KP Tissue Inc.

Mike Baldesarra - Director, IR Dino Bianco - CEO Mark Holbrook - CFO

Sean Steuart - TD Securities Paul Quinn - RBC Capital Markets Hanbo Xia - Desjardins Securities Zachary Evershed - National Bank

Thank you, operator and good morning, ladies and gentlemen. My name is Mike Baldesarra.

I am the Director of Investor Relations at KP Tissue Inc. The purpose of this conference call is to review the financial results of the third quarter of 2018 for Kruger Products L.P., which I’ll refer to as KPLP going forward.

With me this morning is Dino Bianco, the Chief Executive Officer of KP Tissue and Kruger Products L.P.; and Mark Holbrook, the Chief Financial Officer of KP Tissue and Kruger Products L.P. The following discussions and responses to questions contain forward-looking statements concerning the company's activities.

Forward-looking statements involve known and unknown risks and uncertainties, which could cause the company's actual results to differ materially from those in the forward-looking statements. Investors are cautioned not to rely on these forward-looking statements.

The company does not undertake to update these forward-looking statements except if required by applicable laws. There is a page at the beginning of the written presentation, which contains the usual legal cautions including as to forward-looking information, which you should be aware of.

I'd like to point out that all figures expressed in today's call are in Canadian dollars unless otherwise stated. The press release reporting our Q3 2018 results were published this morning and will be accessible from our website at kptissueinc.com.

Please be aware that our MD&A will be posted on our website and will also be available on SEDAR. Final I'd ask that during the call you refer to the presentation we've prepared to accompany these discussions, which is also available on our website.

We also appreciate that during the question and answer period, please limit your questions to two. Thank you for your cooperation.

Ladies and gentlemen, I'll now turn the call over to Dino Bianco our CEO. Dino?

Thank you, Mike. Good morning, everyone, and thank you for joining us on our conference call today.

We are pleased to report continued sales growth for the third quarter as we continue to maintain our market leadership position in Canada. However, our results continue to be impacted by higher pulp and freight cost.

Despite this difficult cost environment, we have undertaken several key initiatives that will strengthen our business over the longer-term and reinforce our leadership position in the market including the decision to proceed with the TAD2 Project and I’ll address these additions in more detail shortly. Let's turn to Slide 5 of the presentation for our third quarter highlights.

In Q3 2018, revenue increased by 3.6% to $348.4 million. Revenues increased in the U.S.

and Mexico but slightly decreased in Canada as we lapped a price increase pre-buy in 2017 in our Canadian consumer business and AFH was softer due to a very competitive marketplace. Although Mexico was a solid revenue contributor for the quarter due to the nature of our business model in Mexico, the profitability on that business is low.

Adjusted EBITDA totaled $28.3 million, a decrease of 28.2% over the last year due to significantly higher pulp and freight costs. However, Q3 adjusted EBITDA was up 6% from the previous quarter driven by the consumer segment and normal seasonality.

Slide 6 presents the market pulp prices in U.S. and Canadian dollars.

Unfortunately, the picture is no different than other quarters with NBSK pulp prices in Canadian dollars and BEK which is eucalyptus pulp prices are on upper trend since the end of 2016. Q3 pulp prices rose sequentially compared to Q2 and year-over-year in both U.S.

and Canadian dollars and pulp prices in Canadian dollars continue to be at a historical highs. As a result, overall higher pulp prices that had an impact on our Q3 results it will continue to have an impact for the remainder of 2018.

And based on industry sources, we expect pulp prices in U.S. dollars to remain high through 2019.

Let's turn to Slide 7 which summarizes the situation we experienced with freight costs. As you can see these costs are also at an all-time high, and we expect that they will remain high for the balance of 2018.

In this marketplace, our primary focus has been on securing carrier capacity to meet our customer needs, we're trying to mitigate costs at the same time. On Slide 8, we present the steps we have taken and the measures we are implementing to counteract these high input costs which have risen 30% since the previous July 2017 price increase announcement.

