UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

For the quarterly period ended September 30, 2018

or

For the transition period from          to          

Commission file number 1-15399

 

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Registrant's telephone number, including area code

(847) 482-3000

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

As of November 2, 2018 the Registrant had outstanding 94,497,298 shares of common stock, par value $0.01 per share.

 

 

 

 

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Table of Contents

 

 

All reports we file with the Securities and Exchange Commission (SEC) are available free of charge via the Electronic Data Gathering Analysis and Retrieval (EDGAR) System on the SEC website at www.sec.gov. We also provide copies of our SEC filings at no charge upon request and make electronic copies of our reports available through our website at www.packagingcorp.com as soon as reasonably practicable after filing such material with the SEC.

 

 

 

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PART I

FINANCIAL INFORMATION

Packaging Corporation of America

Consolidated Statements of Income and Comprehensive Income

(unaudited, dollars in millions, except per-share data)

 

 

See accompanying condensed notes to unaudited quarterly consolidated financial statements.

 

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Packaging Corporation of America

Consolidated Balance Sheets

(unaudited, dollars and shares in millions, except per-share data)

 

 

See accompanying condensed notes to unaudited quarterly consolidated financial statements.

 

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Packaging Corporation of America

Consolidated Statements of Cash Flows

(unaudited, dollars in millions)

 

 

See accompanying condensed notes to unaudited quarterly consolidated financial statements.

 

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Condensed Notes to Unaudited Quarterly Consolidated Financial Statements

Packaging Corporation of America ("we," "us," "our," PCA," or the "Company") was incorporated on January 25, 1999. In April 1999, PCA acquired the containerboard and corrugated packaging products business of Pactiv Corporation (Pactiv), formerly known as Tenneco Packaging, Inc., a wholly owned subsidiary of Tenneco Inc. We are a large diverse manufacturer of both packaging and paper products. We are headquartered in Lake Forest, Illinois and we operate primarily in the United States.

We report our business in three reportable segments: Packaging, Paper, and Corporate and Other. Our Packaging segment produces a wide variety of corrugated packaging products. The Paper segment manufactures and sells a range of communication-based papers. During the second quarter of 2018, the Company discontinued the production of uncoated free sheet and coated one-side grades at the Wallula, Washington mill and converted the No. 3 machine to a virgin kraft linerboard machine. Subsequent to the date of conversion in May 2018, operating results for the Wallula mill are primarily included in the Packaging segment. Corporate and other includes support staff services and related assets and liabilities, transportation assets, and activity related to other ancillary support operations. For more information about our segments, see Note 18 Segment Information.

In these consolidated financial statements, certain amounts in prior periods' consolidated financial statements have been reclassified to conform with the current period presentation.

The consolidated financial statements of PCA as of September 30, 2018 and for the three and nine months ended September 30, 2018 and 2017 are unaudited but include all adjustments (consisting only of normal recurring adjustments) that management considers necessary for a fair presentation of such financial statements. The preparation of the consolidated financial statements involves the use of estimates and accruals. Actual results may vary from those estimates. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with Article 10 of Regulation S-X of the Securities and Exchange Commission (SEC). Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete audited financial statements. Operating results for the three and nine months ended September 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. These consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2017.

The consolidated financial statements include the accounts of PCA and its majority-owned subsidiaries after elimination of intercompany balances and transactions.

 

 

Recently Adopted Accounting Standards

 

Effective January 1, 2018, the Company adopted Accounting Standards Update (“ASU”) 2014-09 (Topic 606): Revenue from Contracts with Customers. This ASU supersedes the revenue recognition requirements in Topic 605 Revenue Recognition (Topic 605) and requires entities to recognize revenue when control of the promised goods or services is transferred to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU requires additional disclosure about the nature, amount, timing, and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and estimates, and changes in those estimates. The Company adopted the standard utilizing the modified retrospective method, in which case the cumulative effect was recognized at the date of initial application on January 1, 2018. The adoption of the standard did not have a material effect on the Company’s financial position or results of operations; however, the following adjustment and reclassification of certain costs were made for the three and nine months ended September 30, 2018:

 

a. The Company ships a portion of its products to customers under consignment agreements. These products do not have an alternative use, and, under the new standard, revenue associated with these products is required to be recognized earlier than under prior revenue recognition standards. Utilizing the modified retrospective method, the cumulative impact of adopting the new standard resulted in an increase of approximately $1.6 million, net of tax, to opening retained earnings as of January 1, 2018.

 

b. The new revenue standard also provides additional clarity concerning contract fulfillment costs, which resulted in certain costs being classified as cost of sales rather than selling, general and administrative expenses beginning January 1, 2018. For the three and nine months ended September 30, 2018, this amount totaled $6.9 million and $20.0 million, respectively.

 

See Note 3, Revenue, for more information.

 

Effective January 1, 2018, the Company adopted ASU 2017-07, Compensation: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. The guidance in this update requires that an employer disaggregate the service cost component from the other components of net benefit cost. Non-service cost components of net periodic benefit cost are required to be presented in the income statement separately from the service cost component and outside the subtotal of operating income. The update also allows only the service cost component to be eligible for capitalization for internally developed capital projects. The amendments in this update are applied retrospectively for the income statement presentations and prospectively for the capitalization of service costs.

 

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The adoption of this ASU retrospectively resulted in a $0.3 million and $0.9 million reclassification between cost of sales and selling, general and administrative expenses (both components of income from operations) and interest expense, net and other (a component outside of income from operations) for the three and nine months ended September 30, 2017, respectively.

Effective January 1, 2018, the Company adopted ASU 2017-09, Compensation - Stock Compensation (Topic 718): Scope of Modification Accounting, which clarifies what changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718. This ASU will be applied prospectively when changes to the terms or conditions of a share-based payment award occur.

Effective January 1, 2018, the Company adopted ASU 2017-01 (Topic 805): Clarifying the Definition of a Business, which amends the guidance in ASC 805, “Business Combinations”. The ASU changes the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. Under the new guidance, an entity first determines whether substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets. If this threshold is met, the set is not a business. If it is not met, the entity then evaluates whether the set meets the requirements that a business include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create outputs. The ASU defines an output as “the result of inputs and processes applied to those inputs that provide goods or services to customers, investment income (such as dividends or interest), or other revenues.” The ASU will be applied prospectively to any transactions subsequent to adoption.

Effective January 1, 2018, the Company adopted ASU 2016-15 (Topic 230), Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments. This ASU adds or clarifies guidance on the classification of certain cash receipts and payments in the statement of cash flows. The adoption of this guidance did not have a material impact on the Company's financial condition, results of operations, or cash flows.

New Accounting Standards Not Yet Adopted

 

In August 2018, the Financial Accounting Standards Board (“FASB”) issued ASU 2018-14, Compensation – Retirement Benefits – Defined Benefit Plans – General (Subtopic 715-20): Disclosure Framework – Changes to the Disclosure Requirements for Defined Benefit Plans. ASU 2018-14 removes certain disclosures that are not considered cost beneficial, clarifies certain required disclosures and adds additional disclosures. The ASU is effective for annual periods beginning after December 31, 2020, with early adoption permitted. The amendments in ASU 2018-14 would need to be applied on a retrospective basis.  The Company is currently evaluating the impact this guidance will have on its related disclosures.

