Westrock Co

LSE:0LW9

Earnings Call Transcript 2022-Q2

[Operator]

Good morning and welcome to the WestRock Company Fiscal Q2 2022 Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Rob Quartaro, Senior Vice President of Investor Relations. Please go ahead.

[Robert Quartaro, Senior Vice President of Investor Relations]

Good morning and thank you for joining our second fiscal quarter 2022 earnings call. We issued our press release this morning and posted the accompanying presentation to the Investor Relations section of our website. They can be accessed at ir.westrock.com or via a link on the application you are using to view this webcast. With me on today's call are WestRock's Chief Executive Officer, David Sewell; and our Chief Financial Officer, Alex Pease. Following our prepared comments, we will open the call for a question-and-answer session.

During today's call, we will be making forward-looking statements involving our plans, expectations, estimates and beliefs related to future events. These statements may involve a number of risks and uncertainties that could cause actual results to differ materially from those we discussed during the call. We describe these risks and uncertainties in our filings with the SEC, including our 10-K for the fiscal year ended September 30, 2021. We will also be referencing non-GAAP financial measures during the call. We have provided reconciliations of these non-GAAP measures to the most directly comparable GAAP measures in the appendix of the slide presentation. As mentioned previously, the slide presentation is available on our website.

With that, I'll now turn it over to you, David.

[David Sewell, President & Chief Executive Officer]

Thank you, Rob and thank you all for joining our earnings call today. To begin our call, I'll provide a brief summary of the recent actions we've taken and provide an overview of our fiscal second quarter results. Following that, our CFO, Alex Pease, will provide a deep dive into the quarterly performance for our segments and other critical financial performance. I'll also provide guidance for the fiscal third quarter and the full year. We will then move to Q&A to answer any questions you may have.

Over the past year, we've been making significant progress in our efforts to transform WestRock into the very best paper and packaging company. We have aligned our mills into one organization and updated our operating segments to provide increased transparency and better reflect how we manage our business. We've established a global supply chain organization to reduce costs and drive efficiencies. We've launched the WestRock operating system to standardize reporting and drive greater productivity and we have completed a strategic review of our assets, taking our first step to rationalize our portfolio and drive improved return on invested capital. From a balance sheet and capital allocation perspective, we achieved our initial leverage target last year. At the same time, we have increased our dividend 25% and completed approximately $700 million of share repurchases over the last 12 months. While we already have a lot to be proud of, we are only just beginning.

Turning to Slide 4. Today, we've reported strong results with record second fiscal quarter consolidated adjusted EBITDA and adjusted EPS above the high end of our guidance. I want to take just a minute to thank all of our team members at WestRock for their hard work in helping us achieve this success. Second quarter sales were a record $5.4 billion, up 21% year-over-year. We delivered consolidated adjusted EBITDA of $854 million, up 33% year-over-year and adjusted earnings per share of $1.17, more than double the year ago numbers. We achieved these outstanding results during another quarter of heavy scheduled maintenance and I'm happy to report that our maintenance projects were completed successfully. We have already finished the majority of our planned maintenance for this fiscal year. We continue to see robust demand and strong backlogs across our entire system while also navigating the tight labor market and supply chain disruptions.

As the second quarter progressed, we experienced declines in COVID-related absenteeism and improved production levels at our converting facilities. We exited the quarter with appropriate inventory levels, as we enter the stronger demand season in the back half of the year. We ended the quarter with net leverage of 2.34x while aggressively buying back stock. We have nearly completed the $500 million buyback target that we spoke about last quarter and expect to finish by the end of May. Once completed, we will have repurchased approximately $700 million of our stock over the last 12 months. Today, we also announced that our Board has authorized an additional 25 million shares for repurchase, representing approximately 10% of our outstanding shares. Looking ahead, we will continue to return capital to our shareholders through a sustainable and growing dividend as well as opportunistic share repurchases.

Turning to Slide 5. Our previously published price increases have more than offset unprecedented inflation in fiber, labor, freight, energy and chemicals. We are still implementing containerboard and boxboard price increases and we expect these price realizations to more than offset inflation for the foreseeable future.

On the next slide, as we've previously discussed, we completed a portfolio review and have identified assets that don't meet our return thresholds or align with our strategic priorities. In April, we announced the decision to close our Panama City mill as a first step in this portfolio refinement effort. I am incredibly grateful for our mill employees and their contributions to building our company. We are continuing to support our employees during this difficult transition by offering opportunities at other facilities and providing outplacement assistance. This is never an easy decision. However, given the significant capital investments required to keep the mill operational, we do not see a path to achieving our ROIC targets. We are also strategically reducing our exposure to the fluff pulp market and will direct our resources toward more attractive end markets.

Our Panama City mill provided containerboard capacity of 353,000 tons and pulp capacity of 292,000 tons. We expect to shift some containerboard grades to other mills within our network. As a result of the closure, we expect approximately $450 million of onetime costs, of which approximately 3/4 are noncash. We recognized $355 million of expense in the second quarter and we expect to incur the remainder over the next several years. Going forward, we expect ongoing EBITDA to be negatively impacted by approximately $65 million annually.

Before I turn it over to Alex to discuss the detailed results for the quarter, I wanted to remind you once again about our Investor Day coming up next week. We are looking forward to seeing many of you in New York, where we will outline our long-term strategy and goals. We have a great story to share with you and you will get a chance to hear from many members of our talented management team. As a preview and part of our updated capital allocation strategy, one of our goals will be to reduce our leverage even further with a new net leverage target of 1.75x to 2.25x. We remain committed to prudent balance sheet management and we are maintaining our free cash flow guidance of over $1.3 billion in fiscal 2022.

