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International Paper Co. (NYSE:IP)

Q2 2009 Earnings Call

July 30, 2009; 10:00 am ET

Executives

John Faraci - Chairman & Chief Executive Officer

Tim Nicholls - Senior Vice President & Chief Financial Officer

Tom Cleves - Vice President of Investor Relations

Carol Roberts - Senior Vice President - Industrial Packaging

Wayne Brafford - Senior Vice President - Printing & Communications Papers

Analysts

Gail Glazerman - UBS

Mark Wilde - Deutsche Bank

George Staphos - Bank of America/ Merrill Lynch

Richard Skidmore - Goldman Sachs

Mark Weintraub – Buckingham Research

Peter Ruschmeier - Barclays Capital

Steve Chercover - D.A. Davidson

Chip Dillon -Credit Suisse

Mark Connelly - Sterne Agee

Operator

Good morning. My name is Stephanie and I will be your conference operator today. At this time, I would like to welcome everyone to the second quarter 2009 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. (Operator Instructions)

I would now like to turn the conference over to Tom Cleves, Investor Relations. Mr. Cleves, you may begin your conference.

Tom Cleves

Thanks, Stephanie. Good morning everyone and thanks for joining International Paper’s second quarter 2009 earnings conference call. Our key speakers this morning are John Faraci, Chairman and Chief Executive Officer, and Tim Nicholls, Senior Vice President and our Chief Financial Officer.

During this call we will make forward-looking statements that are subject to risks and uncertainties, which are outlined on slide two of our presentation. We’ll also present certain non-US GAAP financial information. A reconciliation of those figures to US GAAP financial measures is available on our website. Our website also contains a copy of our second quarter 2009 earnings press release and today’s presentation slides.

Stephanie, before I turn the call over to John, could you please figure out how to mute the other line?

Operator

Yes, sir, that line has been muted.

Tom Cleves

Thank you. I’ll now turn the call over to John Faraci.

John Faraci

Thanks, Tom and good morning, everybody. Thanks for joining us. As usual, Tim Nicholls and I are going to first review our second quarter 2009 results with you and the performance of our individual business and then we’ll talk about the third quarter and take your questions.

Let me start off and just say International Paper had a solid second quarter. Despite the continuation of challenging economic conditions, we posted better results in the second quarter than in the first quarter. Once again, we demonstrated that we can execute in a tough economic environment, when I speak of executing, I’m referring to a couple of things; cost reduction, cash generation and debt reduction.

We increased our earnings by 160% relative to the first quarter, generated $1.3 billion in free cash flow and I think really importantly, increased our EBITDA margins by 180 basis points in the second quarter compared to the first. These strong results allowed us to reduce debt by $600 million during the quarter.

Once again, our operations, big and small, all around the world, ran very well, despite a huge amount of down time we are taking in our North America paper and packaging business. We made strong progress all around International Paper, both reducing operating and overhead costs during the quarter. We also had a great quarter in terms of accelerating the integration synergies in our industrial packing business.

During the second quarter, which is the third full quarter since we merged Weyerhaeuser Industrial Packing business with ours, we exceeded the three year synergy target. So, we have gotten to year three within nine months. I’ll share more details on that with you in a minute.

Slide five contains a second quarter summary for you. Sales were up slightly from first quarter levels to just under $6 billion. EBITDA increased 21% from $604 million in the first quarter to $729 million in the third quarter. Free cash flow increased by 90% from $666 million to $1.3 billion and after $600 million of debt repayment during the quarter, we ended the quarter with $1.7 billion of cash on hand.

Tim Nicholls, or CFO, is going to discuss each business in detail; but before he does, I just want to highlight the outstanding performance of our industrial packaging business, which delivered a 22% EBITDA increase over their strong first quarter earnings of this business increased EBITDA from $331 million in the first quarter to $405 million in the second quarter.

These excellent results were achieved despite more than 580,000 tons of down time, or 21% of our capacity. Those of you who are on our conference call when we announced the Weyerhaeuser acquisition last year remember that we said we could generate a combined $1.7 million of EBITDA within three years. That is what we said when we bought the business.

As slide six shows, our second quarter EBITDA analyzes to $1.6 billion and we have achieved these strong EBITDA results despite industry box shipments that are 10% lower than last year’s levels and taking a huge amount of down time as well.

When the economy and box demand recover and they will recover, we are going to be very well positioned to meet or exceed our three-year EBITDA objective ahead of schedule. We’ve got a lot more earnings runway in this business, when volume improves and more improvement within the business to get.

So I’m very pleased with the results being generated by our industrial packaging team. It’s a combination of International Paper and Weyerhaeuser. It goes without saying the results are having a big positive impact on IP’s overall performance.

Let me now turn the call over to Tim, who will discuss the results of our businesses in more detail.

Tim Nicholls

Thanks, John and good morning, everybody. The waterfall chart on slide seven shows our change in earnings from first quarter to second quarter. In the second quarter from our operating businesses, earnings were $0.20 per share versus $0.08 in the prior quarter. Higher volumes increased earnings by $0.20, which was offset by lower selling prices, which reduced earnings by $0.19.

Lower prices for inputs, wood, chemicals, purchased energy increased earnings by $0.12 and cost performance was really exceptional in this environment. Our mills, our converting operations continue to run exceptionally well.

We continue to make strong progress on our overhead cost reduction efforts, so strong cost performance added $0.12 to earnings, a really good outcome with the organization focused on cost management across the number of fronts. A higher mix of export shipments reduced earnings by $0.05 and higher planned maintenance outages decreased earnings by $0.06.

