expense over the useful life of the asset.
The potential costs for various environmental matters are uncertain due to such factors as the unknown magnitude of possible cleanup costs, the complexity and evolving nature of governmental laws and regulations and their interpretations, and the timing, varying costs and effectiveness of alternative cleanup technologies. Liabilities recorded for environmental contingencies are estimates of the probable costs based upon available information and assumptions. Because of these uncertainties, however, the Company’s estimates may change. PCA believes that any additional costs identified as further information becomes available would not have a material effect on its financial statements.
In connection with the sale to PCA of the containerboard and corrugated products business of Pactiv Corporation in April 1999, Pactiv agreed to retain all liability for all former facilities and all sites associated with off-site waste disposal prior to April 12, 1999. Pactiv also retained the environmental liability for a closed landfill located near the Filer City mill.
Revenue Recognition
PCA recognizes revenue as title to the products is transferred to customers. Shipping and handling costs are included in cost of sales. Shipping and handling billings to a customer are included in net sales. In addition, PCA offers volume rebates to certain of its customers. The total cost of these programs is estimated and accrued as a reduction to net sales at the time of the respective sale.
Impairment of Goodwill and Long-Lived Assets
Goodwill is tested for impairment annually at year end or sooner if events or changes in circumstances indicate that the carrying amount may exceed fair value. Recoverability of goodwill is determined by comparing the fair value of the reporting unit with its carrying value, including goodwill. If the carrying amount of the reporting unit exceeds the fair value, the implied fair value of the reporting unit’s goodwill is compared to the carrying amount of its goodwill to determine if a write-down to fair value is necessary.
Long-lived assets other than goodwill are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of any long-lived asset may not be fully recoverable. In the event that facts and circumstances indicate that the carrying amount of any long-lived assets may be impaired, an evaluation of recoverability would be performed. If an evaluation were required, the estimated future undiscounted cash flows associated with the asset (or group of assets) would be compared to the asset’s (or group of assets’) carrying amount to determine if a write-down to fair value is required.
Stock-Based Compensation
PCA measures and records stock-based compensation cost in accordance with ASC 718, “Compensation — Stock Compensation.” Stock compensation cost includes: (a) compensation cost for all share-based payments granted prior to, but not vested as of January 1, 2006, the effective date of ASC 718, and (b) compensation costs for all share-based payments granted subsequent to January 1, 2006. The grant date fair value is estimated in accordance with the provisions of ASC 718.
PCA recognizes compensation expense associated with option awards ratably over their vesting periods. The Company uses the Black-Scholes-Merton option-pricing model to estimate the fair value of each option grant as of the date of grant. Expected volatilities are based on historical volatility of the Company’s common stock. The expected life of the option is estimated using historical data pertaining to option exercises and
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employee terminations. Separate groups of employees that have similar historical exercise behavior are considered separately for estimating the expected life. The risk-free interest rate is based on U.S. Treasury yields in effect at the time of grant. The Company has not granted any option awards since 2007.
The fair value of restricted stock awards is determined based on the closing price of PCA’s common stock on the grant date. The Company generally recognizes compensation expense associated with restricted stock awards ratably over their vesting periods. As PCA’s Board of Directors has the ability to accelerate the vesting of restricted stock upon an employee’s retirement, the Company accelerates the recognition of compensation expense for certain employees approaching normal retirement age.
Income Taxes
PCA’s annual tax rate is determined based on income, statutory tax rates and the tax impacts of items treated differently for tax purposes than for financial reporting purposes. Tax law requires some items to be included in the tax return at different times than the items reflected in the financial statements. As a result, the annual tax rate in the financial statements is different than the rate reported on PCA’s tax return. Some of these differences are permanent, such as expenses that are not deductible in the tax return, and some differences are temporary, reversing over time, such as depreciation expense. These temporary differences create deferred tax assets and liabilities.