On Investor Day, we'll also share information about the many efforts underway across WestRock to focus on high-value markets, enhance our margins and improve our productivity.

Now, I'll turn it over to Alex to review our results.

[Alex Pease]

Thanks, David. Moving to our consolidated quarterly results on Slide 7. Second quarter revenue increased 21% to $5.4 billion and consolidated adjusted EBITDA increased 33% to $854 million. Consolidated adjusted EBITDA margin was 15.9%, up 150 basis points year-over-year.

Our diverse portfolio enables us to deliver higher value solutions to our customers, capturing stronger price with enhanced product mix. Price and mix positively contributed over $700 million year-over-year. We also saw an $88 million benefit as last year we were negatively impacted by the ransomware incident and weather. However, continuing inflation headwinds in fiber, labor, freight, energy and chemicals, along with foreign exchange and other challenges, largely offset the benefits.

As David noted, we experienced significant improvement in COVID-related absenteeism, as the quarter progressed but still see continuing risks in logistics and other input costs. We successfully executed significant planned maintenance downtime during the quarter. And looking ahead, we expect significantly less planned downtime through the remainder of the year.

Turning to Slide 8. corrugated Packaging sales were $2.2 billion, an increase of $281 million or 14% year-over-year. Adjusted EBITDA increased $8 million or 2%, though adjusted EBITDA margin declined 180 basis points to 14.7%, as we continue to work through the impact of labor issues that we experienced early in the quarter. Strong pricing and mix contributed $275 million but was offset by $200 million of inflation and an $80 million decline in productivity. Productivity was negatively impacted by heavy mill maintenance and labor challenges during the quarter. We experienced continued inflation in fiber, labor, freight, energy and chemicals during the quarter.

In addition, as mentioned, COVID-related absenteeism negatively impacted converting operations in January and February. However, we experienced significant improvement as the quarter progressed.

Favorable comparisons to last year's weather and ransomware events also benefited adjusted EBITDA by $20 million year-over-year. Per day, North American box shipments were slightly softer year-over-year, mainly due to labor issues early in the quarter. However, as we exited the quarter, our run rate significantly improved and we're currently selling everything we can produce. When looking at our end markets, we're seeing a shift due to reopening as the pandemic eases. Our pure-play e-commerce volumes are softer year-over-year but are being more than offset by expanding omnichannel retail volume. We are also seeing shifting buying patterns with pizza volumes declining as people return to restaurants but growth in areas like bakery.

Geographically, our Brazil business outperformed in a challenging market, producing EBITDA margins over 30% across our combined corrugated and Paper segments. Longer term, we continue to see significant opportunities in Latin America. Overall, demand throughout our corrugated business remains strong and our shipments have been limited by production capacity rather than customer demand. This strength demonstrates the value we provide our customers and our flexibility to serve a diverse range of end markets. We remain optimistic for the remainder of the fiscal year. Our backlogs are healthy and demand is solid. We're also in the early stages of implementing the previously published March containerboard price increase. Productivity has improved and we exited the quarter with March EBITDA margins of approximately 17%. Looking ahead, we remain relentlessly focused on improving our margins as we continue to implement the WestRock operating system.

Turning to the consumer packaging business on Slide 9. Sales increased to $170 million or 16% to $1.25 billion. Adjusted EBITDA increased $42 million or 25% and adjusted EBITDA margin was 16.5%, an increase of 130 basis points year-over-year. Higher volumes added $31 million and strong price and mix contributed $111 million. These volumes more than offset a negative impact of $93 million due to inflation, primarily in freight, energy and labor.

Plastic replacements and other transitions to sustainable packaging provide continued attractive growth opportunities. Our broad portfolio and product innovations enable us to provide unique solutions and help our customers reduce their environmental footprint. Our current run rate for plastic replacements revenue is now exceeding $300 million annually. We are executing well and we continue to implement the previously published price increases across all consumer grades. We have more demand than we can meet with backlogs of six to eight weeks. We saw particular strength in beverage and retail food during the quarter.

Turning to Slide 10. Global Paper revenue increased $407 million or 36% to $1.5 billion. Adjusted EBITDA increased $149 million or 93% and adjusted EBITDA margin increased 600 basis points to 20.1%. It's important to note that this strong margin would have been reported in our corrugated and consumer segments under our prior reporting structure. Our Paper business continues to benefit from previously announced pricing realization and higher volumes, partially offset by energy, freight and other costs.

Price and mix contributed $311 million to adjusted EBITDA, while inflation negatively impacted results by $166 million. Favorable comparisons to last year's second quarter which had the impact of winter weather and ransomware event, also benefited adjusted EBITDA by $63 million year-over-year.

We continue to see strong demand for our paper products in both independent domestic and export markets, though logistics continued to be impacted by ongoing supply chain disruptions. Our Global Paper business is a competitive differentiator, enabling us to strategically balance our production and provide flexibility to quickly adapt to current market trends. We remain optimistic for our Paper business through the remainder of the fiscal year due to our strong backlogs and the realization of previously published price increases.

Next, our Distribution results are on Slide 11. Our Distribution performance was strong with revenue increasing 29% year-over-year to $362 million. Adjusted EBITDA more than doubled to $28 million. Our impressive results were driven by robust demand and strong execution across our distribution network. Results also benefited from fulfillment of a large health care order.