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement.  ASU 2018-13 removes or modifies certain disclosure requirements and adds additional requirements to improve the usefulness of the fair value measurement disclosure for financial statement users. The ASU is effective for annual and interim periods beginning after December 15, 2019, with early adoption permitted. Certain amendments of ASU 2018-13 are required to be applied prospectively for the first interim period of the initial year of adoption. All other amendments need to be applied retrospectively. The Company is currently evaluating the impact of the new guidance.

In February 2018, the FASB issued ASU 2018-02 (Topic 220): Income Statement – Reporting Comprehensive Income – Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, which allows for optional reclassification from accumulated other comprehensive income to retained earnings for the stranded tax effects resulting from the enactment of H.R.1 (P.L. 115-97), originally known as the “Tax Cuts and Jobs Act,” in December 2017. An entity that elects to reclassify these amounts must reclassify stranded tax effects related to the change in federal tax rate for all items accounted for in other comprehensive income (e.g., pension and postretirement benefits and cash flow hedges). Entities may also elect to reclassify other stranded tax effects that relate to the Act but do not directly relate to the change in the federal tax rate (e.g., state taxes). Upon adoption of ASU 2018-02, entities are required to disclose their policy for releasing the income tax effects from accumulated other comprehensive income. ASU 2018-02 is effective for annual periods beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. The Company does not expect this ASU to have a material impact on the Company’s financial position, results of operations, or cash flow.

In February 2016, the FASB issued ASU 2016-02 (Topic 842): Leases. This ASU amends a number of aspects of lease accounting, including requiring lessees to recognize operating leases with a term greater than one year on their balance sheet as a right-of-use asset and corresponding lease liability, measured at the present value of the lease payments. Additionally, the guidance requires qualitative and quantitative disclosures designed to assess the amount, timing and uncertainty of cash flows arising from leases. In July 2018, the FASB issued ASU 2018-10: Codification Improvements to Topic 842, Leases and ASU 2018-11: Leases (Topic 842): Targeted Improvements. These ASUs provide clarification to the lease standard and allow entities an optional transition method for implementing ASU 2016-02 and a lessor practical expedient for separating lease and non-lease components. The optional transition method allows companies the option to use the effective date as the date of initial application on transition. The Company plans to elect this transition method, and as a result, we will not adjust our comparative period financial information or make the new required lease disclosures for periods before the effective date.

ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, and early adoption is permitted. We are in the process of implementing changes to our systems and processes in conjunction with our review of existing lease agreements, which primarily consist of equipment and real estate leases. In addition, we are currently working with a vendor to implement a technology tool to assist with the accounting and reporting requirements of the new standard. We will adopt Topic 842 effective January 1, 2019 and expect to elect certain available transitional practical expedients. We are still in the process of determining the effects on our financial statements but do expect to recognize a liability and corresponding asset associated with in-scope operating leases.

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There were no other accounting standards recently issued that had or are expected to have a material impact on our financial position or results of operations.

 

 

Revenue Recognition

Revenue is recognized when control of the promised goods or services is transferred to customers in an amount that reflects the consideration expected to be entitled in exchange for those goods or services. Sales, value added, and other taxes collected concurrently with revenue-producing activities are excluded from revenue.

The following table presents our revenues disaggregated by product line (dollars in millions):

 

 

 

Packaging Revenue

Our containerboard mills produce linerboard and semi-chemical corrugating medium which are papers primarily used in the production of corrugated products. The majority of our containerboard production is used internally by our corrugated products manufacturing facilities. The remaining containerboard is sold to outside domestic and export customers. Our corrugated products manufacturing plants produce a wide variety of corrugated packaging products and retail merchandise displays. We sell corrugated products to national, regional and local accounts, which are broadly diversified across industries and geographic locations.

The Company recognizes revenue for its packaging products when performance obligations under the terms of a contract with a customer are satisfied. This occurs with the transfer of control of our products at a specific point in time. Based on our express terms and conditions of the sale of products to our customers, as well as terms included in contractual arrangements with our customers, we do not have an enforceable right of payment that includes a reasonable profit throughout the duration of the contract for products that do not have an alternative use. Revenue is recognized when the product is shipped from the mill or from our manufacturing facility to our customer. Certain customers may receive volume-based incentives, which are accounted for as variable consideration. We estimate these amounts based on the expected amount to be provided to customers and reduce revenue recognized.

Certain customers receive a portion of their packaging products as consigned inventory with billing triggered once the customer uses or consumes the designated product. Prior to invoicing, these amounts are handled as unbilled receivables. Total unbilled receivables, which are immaterial in amount, are included in the accounts receivable financial statement caption.

 

Paper Revenue

We manufacture and sell a range of communication-based papers. Communication papers consist of cut-size office papers, and printing and converting papers. Pressure sensitive papers, including release liners, are used for specialty applications such as consumer and commercial product labels.

The Company recognizes revenue for its paper products when performance obligations under the terms of a contract with a customer are satisfied. This occurs with the transfer of control of our products at a specific point in time. Revenue is recognized when the product is shipped from the mill or from our manufacturing facility or distribution center to our customer. Certain customers may receive volume-based incentives, which are accounted for as variable consideration.  We estimate these amounts based on the expected amount to be provided to customers and reduce revenue recognized.

 

Corporate and Other Revenue

Revenue in this segment primarily relates to Louisiana Timber Procurement Company, L.L.C. (LTP), a variable-interest entity that is 50% owned by PCA and 50% owned by Boise Cascade Company (Boise Cascade). PCA is the primary beneficiary of LTP and has the power to direct the activities that most significantly affect the economic performance of LTP. Therefore, we consolidate 100% of LTP in our financial statements. See Note 17, Transactions With Related Parties, for more information related to LTP.

The Company recognizes revenue within this segment when performance obligations under the terms of a contract with a customer are satisfied. This occurs with the transfer of control of our products at a specific point in time.

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Practical Expedients and Exemption

Shipping and handling fees billed to a customer are recorded on a gross basis in "Net sales" with the corresponding shipping and handling costs included in "Cost of sales" in the concurrent period as the revenue is recorded. We expense sales commissions when incurred because the amortization period is one year or less. Sales commissions are recorded in "Selling, general, and administrative expenses".

We do not disclose the value of unsatisfied performance obligations for contracts with an original expected duration of one year or less.

 

Sacramento Container Acquisition

On October 2, 2017, PCA acquired substantially all of the assets of Sacramento Container Corporation, and 100% of the membership interests of Northern Sheets, LLC and Central California Sheets, LLC (collectively referred to as “Sacramento Container”) for a purchase price of $274 million, including working capital adjustments. Funding for the $274 million purchase price came from available cash on hand. Assets acquired include full-line corrugated products and sheet feeder operations in both McClellan, California and Kingsburg, California. Sacramento Container provides packaging solutions to customers serving portions of California’s strong agricultural market. Sacramento Container’s financial results are included in the Packaging segment from the date of acquisition.

The Company accounted for the Sacramento Container acquisition using the acquisition method of accounting in accordance with ASC 805, Business Combinations. The total purchase price has been allocated to tangible and intangible assets acquired and liabilities assumed based on respective fair values, as follows (dollars in millions):

 

 

During the second quarter ended June 30, 2018, we made a $5.5 million net adjustment based on the final valuation of the intangible assets. We recorded the adjustment as a decrease to other intangible assets with an offset to goodwill.

Goodwill is calculated as the excess of the purchase price over the fair value of the net assets acquired. Among the factors that contributed to the recognition of goodwill were Sacramento Container’s commitment to continuous improvement and regional synergies, as well as the expected increases in PCA’s containerboard integration levels. Goodwill is deductible for tax purposes.