As indicated before, one of the major steps we have taken to mitigate the continuous rise in input costs is a price increase in a Canadian consumer business which was announced on July 26 and will take effect in Q4 of this year. We have completed the sell-in and expect the full impact to start materializing in the marketing Q1 2019.

Our other initiative consists of our value creation program that was announced last quarter. The smart cost reduction program is much larger in scope and size compared to our previous programs as we are essentially doubling the size of expected savings compared to past years.

We’re continuing to make significant progress in this area. Finally we're also going to undertake a network optimization program that will involve a comprehensive review of our operations starting in Q4 of this year.

We will communicate more information about these programs when we release our fourth quarter results in March. We believe that these initiatives will allow us to improve our profitability within the next 6 to 12 months and it should largely offset the significant rise in input prices.

On Slide 9, we present an overview of our TAD2 Project. Following the success of our TAD1 machine, we recently announced our decision to proceed with a $575 million investment in our TAD2 Project.

We believe that the second machine will significantly increase the competitiveness operations and our brands and will further reinforce our market strengths in North America. We choose to build a plant in Sherbrooke, Québec, as at this location is well positioned for the products we are marketing and was the most financially attractive option.

TAD2 will be designed to allow paper towels manufacturer a very high speeds and is expected to produce an additional 70,000 metric tonnes per year of maturity. This project is central to our long-term North American growth strategy and the ultra-premium paper tissue segment.

As Mark will indicate a bit later, the financing structure will be nondilutive to KPT shareholders but will require period of higher leverage ratios during the construction and startup period. I will now turn the call over to Mark who will review our quarterly results and present the financing details of our TAD2 Project.

Thank you, Dino, and good morning ladies and gentlemen. I want to ask you to refer to Slide 10 which summarizes our financial performance for the third quarter.

Our revenues reached $348.4 million, a 3.6% increase compared to last year. However adjusted EBITDA decreased $39.4 million in Q3 last year to $28.3 million in Q3 of 2018.

From a margin perspective, adjusted EBITDA decreased to 8.1% from 11.7% last year but improved sequentially from 7.9% in Q2 2018. As Dino mentioned, higher pulp and freight cost continued to have a significant impact on our results both sequentially and year-over-year.

Net income stood at $4.2 million in the third quarter compared to $16.5 million last year. The decrease was primarily due to the lower adjusted EBITDA, also an increase in interest expense and increase in the change in the amortized cost of partnership units liability, and a change in foreign exchange and these were partially offset by lower depreciation expense and a decrease in income taxes.

In the quarterly segmented view on Slide 11, consumer revenue increased by 5.2% year-over-year to reach $287.1 million, while away from home revenue decreased by 5% to $59.4 million. Adjusted EBITDA decreased by $2.8 million to $35.3 million for the consumer segment and decreased by $6.6 million to negative $4.8 million for the away-from-home segment.

At the same time margins decreased year-over-year in the consumer segment from 14% to 12.3% and decreased in away-from-home segment from 2.9% to negative 8.1%. On Slide 12, we will review Q3 2018 revenue over Q3 2017 which was up by $12.1 million or 3.6%.

The increase was due to the consumer selling price increase implemented in Canada in Q4 of 2017, increased sales volume in the U.S. and Mexico and the favorable impact of foreign exchange fluctuations on U.S.

sales. Looking at this regionally, sales increased by $6.6 million or 5.8% in the U.S.

and decreased by $4.2 million or 2% in Canada. Sales also increased significantly in Mexico which as Dino mentioned has a low contribution business model.

On Slide 13, we provide some insight into our Q3 2018 adjusted EBITDA which decreased by $11.1 million or 28.2%. Q3 gross margin also decreased from 13.5% to 10.3%.

The decrease in adjusted EBITDA and gross margin was due to a significant increase in pulp and freight cost and unfavorable sales mix and the net unfavorable impact of foreign exchange fluctuations partially offset by the Q4 2017 Canadian consumer selling price increase. The benefits from cost reduction initiatives and capital projects offset other manufacturing cost inflation.

On Slide 14 we compare Q3 2018 and Q2 2018 revenue which increased by $9.6 million or 2.8%. The consumer segment increased by 3.5% due to normal seasonality, whereas away-from-home decreased slightly by 0.3%.