Turning to Slide 12. During the quarter, we generated $213 million in adjusted free cash flow, up significantly from the previous year's levels, as last year was negatively impacted by the ransomware incident. We still expect fiscal year '22 to be a very strong year for cash generation with adjusted free cash flow of more than $1.3 billion for the year, making this year the seventh straight year of adjusted free cash flow above $1 billion. Additionally, though we aggressively repurchased shares in the quarter, our leverage ended the quarter at 2.34x, approaching our new long-term targeted net leverage ratio of 1.75x to 2.25x.

Turning to Slide 13 and our financial guidance for the third quarter. We continue to implement all previously published price increases. We still have approximately 54,000 tons of scheduled downtime across our system in the third quarter. This is due to delays in mill maintenance from earlier in fiscal 2021, along with our originally planned outages. We are early in the process of evaluating our 2023 maintenance schedule and we are considering shifting maintenance forward into fiscal 2022. Our forecast for third quarter consolidated adjusted EBITDA is $930 million to $990 million and adjusted EPS of $1.36 to $1.54. Some assumptions behind our outlook include OCC costs roughly flat quarter-over-quarter, natural gas costs up approximately $2 per MMBTU sequentially, continued inflation in freight and logistics expense and a tax rate between 24% and 26%.

On Slide 14, we're also updating our full year guidance, both tightening the range and raising the low end. We now expect to achieve $3.5 billion to $3.7 billion in consolidated adjusted EBITDA and $4.75 to $5.35 in adjusted EPS during fiscal 2022. Looking forward, given the strength of our differentiated solutions, we're positioned well for sales, earnings and free cash flow growth this year and beyond.

I'll now turn it back to David to conclude before we move to Q&A.

[David Sewell, President & Chief Executive Officer]

Thank you, Alex. Due to the hard work of our teammates, we had an outstanding quarter and we are well positioned for the remainder of the year and beyond. I look forward to meeting many of you next week, as we provide a deep dive into our long-term strategy and goals at our 2022 Investor Day in New York. I am incredibly excited about our future and I can't wait to share our plans with you. Thank you.

And with that, Rob, let's move to Q&A.

[Robert Quartaro, Senior Vice President of Investor Relations]

Thank you, David. Operator, may we take our first question?

[Operator]

[Operator Instructions] Our first question will come from George Staphos with Bank of America.

[George Staphos, Bank of America]

Lots to cover here guys and congratulations on the performance. So I kind of apologize just asking kind of a shorter-term question. But can you talk and provide a little bit more detail on what you're seeing early into the calendar second quarter in terms of box volumes? And for that matter, consumer volumes as well with the backdrop in particular on the corrugated side of volumes in 1Q being a bit soft, obviously, there were a lot of supply chain issues. What are you seeing right now? And then I had a couple of quick follow-ons.

[David Sewell, President & Chief Executive Officer]

George. Thanks for the question. We are still seeing very strong demand. And to break it down between consumer and corrugated, our corrugated demand was very strong throughout the quarter, where we were challenged as Alex mentioned in the earlier comments, was we had significant COVID absenteeism, actually disproportional to the rest of our business for whatever reason and our corrugated converting plants. And so we just did not get the production out that we needed. As the quarter went on and we saw that COVID absenteeism reduced, we really started seeing much better production rates to meet the demands of our customers. And as mentioned, we had a record run rate of the year in March. We saw the better productivity. The WestRock operating systems was able to start generating that productivity. So we saw the box production much improved. We saw our margins much improved, about 17%. And we are seeing that strong demand continue into April.

And on the consumer side, it's the same thing. We are basically in a sold-out environment. That has not changed at all. Our backlogs are strong at six to eight weeks. Our plastics replacement opportunities continue to expand. So we're working very hard on the innovation side. So we feel great about the demand of our business across all of our business segments, including Global Paper and that trend is continuing which is why we took up the midpoint of our year.

[George Staphos, Bank of America]

My other two questions, can you talk directionally about demand and any other factors, nonpricing, obviously related to your assumptions built into your guidance for the paper segment as we look out over the rest of the year, both in terms of domestic third party and export? What are you seeing in those markets? And then I know you might not want to get too far ahead of your Analyst Day next week but can you talk directionally about some of the opportunities that you're seeing in productivity, whether it's in employee bases, SG&A? Any color on that ahead of the conference call -- or excuse me, the Analyst Day would be helpful. And good luck in the quarter.

[David Sewell, President & Chief Executive Officer]

Thanks, George. So to answer your first question on our Global Paper business, this is one of the reasons why we wanted to split this business out from a reporting standpoint just because of how strategic we view this business for our company, our ability to balance our entire portfolio, our ability to flex manufacture to meet the changing market dynamics. And what our global paper business is able to do and I'm going to stop a little short because I'm really excited about our Investor Day and John O'Neal, who runs that Global Paper business is going to talk about our strategy, the segments and how we see the growth moving forward. But just at a higher level, this business allows us to get a global overview the market dynamics. And with the broad portfolio of products that we're able to manufacture and recognizing what our packaging business needs are, that business is able to really take advantage and strategically position us so we maximize value. And we see that continuing to be a differentiator for us moving forward. You'll hear a lot more about that at our Investor Day next week.

And George, I apologize, I can't remember what the second part of your question was.