Slide eight just illustrates one component of that ongoing cost management effort. It shows our headcount and you can see that we have continued to act very quickly to drive out operating costs. Relative to second quarter of last year, we’ve reduced the total number of employees by 8,000. That’s a 12% reduction in 12 months. It was our year end goal to be at 58,000 employees by the end of this year. We are now going to be below that by the end of the year.

Slide nine shows the favorable impact of declining input costs in the second quarter. Input cost reductions increased our quarterly earnings by $0.12 a share as I mentioned or $77 million. Reduced costs for wood, OCC added $25 million, lower chemical prices increased earnings by $24 million and energy cost reductions boosted earnings by $23 million, with transportation adding another $5 million.

During the second quarter, we continued to match production to our customers needs and as a result, we recorded nearly 700,000 tons of lack of order downtime in North America, which was in addition to almost 200,000 tons of maintenance downtime. We took more than 580,000 tons of downtime in our North American Containerboard system, which is about 21% of total capacity.

We took 170,000 tons total downtime in the Uncoated Freesheet system in North America or approximately 23% of total capacity and also took another 110,000 times total downtime in the Coated Paperboard system in North America or about 23% of its capacity.

So, we continue to take substantial amounts of lack of order downtime, in order to manage our gross margins and because, the cumulative costs of this downtime is far or less than the negative impact of chasing volume or building unneeded inventories, we will continue to manage our production to meet our customers immediate needs.

So, with that let me turn to segment earnings. As John discussed, industrial packaging generated exceptional earnings in the second quarter, increasing earnings by 36% from a $188 million to $255 million. Increased shipment volumes added $76 million, and that was offset by $75 million in price erosion.

We did benefit from declining input costs, which increased earnings by $38 million and here again, cost performance made a big difference to earnings, capturing the synergies, strong mill and box operations added $37 million to earnings. Maintenance outage expenses were similar to the first quarter, but a higher mix of open market export sales reduced earnings.

The North American box business had a box increase in shipments of 5.8%, which compares favorably to the Fiber Box Association level of 5%. We now believe that through the second quarter, we’ve probably passed the bottom of the downturn in box demand.

During the second quarter, domestic containerboard prices stabilized and as I said, our mills and box plants ran very well and earnings also benefited from significant structural cost reduction and the merger synergies. As we exited the quarter, we did see an increase starting for OCC, and we expect that to continue in the third quarter, but overall, inventories are lean, which should help us capitalize on any up-tick in demand.

Turning to synergies, during the second quarter, we achieved nearly a $120 million in merger synergies, which contributed strongly to the results and just as a reminder, there were four major categories of synergies that were going to drive the total improvement. One was rationalizing box plants, which we’ve been very aggressive in doing, mix improvements in the box business was the second one. Optimization of mills and logistics, and also a reduction in overhead rounded it out.

Using the June synergy rate, we are on track to achieve nearly $500 million in merger synergies. So to put this in perspective, after the first 11 months of combined operations, we’re at an annual synergy run rate of nearly 20% greater than the total we were going to achieve over the first three years of the acquisition. The combination of capacity management and cost performance is driving improved margins.

If you turn over to slide 14, you see when we acquired Weyerhaeuser’s Packaging assets, we had a goal of creating the premier North American industrial packaging business with the highest margins and we feel like we’re well on our way to achieving that goal. Our EBITDA margins improved from 17.5% in the first quarter to nearly 21% in the second quarter; and we’re almost double the second quarter 2008 levels, despite more than 20% of total downtime.

So our second quarter year-over-year shipments were down more than the industry average and significantly more than some key competitors, but our margins and our profits are up. Our objective is not to maximize volume, but rather to maximize profitability.

Moving on to printing papers, the global Printing Paper business earnings declined from $101 million to $86 million, higher shipments and favorable input costs in all global regions were more than offset by lower selling prices in all regions. For the North American Printing Papers business, where earnings declined by $24 million, favorable input costs and improved volumes were offset by lower selling prices and lower margins from increased export shipments.

The North American Market Pulp business, where earnings were up $16 million, had strong mill operations, lower input costs and higher shipments that more than offset the lower selling prices. European Papers’ earnings declined by $9 million; improvements in volumes and input costs were offset by higher operating costs and maintenance outage expenses. In Brazil, where earnings increased by $2 million, seasonally higher volumes, strong operating results and favorable input costs were offset by reduced domestic and export selling prices.

Consumer Packaging earnings, it increased by $16 million to $38 million for the quarter, our increased shipments improved earnings by $18 million. We had just a small erosion in selling prices and then favorable input costs increased earnings by $6 million, costs were $9 million favorable and mixed improvements increased earnings by $2 million. We did have more planned maintenance outages in the quarter than the prior quarter.

For xpedx, earnings increased to $10 million in the quarter. Shipment volumes improved, but the sales revenue remained relatively flat, reflecting the decline in paper selling prices, especially the prices for coated papers, which represent the majority of xpedx’s printing paper sales. Sales revenue per day was flat with the first quarter levels, about 20% lower than second quarter of 2008 levels. xpedx is continuing to focus on reducing operating expense to match it to its current revenue levels.

Now let me turn to Ilim. Slide 18 provides the summary of Ilim’s first quarter 2009 results. I’d just remind everyone that, we do report Ilim on a one quarter lag. Sales of the joint venture declined by 27%, reflecting the weak pulp market at the time in China and the weak demand for paper and packaging within Russia. Pulp shipments declined by 1%, and pulp prices dropped by $148 per ton. Containerboard shipments declined by 5%, and selling prices declined by $110 per ton.