By region revenue increased in Canada by $2.7 million or 1.4% and in the U.S. by $3.4 million or 2.9%.

Revenue also increased in Mexico. On Slide 15, Q3 adjusted EBITDA increased by $1.6 million compared to Q2.

Gross margin also increased from 10% to 10.3%. The increase in adjusted EBIT and gross margin is explained by higher revenues due to normal seasonality partially offset by higher fiber and freight cost.

I'll now ask you to refer to Slide 16 which sets out our balance sheet. Our cash position including bank indebtedness was $26.9 million as of the end of Q3 2018 up from approximately $16 million at the end of Q2.

Overall, net debt at the end of Q3 stood at $462.4 million down $14.6 million from $477 million at the end of Q2 2018. As of the end of Q3 we had $202.6 million in the current portion of long-term debt related primarily to our KTG subsidiary or in the final stages to refinance this portion of the debt which now has an extended maturity date of December 31.

Our net debt to latest 12 month adjusted EBITDA ratio is now at 4.0 times up compared to 3.8 times at the end of Q2. Looking forward, the TAD2 Project will result in the leverage ratio increasing as spending on the project occurs over the next two years.

On Slide 17, we present an overview of the TAD2 project financing which is expected to be nondilutive to KP Tissue's shareholders. Our newly created subsidiary which will own and operate the TAD2 Project, Kruger Products Sherbrooke Inc.

will be financed by 60% debt and 40% equity. The equity component is comprised of $125 million from Kruger Products L.P.

in the form of long-term senior secured fixed debt, a new accounts receivable factoring program and cash. The equity component also includes a $105 million convertible debenture with investment Québec at a fixed 3% capitalized interest rate over 10 years.

The weighted average cost of capital for the $575 million of TAD2 financing is expected to be in the 5% to 7% range. Furthermore, the existing KTG debt of US$147 million is being refinance concurrently with the TAD2 Project and is expected to be an 18-year term loan with an anticipated fixed interest cost in the 6% to 8% range compared to 14% to 15% under the current KTG debt structure related to the TAD1 Project.

We expect the closing of various debt financings to occur prior to year-end 2018. Finally as we can see on Slide 18, our expected CapEx for fiscal 2018 is between $70 million and $80 million of which $30 million to $35 million is allocated to the TAD2 Project.

Approximate $40 million to $45 million is regular CapEx for 2018. CapEx decreased to $7.5 million in Q3 2018 from $12.5 million a year ago due to the Crabtree CME project.

Year-to-date CapEx for the TAD2 Project was approximately $15 million. Thank you for your attention and now I’ll turn the call back over to Dino.

Thank you, Mark. Let's now turn to Slide 19.

Beyond TAD2 our other key focus is to strengthen our way from home business where we hold a leading position in Canada with a market share of approximately 30% and a growing presence in the U.S. across multiple segments.

As I mentioned earlier, the continue to hire pulp and freight costs combined with a competitive AFH environment with the main reasons behind the weak performance of our AFH segment. This segment is less flexible in terms of selling price as pricing will generally increase when annual customer contracts are renewed.

At this time, the intense competitive environment is also limiting our capacity and ability to increase prices with our customers. In the coming months we will undergo a companywide optimization program with a deeper dive in AFH in order to reset this business.

Let me turn to Slide 20 and 21, where we provide a summary of our share position in the Canadian consumer segment. Despite a challenging Q3, our business remains healthy as we continue to be the overall leading tissue company in Canada.

We are the market leader in bathroom tissue and facial tissue and have a strong number two position in paper towels. Let me take a little time to explain the market share decrease in bathroom tissue in particular.

It can be explained by three factors, one we discontinue to sub line in [indiscernible] bath tissue in 2017. Two, we exited a low proper customer segment early in 2018; and three, we continue to see growth in large-size private label formats particularly in bathroom tissue.

We plan to rebuild our shares in 2019 through increased marketing investment, new products and strengthen customer support. Turning to Slide 22, this is a high-level presentation of our vision, our mission and our five pillars that allows to drive strong revenue, profit and shareholder value.