[George Staphos, Bank of America]

Just some thoughts on what you'll talk about in productivity, opportunities you have. But just are you seeing growth in export or independent channels in the paper business in terms of what you're looking at for the year? Sorry about that.

[David Sewell, President & Chief Executive Officer]

Yes. No, that's my fault. Thanks. So our -- on the Global Paper business, we have seen a significant increase in export. But also, I mean, if you just look at our volumes, we had strong volumes. Our domestic was very strong as well. Central America has been a big growth lever for us. We're seeing nice growth in Europe as well but our domestic business is also seeing growth. So it's really across the board. And as far as productivity, that's a point very close to home for me. We're really starting to get momentum on our productivity programs. We've built our global supply chain. We're now starting to get momentum around that. We've developed the WestRock operating system which we'll talk more about next week which is a really important productivity driver from an operational standpoint as well as commercial standpoint.

And then on key areas like SG&A that you referenced, as we build the shared services and centers of excellence which we've now got established, that's going to allow us to reduce and eliminate the redundancies of having siloed organizations. So you'll continue to see reduction in SG&A as we move forward and we'll give insights in how we see productivity and SG&A and the impact that's going to have on our margins as we move forward.

[Operator]

Our next question will come from Mark Weintraub with Seaport.

[Mark Weintraub, Seaport]

Congrats on a great quarter. And I do apologize. I had a little technical difficulty right at the beginning but I'm pretty sure this wasn't covered. On Slide 5, we can see there's some pretty big differences in the amount of pricing you've gotten in boxboard versus what you've gotten in containerboard to date. Can you provide any thoughts on that? And relatedly, are you seeing or have you seen an ability this cycle to get significantly more pricing into boxes than into containerboard? Has there been more than full pass-through? And maybe talk a little bit about that, if that's the case and whether or not that's a realistic expectation to have for the current March price increase in containerboard as well.

[David Sewell, President & Chief Executive Officer]

So we -- it's an interesting question. We have not seen any material difference. So as we look at our published price increases, we are executing those price increases in totality and where our contracts allows us to maximize. There may be a little bit of a difference in just volumes and how we're seeing that pricing flow through. Obviously, there's some contractual differences between the two businesses as well. But there's no material difference as far as consumer versus corrugated and our ability to get prices. Demand is very strong. Our customers understand the incredible inflationary pressure we're under. And we've just announced in the marketplace, that's been published, it's been higher price increases published for, say, SBS at $400 a ton versus $200 a ton announced price increase -- published price increases in North American containerboard.

[Mark Weintraub, Seaport]

Okay. And one quick follow-up. If -- and I know we talked about this in other contexts. But it strikes me that you guys report on a fiscal year basis, everybody else is on a calendar year basis, given that we've had these price increases in motion and given just -- even just looking at the trajectory of your profits this year, it looks like the second half being a lot better than the first half. Is it fair to think that your first fiscal quarter for next year or the fourth calendar quarter would likely be much stronger than that year ago period? So that if we were to think about where your calendar '22 earnings and cash generation would be, it would be substantially higher than the calendar of the prior year? And is there any way you can -- if it's a fair -- I don't know if you've had a chance to look at it and would be willing to share a perspective on how significant a difference it would be if that is indeed the case.

[David Sewell, President & Chief Executive Officer]

Yes, Mark, thanks for that. We actually talk quite a bit about fiscal year versus calendar year. And I think your assumption is spot on as we think about our setup for 2023 -- in fiscal year 2023 and a very good start to that year. And I'll let Alex speak just a little bit more about that.

[Alex Pease]

Yes. So Mark, maybe the best way to answer your question is to just help you with the trajectory of pricing and the trajectory of inflation because those are going to be the biggest kind of drivers in the model. So as we think about sort of the back half of the year, sequentially we're expecting about $130 million of incremental flow-through from previously published pricing. So that gets you to about $650 million year-over-year. And part of the answer to your prior question was also -- you have to remember, there's about a three to six month lag on containerboard pricing to flow through given the nature of the contracts. And then there's about a six to nine month lag in the consumer business. So you'll see that pricing flow through accelerate, as we get to the back half of the year. So that's the first point.

On pricing which absolutely reinforces what David said, that you'll see incremental pricing as you go from Q4 of our fiscal year to Q4 of the calendar year and setting us up for 2023. On inflation, really, all of the significant inflation we've seen has mitigated quite dramatically, still at elevated rates but mitigated dramatically. So if you think about where we are year-over-year, on OCC, you're going to be up about 50% to $153 a ton. Virgin is going to be up incrementally, call it, 10% year-over-year. Natural gas is up significantly from $3 to about almost $8 where we exit the year. And then freight continues to be up about 10%. So that's where -- what it looks like if you were to look at '21 versus '22. But then, if you were to look at Q2 versus Q4, it's largely flat in almost all of those dimensions with the exception of natural gas which is going to be up about $2 on MMBTU; and then freight which will continue to be up sequentially, call it, 10% or so. So those significant inflationary effects we've been battling from a comparability standpoint over the first half of the year mitigate dramatically over the second half of the year and will continue to mitigate in 2023.

So I think just to put some numbers to what David said, I think we absolutely feel as though we're being set up for continued strength in 2023 from a margin standpoint, even before we take into account the effects of the WestRock operating system and all the productivity measures that David talked about.

[Mark Weintraub, Seaport]

That's super helpful. I'll get to work trying to figure that all out. But one -- the freight, how big is the freight bucket approximately right now?

[Alex Pease]

So freight in rough terms, it's about a $2 billion spend annually.