IP’s share of the joint ventures, earnings declined to a loss of $30 million, $22 million of that equity earnings loss was due to unfavorable foreign exchange losses. We believe that this quarter of performance, their first quarter reported and our second represents the bottom for Ilim, as prices and demand for market pulp have improved during the second quarter calendar year, and the results continue to improve in July. So their second quarter will be part of our third quarter earnings release.

In Ilim, we’re approaching the two year anniversary of the joint venture. We’ve been through a great first year, followed by a tough second year, driven by dramatic changes in both the global and Russian economic climates. Because of that, we haven’t had as much progress on the capital investment program that will drive the future earnings growth of the joint venture.

We now see the economy and their performance of the business improving, which will allow us to get the joint venture back on track with the investment plan that remains attractive. The original partnership agreement allows each partner the right to reassess their ongoing participation in the joint venture anytime after the second anniversary.

Right now, neither party is interested in changing the ownership structure of the joint venture, but it’s possible that either partner could elect to do so. If the decision to exit the joint venture were made, it would take up to six months or even longer for a transition to occur.

So given the current economic conditions and their impact on the joint venture, we and our partners are discussing potential revisions to the original agreement, including a proposed scope and timeline for a revised capital investment program. At the moment, we look forward to continuing in this joint venture, which is in a low cost high demand growth region, especially as business conditions improve.

Before I complete the earnings review segment of the presentation this morning, I’d like to just mention a few highlights from some of our international operations. As you know, we completed the construction of our new uncoated freesheet machine in Brazil, and it started up earlier this year, and it’s had a very successful start up. It’s currently running seven months ahead of the production ramp plan.

We’re also very pleased with the significant mix improvement on our coated paperboard machine in Svetogorsk. That improvement is worth $12 million on an annualized basis. The mill in Poland continues to perform very well, running extremely well, setting new production records and operating at a high level of machine efficiency.

Our coated paperboard shipments through our Sun joint venture were up 75% versus the second quarter of 2008, reflecting the new production on the new paperboard machine, which is targeted for domestic China consumption. So with that, let me turn to cash flow and balance sheet. As we shared with you during the recent Investor Day, maximizing cash flow remains a top priority.

Despite the continuing economic recession, our operations generated $700 million in cash during the second quarter, and margin management and strong focus on working capital are contributing strongly to the cash flow generation. The result was nearly $1.3 billion of free cash flow in the quarter.

Even excluding the cash from the alternative fuel tax credits, our free cash flow is the second highest free cash flow in the last six quarters. Strong free cash flow has allowed us to make significant progress on debt reduction as John mentioned. Slide 21 shows you, where we are through the end of July.

By the end of the first quarter we reduced our debt by $1.2 billion, and in the second quarter we reduced debt by another $600 million. By the end of this month, we will have reduced debt by another $600 million. So in the 12 months, since we completed the acquisition of Weyerhaeuser’s packaging assets, we have reduced our pro forma debt by $2.4 billion.

In doing that, we’ve already surpassed our target for debt reduction of $2 billion within the first 24 months, and continue to be strongly committed to further strengthening the balance sheet, and we’re now projecting that by the end of this year, we will have reduced our debt by around $3.2 billion or more than half of the acquisition debt.

Slide 22 shows our debt maturities through 2012. In July, we reduced 2011 debt maturities by $280 million and in 2012 by $200 million. As of today, we have sufficient cash on hand to meet the $1 billion of cumulative debt maturities through 2012.

So, with that I’m going to turn it back over to John, who will summarize second quarter and give you an outlook for the third quarter.

John Faraci

Thanks, Tim. So, in summary, despite continued strong economic headwinds, we posted solid results in the second quarter. We continue to match our production to our customers needs to avoid tying up working capital and unneeded inventories, that would only put pressure on pricing.

We ran our operations very efficiently and generated nearly $120 million in integration synergies in our industrial packaging business. We generated $1.3 billion in free cash flow, which contributed to our ability to reduce debt by $600 million in the second quarter and, as Tim said another $600 million just in the month of July.

In other words, we have reduced our debt by $1.8 billion for the first seven months of 2009. Since we closed the Weyerhaeuser acquisition, we have reduced debt by $2.4 billion, as Tim said and are going to we plan to have more than 50% of the acquisition debt paid off by the end of the year.

So, let’s look ahead to the third quarter. We anticipate that we’ll continue to face challenging conditions in North America. I’m on slide 24 here, which gives you a snapshot how we see volume pricing, maintenance outages and input costs for all of our businesses, North America, Europe, Brazil, Russia and Asia.

We expect a slow recovery in North American demand. This recession’s going to end. How it’s going to end and when it’s going to end is yet unclear. The good news is mill and channel inventories are lean in both paper and containerboard, which positions us well for the eventual upturn in demand.

Looking at volume, we anticipate demand for printing papers in North America and global market pulp to be similar to second quarter levels, and we expect paper shipments from our Brazilian business to increase. We expect North American demand for containerboard and boxes to increase and we expect higher export shipments of containerboard.

Those increases in North America are going to be very, very modest. We also expect increased shipments of our paperboard business in our Sun joint venture. The domestic economy in China is quite strong, as you’ve all read about. In fact our shipments in second quarter of folding box coordination were double than they were same quarter last year.

Now looking at pricing, we expect global prices for uncoated free sheet to remain at end of second quarter levels; and global pulp prices continue to increase, although from very, very low levels, given what’s happened over the last nine months to pulp prices. We expect North American containerboard prices to remain stable at second quarter levels.

