Description

International Paper is cheap based on the current run rate of free cash flow, but is set to capitalize on further price increases in containerboard.  A long history of awful return on capital produces skepticism among investors, but this is an industry that seems to have changed significantly in the last several years and a company very much managing to maximize free cash flow.  We expect a further containerboard price increase in the spring which will add about 75 cents per share (10mm tons of annual capacity x $50/ton x 35% tax rate divided by 434mm shares) to the earnings run rate, taking it to the $3.50/share range. At the current stock price of $27.75, IP is trading 7.9x at the earnings run-rate, 4.3x EBITDA, 75% of sales, and has a 16% free cash flow yield on equity.

Going backwards in history there are a few things we would note.  First, return on capital has been awful.  IP aspires to earn its cost of capital.  In the last few years, there were many one time items, most significantly the "black liquor" tax credit in 2009 as well as a lot of land sales.  While we would not put a multiple on any of these items, the one good thing we can say about them is that they were cash earnings so the balance sheet has improved tremendously since the acquisition of Weyerhauser's packaging business in mid '08.  IP has paid down $4 billion of debt.  Further observe that this acquisition, while temporarily scaring the hell out of investors due to the timing just before the economy crashed, consolidated two of the top players in the containerboard market.

To keep things simple, containerboard is what you make cardboard boxes out of.  [For you paper purists out there we are using "containerboard" and "linerboard" interchangeably here to keep it simple - it's cardboard boxes.]  Generally, if you make containerboard you are forward integrated into boxes (though not vice-versa), so the prices of the two move together.

There are two ways to make containerboard - virgin fiber or recycled (Old Corrugated Containers -"OCC").  The U.S. market is heavily weighted toward virgin fiber, while China and Europe are heavily weighted toward recycled.  There is a limit to how much you can just keep recycling cardboard without it falling apart, so you need a supply of virgin fiber going into the pool to replenish the stream.  This is why you see such high demand for OCC shipped from the U.S. to China, and why 10-15% of U.S. containerboard production is exported to Europe.  From IP's perspective, this is an export industry, not one where imports are going to get you.

Unlike paper categories such as newsprint (which they are not in) and free sheet (more on that later), cardboard is not in secular decline.  Half of the U.S. demand comes from food and beverages which grows at some modest function of GDP. The recession hit the industry, with demand falling in 2008 and 2009 but pricing holding relatively firm.  Unlike other packaging categories (think bottles vs. cans vs. plastic), there are not close substitutes for cardboard boxes.  Think shipping packaged food and beverages (not the box the food comes in, but the cardboard boxes that ship the food to the supermarket) which. Perhaps the most visible example would be pizza boxes.  Ever see a plastic pizza box?

IP is 70% virgin fiber/30% recycled input, so rising OCC costs are not a bad thing at all if accompanied by price increase in end product containerboard.  OCC prices are currently high, driven by China and by some degree of supply shortage.  The industry seems to think of the indifference level between virgin and OCC at about $125-150/ton OCC price.  The price is currently $140 and has been as high as $180 earlier this year, however, at current prices OCC producers have given up their historical cost advantage versus virgin producers and likely operate at low profitability, probably with little incentive to add capacity.

Containerboard pricing is a function of (obviously) demand, supply and inventory levels.  Demand is GDP driven, so we suspect a bias up near term as the economy recovers.  Unit demand is still 4% below what IP considers mid-cycle after falling in 2008 and 2009.

With IP's acquisition of Weyerhaeuser's business in 2008, an industry major was consolidated into another.  Market share in North American containerboard is approximately as follows:

            International Paper                    29%

            Smurfit-Stone                           18%

            Georgia Pacific (Koch) 10%

            Temple Inland                           10%

In just the last year, IP has shut down 1.4 million tons of capacity and Smurfit another million.  Capacity is very tight, with utilization running in the mid-high 90s.  The last big virgin fiber containerboard mill built in the U.S. was over 25 years ago.