[Operator]

Our next question will come from Cleve Rueckert with UBS.

[CleveRueckert]

I have a couple. And the first one was, I think, just on the maintenance. You guys mentioned some -- maybe thinking about shifting the maintenance schedule and pulling maintenance forward into 2022. I think you just answered the question but maybe I'll ask it just for clarification. If you're selling everything you can produce right now, why would you pull maintenance forward?

[David Sewell, President & Chief Executive Officer]

So good question, Cleve. We're looking at that right now. And the reason why we're looking at that is we're also anticipating, as Alex said, a very strong first quarter of fiscal '23 which we have a very heavy maintenance potential schedule and a very light Q4 schedule. So we're just trying to balance what's the best thing to do so we can ensure we're servicing our customers the best way possible. We haven't made any final decisions yet but we just wanted to put it on the radar, how we look at it, because we do have such a low maintenance quarter scheduled in Q4 and a much higher one in Q1 fiscal year '23. So we're just looking at it right now.

[Alex Pease]

So let me just add a little bit of color. So if you think about Q1 of this year, we had about 192,000 tons of downtime for Q1 which led to higher absorptions. And that's why you saw the results you did in Q1. And then Q2 was about 158,000 tons of downtime. Q3, that number drops to 57,000 tons and then it drops from there into Q4. So exactly what David mentioned, part of the effort is to more level load the plants so we don't have that significant seasonality effect in the first part of the year. So it's really just an economic decision on how we balance delivering on demand versus managing the downtime that we need to take.

[CleveRueckert]

Okay, that's clear. And I guess -- and just sort of following up on the margin question. You didn't reduce the margin guidance at the high end of the range. There's been, I think, a lot of good discussion over the last couple of minutes about margin improvement into next year. And I guess if you could just give us maybe a little bit more color on what needs to happen to get back to the high end of the range? And I don't know if you can kind of frame what's achievable for some of these new segments? The paper segment is doing very well right now. I mean, is that kind of performance achievable in the corrugated segment? And should we kind of expect corrugated margins to exceed paper margins over kind of like a more longer-term time period?

[Alex Pease]

Yes. I'll let David pile on. I'll just help you understand a little bit about what was embedded in the assumptions behind the guidance. So we did take up the midpoint of the range. We tightened it and took up the midpoint. And I think that reflects the continued strength we see in our business. I talked about some of the inflationary trends that we're seeing and those will likely mitigate towards the back half of the year. And then obviously, we're going to have significant pricing advantages as we get to the back half of the year. So, if I talk to kind of the results in each one of the segments sort of first half to the back half. On paper, we see continued strengthening on the margin standpoint, as we get through the second half of the year, largely driven by pricing and continued volume strength. The biggest upside in the model is really on the corrugated margins. David mentioned we exited March of Q2 at a run rate of around 17% and we see that continuing to go north as we get to the back half of the year.

Seasonally, corrugated volume tends to be stronger in the second half of the year. They'll also benefit from this lower downtime issue that we talked about and then continued flow-through of pricing. They also exited. David referred to this in some of his prior comments. They -- in April, their daily shipment volume was the strongest we've seen so far this year. So their shipment volume has really accelerated, as they've broken the back of some of these absenteeism and labor issues and also getting the benefits of the WestRock operating system. Consumer will also strengthen towards the back half of the year. And then, really the only business that will likely weaken towards the back half of the year is the segment.

So David mentioned or maybe I mentioned in my prepared remarks, they benefited from a very large health care order this quarter. And so their margins will likely weaken somewhat, not significantly but somewhat as we get to the back half of the year.

And David, what would you add?

[David Sewell, President & Chief Executive Officer]

No, the only thing I'd add, if I understood your question correctly, Cleve, is on our margins. We actually did up the midpoint of our margins. We initially provided guidance of 16.5% to 17.5% of margin range for fiscal year '22. We've tightened that now to 17% to 17.5%. So you will see both the midpoint of our margins as well as our EBITDA increase as well.

[CleveRueckert]

Okay. Maybe there was just a little confusion because I think on the slide, it says 16.5% to 17%.

[Alex Pease]

We -- maybe we can take it offline. We can tighten that up. But yes, our margin -- we do expect our margins to improve through the second half of the year.

[David Sewell, President & Chief Executive Officer]

I apologize on that. We'll double check on those numbers. We might have different numbers here.

[Operator]

Our next question will come from Mike Roxland with Truist Securities.

[Mike Roxland, Truist Securities]

Congrats on the quarter. Just wanted to kick it off with the Panama City closure. David, you mentioned shifting some containerboard grades to other mills in the network. Does that imply that you're going to be walking away from some business -- you mentioned the word some. So I'm wondering if there's some business that may not have been profitable that you decided to walk away from them?

[David Sewell, President & Chief Executive Officer]

Well, I think the way I would answer that is we're going to move as much -- I mean, we obviously run our mills 24/7, 365. But as part of our unlocking of the hidden factory, we're trying to drive our productivity where we're just driving more volume through our mills. So -- and with the environment where we're in and basically a sold-out environment, we will move as much volume as we can to other plants on the containerboard side through our productivity efforts to drive that volume. So it's not a question of not wanting some versus walking away from some. It's just how much we can move into production productivity at other mills.