Inherent in determining the annual tax rate are judgments regarding business plans, planning opportunities and expectations about future outcomes. Significant management judgments are required for the following items:
| • | Management reviews PCA’s deferred tax assets for realizability. Valuation allowances are established when management believes that it is more likely than not that some portion of the deferred tax assets will not be realized. Changes in valuation allowances from period to period are included in the tax provision. |
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| • | PCA establishes accruals for unrecognized tax benefits when, despite the belief that PCA’s tax return positions are fully supported, PCA believes that an uncertain tax position does not meet the recognition threshold of ASC 740, “Income Taxes.” The tax contingency accruals are adjusted in light of changing facts and circumstances, such as the progress of tax audits, the expiration of the statute of limitations for the relevant taxing authority to examine a tax return, case law and emerging legislation. While it is difficult to predict the final outcome or timing of resolution for any particular tax matter, PCA believes that the accruals for unrecognized tax benefits at December 31, 2012 reflect the likely outcome of known tax contingencies as of such date in accordance with accounting for uncertainty in income taxes under ASC 740. |
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Reconciliations of Non-GAAP Financial Measures to Reported Amounts
Income from operations, net income and diluted earnings per share excluding special items are non-GAAP financial measures. Management presents income from operations, net income and diluted earnings per share excluding these special items to focus on PCA’s on-going operations and assess its operating performance and believes that these measures provide useful information to investors because they enable them to perform meaningful comparisons of past and present operating results. Reconciliations of those non-GAAP measures to the most comparable measure reported in accordance with GAAP for the three months ended December 31, 2012 and the years ended December 31, 2012, 2011 and 2010 follow:
| Three Months Ended December 31, 2012 | ||||||||||||
| Income from Operations | Net Income | Diluted EPS | ||||||||||
| (In thousands except per share amounts) | ||||||||||||
| As reported in accordance with GAAP | $ | 98,419 | $ | 61,031 | $ | 0.63 | ||||||
| Special items: | ||||||||||||
| State income tax adjustments | — | (3,393 | ) | (0.03 | ) | |||||||
| Facility closure charges | 1,961 | 1,358 | 0.01 | |||||||||
| Total special items | 1,961 | (2,035 | ) | (0.02 | ) | |||||||
| Excluding special items | $ | 100,380 | $ | 58,996 | $ | 0.61 | ||||||
| Year Ended December 31, | ||||||||||||||||||||||||||||||||||||
| 2012 | 2011 | 2010 | ||||||||||||||||||||||||||||||||||
| Income from Operations | Net Income | Diluted EPS | Income from Operations | Net Income | Diluted EPS | Income from Operations | Net Income | Diluted EPS | ||||||||||||||||||||||||||||
| (In thousands except per share amounts) | ||||||||||||||||||||||||||||||||||||
| As reported in accordance with GAAP | $ | 443,459 | $ | 163,820 | $ | 1.68 | $ | 272,749 | $ | 158,027 | $ | 1.57 | $ | 185,382 | $ | 205,435 | $ | 2.00 | ||||||||||||||||||
| Special items: | ||||||||||||||||||||||||||||||||||||
| State income tax adjustments | — | (3,393 | ) | (0.03 | ) | — | — | — | — | — | — | |||||||||||||||||||||||||
| Debt refinancing charges | 10 | 15,952 | (a) | 0.16 | — | — | — | — | — | — | ||||||||||||||||||||||||||
| Medical benefits reserve adjustment | — | — | — | (1,600 | ) | (1,016 | ) | (0.01 | ) | — | — | — | ||||||||||||||||||||||||
| Biofuel tax credits | (95,500 | ) | 23,012 | 0.24 | — | — | — | 86,804 | (47,697 | ) | (0.46 | ) | ||||||||||||||||||||||||
| Asset disposal and facilities closure charges | 1,961 | (b) | 1,358 | 0.01 | 7,406 | (b) | 4,783 | 0.05 | 13,213 | (b) | 8,557 | 0.08 | ||||||||||||||||||||||||
| Total special items | (93,529 | ) | 36,929 | 0.38 | 5,806 | 3,767 | 0.04 | 100,017 | (39,140 | ) | (0.38 | ) | ||||||||||||||||||||||||
| Excluding special items | $ | 349,930 | $ | 200,749 | $ | 2.06 | $ | 278,555 | $ | 161,794 | $ | 1.61 | $ | 285,399 | $ | 166,295 | $ | 1.62 | ||||||||||||||||||
| (a) | Consists of after-tax charges related to the Company’s refinancing of debt completed in 2012, including the redemption premium ($13.6 million), the charge to settle the treasury lock prior to its maturity ($2.3 million), and other items ($0.1 million). |
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| (b) | Consists of plant closure charges in 2012 and energy project related disposals in 2011. For 2010, consists of energy project related disposals ($6.2 million), plant closures ($4.2 million) and other assets no longer in service ($2.8 million). |
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