Other intangible assets, primarily customer relationships, were assigned an estimated weighted average useful life of 9.6 years.

Property, plant, and equipment were assigned estimated useful lives ranging from one to 13 years.      

 

The following table sets forth the computation of basic and diluted income per common share for the periods presented (dollars and shares in millions, except per share data):

 

 

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The components of other income (expense), net, were as follows (dollars in millions):

 

 

 

On December 22, 2017, the President signed into law H.R.1 (P.L. 115-97), originally known as the “Tax Cuts and Jobs Act” (the “Tax Act”). The Tax Act significantly revises the U.S. tax code by, among other items, reducing the federal corporate tax rate from 35% to 21%, providing for the full expensing of certain depreciable property, eliminating the corporate alternative minimum tax, limiting the deductibility of interest expense, further limiting the deductibility of certain executive compensation, limiting the use of net operating loss carryforwards created in tax years beginning after December 31, 2017, and implementing a territorial tax system imposing a deemed repatriation transition tax (“Transition Tax”) on earnings of foreign subsidiaries.

 

The SEC staff issued Staff Accounting Bulletin (“SAB”) 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act, which provides guidance on accounting for the effects and includes a measurement period that ends when a company has obtained, prepared, and analyzed the information necessary to finalize its accounting of the Tax Act, which cannot extend beyond one year. In accordance with SAB 118, the Company recorded provisional estimates of the income tax effects of the Tax Act in the 2017 Form 10-K.

 

During the three and nine months ended September 30, 2018, we have recorded an immaterial favorable adjustment for the Transition Tax originally recorded with the measurement period provisional estimates at December 31, 2017. We expect to record our final adjustment for the income tax effects of the Tax Act after the completion and filing of our 2017 federal and state income tax returns during the fourth quarter and before the SAB 118 measurement period ends. We estimate this final adjustment, primarily from favorable timing item differences, to also be immaterial.

 

For the three months ended September 30, 2018 and 2017, we recorded $67.4 million and $77.8 million of income tax expense and had an effective tax rate of 24.6% and 35.9%, respectively. For the nine months ended September 30, 2018 and 2017, we recorded $172.6 million and $204.9 million of income tax expense and had an effective tax rate of 24.4% and 33.9%, respectively. The decrease in our effective tax rate for both the three and nine months ended September 30, 2018 compared with the same periods in 2017 was primarily due to the Tax Act (P.L. 115-97), which included a reduction in the federal tax rate of 14.0% offset by the loss of the Domestic Production Activities Deduction benefit of about 3.2% and a reduction in the federal benefit of state tax deductions of about 0.8%, as well as an internal legal entity consolidation that took place in the third quarter of 2017, partially offset by lower excess tax benefits from employee share-based payment awards under ASU 2016-09 in 2018 compared to the same periods in 2017.

Our effective tax rate may differ from the federal statutory income tax rate of 21.0% due primarily to the effect of state and local income taxes. During the nine months ended September 30, 2018 and 2017, cash paid for taxes, net of refunds received, was $73.2 million and $208.3 million,

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respectively. The decrease in cash tax payments between the periods is due to the lower statutory tax rate and a federal overpayment carryforward from the 2017 tax year into the 2018 tax year as a result of Tax Act related changes.

During the three and nine months ended September 30, 2018, there were no significant changes to our uncertain tax positions. For more information, see Note 6, Income Taxes, of the Notes to Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of our 2017 Annual Report on Form 10-K.

 

We value our raw materials, work in process, and finished goods inventories using lower of cost, as determined by the average cost method, or market. Supplies and materials are valued at the first-in, first-out (FIFO) or average cost methods.

The components of inventories were as follows (dollars in millions):

 

 

The components of property, plant, and equipment were as follows (dollars in millions):

 

 

Depreciation expense for the three months ended September 30, 2018 and 2017 was $89.0 million and $87.0 million, respectively. During the nine months ended September 30, 2018 and 2017, depreciation expense was $275.3 million and $253.0 million, respectively. We recognized $14.0 million of incremental depreciation expense during the nine months ended September 30, 2018 as a result of shortening the useful lives of certain assets related to the Wallula mill restructuring and a corporate administration facility.

At September 30, 2018 and December 31, 2017, purchases of property, plant, and equipment included in accounts payable were $46.2 million and $29.8 million, respectively.

Goodwill

Goodwill represents the excess of the cost of an acquired business over the fair value of the identifiable tangible and intangible assets acquired and liabilities assumed in a business combination. At September 30, 2018 and December 31, 2017 we had $833.5 million and $828.0 million of goodwill recorded in our Packaging segment, respectively. At both September 30, 2018 and December 31, 2017, we had $55.2 million of goodwill recorded in our Paper segment.

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Changes in the carrying amount of our goodwill are as follows (dollars in millions):

 

 

Intangible Assets

Intangible assets are primarily comprised of customer relationships and trademarks and trade names.

The weighted average remaining useful life, gross carrying amount, and accumulated amortization of our intangible assets were as follows (dollars in millions):

 

 

 

During the three months ended September 30, 2018 and 2017, amortization expense was $10.2 million and $8.4 million, respectively. During the nine months ended September 30, 2018 and 2017, amortization expense was $30.7 million and $25.3 million, respectively.

The components of accrued liabilities were as follows (dollars in millions):

 

 

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At September 30, 2018 and December 31, 2017, our long-term debt and interest rates on that debt were as follows (dollars in millions):

 

 

During the nine months ended September 30, 2018, we used cash on hand to repay debt outstanding of $150.0 million under the 6.50% Senior Notes due March 2018. For the nine months ended September 30, 2018 and 2017, cash payments for interest were $58.6 million and $67.2 million, respectively.

Included in interest expense, net and other, are amortization of treasury lock settlements and amortization of financing costs. For the three months ended September 30, 2018 and 2017, amortization of treasury lock settlements was $1.3 million and $1.4 million, respectively, and for the nine months ended September 30, 2018 and 2017, amortization of treasury locks was $4.0 million and $4.2 million, respectively. For the three months ended September 30, 2018 and 2017, amortization of financing costs was $0.7 million and $0.5 million, respectively, and during the nine months ended September 30, 2018 and 2017, amortization of financing costs was $2.0 million and $1.5 million, respectively.

At September 30, 2018, we had $2,496.2 million of fixed-rate senior notes outstanding. The fair value of our fixed-rate debt was estimated to be $2,478.0 million. The difference between the book value and fair value is due to the difference between the period-end market interest rate and the stated rate of our fixed-rate debt. We estimated the fair value of our fixed-rate debt using quoted market prices (Level 2 inputs) within the fair value hierarchy, which is further defined in Note 2, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of our 2017 Annual Report on Form 10-K.

For more information on our long-term debt and interest rates on that debt, see Note 9, Debt, of the Notes to Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of our 2017 Annual Report on Form 10-K.

The components of net periodic benefit cost for our pension plans were as follows (dollars in millions):

 

 

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PCA makes pension plan contributions that are sufficient to fund its actuarially determined costs, generally equal to the minimum amounts required by the Employee Retirement Income Security Act (ERISA). From time to time, PCA may make additional discretionary contributions based on the funded status of the plans, tax deductibility, income from operations, and other factors. During the three and nine months ended September 30, 2018 and 2017, payments to our nonqualified pension plans were insignificant. For the three and nine months ended September 30, 2018, we made contributions of $18.0 million and $21.2 million, respectively, to our qualified pension plans, which exceeded our 2018 minimum pension contributions of $4.6 million. We made contributions of $36.2 million and $42.1 million to our qualified plans during the three and nine months ended September 30, 2017, respectively.