The Box prices will decline, reflecting the impact of containerboard price decreases, which occurred in the second quarter. We expect steady North American coated paperboard prices. Planned outages are going to decrease by about $16 million. We expect in North America input costs to increase, and that’s principally going to be through OCC.

OCC prices bottomed in the second quarter and actually moved up slightly in the second quarter from where they from the first quarter average. We probably have gotten more input cost relief over the first nine months than we are going to get over the next nine months.

Finally, we expect a significant improvement in equity earnings from our Ilim joint venture, which as Tim said, remember that is reported in our one quarter lag; and as pulp volume and pulp prices improve, so will Ilim’s earnings. In our second quarter outlook, we have said that we expected the land sales from American Timberlands to close in the third quarter.

American Timberlands investors are progressing with their due diligence, but it’s taking longer. So, we no longer expect this transaction to close in the third quarter. So, taking that all in and I realize there are a lot of colors on this chart here, and we don’t have, perfect clarity on what’s ahead, we are still in a global recession and we expect third quarter earnings to be about the same as they were in the second quarter.

Going forward, our priorities remain the same. We are going to focus on aggressive cost management, we are going to continue to match our production to our customers needs, and finally, we are going to continue to strengthen our sheet by continuing to pay down debt.

Our goal remains the same, to reduce total debt to less than three times EBITDA over the cycle. A basically International Paper is getting ready for an improvement in the economy. We don’t see one yet, but one is out there, and we are going to be ready for it with a stronger better company when that happens.

So, with that I’ll turn it back over to Tom Cleves, and we’ll go to your questions.

Tom Cleves

Thanks, John. Thank you, Tim. Stephanie, we are ready for our first question, please.

Questions-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Gail Glazerman with UBS.

Gail Glazerman - UBS

Hi, good morning. I guess just to start; can you give maybe a little bit more color on what you are seeing in demand, maybe talking about what you are seeing in July relative to June?

John Faraci

I’ve got, Wayne Brafford runs our paper business here and Carol Roberts, who runs our packaging business. I’ll let them talk about North America and I’ll fill in on outside North America, just briefly. Wayne.

Wayne Brafford

Well very briefly, as John mentioned earlier, the pulp business has improved. Most of that is related to China. In fact I would say the rest of the world has not improved a whole lot at all, but China is up quite a bit. On the paper side Gail, shipments are solid, solid relative to where they’ve been.

We are seeing some dip in the order book and that’s kind of anticipated in July. There is a bit of a seasonal factor there. So, I feel the order levels have lightened up a bit versus June, but again, that’s not unusual for July, but still, it is a lightening.

Carol Roberts

Gail, this is Carol. In U.S. boxes, we had a good strong beginning of July, which was very encouraging, because that’s around a holiday and you could expect people to be down and that’s kind of moderated a little bit towards the second half of the month. So, I would say categorized July as kind of very similar in aggregate to June levels.

John Faraci

It feels like demands going sideways in North America. Tom Kadien, were he say xpedx sales are up, sales greater, just up a little bit. It just feels like more of the same. Asia is solid for us and that’s again, most of our business is for the Chinese domestic economy.

Europe is in a slow time of year. So, summer is not a heavy shipment month and our shipments are probably going to be not much changed from where they were in the second quarter.

Gail Glazerman - UBS

Okay. Carol, can you talk maybe specifically about exports and containerboard? Obviously, the industry data showed a very solid up-tick in June. Is that something that you think can be sustained?

Carol Roberts

Yes, Gail. I mean, the export did show an up-tick and I think there’s lots of reasons for that. I think that once again we saw the bottom on exports earlier when, that supply chain is a little bit longer. So, people have more on the floor. We kept shipping into that pipeline longer when the downturn came and so we are coming out of that.

I think there’s some parts of the world that are maybe being opportunistic and taking some orders now because, prices are at a fairly low level, but I feel pretty good about the sustainability of the exports at a pretty decent levels going forward.

Gail Glazerman - UBS

Okay and just two more quick questions. The comments on renegotiating the Ilim joint venture and I just want to be clear, is one of the options you’d consider putting more cash in or is that completely off the table?

John Faraci

As Tim said, we are satisfied with the ownership structure the way it is and that joint venture Gail, is meant to be self-funding, as it relates to the capital investment program.

Gail Glazerman - UBS

Okay and just one last quick question. The debt reduction target this year is there any sort assumption on fuel credit lasting through December 31 on that or do you give any --?

Tim Nicholls

I mean, we are taking the fuel credits as they come. We have no line of sight on when they might end. So, but we are pretty confident that somewhere around the $9.5 billion level is a realistic target.

John Faraci

We are going to get there with or without the fuel credits.

Gail Glazerman - UBS

Okay, great. Thank you.

Operator

Your next question comes from the line of Claudia Hueston with JP Morgan.

Claudia Hueston – JP Morgan

Thanks very much. Good morning and congratulations on the quarter. You talked a little bit about trade flows in containerboard and I just wondered if you could comment on what you are seeing in terms of exports in your other business and if there’s been any real change in imports noticeable in your businesses?

John Faraci

Wayne, do you want to talk about paper?

Wayne Brafford

Yes, just a brief comment. We are exporting paper as John mentioned. Interestingly, overall exports from North America through June reported by AF&PA did not show an increase in exports on Uncoated Freesheet, but we have been successful at exporting paper and interestingly, we are seeing some pricing lift in the export markets, off the American shore markets. I believe that’s related to the fact pulp is moving up and energy is moving up, and a lot of the offshore suppliers of paper are not integrated.