[Mike Roxland, Truist Securities]

Got it. And just one quick follow-up on corrugated. You're generating the 14.7% margin. This quarter, you mentioned the run rate exit was about 17%. I think, David, you mentioned last quarter that margins historically in the business have been 18%. Given where you stand today, over what time do you expect to return to those types of levels? It sounds like you have a lot of momentum going into the back half. Could you get to that 18% level this year? And is that 18% still a target? Or if you look at some of your peers, they're targeting -- they have -- or generate, I should say, 20% plus EBITDA margin. So is there something higher that you're going to be reaching for given some of the benefit from price cost and also given indeed the WestRock operating model?

[Alex Pease]

Yes. So let me take a stab at it and then I'll let David add additional color. So I mentioned in my answer to the prior question, we do anticipate significant strengthening in the back half of the year benefiting from really three things: improved production volume and lower downtime on the plant side. On the mill side, improved labor issues, so improve labor productivity, pricing flow through and then continued implementation of the WestRock operating system. So, I think you'll see us exit the year much closer -- on a full year basis, much closer to the numbers that you're referencing as opposed to where we started the year. So that's, I guess, the first point. The second point is you'll hear from Pete during our Investor Day next week all of the actions that we're taking within the business to improve both the local mix which will have a significant margin impact, as well as the manufacturing efficiency of the assets which will get us much closer to something, I think, more exciting from a margin standpoint.

I'm stopping shy of giving you specific segment guidance because I don't think we want to go there. But hopefully, directionally, you can understand some of the actions that we're taking.

[Mike Roxland, Truist Securities]

Good luck in the quarter.

[David Sewell, President & Chief Executive Officer]

Thanks.

[Operator]

Our next question will come from Anthony Pettinari with Citi.

[Anthony Pettinari, Citi]

Just following up on an earlier question on pricing. One of your peers in consumer has made an effort to kind of move away from Pulp & Paper Week published list prices and move more towards cost indices with automatic pass-throughs. Just wondering if that's something you'd consider or pursue? And then maybe just broadly, as you've looked at pricing in this business, coming from other industries and companies, are you seeing other opportunities to kind of improve pricing mechanisms or how WestRock sets contract terms? So just wondering if you could talk about that commercial and pricing piece?

[David Sewell, President & Chief Executive Officer]

So I'll talk about it as sensitively as I can speak to it. We are relentlessly looking at how to optimize pricing and partnering with customers to provide the right mechanisms to manage pricing moving forward. On the consumer business which you referenced, about 50% of our business is tied to contract pricing. But in the environment that we're in today, we're actively having discussions in new approaches to pricing. And that dovetails into our corrugated business as well as our Global Paper business. So this is something that is really important to our business moving forward and we'll continue to provide updates as we make changes to our approach.

[Anthony Pettinari, Citi]

Okay, that's helpful. And then, can you talk a little bit more about the decision to move the leverage target to 1.75x to 2.25x? M&A has historically been a feature of the company. Should we think about that as maybe be prioritized? And maybe you can just talk about the willingness to potentially go above the range or maybe below the range, depending on conditions?

[David Sewell, President & Chief Executive Officer]

Yes. So we lowered our range to 1.75x to 2.25x as we just see that is a very prudent range in the midterm that further reduces our risk while properly using our leverage to drive value. It doesn't mean we're not going to continue to pursue bolt-on acquisitions that fit our strategy, that meets our leverage profile in the midterm. But it really underscores our commitment to an investment-grade rating and the confidence we have in the portfolio that we have today and the improvements that we can make.

[Operator]

Our next question will come from Phil Ng with Jefferies.

[Unidentified Analyst]

This is actually John on for Phil. I -- first, I want to say congrats on a solid quarter. And just focusing on Panama City, the $65 million annual EBITDA drag, is that a net number consisting of any cost savings from that? And I appreciate the return focus on your actions but given the EBITDA leakage and $112 million of cash to shut the facility, I'm curious what type of capital would you have to spend on the -- to keep that facility in a good spot?

[David Sewell, President & Chief Executive Officer]

That number was not net. That was a gross number on the $65 million. And from a capital standpoint, not -- without getting into specifics, I would tell you it was in the hundreds of millions of dollars.

[Alex Pease]

Phil, maybe just to pile on. David mentioned this in his remarks but this is all about optimizing for ROIC and margin performance of the business. So when we looked at the investment that was required to get that mill sort of to our return thresholds, it just didn't make sense. And as David mentioned, it's 645,000 tons of capacity, 350,000 tons of linerboard capacity that we think we can capture in our remaining footprint because of improved asset productivity and hidden factory and those sorts of things. And then the pulp capacity, quite honestly, it's just not a strategic business for us to be in. So this was all about really signaling the first move on the portfolio-shaping actions that David's talked about a lot.

[Unidentified Analyst]

Got it. I appreciate that. And I realize that the flow-through on pricing in the paper segment, just because it's more open market and exports is tied to the spot. But how long should we think of the pricing to take to completely flow-through? Maybe if you could quantify kind of where you're at in terms of the price realization in that segment given its pretty significant compared to the other segments and there's less of a lag. And then I apologize if I missed this but did you have any insurance recovery in the quarter or the benefits from the ransomware and winter outages from last year, those were just nonrepeats this year?

[Alex Pease]

So maybe I'll just -- because the pricing thing is tricky. Obviously, the only thing we talked to on pricing are previously published pricing. And I mentioned again sequentially in Q3, we expect about $130 million of flow-through which translates to about $650 million year-over-year. And that's published pricing. So then as it relates to each one of the segments, it's about a three to six month lag in containerboard to flow through in the contractual side of the business and then that's about six to nine months lag in the consumer business. So, I think with the data that's out there externally, you can sort of do the math to figure out how that's going to translate through to the P&L. We -- obviously, demand continues to be strong and so this is something that we evaluate on a regular basis. But obviously, we're not going to talk about any forward pricing.