The components of net periodic benefit cost for our postretirement plans were as follows (dollars in millions):

 

 

The Company has a long-term equity incentive plan, which allows for grants of restricted stock, performance awards, stock appreciation rights, and stock options to directors, officers, and employees, as well as others who engage in services for PCA. The plan, as amended, terminates May 1, 2023 and authorizes 10.6 million shares of common stock for grant over the life of the plan. As of September 30, 2018, 0.7 million shares were available for future grants under the plan. Forfeitures are added back to the pool of shares of common stock available to be granted at a future date.

The following table presents restricted stock and performance unit award activity for the nine months ended September 30, 2018:

 

 

Compensation Expense

Our share-based compensation expense is recorded in "Selling, general, and administrative expenses." Compensation expense for share-based awards recognized in the Consolidated Statements of Income, net of forfeitures, was as follows (dollars in millions):

 

 

The fair value of restricted stock is determined based on the closing price of the Company’s stock on the grant date. Compensation expense, net of estimated forfeitures, is recorded over the requisite service period. As PCA’s Board of Directors has the ability to accelerate the vesting of these awards upon an employee’s retirement, the Company accelerates the recognition of compensation expense for certain employees approaching normal retirement age.

Performance unit awards are earned based on the achievement of defined performance rankings of Return on Invested Capital (ROIC) or Total Shareholder Return (TSR) compared to ROIC and TSR for peer companies. For performance unit awards made in 2018, 50% used TSR as the

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performance measure and 50% used ROIC as the performance measure. All units awarded before 2018 used ROIC as the performance measure. The ROIC component of performance unit awards are valued based on the closing price of the stock on the grant date. As the ROIC component contains a performance condition, compensation expense, net of estimated forfeitures, is recorded over the requisite service period based on the most probable number of awards expected to vest. The TSR component of performance unit awards is valued using a Monte Carlo simulation as the TSR component contains a market condition. The Monte Carlo simulation estimates the fair value of the TSR component based on the expected term of the award, a risk-free interest rate, expected dividends, and expected volatility of the Company’s common stock and the common stock of the peer companies. Compensation expense is recorded ratably over the expected term of the award.

The unrecognized compensation expense for all share-based awards at September 30, 2018 was as follows (dollars in millions):

 

 

Dividends

During the nine months ended September 30, 2018, we paid $193.4 million of dividends to shareholders. On May 15, 2018, PCA announced an increase of its quarterly cash dividend on its common stock from an annual payout of $2.52 per share to $3.16 per share. On August 30, 2018, PCA’s Board of Directors declared a regular quarterly cash dividend of $0.79 per share of common stock, which was paid on October 15, 2018 to shareholders of record as of September 14, 2018. The dividend payment was $74.7 million.

Repurchases of Common Stock

On February 25, 2016, PCA announced that its Board of Directors authorized the repurchase of $200.0 million of the Company’s outstanding common stock. Repurchases may be made from time to time in open market or privately negotiated transactions in accordance with applicable securities regulations. The timing and amount of repurchases will be determined by the Company in its discretion based on factors such as PCA’s stock price and market and business conditions.

The Company did not repurchase any shares of its common stock under this authority during the three and nine months ended September 30, 2018. At September 30, 2018, $193.0 million of the authorized amount remained available for repurchase of the Company’s common stock.

Accumulated Other Comprehensive Income (Loss)

Changes in accumulated other comprehensive income (loss) (AOCI) by component were as follows (dollars in millions). Amounts in parentheses indicate losses:

 

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Reclassifications out of AOCI were as follows (dollars in millions). Amounts in parentheses indicate expenses in the Consolidated Statements of Income:

 

 

Our Paper segment has a long-standing commercial and contractual relationship with Office Depot, our largest customer in the paper business. This relationship exposes us to a significant concentration of business and financial risk. Our sales to Office Depot represent approximately 7% of our total Company sales revenue for both the nine month periods ended September 30, 2018 and 2017 and approximately 46% and 42% of our Paper segment sales revenue for both of those periods, respectively. At September 30, 2018 and December 31, 2017, we had $73.5 million and $33.3 million of accounts receivable due from Office Depot, which represents 7% and 4% of our total Company accounts receivable for both of those periods, respectively. The increase in accounts receivable corresponds to a negotiated extension of credit terms effective during the first quarter of 2018.

For full year 2017, sales to Office Depot represented 43% of our Paper segment sales. If these sales are reduced, we would need to find new customers. We may not be able to fully replace any lost sales, and any new sales may be at lower prices or higher costs. Any significant deterioration in the financial condition of Office Depot affecting its ability to pay or any other change that affects its willingness to purchase our products will harm our business and results of operations.

Louisiana Timber Procurement Company, L.L.C. (LTP) is a variable-interest entity that is 50% owned by PCA and 50% owned by Boise Cascade Company (Boise Cascade). LTP procures sawtimber, pulpwood, residual chips, and other residual wood fiber to meet the wood and fiber requirements of PCA and Boise Cascade in Louisiana. PCA is the primary beneficiary of LTP and has the power to direct the activities that most significantly affect the economic performance of LTP. Therefore, we consolidate 100% of LTP in our financial statements in our Corporate and Other segment. The carrying amounts of LTP's assets and liabilities (which relate primarily to non-inventory working capital items) on our Consolidated Balance Sheets were $3.5 million at September 30, 2018 and $3.0 million at December 31, 2017. During the three months ended September 30, 2018 and 2017, we recorded $22.4 million and $20.8 million, respectively, and during the nine months ended September 30, 2018 and 2017 we recorded $65.5 million and $66.0 million, respectively, of LTP sales to Boise Cascade in "Net Sales" in the Consolidated Statements of Income and approximately the same amount of expenses in "Cost of Sales".

During the three months ended September 30, 2018 and 2017, fiber purchases from related parties were $4.1 million and $4.0 million, respectively. Fiber purchases from related parties were $12.8 million and $13.6 million, respectively, during the nine months ended September 30, 2018 and 2017. Most of these purchases related to chip and log purchases by LTP from Boise Cascade's wood products business. These purchases are recorded in "Cost of Sales" in the Consolidated Statements of Income.

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We report our business in three reportable segments: Packaging, Paper, and Corporate and Other. These segments represent distinct businesses that are managed separately because of differing products and services. Each of these businesses requires distinct operating and marketing strategies.

During the second quarter of 2018, the Company discontinued the production of uncoated free sheet and coated one-side grades at the Wallula, Washington mill and converted the No. 3 machine to a virgin kraft linerboard machine. Subsequent to the date of conversion in May 2018, operating results for the Wallula mill are primarily included in the Packaging segment.

Each segment’s profits and losses are measured on operating profits before interest expense, net and income taxes. For certain allocated expenses, the related assets and liabilities remain in the Corporate and Other segment.

Selected financial information by reportable segment was as follows (dollars in millions):

 

 

 

 

 

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The components of our financial statements affected by the change in presentation of operating and non-operating pension expense as originally reported in 2017 and as adjusted for the requirements per the new standard are as follows (dollars in millions):

 

 

 

 

 

 

 

 

 

 

 

 

We have financial commitments and obligations that arise in the ordinary course of our business. These include long-term debt, capital commitments, lease obligations, and purchase commitments for goods and services, and legal proceedings, all of which are discussed in Note 9, Debt, and Note 18, Commitments, Guarantees, Indemnifications, and Legal Proceedings, of the Notes to Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of our 2017 Annual Report on Form 10-K.