Inventories are very close to historically low levels at present, currently 2.3mm tons vs. 2mm tons trough reached in late 2009. Thought of another way, there are about 25 days of inventory in the system which is also close to historical lows (days of supply were in the high 20s - low 30s earlier in the decade). Coupled with utilization rates in the high 90% range, the entire system is very tight.

The industry has been taking advantage of this tight capacity, raising prices twice in 2010 (total of $110) to $635/ton.  They tried to raise prices a third time in August and the effort failed.  After talking to a couple of the majors, the August event is very interesting to us.

The industry's pricing mechanism is unusual.  Customers (say P&G) contract volume for 1-6 months at a price determined by the Pulp & Paper Weekly publication.  If the magazine says a price increase happened, it happened.  August was interesting as at first it appeared an increase went through and then a month later the publication rescinded it.  The reaction of the companies was also interesting - we spoke to two of the top three public companies in the industry and both were adamant that they had their customers ready to go at the higher prices and were surprised when it failed.  We know Georgia Pacific led one of the price increases earlier in the year so no reason to believe they wouldn't play ball.  By process of elimination most seem to blame Smurfit Stone, a company just out of bankruptcy with some real question about who is running the company in the future.  Some resolution at Smurfit, somebody buying them for example, would be a welcome development.

We do know that most of the majors were fully behind the August price increase, and the two we talked to were adamant about trying again.  You wouldn't expect to see a price increase in the winter when demand historically troughs, but as we get into the spring we are looking for another $50/ton. 

Uncoated free sheet

Uncoated free sheet unfortunately tells a different story, though still a profitable one. The UFS category comprises mostly printing and copy papers which were placed into secular decline in the developed world by the pervasiveness of electronic files and documents. While U.S. industry capacity has declined 25% from 2000-2009, demand has fallen 30%, yet pricing has improved, having risen 25% over that period. UCF is a significant part of IP's business, roughly 25% of FY09 revenues and 33% of EBIT. Since the start of 2010 the industry has put through two price increases - $40/ton in March and another $60/ton in May. The $100 combined price increase equates to about $0.80 in annualized EPS (assumes 100% incremental margin on flat volumes, ex any raw materials increase).  The resiliency in pricing is very much a function of industry structure.  Domtar, IP and Boise Cascade combine for 73% market share and the leaders have been extremely disciplined on managing capacity to falling demand.  For the purposes of this analysis we are assuming that the free sheet business neither helps us nor hurts us going forward.

Price Target

Assuming a further price increase in the spring, earnings power looks to go to about $3.50.  Free cash flow should exceed earnings as capital spending is about $1.00 per share below depreciation.  6x EBITDA would be about $40/share, which would reflect a free cash flow yield north of 10%.  For now we would think of that as an initial target price, and a point at which to reevaluate assuming we have seen our price hike.

What makes IP especially interesting is thinking about optionality on further earnings upside.  Given the discipline evident in the industry, there is no reason pricing has to stop at $685/ton.  This kind of reminds us of the beverage can industry ten years ago where pricing started to rise and then just kept going as capacity stayed tight.  We saw similar pricing strength at various times in the last decade in refining, railroads and steel to name a few examples.  What these businesses all had in common if I can recall correctly was very little capacity added in a long time, and demand caught up with supply as evidenced by utilization levels in the mid-high 90s. They all looked pretty bad, just like the containerboard industry, looking backward before managements got religion on pricing, and then surprised a lot of investors.

Below is an earnings walk how we get to $3.50 in EPS:

2009 EPS, adjusted*                                                              $0.88

            + $110/ton higher containerboard pricing                      +$1.65

            - $50mm Forest Products EBIT contribution                 -$0.10

            + $50/ton price increase in 2011 (forecast)                   +$0.75

            + Operational improvements                                         +$0.32

Earnings Power                                                                      $3.50

*EPS adjusted for one-time gains, restructuring charges, and other non-recurring non-operating items.

  Below is a quarterly table summarizing the earnings contributors to get to an annualized $3.50 earnings run rate:

The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing. The author will not undertake to supplement, update, or revise such information at a later date. The author may hold a position in the securities mentioned.

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