John Faraci

Where we’re doing most of our exporting, Claudia, is out of Brazil. About 58% of Brazil’s production now, with the new machine is for export out of Brazil. That includes the region and also Europe. A little bit into North America.

Claudia Hueston – JP Morgan

Okay and then on the bleach board side? Has there been much change…

John Faraci

Bleach board is pretty steady. I mean, the way I think about exports is, exports were very strong in 2008. They collapsed in the fourth quarter of 2009 in the beginning and so they have come back. Have they come back to the levels they were at in the beginning of 2008? They haven’t, but they’re significantly better than they were.

Claudia Hueston – JP Morgan

Okay. Thanks very much.

Operator

Your next question comes from the line of Mark Wilde with Deutsche Bank.

John Faraci

Hi, Mark.

Mark Wilde - Deutsche Bank

Good morning and congratulations on a really solid result, John. I think the impact of that Weyerhaeuser transaction, both for you and for the industry has been more powerful than most of us on the outside assumed.

I wonder, if we can talk about those comments you made about China, and try to tie them together with the strength that we’re seeing in Chinese purchases of pulp? Do you have a view, based on what you see at Sun and elsewhere in China, of how much of those increased pulp purchases may be just ending up in inventory? And how much of it may reflect to kind of just strong internal demand China?

John Faraci

I think, we’re in the pulp business in China in a lot of ways, Mark. Ilim exports pulp to China, we have a distribution company that sells pulp in China, some of it from, not produced by International Paper, and then we also buy pulp through Sun. You know, frankly, so I think we can triangulate this pretty well. I mean there isn’t the transparency across China that we have here in North America, but it looks like this is consumption-driven, and it looks like it is demand driven.

I think you kind of had make sense when you see what’s going on in automobile sales and you know consumer sales, the housing market, the stock market in China. You know it’s hard to say there’s no inventory building up anywhere, but it appears to us that the consumption in China is pretty healthy. If you think about GDP growth, even in the ballpark of 7% to 8%, with the domestic economy being I think 65% of China’s GDP, exports being 35%, that all fits together with GDP growth slowing from 12% to 7% to 8%.

Mark Wilde - Deutsche Bank

In other words, you guys might view then this pickup in Chinese pulp purchases as something that’s maybe a little more sustainable?

John Faraci

Yes.

Mark Wilde - Deutsche Bank

Okay and a question for Carol. Back to this containerboard export question, I’m just curious with the very low prices that the trade papers are reporting on export sales, why you think U.S. producers would be exporting more into that kind of pricing environment? Or are the trade papers missing something?

Carol Roberts

Well, you know, Mark, I think we do know that those prices are under pressure, and it is just a, it’s a business decision and an economic decision to decide whether that makes sense for you or not.

Ultimately, I don’t believe those prices will stay there long term, so I think it just comes down to a decision around your cost competitiveness and whether it make sense to participate at all those levels or not. I would say that, I continue to believe that U.S. kraft linerboard is globally competitive. So if somebody’s going to participate, we ought to be taking a look at it and then just make the best business decision that we can.

Mark Wilde - Deutsche Bank

Okay and then the last question I had, on both of the waterfall slides for the segments, you showed a negative impact from mix in both containerboard and in Uncoated Freesheet, and I wondered if you could just give us a little sense of what that negative mix was in both of those businesses?

John Faraci

That’s geographic mix in both and what that is, that is, the way we do that is there is a negative impact because you’re shipping at lower margins, both in paper and in containerboard when we ship export.

Mark Wilde - Deutsche Bank

Okay. Very good.

John Faraci

We do have some positive mix you know when we ship, let’s say make more accepted packaging board in Russia, and sell it in Russia that is better than making weight line carton. So the big ones that are standing out are are geographic.

Carol Roberts

Mark, I would add that over on that swing chart, there’s a positive from that volume, that’s over in the volume bucket. So it’s probably just the way we categorized it on that swing chart, but there is a corollary positive from volume.

John Faraci

If we didn’t believe we were making more money by selling that product, we’d be taking the downtime.

Mark Wilde - Deutsche Bank

Okay. Again, congratulations. I think a really great performance.

John Faraci

Thanks Mark.

Operator

Your next question comes from the line of George Staphos with Bank of America/ Merrill Lynch.

George Staphos - Bank of America/ Merrill Lynch

Thanks. Hi, everyone. Good morning, again congratulations on the performance of containerboard and overall. I guess the first question I had and I realize you haven’t hit your full targets yet, but given the progress you’re making with the Weyerhaeuser acquisition, that you are nearly at the synergy target. What is holding back from perhaps raising that synergy target overtime? Is it just the fact that you haven’t achieved it yet? Are you just trying to guard against macroeconomic conditions or some other factors, John?

John Faraci

So we didn’t raise…

George Staphos - Bank of America/ Merrill Lynch

I understand that.

John Faraci

In the coming quarters, we’re going to be talking to you more about what’s next for containerboard. That business didn’t finish with its improvement plan. There’s a lot of runway, that’s more than volume runway, in terms of improving earnings in that business. Even once the synergies are over, because we haven’t even gotten to work on of the footprint and the cost structure and the optimization, all of which are got significant upsides for us.

Tim Nicholls

I would just add to that, John that past a certain point of the combined business, it’s less about synergies. I’m just driving total business improvement.

George Staphos - Bank of America/ Merrill Lynch

Alright.

Tim Nicholls

So that’s where the business is focused now.