Guarantees and Indemnifications

We provide guarantees, indemnifications, and other assurances to third parties in the normal course of our business. These include tort indemnifications, product guarantees, environmental assurances, and representations and warranties in commercial agreements. At September 30, 2018, we are not aware of any material liabilities arising from any guarantee, indemnification, or financial assurance we have provided. If we determined such a liability was probable and subject to reasonable determination, we would accrue for it at that time.

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DeRidder Mill Incident

On February 8, 2017, a tank located in the pulp mill at the Company's DeRidder, Louisiana facility exploded, resulting in three contractor fatalities and other injuries. The Company has been served with multiple lawsuits involving the decedents and other allegedly injured parties, alleging negligence on the part of the Company and claiming compensatory and punitive damages. The Company is vigorously defending these lawsuits. The Company believes that these suits are covered by its liability insurance policies, subject to an aggregate $1.0 million deductible. The incident remains under investigation and all lawsuits are in the early stages. Accordingly, the Company is unable to estimate a range of reasonable possible losses at this time.

The Company has also incurred property damage and business interruption losses and has claimed these losses, subject to a $5.0 million deductible, under its property damage and business interruption insurance policy. As of December 31, 2017, the Company finalized the claim with the insurance carrier and received $17.0 million in insurance proceeds during the first quarter of 2018. The insurance proceeds are included in net cash provided by operating activities ($14.5 million) and in net cash used for investing activities ($2.5 million) based on the nature of the reimbursement.

The Company has cooperated with investigations from the U.S. Occupational Health and Safety Administration (OSHA), the U.S. Chemical Safety Board (CSB) and the U.S. Environmental Protection Agency (EPA). The U.S. Chemical Safety Board completed its investigation and issued its report during the second quarter of 2018. The Company settled with OSHA during the second quarter of 2018 and paid approximately $40,000 in penalties for citations. The EPA investigation is ongoing.

Legal Proceedings

We are also a party to various legal actions arising in the ordinary course of our business. These legal actions include commercial liability claims, premises liability claims, and employment-related claims, among others. As of the date of this filing, we believe it is not reasonably possible that any of the legal actions against us will, either individually or in the aggregate, have a material adverse effect on our financial condition, results of operations, or cash flows.

 

This management’s discussion and analysis includes statements regarding our expectations with respect to our future performance, expected business conditions, liquidity, and capital resources. Such statements, along with any other statements that are not historical in nature, are forward-looking. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in our 2017 Annual Report on Form 10-K, as well as those factors listed in other documents we file with the Securities and Exchange Commission (SEC). We do not assume any obligation to update any forward-looking statement. Our actual results may differ materially from those contained in or implied by any of the forward-looking statements in this Form 10-Q. Please see “Forward Looking Statements” elsewhere in this Item 2.

Overview

PCA is the third largest producer of containerboard products and the third largest producer of uncoated freesheet paper in North America. We operate six containerboard mills, two paper mills, and 95 corrugated products manufacturing plants. Our containerboard mills produce linerboard and corrugating medium, which are papers primarily used in the production of corrugated products. Our corrugated products manufacturing plants produce a wide variety of corrugated packaging products, including conventional shipping containers used to protect and transport manufactured goods, multi-color boxes and displays with strong visual appeal that help to merchandise the packaged product in retail locations, and honeycomb protective packaging. In addition, we are a large producer of packaging for meat, fresh fruit and vegetables, processed food, beverages, and other industrial and consumer products. We also manufacture and sell white papers, including both commodity and specialty papers, which may have custom or specialized features such as colors, coatings, high brightness, and recycled content. We are headquartered in Lake Forest, Illinois and operate primarily in the United States.

This Item 2 is intended to supplement, and should be read in conjunction with, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our 2017 Annual Report on Form 10-K.

Executive Summary

Third quarter net sales were $1.81 billion in 2018 and $1.64 billion in 2017. We reported $207 million of net income, or $2.18 per diluted share, during the third quarter of 2018, compared to $139 million, or $1.47 per diluted share, during the same period in 2017. Net income included $4 million of expense for special items (discussed below) in the third quarter of 2018, compared to $20 million in 2017. Excluding special items, net income was $211 million, or $2.23 per diluted share, during the third quarter of 2018, compared to $159 million, or $1.68 per diluted share, in the third quarter of 2017. The increase was driven primarily by higher prices and mix and volumes in our Packaging segment, higher prices and mix in our Paper segment, lower wood and recycled fiber costs, and a favorable tax rate resulting primarily from changes resulting from the Tax Act. These items were partially offset by lower volumes in our Paper segment, higher operating and converting costs, higher freight and logistics expenses, higher annual outage costs, and higher depreciation and other costs. For additional detail on special items included in reported GAAP results, see “Item 2. Reconciliations of Non-GAAP Financial Measures to Reported Amounts.”

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Packaging segment income from operations was $284 million in the third quarter of 2018, compared to $263 million in the third quarter of 2017. Packaging segment earnings before interest, taxes, depreciation, amortization, and depletion (EBITDA) excluding special items was $378 million in the third quarter of 2018 compared to $343 million in the third quarter of 2017. The increase in EBITDA excluding special items was due to higher containerboard and corrugated products prices and mix and sales and production volumes driven by strong demand, and lower wood and recycled fiber costs, partially offset by higher operating and converting costs, higher freight and logistics expenses, higher annual outage expenses, and other fixed costs.

Paper segment income from operations was $32 million in the third quarter of 2018, compared to a loss of $3 million in the third quarter of 2017. Paper segment EBITDA excluding special items was $44 million in the third quarter of 2018, compared to $38 million in the third quarter of 2017. The increase in EBITDA excluding special items was due to higher prices and mix and lower operating costs, partially offset by lower volume and higher freight and logistics expenses.

During the first nine months of 2018 we reported $533 million of net income, or $5.64 per diluted share, compared to $400 million of net income, or $4.23 per diluted share, during the same period in 2017. Net income included $22 million of expense for special items (discussed below), in 2018 and 2017. Excluding special items, net income was $555 million, or $5.87 per diluted share, during the first nine months of 2018, compared to $422 million of net income, or $4.47 per diluted share, in the first nine months of 2017. The increase was driven primarily by higher containerboard and corrugated products prices and mix and higher sales and production volumes, higher Paper segment prices and mix, lower wood and recycled fiber costs, and lower taxes, partially offset by higher operating and converting costs, higher freight and logistics expense, higher annual outage expense, and higher depreciation and other costs.

Packaging segment income from operations was $782 million in the first nine months of 2018, compared to $682 million in the same period in 2017. Packaging segment EBITDA excluding special items was $1.05 billion in the first nine months of 2018, compared to $922 million in the first nine months of 2017. The increase in EBITDA excluding special items was driven primarily by higher containerboard and corrugated products prices and mix and sales and production volumes, and lower wood and recycled fiber costs, partially offset by higher operating and converting costs, higher freight and logistics expense, and higher annual outages, and other costs.