These pillars include building our consumer muscle, expanding in the U.S. and Mexico, building an efficient supply chain, evolving our customer's strategy and having a winning team and culture.

This is a five year journey with various initiatives over that time period. I'll communicate the details of this strategic plan in more detail over the coming months.

Finally, I would like to conclude the call with Slide 23 that summarizes our objectives and the steps we have taken and will pursue for fiscal 2018 and into 2019. Our key objectives are to build revenue, grow market share and service our private-label customers.

Also return our away-from-home business to profitability and proceed with the TAD2 Project. And in order to mitigate continues pulp and freight price increases, we have taken appropriate measures which include the price increase announced in Canada consumer and we are also looking to price our U.S.

private label and our North American AFH businesses. We have escalated value creation program and we are also going to be undertaking a companywide network optimization program in 2019.

We will continue to leverage our TAD product market potential with a successful startup of TAD2. In the away-from-home segment we are resetting the AFH business to create a more efficient manufacturing footprint, and in the U.S.

we will continue to build a premium private-label business and pursue our white cloud brand repositioning. Looking forward KPLP continues to have strong long-term business fundamentals.

However, due to continued pressure from high input costs, Q4, 2018 adjusted EBITDA is expected to be lower than Q4, 2017 which was $33.7 million. We are confident that we have the right vision and strategy to move the company forward and create increase value for our shareholders.

Thank you for your time and attention. And at this point Mark and I will be pleased to answer any questions you may have.

Two questions. Appreciate the incremental detail you've given us on the TAD2 financing terms.

Are you in the position yet where you can provide some broader context on expected contribution from the project, returns on the project EBITDA guidance any context you can provide there yet?

I would say we are not - but it is a very similar project to TAD1, so I think if you use that as a surrogate you’ll probably be in the right space.

But when you reach financial close, you guys were pretty categorical about targets for TAD1 once that project was in place. Should we expect that you’re going to provide that sort of guidance eventually?

Sean, we see this as being an integral part of the overall business so it would be unlikely that we would give a specific amount as we had done in TAD1 but certainly we’d be talking about it at length in every conference call as to how the progress is going.

Second question is on pulp costs, you guys I believe don't participate in the spot market too aggressively. Can you speak to discount spreads on list and how that has trended and what you might expect in the near to mid-term on your discount spread for pulp input?

I will talk about our position specifically. I think your point about we don't participate in the pulp market is correct.

We do operate off of a discount. What we're seeing in the market and what we're hearing is that after years of spreads actually increasing, we're now seeing a reverse in that trend as it relates to 2019 and beyond.

So I think anybody who's buying on a discount start to see contraction in that discount. Nothing significant but it is definitely moving in a different direction than it has been for us for few years.

The $575 million on TAD2 is a whopping big number. Just wondered if you could break that down between the paper machine costs and converting?

Paul, at this point I think we would leave that for a future disclosure as to how that all breaks down. Certainly it's a significant portion as papermaking and converting and there's also a brand new state-of-the art plants involved as well.

So we'll break that down in the future.

And then maybe Dino, you could understand your embarking on this network optimization, maybe you can give us some high level thoughts as to what that program is about and what it hopes to deliver?

Yes Paul. So we're early in the process.

Essentially we'll look at our entire North American network, not just manufacturing but distribution also in the outside co-manufacturers that we use. The primary focus will be on increasing our operating efficiencies on our lines.

Obviously as you increase operating efficiency, you drive down costs plus you also increase capacity, which will allow us to produce our needs internally versus a mix today where some our produced externally. So OEE as we call it will be the primary focus.

Waste reduction will be another focus, yield reduction as you can imagine, price of fiber any savings in yield will yield big dollars. And we are also looking at transportation and warehousing optimization across the network.

So those are the primary focus areas and that will - I think we've always done a good job within our facilities of trying to maximize our or minimize our cost structure, maximize our profit. This one is going to look across and we'll also look at how we load our assets and is there a better way more efficient way of loading our assets than we're doing today.

And then just you’ve been negative margin and away-from-home for a couple quarters now, how long are we expected this to persist?