George Staphos - Bank of America/ Merrill Lynch

Could you give us a quick update on what the level of investment is right now within industrial packaging? I remember something around $10 billion. Has that number changed much year-to-date? Where do you think returns are, if you can comment at all, what the spread might be between virgin recycled right now, either with you or within the industry?

John Faraci

Well, capital employed in the industrial packaging business is what, Tim?

Tim Nicholls

Total capital employed is about $8.8 billion, George.

George Staphos - Bank of America/ Merrill Lynch

Okay.

John Faraci

Your second question was returns?

George Staphos - Bank of America/ Merrill Lynch

Yes, just the spread in returns that you’re seeing rights now, either you or what you suspect is in the market, virgin versus recycled?

John Faraci

I’ll let Carol comment on that, probably closer to it than I am.

Carol Roberts

George, I really don’t have a view on that relative to returns right now. So we could probably get back to you and think about that, but we look at ours as a system and optimize it. So I can’t comment on returns relative to recycled versus virgin right at this moment.

John Faraci

Do you think, you return on investment George, or margins?

George Staphos - Bank of America/ Merrill Lynch

Really more return on investment, but either way you wanted to answer the question would be fine. We can follow-up with you afterwards, that’s fine, too.

John Faraci

We look at return on investment in the business and by customer, but not by grade of product.

George Staphos - Bank of America/ Merrill Lynch

Okay. Two last questions and I’ll turn it over. Looking at the price charts in the slide deck, it looked like you saw a bit more of an accelerated drop in uncoated freesheet pricing in the second quarter versus 1Q, relative to what you saw 1Q versus 4Q.

Wayne, was that more geographically driven or market driven to say, offset versus cut size? Could you give us a bit more clarity there? On the timber sale, John, can you comment at all on whether you still expect to get the proceeds that you initially targeted on that sale? Thanks, guys.

Wayne Brafford

Quick comment on that, you called it right. It’s primarily driven geographically driven like the mix. There was some drifting down, but I would say the pundits are pretty close to being right. It is in the $5 to $10 drift, depending on whether you’re talking about rolls or cut size, rolls having more drift down than cut size.

John Faraci

On the timberlands sale, George, in terms of the agreement haven’t changed.

George Staphos - Bank of America/ Merrill Lynch

Okay, fair enough. Thanks, guys.

Operator

Your next question comes from the line of Richard Skidmore with Goldman Sachs.

Richard Skidmore - Goldman Sachs

Good morning. Just to follow-up, perhaps on George’s question with regards to synergies in containerboard John. What’s really the key driver to getting the synergies faster thus far than what you had initially anticipated?

Then a second part to that is that as you had mapped out the road to $400 million over three years. Would it be reasonable to assume that years two and three, those benefits would be kind of on top of what you’ve already achieved thus far? So you could maybe extrapolate that you’re going to be somewhere north of $600 million, $650 million in year three?

John Faraci

Well, I think the reason we got the merger benefits for more faster is because of the planning that went into the integration. We announced the acquisition in March, we closed it in August and it was really, really important that everybody knew what their job was day one, all the leadership was in place day one. Day two, they knew what the strategy vision message was and everybody started paddling real hard on day one.

There was no confusion about where we were going, who was responsible, and that’s what happens when an organization has got the right people, and they know what the plan is. In terms of synergies going forward, I think we are beyond the synergies that come from, putting two organizations together and defining a box plant footprint.

How do we run this business better and there are lots of levers in this business now, twice as big as there was before, that we haven’t tapped into yet, which will take sometime, but as I said, we are going to get the $1.6 billion EBITDA, even without the volume, over time. The volume, when it comes back, and it will, we’ll be on top of that. So, we are pretty positive about those synergies are going to stay with us and there is more we can do that is not synergy-related.

Richard Skidmore - Goldman Sachs

John, in that initial $400 million of synergies, was that second step of running the whole business better, was that included in that $400 million?

John Faraci

No. No. That was all headcount, box plant rationalization, logistics and the commercial side of it, which was the box contract.

Richard Skidmore - Goldman Sachs

Then just maybe shifting just to one other topic, in terms of input costs you mentioned you thought input costs in North America would essentially be flat, except for OCC. Can you talk about caustic soda? Is caustic soda going to be flat from here? Or should you see more meaningful or continued improvement from caustic soda?

John Faraci

There is a charge in the appendix, George. I’m not sure what page it’s, on maybe Tom can point it out. Right near the very end, it shows caustic soda trends. Caustic soda has come down sharply. The pricing at the end of the quarter probably is maybe close to our low pricing, because we have got a mix of pricing, is probably as low as it’s going to go.

Richard Skidmore - Goldman Sachs

Thank you.

Operator

Your next question comes from the line of Mark Weintraub with Buckingham Research.

Mark Weintraub – Buckingham Research

Staying with the input costs, you guys, I believe, have historically had some hedges on that gas and on that final slide, I think it says that your total net gas consumption is in order of magnitude 65 billion BTUs. How much of that is hedged? If we were to basically assume the current cost of net gas, what type of tailwind would that be to your earnings?

John Faraci

Well, it wouldn’t be a huge material number in this year, Mark. We are about in the mid-40s in terms of a hedge position versus our total consumption, and the hedges are underwater right now. Last year they were, in the money by a long shot. The markets flipped around on us, but if you think of spot being somewhere sub $4, it’s going to be closer to $8, $8.5, so, on the edges that meet up.