Paper segment income from operations was $56 million in the first nine months of 2018, compared to $53 million in the first nine months of 2017. Paper segment EBITDA excluding special items was $113 million in the first nine months of 2018, compared to $121 million in the same period in 2017. The decrease in EBITDA excluding special items was due primarily to lower volumes, higher freight and logistics expense, and higher wood and recycled fiber costs, partially offset by higher prices and mix, lower input and operating costs, and lower annual outage expense.

During the second quarter of 2018, the Company ceased production of white papers on the No. 3 paper machine at the Wallula Mill and began producing virgin kraft linerboard on the machine. The Company will take an extended outage on the machine to complete the conversion in the fourth quarter of 2018. The Company incurred charges in the Paper and Packaging segments relating to these activities during the third quarter of 2018 as described below under “Special Items and Earnings per Diluted Share, Excluding Special Items,” and will incur future charges.

Special Items and Earnings per Diluted Share, Excluding Special Items

A reconciliation of reported earnings per diluted share to earnings per share, excluding special items, for the three and nine months ended September 30, 2018 and 2017 are as follows:

 

 

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Included in this Item 2 are various non-GAAP financial measures, including diluted EPS excluding special items, segment income excluding special items and EBITDA excluding special items. Management excludes special items as it believes these items are not necessarily reflective of the ongoing results of operations of our business. We present these measures because they provide a means to evaluate the performance of our segments and our Company on an ongoing basis using the same measures that are used by our management, because these measures assist in providing a meaningful comparison between periods presented and because these measures are frequently used by investors and other interested parties in the evaluation of companies and the performance of their segments. A reconciliation of diluted EPS to diluted EPS excluding special items is included above and the reconciliations of other non-GAAP measures used in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, to the most comparable measure reported in accordance with GAAP, are included in Item 2 under “Reconciliations of Non-GAAP Financial Measures to Reported Amounts.” Any analysis of non-GAAP financial measures should be done in conjunction with results presented in accordance with GAAP. The non-GAAP measures are not intended to be substitutes for GAAP financial measures and should not be used as such.

Industry and Business Conditions

Trade publications reported North American industry-wide corrugated products shipments with one additional working day increased 1.4%, and shipments per day were flat, during the third quarter of 2018 compared to the same quarter of 2017. Reported industry containerboard production increased 3.7% compared to the third quarter of 2017. Reported industry containerboard inventories at the end of the third quarter of 2018 were approximately 2.6 million tons, up 8.7% compared to the same period in 2017 and weeks of supply was 3.9. Reported containerboard export shipments were up 11.6% compared to the third quarter of 2017. Trade publications reported no price change on domestic linerboard and corrugating medium during the third quarter of 2018.

The market for communication papers competes heavily with electronic data transmission and document storage alternatives. Increasing shifts to these alternatives have reduced usage of traditional print media and communication papers. Trade publications reported North American uncoated freesheet paper shipments were down 8.2% in the third quarter of 2018, compared to the same quarter of 2017. Average prices reported by a trade publication for cut size office papers were higher by $107 per ton, or 11.2%, in the third quarter of 2018, compared to the third quarter of 2017.

Outlook

Looking ahead to the fourth quarter of 2018, we expect Packaging segment demand to remain strong although there will be two less shipping days, and we expect a seasonally less rich mix in corrugated products, compared to the third quarter. In our Paper segment, we will continue implementing price increases that we recently communicated to customers, but expect a seasonally less rich mix. Although paper volumes will be seasonally lower, we expect demand to remain strong as we manage our already tight inventory levels. With seasonally colder weather, fuel costs are expected to be higher across the company, and we expect continued inflation in most of our operating and converting costs, including incremental wage pressure with a tighter labor market. We will also have an extended outage at our Wallula Mill to complete the remaining work related to the conversion of the No. 3 machine from paper to linerboard. Considering these items, we expect fourth quarter earnings, excluding special items to be lower than third quarter 2018.

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Results of Operations

Three Months Ended September 30, 2018, compared to Three Months Ended September 30, 2017

The historical results of operations of PCA for the three months ended September 30, 2018 and 2017 are set forth below (dollars in millions):

 

 

Net Sales

Net sales increased $170 million, or 10.4%, to $1,810 million during the three months ended September 30, 2018, compared to $1,640 million during the same period in 2017.

Packaging. Net sales increased $188 million, or 14.0%, to $1,535 million, compared to $1,347 million in the third quarter of 2017 due to increased containerboard and corrugated products volume ($129 million) and higher domestic and export containerboard and corrugated products prices and mix ($59 million). In the third quarter of 2018, our domestic containerboard prices increased 6.1%, and export prices increased 15.3%, compared to the same period in 2017. In the third quarter of 2018, containerboard outside shipments increased 11.4%, and total corrugated products shipments were up 8.2%, compared to the third quarter of 2017.

Paper. Net sales during the three months ended September 30, 2018 decreased $17 million, or 6.3%, to $254 million, compared to $271 million in the third quarter of 2017, due to decreased volume ($36 million), partially offset by favorable changes in prices and mix ($19 million).

Gross Profit

Gross profit increased $46 million during the three months ended September 30, 2018, compared to the same period in 2017. The increase was driven primarily by higher containerboard and corrugated products prices and mix and sales and production volumes and lower wood and recycled fiber costs, partially offset by lower volumes in our Paper segment and higher operating and converting costs. In the three months ended September 30, 2018 and 2017, gross profit included special items of $0.3 million and $3 million, respectively, of Wallula Mill restructuring charges.

Selling, General, and Administrative Expenses

Selling, general, and administrative expenses (“SG&A”) increased $5 million during the three months ended September 30, 2018, compared to the same period in 2017. The increase was primarily due to employee salaries and fringes ($5 million), the Sacramento Container acquisition ($3 million), and various other administrative expenses individually insignificant ($3 million). These increases were partially offset by certain expenses

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that were previously recorded in SG&A for the third quarter of 2017 which are now recorded in cost of sales for the third quarter 2018 ($6 million). Effective January 1, 2018, the Company adopted ASU 2014-09 (Topic 606): Revenue from Contracts with Customers using the modified retrospective method. The new standard provides additional clarity concerning contract fulfillment costs, which resulted in certain costs being classified as cost of sales rather than SG&A for 2018.

Other Income (Expense), Net

Other income (expense), net, for the three months ended September 30, 2018 and 2017 are set forth below (dollars in millions):

 

 

We discuss these items in more detail in Note 6, Other Income (Expense), Net of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in “Part I, Item1. Financial Statements” of this Form 10-Q.

Income from Operations

Income from operations increased $56 million, or 23.0%, during the three months ended September 30, 2018, compared to the same period in 2017. The third quarter of 2018 included $6 million of expense for special items primarily related to Wallula Mill restructuring. Third quarter 2017 included expense from special items of $25 million of charges related to the Wallula Mill restructuring and $2 million of closure costs related to corrugated products facilities and a paper administration facility and integration costs related to the TimBar Corporation and Columbus Container, Inc. acquisitions.  

Packaging. Packaging segment income from operations increased $21 million to $284 million, compared to $263 million during the three months ended September 30, 2017. The increase related primarily to higher containerboard and corrugated products prices and mix ($56 million), higher containerboard and corrugated products sales and production volumes ($51 million), and lower wood and recycled fiber costs ($7 million), partially offset by higher operating and converting costs ($60 million), higher freight expense ($7 million), higher annual outage expense ($7 million), higher depreciation expense ($6 million), a partial insurance recovery related to the DeRidder Mill incident in 2017 ($3 million), fixed asset disposals ($2 million) and other expenses ($2 million). Special items during the third quarter of 2018 included $6 million of Wallula Mill restructuring and corrugated facility closure charges. Special items for the third quarter 2017 included expense of $1 million related to closure costs for corrugated products facilities and integration costs related to the TimBar Corporation and Columbus Container, Inc. acquisitions.  

