International Paper Co (IP)

[Enterprising Investor]

International Paper Is Packaging Up Profits (6/28/14)

International Paper is ramping up payouts and stock buybacks. Shares could rise 40% and a 2.9% dividend.

Don't be fooled by the name: International Paper is a cash machine.

International Paper (ticker: IP) expects to produce about $1.5 billion in free cash this year and $2 billion next year, after funding pension obligations. That's up from about $400 million a year before the company bought Weyerhaeuser's packaging operations in 2008; it then acquired rival Temple-Inland in 2012. With the debt from those acquisitions now paid down to a comfortable level, the company is turning its attentions to returning more capital to shareholders.

"International Paper isn't a growth story," CEO John Faraci told Barron's. Faraci has led the packaging giant since 2003, transforming it to a global powerhouse. "It's about free cash flow."

The company's shares have been under pressure from unusual factors, from a weak ruble to bad weather, but the company looks poised to regain momentum as it continues to improve operations, expand margins, and use its enormous free cash flow for dividend increases and share buybacks. The combination of improving fundamentals and the return of cash to shareholders should translate into a higher stock valuation and outstanding total return for shareholders.

International Paper is expected to post earnings of $1.5 billion this year, or $3.57 a share, on revenue of $29.2 billion. The company's shares closed on Friday at $49.05.

Some on Wall Street see the shares rising as high as $66 to $70 a share—as much as 43% higher—in the next 12 months, as strong demand leads to tighter supplies in the containerboard market, eventually leading to rising prices and substantial earnings growth.


AT CURRENT LEVELS, the shares are a bargain. International Paper ranks among the least expensive in its peer group, trading at 6.8 times estimates for 2014 earnings before interest, taxes, depreciation, and amortization, compared with the 8.2 times that Packaging Corp. of America (PKG) fetches and 9.3 times for MeadWestvaco (MWV). A year ago, International Paper traded closer to eight times Ebitda. International Paper is also less expensive than its peers, based on a multiple of projected 2015 earnings.

"We're very positive on the stock," says Philip Ng, analyst at Jefferies Group. "It's a cheap stock; the fundamentals have bottomed; it's generating a ton of cash flow; and it's a play on the recovering U.S. economy."

The Memphis-based company is the world's leading producer of the containerboard used to make corrugated brown boxes in which 95% of all goods are shipped. And the company is seeing hopeful signs that the U.S. economy might be gaining steam. Sales in its industrial-packaging business were up 3% year over year in April, the best performance it has posted in more than three years. Stronger sales continued into May, and Faraci says the business climate in the second quarter "feels a whole lot better" than that of the first quarter, when the box business declined amid a contracting economy.

NOTWITHSTANDING THE LOWER volumes and weather-related high costs in the first quarter, the industrial-packaging business still managed to post record first-quarter operating profits. While 75% of its revenue is domestic, International Paper's operations in Russia, Brazil, China, and India position it to take advantage of growth opportunities in the emerging markets.

Industrial packaging is International Paper's biggest business, generating 48% of annual sales; the company derives 21% of its revenue from its printing-papers division, which makes office paper as well as pulp for fluff used in tissue and diapers. And its consumer-packaging group, which makes cartons and containers and cups, constitutes 12% of total sales.

IP's distribution-solutions group, which makes up 19% of sales, is set to be spun off July 1 and merged with UWW Holdings to form a new company, Veritiv, of which International Paper shareholders will own 51%.

International Paper will get $400 million from the Veritiv transaction, which, along with IP's estimated $1.5 billion in free cash from operations this year, can go to buy back shares and continue to increase the dividend payout. (The company has $8.9 billion in debt, which is manageable at three times Ebitda.) IP has bought back more than $1 billion of its shares since it authorized the $1.5 billion program last September, well ahead of what it thought would be a two- to three-year time frame. It hiked its dividend in September by 17%, to $1.40 a share annually. The stock has a dividend yield of 2.9%.

The Bottom Line

IP shares are among the least expensive in its peer group. Some analysts see the company as a play on a recovering economy; shares could rise to $70 from a recent $49.05.

Based on a target for IP of eventually paying out between 30% and 40% of its free cash flow, CEO Faraci sees the potential for the dividend to increase to a sustainable level of between $1.80 and $2 a share. "Our approach to raising the dividend will be periodic and incremental, but it will be meaningful," he said in a telephone interview.

REGARDLESS OF WHAT happens on the macroeconomic front—Faraci cautions that overall economic growth remains "choppy"—International Paper is still finding ways to fine-tune its business and reduce costs, and it expects to add $200 million in additional earnings in the next few years as it tweaks its supply-chain processes and makes changes at its mills and in its customer base. Ebitda margins in the North American industrial packaging business have risen to 22% from 13% since completing the Temple-Inland and Weyerhaeuser deals, and they are not yet at peak levels.

The company expects that margins will be much higher three to five years from now, as worldwide demand for containerboard drives prices higher. Ng, the Jefferies analyst, notes that a $50-a-ton price increase in containerboard—from around $630 now—would result in more than a $1 per share of extra earnings at International Paper.

IP's consumer-packaging business is seeing a pickup in demand and pricing improvement as major fast-food chains such as McDonald's and Dunkin' Donuts switch to recyclable paper cups and containers from Styrofoam because of environmental concerns.

Earlier this month, International Paper named Mark Sutton, a 30-year veteran of the company who most recently oversaw industrial-packaging operations, to the posts of president and chief operating officer. That makes him the heir apparent to the CEO position when Faraci steps down next year at the age of 65, as mandated by the company's bylaws.

International Paper is stronger—and far more profitable—than it was when Faraci took the top spot. Its best days could be yet to come.

http://online.barrons.com/news/articles/SB50001424053111904544004579642563115909636