Mark Weintraub – Buckingham Research

Doesn’t that mean though that you basically have, let’s say, you have 20 billion BTU hedged and can we say that as those hedges roll off you get the benefit of $4, $4.5? So that’s worth $80 million, $90 million, is that about right?

Tim Nicholls

You could say that, except we don’t do it year-by-year. We look out in time. So, we are putting on positions, into 2010 and 2011 as well.

Mark Weintraub – Buckingham Research

Okay and those positions that you are putting on I presume are at much lower prices than the $8, $8.5?

Tim Nicholls

That’s correct. They are going to be lower, but just to remind everyone of how we do this, we don’t try to develop a point of view, we try to reduce volatility in the numbers. So, we may move slower or faster at given points in time, but it’s within ranges, and all we are trying to do is lessen the impact, that would be overly dramatic from one quarter to the next if we didn’t have the hedges in place.

John Faraci

Mark, it surprises me too, I think you are alluding to this, but the forward price for 2011 gas is still close to $7, which is a whole heck of a lot higher than the spot price.

Mark Weintraub – Buckingham Research

Fair enough and true enough. Shifting gears, just the second question and I’ll be done. It seems that your operating rate in your containerboard business order of magnitude was about 79%, is that about right for the quarter?

Tim Nicholls

Yes, I think it may have been just a little bit lower than that Mark, but its right around the mid-70s, 75, and 76.

Mark Weintraub – Buckingham Research

Okay and in the past, you’ve talked about eventually shifting your containerboard footprint and most likely being more productive with fewer facilities. When do you think you will be ready to start making decisions on that part of the process?

John Faraci

When we are ready, you’ll hear about it.

Mark Weintraub – Buckingham Research

I’m waiting. I’ll be listening.

John Faraci

We’ll know where to find you.

Mark Weintraub – Buckingham Research

Okay, terrific. Thank you.

Operator

(Operator instructions) Your next question comes from the line of Peter Ruschmeier with Barclays Capital.

Peter Ruschmeier - Barclays Capital

Thanks, good morning and congratulations on a strong result. John, if you keep this up, maybe you can lease Mark some space in the Buckingham Palace. I wanted to ask a question, if I could on slide 39, as it relates to alternative fuel credits. It looks like $482 million pre-tax, $294 million after tax. I want to make sure, I better understand the cash effect and whether you have in fact received the cash that you’re due to-date or if there is some carry into the third quarter?

Tim Nicholls

Well, there is going to be carry, as we file the claims and the claims are paid, but we are current on filing. So, through the end of the second quarter, we had received $840 million in cash.

Peter Ruschmeier - Barclays Capital

Okay and do I understand correctly that there is not much of a tax effect, because you are going to use NOLs against this?

Tim Nicholls

Well, we are booking book tax, but the cash tax impact is going to be minimal.

Peter Ruschmeier - Barclays Capital

Okay. That’s helpful and Tim, how do you think about working capital second half of the year, in terms of opportunity, a plus or a minus?

Tim Nicholls

Well, it depends in some measure on what happens with overall demand levels, but I can tell you that, as an organization across all businesses, there is an extreme focus on managing working capital as tightly as possible. So, we are not going to let up on how tightly we squeeze it.

Peter Ruschmeier - Barclays Capital

Okay.

John Faraci

The improvement we’ve got or the cash generated from working capital on the first half of the year is going to be tough to replicate in the second half of the year, unless sales continue to decline, because part of that is just collecting receivables faster than you are putting on sales. Because we had sales decline of 20%, got masked overall because of addition of Weyerhaeuser.

So, Tim is right, we’ve got the full court press on managing inventories and collecting receivables, but we’ve got helped by a weak economy, which we’d rather have a strong economy and generate some more sales.

Peter Ruschmeier - Barclays Capital

Okay.

Tim Nicholls

But we continue, I mean the receivables is going to go up and down pretty closely correlated in time with what happens with sales, but we continue to really focus on inventory levels and inventory management.

Peter Ruschmeier - Barclays Capital

Okay, that’s helpful and there was a headline, I think it came from one of your slides, but 8,000 job cuts on a year-over-year basis, is that accurate and I presume that’s largely containerboard, but can you elaborate on that figure and kind of the source of those eliminations?

John Faraci

It’s all around the company. It’s not just containerboard, a big chunk of it did come from merger benefits, but it’s been all over the company. Not just North America, but most of it in North America.

Tim Nicholls

That is total employees, Pete that’s salaried and hourly; part of this is getting the footprint right and taking costs out where you don’t need it.

Peter Ruschmeier - Barclays Capital

Okay and then how does that progress for the next two quarters, as you get to the year end targets that you have?

John Faraci

We’re not going to make a year end headcount target, but we’re not finished.

Peter Ruschmeier - Barclays Capital

Okay. Very good, congratulations on the quarter.

Operator

Your next question comes from the line of Steve Chercover with D.A. Davidson.

Steve Chercover - D.A. Davidson

Thank you and good morning. First question is with respect to white paper. I guess the comment that it will be similar to Q2, does that imply negative 15% is the new negative 5%? Can you maybe discuss a little bit how, you know, market share in Brazil figures into that?

John Faraci

Well, I’ll let Wayne, you know, comment on that, but I’d say you know, we’re still in the middle of the worst recession we’ve had in 80 years. So you know, you’ve got yes, there’s a structural decline in the demand for Uncoated Freesheet North America, which I think Wayne at Investor Day said, we think it is about 4% plus or minus, but you’ve got the recessionary impact of a decline in demand that is not permanent, but it’s going to be with us as long as we have this economy.