Paper. Paper segment income from operations increased $35 million to $32 million, compared to a loss of $3 million during the three months ended September 30, 2017. The increase primarily related to higher prices and mix ($19 million) and lower operating costs ($13 million), partially offset by lower sales and production volumes ($21 million) and higher freight expense ($4 million). Special items during the third quarter of 2018 included $1 million of Wallula Mill restructuring charges. Special items for the third quarter 2017 included $26 million of Wallula Mill restructuring charges and facilities closures.  

Interest Expense and Income Taxes

Interest expense, net, and other decreased $1 million during the three months ended September 30, 2018, compared to the same period in 2017. The decrease in interest expense was primarily due to no term loan interest as these were repaid in December 2017 and no interest on the Company’s 6.50% Senior Notes as these were repaid in March 2018, partially offset by the interest on the new notes related to the December 2017 refinancing.  

 

During the three months ended September 30, 2018, we recorded $67 million of income tax expense, compared to $78 million of expense during the three months ended September 30, 2017. The effective tax rate for the three months ended September 30, 2018 and 2017 was 24.6% and 35.9%, respectively. The decrease in our effective tax rate was primarily due to federal tax reform as a result of the Tax Act, which the President signed into law on December 22, 2017, as well as an internal legal entity consolidation that took place during the three months ended September 30, 2017.

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Nine Months Ended September 30, 2018, compared to Nine Months Ended September 30, 2017

The historical results of operations of PCA for the nine months ended September 30, 2018 and 2017 are set forth below (dollars in millions):

 

 

Net Sales

Net sales increased $507 million, or 10.7%, to $5,268 million during the nine months ended September 30, 2018, compared to $4,761 million during the same period in 2017.

Packaging. Net sales increased $519 million, or 13.3%, to $4,434 million, compared to $3,915 million in the nine months ended September 30, 2017, due to increased containerboard and corrugated products volume ($324 million) and higher domestic and export containerboard and corrugated products prices and mix ($195 million). Our domestic containerboard prices in the first nine months of 2018 increased 6.7%, and export prices increased 20.8%, compared to the same period in 2017. In the first nine months of 2018, containerboard outside shipments increased 13.7%, and total corrugated products shipments were up 7.5%, compared to the same period in 2017. Prices reported by trade publications increased by $50 per ton for linerboard and corrugating medium during March 2018.

Paper. Net sales during the nine months ended September 30, 2018 decreased $9 million, or 1.2%, to $775 million, compared to $784 million in the nine months ended September 30, 2017, due to decreased volume ($30 million), partially offset by higher prices and mix ($21 million).

Gross Profit

Gross profit increased $121 million during the nine months ended September 30, 2018, compared to the same period in 2017. The increase was driven primarily by higher containerboard and corrugated products prices and mix and sales and production volumes, higher Paper segment prices and mix, and lower costs for wood and recycled fiber, partially offset by higher operating costs and higher annual outage expense. In the nine months ended September 30, 2018 and 2017, gross profit included special items of $14 million and $3 million, respectively, related to Wallula Mill restructuring.

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Selling, General, and Administrative Expenses

Selling, general, and administrative expenses (“SG&A”) increased $20 million during the nine months ended September 30, 2018, compared to the same period in 2017. The increase was primarily due to employee salaries and fringes ($15 million), the Sacramento Container acquisition ($8 million), outside professional services ($6 million), and various other administrative expenses individually insignificant ($9 million). These increases were partially offset by certain expenses that were previously recorded in SG&A in 2017 which are now recorded in cost of sales for 2018 ($18 million). Effective January 1, 2018, the Company adopted ASU 2014-09 (Topic 606): Revenue from Contracts with Customers using the modified retrospective method. The new standard provides additional clarity concerning contract fulfillment costs, which resulted in certain costs being classified as cost of sales rather than SG&A for 2018.

Other Income (Expense), Net

Other income (expense), net, for the nine months ended September 30, 2018 and 2017 are set forth below (dollars in millions):

 

 

We discuss these items in more detail in Note 6, Other Income (Expense), Net of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in “Part I, Item1. Financial Statements” of this Form 10-Q.

Income from Operations

Income from operations increased $101 million, or 14.8%, during the nine months ended September 30, 2018, compared to the same period in 2017. The first nine months of 2018 included $29 million of expense for special items, primarily related to the Wallula Mill restructuring. The nine months ended September 30, 2017 included $25 million of charges related to the Wallula Mill restructuring; $5 million for the property damage and business interruption insurance deductible related to the DeRidder Mill incident; $3 million of charges consisting of closure costs related to corrugated products facilities and a paper administration facility, integration costs related to the TimBar Corporation and Columbus Container Inc. acquisitions, and costs related to a lump sum settlement payment for a multiemployer pension plan withdrawal liability; and $2 million of income related to a working capital adjustment from the April 2015 sale of our Hexacomb corrugated manufacturing operations in Europe and Mexico.    

Packaging. Packaging segment income from operations increased $101 million to $782 million during the first nine months of 2018 compared to the same period last year. The increase related primarily to higher containerboard and corrugated products prices and mix ($176 million), higher containerboard and corrugated products sales and production volumes ($116 million), and lower wood and recycled fiber costs ($28 million), partially offset by higher operating and converting costs ($119 million), higher annual outage expense ($31 million), higher freight expense ($22 million), higher depreciation expense ($12 million), Wallula No. 3 paper machine conversion-related costs ($5 million), an insurance recovery received in 2017 related to the DeRidder incident ($3 million), and other expenses primarily related to the disposal and transfer of fixed assets ($8 million). Special items in the Packaging segment in the first nine months of 2018 included $9 million of Wallula Mill restructuring charges and $2 million of closure costs related to corrugated products facilities and other costs. The nine months of 2017 included $5 million for the property damage and business interruption insurance deductible related to the DeRidder Mill incident; $3 million of charges consisting of closure costs related to corrugated products facilities, integration costs related to the TimBar Corporation and Columbus Container Inc. acquisitions, and costs related to a lump sum settlement payment for a multiemployer pension plan withdrawal liability; and $2 million of income related to a working capital adjustment from the April 2015 sale of our Hexacomb corrugated manufacturing operations in Europe and Mexico.

Paper. Paper segment income from operations increased $3 million to $56 million, compared to the nine months ended September 30, 2017. The increase primarily related to higher prices and mix ($21 million), lower operating costs ($7 million) and lower annual outage expenses ($6 million), partially offset by lower sales and production volumes ($18 million), higher freight expense ($11 million), and higher wood and recycled fiber costs ($10 million). Special items in the first nine months of 2018 included $18 million of Wallula Mill restructuring charges. Special items for the same period in 2017 included $25 million of Wallula Mill restructuring charges.  

Interest Expense and Income Taxes

Interest expense, net, and other was $75 million during the nine months ended September 30, 2018, compared to $76 million during the nine months ended September 30, 2017. The decrease in interest expense was primarily due to no term loan interest as these were repaid in December

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2017 and lower interest on the Company’s 6.50% Senior Notes as these were repaid in March 2018, partially offset by interest on the new notes related to the December 2017 refinancing.