[Unidentified Analyst]

I guess just to clarify, I was looking more on the paper segment given that, that's open market, how much quicker that's flowing through and maybe how quickly we can expect the realization in that particular segment?

[David Sewell, President & Chief Executive Officer]

Yes, John. It's a good question. And I'll -- you hit -- you got the most important part, as we get pricing first in paper, typically. However, we have, as you would imagine, some very large global contracts with customers where that immediate pricing doesn't always take shape. So it's a little bit of a balance where a majority of our business, we get that pricing right away. But we do have large strategic customers where contractually we work through the contract so that would continue to flow through. So you will see a little bit more flow-through on pricing but at a much smaller level than you would see on consumer and corrugated. And then on your other question on the ransomware business interruption insurance, we did receive $5 million in insurance money in the quarter.

[Operator]

Our next question will come from Kyle White with Deutsche Bank.

[Kyle White, Deutsche Bank]

I just wanted to focus on some of the costs and what's embedded in the guidance. On transportation, we've started to see some of the truck kind of spot rates decline even when you factor in the surcharge from diesel. I guess, are you starting to see any benefits of this starting to flow-through to your contract rates? Do you expect any moderation in the second half?

[Alex Pease]

Yes. So I think I mentioned, we do expect freight to continue at inflated rates year-over-year, so call it, in the mid-teens year-over-year. But we do expect that to mitigate as we get to the back half of the year and then for all the reasons that you're talking about. There's improved driver availability and improved lanes, better mode, all of those sorts of things.

[Kyle White, Deutsche Bank]

Got it. Yes. I wasn't sure if the mitigate was just a year-over-year comp thing or it was for sequentially...

[Alex Pease]

No. Sequentially, sorry if it wasn't clear. I'm talking sequentially, not year-over-year.

[Kyle White, Deutsche Bank]

Got it. No, that's probably my fault. And then on nat gas, I appreciate the sensitivity that you guys have in the appendix but curious about kind of the overall purchasing strategy. Do you have any forward contracts that protect you from near-term volatility going into the next quarter? And what does your outlook assume for nat gas prices going forward?

[Alex Pease]

Yes. So obviously, this is a very interesting time in the natural gas markets. And as you might imagine, we're actively evaluating what our forward buying strategy should be. Historically, we've not participated in large sort of either derivatives or forward buys and so been more exposed to spot. Our outlook for the back half of the year does anticipate roughly $2 in MMBTU inflation from where we were exiting the quarter, so really almost 100% up year-over-year. So we are, I think, being appropriately aware of the market conditions, if I can say it that way. Just to help you with the sensitivity, so we're -- on Q4, we're anticipating ending in, call it, the $7.50 [ph] ZIP code. I think yesterday, we were north of $8 an MMBTU. To help you model it, $0.25 per MMBTU is worth about $23 million of EBITDA. So you can sort of, I think, do your own math on how that will translate through to the P&L.

[Operator]

Our next question will come from Mark Wilde with BMO.

[Mark Wilde, BMO]

I wonder, just coming back to Panama City one more time, you said that the prospective capital items were in the hundreds of millions. I'm just curious, over the next three to five years, are there other mills where you expect to be kind of facing kind of similar decisions? I'm not asking you to predict whether there are going to be other closures or anything but just whether there are other mills where you're going to have to take a good hard look at these very lumpy capital items?

[David Sewell, President & Chief Executive Officer]

Yes, Mark. So the best way I could answer that is we look very deep at all of our assets as part of our strategic process. And Panama City was part of an ongoing deliberate and methodical transformation process to improve our return on invested capital. We go through this with every one of our assets. And we take great sensitivity to it. We have employees that have been 30-, 35-year employees of the WestRock family. So we're very sensitive to any commentary on future actions, other than to say our preference is always to invest in the assets we have to deliver the returns and improve the asset base. And where those assets require an investment that don't generate the returns that are needed for the company is where we then look at taking strategic action.

[Mark Wilde, BMO]

Okay. That's fair enough. Then I wondered, just toggling over to the reduction in the leverage target, that 1.75x to 2.25x puts you well below other peers, particularly other packaging companies, who are typically up in the 3x range. Any thoughts on that? Is it just a reflection of a little more cyclicality in the paper packaging business? Or how did you think about that?

[Alex Pease]

Yes. So Mark, I'll -- David took a stab at it, so I'll take a stab at it. Look, this is, I think, a signaling of a couple of things. The first is our extreme level of confidence in the cash flow generation power of the business and the earnings power. And so obviously, the choice when we have that strong sort of value creation algorithm is the first priority, is obviously investing in the business to higher ROIC projects and growth projects. And then we start thinking about how we want to return capital to shareholders through a sustainable and growing dividend and opportunistic share buybacks and then obviously managing the balance sheet. So I think that's probably an important headline. The second important headline is the conviction that David mentioned to really maintain a very prudent balance sheet. And it really doesn't have anything to do with a view on where we are in the cycle as much as just signaling our conviction to maintain a prudent balance sheet and not pursue large-scale transformational M&A.