Well, a couple of things. I mean, that business - all that I've talked about with pulp and freight obviously hits that business.

It's more recycled fiber in that business but those prices continue to escalate as virgin pulp is escalated as well. Then you overlay the very competitive market that exists in AFH.

We have tried to raise prices through Q2, we had some competitor's scoop some of our business, which is why you see a bit of softness in Q2. So we are refocusing our balance to protect our business, at the same time trying to get pricing up.

We also - the other thing that has happened here, we talked a little bit about this at a previous call is because it's part of an integrated network, when we make decisions that benefit the Company and benefit consumers, they tend to be the right decisions for the Company but unfortunately AFH gets a negative hit from that, whether it be the fact that we use a line for consumer and AFH might have to go buy products on the market at a higher cost, or if we shutdown a line and remove any overheads, that may go to a consumer business and AFH may have to actually add some overhead even though the decision is a better decision for the total Company. So there's a bit of marketplace and there's a bit of just the way that we account for decisions that we make as a Company that is affecting that business.

I do want to remind you, EBITDA certainly is a measure but that business absorbs a significant amount of allocated overhead. So we take a view of the benefit that provides for the total business.

Now when will it turn I am not going to predict that, but I think we're doing some pretty good initiatives. One is we are in Phase 2 of the three-year phase around creating a dedicated converting site for our away-from-home business.

And then the network optimization that I talked about just a minute ago will include AFH and will also go little deeper in AFH to be more of a business end-to-end in AFH. So we expect that to yield AFH specific value.

So we think those initiatives will certainly help restore our AFH profitability. At the same time we’re also moving on pricing.

We continue to push the pricing rock up the hill so it’s always a challenge but we are seeing some progress there while since we’re protecting our customer base.

It’s Hanbo filling in for Keith. I was wondering if you could give us your thoughts on what is continuing to push up the price of NBSK even at these levels.

In other words is this just a demand issue or is there something else going on here?

Well I'll tell you what the experts - I'm not an expert to say, but I’ll tell you what the experts are telling me and what we continue to hear in the marketplace. You've got the China demand factor which is happening just as that country continues to urbanize and use of tissue is increasing.

You've also got the fact that China has essentially shut the door on recycled fibers so it’s putting more pressure on Virgin. And then on the on the supply side you really have no major capacity coming on-stream until 2020/2021 and on top of that you had some unplanned downtimes in some of the major mills over the last year.

So you’ve got demand increasing, no new supply and actually some supply erosion based on unplanned downtime. I think the combination of all those factors is driving NBSK to where it is today.

If there is any good news at least short-term, we're starting to see some of the Chinese spot prices starting to stabilize so is that indicative of the future trend I don't know but it's a good sign nonetheless versus what we see in the last few quarters.

And second question if pulp prices and freight costs continue to rise or stay elevated with the additional requirements for TAD2 in terms of CapEx and interest. Would this impact your views or potentially the board views on the $0.18 dividend?

I think at this point when we look at our dividend track record, we’ve certainly had a dividend record of continuing to keep the same dividend each quarter. The board makes that decision each quarter as we go through, but at this point there has been no decision to change that.

In fact the board just approved the next dividend at the same level for the January payment so.

To your point if the pressures on pulp continue obviously, we would look at additional pricing if that was necessary and whether it's in the market we would look at increasing our cost recovery or cost reduction programs that is going to take you next year. So we would respond to those marketplace headwinds with some marketplace actions to try to rebalance our margin.

So we have some guidance for TAD2 CapEx in 2018, I was wondering if you could give us any color on 2019 how front end loaded the spend would be?

Yes, think about the TAD2 Project as over a little more than two-year period from now. So you could look at the spend fairly evenly over that period and then there would be a bit that would come in 2021 as we go live with production.

So fairly evenly spent over that two and plus year period.

And in terms of capital allocation we just went over the dividend with the share price down to where the dividend is around 10% yield. Have you given any thought to share buybacks?

No, at this point that hasn't been considered.

Well, thank you for joining us on this conference call this morning. We look forward to speaking with you again in March 2019, following a release of our fourth quarter results.

Thank you and have a great day.