During the nine months ended September 30, 2018, we recorded $173 million of income tax expense, compared to $205 million of expense during the nine months ended September 30, 2017. The effective tax rate for the nine months ended September 30, 2018 and 2017 was 24.4% and 33.9%, respectively. The decrease in our effective tax rate was primarily due to the Tax Act as well as an internal legal entity consolidation that took place during the nine months ended September 30, 2017, partially offset by lower excess tax benefits from employee share-based payment awards under ASU 2016-09 in 2018 compared with the same period in 2017.

Liquidity and Capital Resources

Sources and Uses of Cash

Our primary sources of liquidity are net cash provided by operating activities and available borrowing capacity under our revolving credit facility. At September 30, 2018, we had $294 million of cash and $327 million of unused borrowing capacity under the revolving credit facility, net of letters of credit. Currently, our primary uses of cash are for operations, capital expenditures, acquisitions, debt service, repurchases of common stock, and declared common stock dividends. We believe that net cash generated from operating activities, cash on hand, available borrowings under our revolving credit facility, and available capital through access to capital markets will be adequate to meet our liquidity and capital requirements, including payments of any declared common stock dividends, for the foreseeable future. As our debt or credit facilities become due, we will need to repay, extend, or replace such facilities. Our ability to do so will be subject to future economic conditions and financial, business, and other factors, many of which are beyond our control.

Below is a summary table of our cash flows, followed by a discussion of our sources and uses of cash through operating activities, investing activities, and financing activities (dollars in millions):

 

 

Operating Activities

Our operating cash flow is primarily driven by our earnings and changes in operating assets and liabilities, such as accounts receivable, inventories, accounts payable and other accrued liabilities, as well as factors described below. 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.  

During the nine months ended September 30, 2018, net cash provided by operating activities was $835 million, compared to $583 million in the same period in 2017, an increase of $252 million. Cash from operations excluding changes in cash used for operating assets and liabilities increased $205 million, primarily due to higher income from operations as discussed above and lower pension contributions. Cash increased by $47 million due to changes in operating assets and liabilities. The increase was primarily due to the following: (a) a reduction in taxes paid in 2018 as a result of Federal Tax Reform, (b) an increase in accrued liabilities due to timing of interest payments associated with the new notes issued in December 2017, and (c) the receipt of the DeRidder insurance proceeds in the first quarter of 2018. These changes were partially offset by an increase in inventories in the Packaging segment in anticipation of the Wallula Mill extended outage in the fourth quarter of 2018 as well as additional inventory build due to the Sacramento Container acquisition.

Investing Activities

We used $405 million for investing activities during the nine months ended September 30, 2018 compared to $228 million during the same period in 2017. We spent $404 million for internal capital investments, including the Wallula No. 3 paper machine conversion to kraft linerboard, during the nine months ended September 30, 2018, compared to $226 million during the same period in 2017.

We expect capital investments in 2018 to be between $530 million and $550 million, not including acquisitions. These expenditures could increase or decrease as a result of a number of factors, including our financial results, strategic opportunities, future economic conditions, and our regulatory compliance requirements. We currently estimate capital expenditures to comply with environmental regulations will be about $8 million in 2018. Our estimated environmental expenditures could vary significantly depending upon the enactment of new environmental laws and regulations, including those related to greenhouse gas emissions and industrial boilers. For additional information, see “Environmental Matters” in “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our 2017 Annual Report on Form 10-K.

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Financing Activities

During the nine months ended September 30, 2018, net cash used for financing activities was $352 million, compared to $225 million during the same period in 2017. The increase primarily relates to the $150 million repayment of our 6.5% senior notes that were due March 2018. During the comparable period in 2017, we made $36 million of principal payments on long-term variable rate debt and capital leases.

For more information about our debt, see Note 9, Debt, of the Notes to Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of our 2017 Annual Report on Form 10-K.

Contractual Obligations

There have been no material changes to the contractual obligations table disclosed in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our 2017 Annual Report on Form 10-K.

Reconciliations of Non-GAAP Financial Measures to Reported Amounts

Income from operations excluding special items, net income excluding special items, EBITDA, and EBITDA excluding special items are non-GAAP financial measures. Management excludes special items, as it believes that these items are not necessarily reflective of the ongoing operations of our business. These measures are presented because they provide a means to evaluate the performance of our segments and our Company on an ongoing basis using the same measures that are used by our management, because these measures assist in providing a meaningful comparison between periods and because these measures are frequently used by investors and other interested parties in the evaluation of companies and the performance of their segments. Any analysis of non-GAAP financial measures should be done in conjunction with results presented in accordance with GAAP. The non-GAAP measures are not intended to be substitutes for GAAP financial measures and should not be used as such. Reconciliations of the non-GAAP measures to the most comparable measure reported in accordance with GAAP for the three and nine months ended September 30, 2018 and 2017 follow (dollars in millions):

 

 

 

 

 

 

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The following table reconciles net income to EBITDA and EBITDA excluding special items for the periods indicated (dollars in millions):

 

 

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The following table reconciles segment income (loss) to EBITDA and EBITDA excluding special items for the periods indicated (dollars in millions):

 

 

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. We periodically enter into derivatives to minimize these risks, but not for trading purposes. We were not a party to any derivatives-based arrangements at September 30, 2018. For a discussion of derivatives and hedging activities, see Note 13, Derivative Instruments and Hedging Activities, of the Notes to Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of our 2017 Annual Report on Form 10-K.

At September 30, 2018 interest rates on 100% of PCA’s outstanding debt are fixed.

Off-Balance-Sheet Activities

The Company does not have any off-balance sheet arrangements as of September 30, 2018.

Environmental Matters

There have been no material changes to the disclosure set forth in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Environmental Matters” filed with our 2017 Annual Report on Form 10-K.

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Critical Accounting Policies and Estimates

Management’s discussion and analysis of 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 us 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 business combinations, pensions and other postretirement benefits, goodwill and intangible assets, long-lived asset impairment, environmental liabilities, and income taxes, among others. 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 2017 Annual Report on Form 10-K a discussion of its critical accounting policies and estimates which require management’s most difficult, subjective, or complex judgments used in the preparation of its consolidated financial statements. PCA has not had any changes to these critical accounting estimates during the first nine months of 2018.

New and Recently Adopted Accounting Standards

For a listing of our new and recently adopted accounting standards, see Note 2, New and Recently Adopted Accounting Standards, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in “Part I, Item 1. Financial Statements” of this Form 10-Q.

Forward-Looking Statements

Some of the statements in this Quarterly Report on Form 10-Q, and in particular, statements found in this 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. Forward-looking statements include statements about our expectations regarding our future liquidity, earnings, expenditures, and financial condition. 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:

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. Given 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, 2017.

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

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procedures as of September 30, 2018. 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 September 30, 2018.

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PART II

OTHER INFORMATION

The disclosure set forth under the caption "Legal Proceedings" in Note 19, Commitments, Guarantees, Indemnifications and Legal Proceedings, of the Condensed Notes to Unaudited Quarterly Consolidated Financial Statements in "Part I, Item 1. Financial Statements" of this Form 10-Q is incorporated herein by reference.

There have been no material changes to the risk factors disclosed in "Part I, Item 1A. Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2017.

The following table presents information related to our repurchases of common stock made under repurchase plans authorized by PCA's Board of Directors, and shares withheld to cover taxes on vesting of equity awards, during the three months ended September 30, 2018:

 

 

None.

Not applicable.

None.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

Date: November 7, 2018

 

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