And we think in the 1.75x to 2.25x range, that we can continue to pursue strategic tuck-in bolt-on acquisitions which we'll describe in more depth next week. But it gives us sufficient flexibility while optimizing our cost of capital. And obviously, if we get below the 1.75x, then we have choices to make around opportunistic share repurchases or dividend or whatnot.

[Mark Wilde, BMO]

Okay. All right. That's fine. And just one other real quick one. Is it possible, Alex, to get some sense, like down at the converting plant level, about what -- how much you're having to move labor rates just to both attract and retain people at this point? I know mill level wages tend to be much higher. So I assume you have less of an issue there. But like bound at a corrugated plant or a carton, just any ballpark?

[Alex Pease]

Yes. I can give you. On an aggregate basis, it's actually not as material as you might think. So if you think year-over-year aggregate labor costs are up, call it, 3% on a full year basis year-over-year. That's what's embedded in the assumptions that we've provided. I think the -- it varies as you get into specific geographies and specific mills. And so what we're trying to do and Pete and Vicki and the team is working very hard on making sure we're competitive to unique local market conditions both in terms of wage rates, over time, those sorts of things. When we talk about labor issues, actually, what's -- the bigger issue is not the wage rate as much as it is just how hard the people are working because the demand environment has been so strong and we've been pushing over time as hard as we've been pushing over time.

People just haven't wanted to work those hours. And so we've been really trying to add labor to address the overtime issues. And as you bring new people onboard, you obviously have to train them and you have productivity issues. So the labor issues that we've talked to are really more related to attrition -- over time-related attrition as opposed to paying below market wages. But 3% year-over-year would be, I think, in line with historical rates.

[Mark Wilde, BMO]

And that would be across the company?

[Alex Pease]

Correct.

[Operator]

Our next question will come from Adam Josephson with KeyBanc.

[Adam Josephson, KeyBanc]

Alex, one more -- or David, for that matter, just one more on the leverage target that Mark was asking about. Had there not -- had the previous management not had a leverage target out there, might you have just -- is there a particular reason for it? In other words, why not just let the chips fall where they may? If your stock is particularly undervalued or there's a really attractive deal out there, then you can proceed accordingly. But why the need for any range?

[Alex Pease]

So Adam, I'm new to the company and so I'll take it as the new CFO and then David has been here a little longer and he can add his sort of points of view. I think given where the company sits and some of what we've observed in the market, it's very important for us to be as transparent as we possibly can be and show as much conviction behind our strategy quantitatively as we possibly can. And I think this is one way for us to show absolute conviction to the desire to focus internally on driving the WestRock operating system, improving margins, improving ROIC and not pursuing a large-scale transformational deal that forces us to lever up. I don't know how to say it more simplistically than that.

[David Sewell, President & Chief Executive Officer]

No, I think -- no, no, I think your point is valid. I'm sorry, I didn't mean to speak over you. No, no I was just going to say -- I'm going to let you finish, Adam and then I'll go.

[Adam Josephson, KeyBanc]

Well, I was just going to -- I mean, this transformational -- obviously, there have been some transformational deals in the company's history that didn't go as perhaps everyone would have hoped. But I don't know why that should affect your thinking about, "hey, if something comes along that's really attractive, why not pursue it?" What is the previous management teams experience have anything to do with it?

[David Sewell, President & Chief Executive Officer]

Well, I think -- I would answer it two ways. The first one is the internal opportunities we have are so significant to the point you just made that we made all of these transformational acquisitions and we haven't seen the value out of them. So let's get the value out of them. And the target range we're saying is not for perpetuity. It's just saying, in the short term we are going to relentlessly focus on extracting the tremendous and unlocked value of these assets that we have acquired. And so there's a little bit of messaging on, okay, over the next short-term period, we are going to get internal right. You are going to see the value from these acquisitions we've made. And if these incredible opportunities come up that fit within our strategic priorities, we'll have that discussion.

But -- I think you've kind of answered the point, Adam, is I think we're seeing as, "hey, a strategy of let's do a lot of M&A, lever the company and focus on free cash flow" where we're now pivoting to, we're going to get return on invested capital, we're going to drive margin expansion, we're going to take out some SG&A and we're going to drive productivity. And so I think that's kind of part of the messaging here.

[Adam Josephson, KeyBanc]

I appreciate that. And just one more -- one last one for me, if you don't mind.

[David Sewell, President & Chief Executive Officer]

Sure.

[Adam Josephson, KeyBanc]

You asked about box demand and what you're seeing in April and I presume that those questions were getting asked because there are numerous economic indicators that are pointing in, shall we say, the wrong direction. And historically, at least box demand has been very economically sensitive, boxboard less so. We saw that in '08, '09. How would you frame the economic sensitivity of these two businesses just from your perspective?

[David Sewell, President & Chief Executive Officer]

Well, this is what the beauty of our model is, is our incredible flexibility across changing market dynamics. We serve more end markets, more geographical touches across more substrates than any other producer. And so what that allows us to do is if there is one or two market dynamics that are softening certain segments, we can pivot and flex to grow in those other segments. And that's why we're so confident in our future with the reduced cyclicality that we're able to provide with our model. And so we're very confident.

[Operator]

This concludes our question-and-answer session. I would like to turn the conference back over to Rob Quartaro for any closing remarks.

[Robert Quartaro, Senior Vice President of Investor Relations]

Great. Thank you, everybody, for joining our call today. As a reminder, James and I are available for any other questions you have. And we look forward to updating everybody next week with more details on our long-term strategy and goals at our Investor Day. So thank you very much.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.