Wayne Brafford

I would just add that, if you look at it year-over-year, through June, you’re right. We’re still seeing from AF&PA mid-teens types of reduction, but if you look at it month-to-month, what we are beginning to see is we’re, I think John characterized it right. We’re kind of bouncing along the bottom here. If you look at the data month-to-month, June was up a little bit from May, but I wouldn’t say there’s a rally going on, I’d say we’re bouncing along on the bottom.

John Faraci

Yes, we won’t get a meaningful improvement that’s cyclically related to Uncoated Freesheet demand until white-collar employment starts stabilizes and starts moving up, because that’s the statistic that consumption’s most correlated with.

Steve Chercover - D.A. Davidson

Got it, thanks. Second question, and please don’t misconstrue it, because I think we’re all delighted with the results, but does IP have a policy on when they would issue a warning if results would be materially better or worse than consensus?

Tim Nicholls

Yes, that was a good question. We do have a policy. We want to make sure we are operating in a way that is, you know, reflective of how, what our obligation is to investors, but our policy is not to give guidance in the first place.

So we look at the business indicators that we do provide an outlook for, and we ask ourselves comprehensively across all of those whether we feel we have a duty to update, and those are ongoing conversations, quarter-by-quarter.

If you recall, we did update, forget the quarter, but around a land transaction, last year or year before, because we felt we, you know, we had an obligation to inform shareholders before the release.

Steve Chercover - D.A. Davidson

Great, thanks. Keep up the good cash flows. Thank you.

Operator

Your next question comes from the line of Chip Dillon with Credit Suisse.

Chip Dillon -Credit Suisse

Yes, good morning. When you look at the reduction target you gave us, and I don’t want to pin you down, because you mentioned you want to hit it with or without the tax credit, but are you depending on the land sale to help you get to that $3.2 billion reduction by year end?

John Faraci

No. It’s a joint answer.

Chip Dillon -Credit Suisse

That is simple enough. Another question, on Ilim, as we look at a lot of companies that operate from the U.S., they’re expecting foreign currency to turn into a positive in the fourth quarter, which would mean for Ilim, the way you report it, we would see that be a positive influence next year in the first quarter.

I’m just wondering if we sort of took the pulp volumes and prices today and overlay that with sort of where currency is now, do you think Ilim could be, you know, would swing into the black, you know, if the dollar doesn’t you know strengthen a lot more and/or pulp stays at or above current levels?

John Faraci

Ilim is going to have a significantly better reported second quarter than they had in the first, because pulp prices started to improve irrespective of currency. So we’re not relying on currency for Ilim to get into the black.

The question is, you know, how much, how fast does their profitability return? You know, if we had 2008 pricing with today’s ruble, Ilim would be making a lot of money. Because a weak ruble and strong pulp pricing, we’ve got pulp pricing improving, and we’ve got a ruble that’s weakened substantially on a year-over-year basis.

Chip Dillon -Credit Suisse

Got you. I guess the last question, and maybe this is better for Carol, but you know, with OCC going up, especially overseas, and with that putting cost pressure on the overseas recycle producers. How do you see the spread between kraft liner, and recycled overseas? Do you think that there is any chance that you would see an opportunity to raise prices in board say before next spring?

Carol Roberts

Well Chip, I would say that absolutely the export prices. For one thing, I know they are got going to go any lower. So I think there is upside. So any price pressure that comes from any front really will help us get those prices backup. So I think there is definitely opportunity for export prices to go up, particularly in the timeframe you mentioned.

Chip Dillon - Credit Suisse

Got it, okay. Thank you.

Operator

Thank you. Your last question comes from Mark Connelly with Sterne Agee.

Mark Connelly - Sterne Agee

Thank you. Hi, John. Two questions for Carol, primarily. The first is what should we be expecting in terms of additional merger integration charges over the next couple of quarters? The second question is, if we look at the cost of the downtime that you’re taking today, how would you compare that to the cost of taking downtime ,the last time we went through this, four or five years ago?

Carol Roberts

Relative to the cost, there are no real significant, one-time charges coming up for the synergies and for the acquisitions. I would defer to my financial partners if we provide more specificity on that, but not a lot.

Mark Connelly - Sterne Agee

Okay.

Carol Roberts

Regarding the costs for the downtime, I would say that definitely this time the costs have been lowered due to the way we’re managing. Part of the reason we’re able to manage differently is we have a lot more choices around mills, around costs, between OCC mills, virgin mills, a lot further reach, whether it would be optimizing the last truck of wood, the last truckload of OCC.

So, we’ve really had a dual effort. One is managing direct variable costs to the optimum level, which we have choices on that, and then just managing overall spending. So we’ve actually done pretty well on managing with a lot of downtime.

Tim Nicholls

I would echo that Mark, across all the businesses here in North America. The mill businesses, they’re all pursuing similar strategies, where we take maintenance outages, we don’t use contracted labor, we don’t do use overtime. Even our capital dollars are going further because of the economic environment that we’re in. I think it’s just all about managing costs and keeping spending as low as possible.

Mark Connelly - Sterne Agee

Very good; thank you.

Operator

There are no further questions at this time. I would like to turn the call back over to Tom Cleves, Investor Relations.

Tom Cleves

Thank you, Stephanie. Wayne, Carol, John, Tim, thank you. Emily and I will be in our offices. If you have any follow-up questions, please give us a call. Thanks for joining us for today’s call.

Operator

Thank you. This concludes today’s conference call. You may now disconnect.

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Source: International Paper Company Q2 2009 Earnings Call Transcript
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