In 2006, International Paper Co. (IP) CEO John Faraci embarked upon a vision to transform the company. He sought a larger, leaner and more competitive enterprise operating in one of the most commoditized of industries: paper and containerboard products.
No one goes to the office copier and worries about what company produced the uncoated white freesheet paper, or shops around for the finest boxes before making a move. Customer interest to differentiate such products is about nil.
Despite the mundane business, seven years later, International Paper represents the largest, best-of-breed paper and packaging company in the world. Emerging from the trough of the 2008-09 market crash, stock price performance has blown out its competitors, as well as the S&P 500:
courtesy of google.com/finance
In this article, we will review the company's fundamentals, stock valuation, and investment thesis.
Let's begin with an overview of the 2006 to 2013 corporate journey, as highlighted below on a slide taken from an IP presentation made at the 2013 J.P. Morgan Diversified Industrial Conference:
Starting Line: The Balance Sheet
When reviewing a company, the first place I look is the balance sheet. In the case of International Paper, this financial document offers immediate insight as to the state of the business.
Liquidity is strong. The 1.6x current ratio is sound. As of June 30, company books record $1.935 billion cash and investments, or $4.35 per share. This represents about 9 percent of the stock's value.
Debt is high, but being managed to come down. Post the late 2012 Temple-Inland acquisition, the Debt-to-Equity and Debt-to-Capital ratios remain high, at 151% and 51% respectively. Therefore, a check on the Interest Coverage ratio (EBIT / Interest Expense) is in order. Through the first six months of 2013, the annualized coverage is 2.8x; within my sideboards of 2.5 to 3.0 times.
Furthermore, IP management and the rating agencies have targeted a 2013 year-end Debt-to-EBITDA ratio of 3.0x. This will require a current year debt pay down of about $1 billion. Through the first half, International Paper is well on its way to making its target.
Returns are good. The 16.5% annualized Return-on-Equity ratio is excellent. For "smokestack" companies, an RoE ratio above 15% is premier. Post-recession, the Return-on-Invested Capital has consistently remained above 8 percent. Prior to the business transition, the 2015 ROIC was 4.5 percent.
Here's a table summarizing the balance sheet analysis:
Growth Engines: Margins and EBITDA
International Paper primarily measures Income Statement results via Revenues, Gross Margin, Total EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), and EBITDA margin.
A key to understanding corporate performance as a function of the ongoing transformational changes involve reviewing the figures for trends as well as absolutes. Let's start with a table outlining these metrics over the past three years and through the first half of 2013.
Revenues have improved annually, and are projected to increase once again in 2013. Gross Margin and EBITDA Margin have remained steady. Total EBITDA has grown modestly, despite a less-than-robust global economy.
Notably, International Paper management has stated that they target mid-cycle EBITDA and EBITDA margins to be $5.1 billion and 15 percent. Once attained, such performance would result in roughly twenty percent improvements from today's figures; and should result in outstanding corresponding returns for investors.
On the bottom line of the table, I have included Operating EPS to highlight and compare this measure versus what International Paper management states is a key driver for building shareholder value: cash. You will notice that Operating EPS has not demonstrated consistent growth. We will explore this in more detail within the next section of the article.
Finally, let's compare how EBITDA margins compare versus competitors. I've included another slide from management's June 5 J.P. Morgan conference to highlight this:
We see that International Paper handily trumps its smaller competitors on EBITDA margin. A significant contributor to this differential is IP's superior size and scope.
Given the recent drive to grow revenue, IP has registered a five-year, 6.7% annualized sales growth rate. Comparatively, RockTenn has shown flat revenues during this period. Packaging Corporation of America bested International Paper; gaining an average of 11 percent per year.
Where the Rubber Hits the Road: Cash
We will conclude the financial analysis section of the article by capturing the essence of CEO Faraci's stated intent for the company: generate sustainable flow in order to create shareholder value.
The following slide covers IP's historic transformation from a more cyclical commodity player into the ratable cash machine it is today.
Global recession notwithstanding, International Paper has re-imagined itself as a strong cash generator. I focus upon Free-Cash-Flow (FCF), thereby subtracting routine capital expenditures from Operating Cash. What remains is what Warren Buffett refers to as "Owner Earnings," or what is left over after a company has handled all aspects of running and maintaining its business.
Based upon mid-year financial statements and management discussion, I conclude 2013 will again see International Paper produce FCF of greater than $1.5 billion, perhaps as high as $1.7 billion. This would result in $3.70 per share or thereabouts.
So what does the company plan to do with its cash?
One of the things I've liked about Faraci and his leadership staff is their willingness to state intentions, then follow through on them.
Management has consistently answered the aforementioned question without stuttering. International Paper expects to:
- reinforce its market leadership position;
- pay down its debt in order to maintain an investment-grade credit rating;
- contribute to its legacy pension fund to ensure its solvency;
- and return capital to shareholders
More specific to the final bullet point has been IP management's repeated call to systematically return cash to shareholders; targeting 30 - 40 percent FCF to the dividend. This payout level is both reasonable and sustainable.
I suggest that International Paper stock may fetch $55 to $60 over the next year, or an approximate 20 percent uplift from the current share price. My basis is accepting the 2014 Street consensus average EPS of $4.52 and placing a 14x multiple on it. Alternatively, I come to the same price range by estimating 2014 Operating Cash Flow at $2.5 billion and multiplying it by 10 times, a reasonable fair-value figure for heavy industrial and materials stocks.
However, investors may wish to take a longer view: since the Great Recession, the economic business cycle has not been completed. Historically, the time for Material sector stocks to shine is mid-to-late cycle. This is what management refers to when offering their ultimate EBITDA, margin, and ROIC forecasts.
Assuming modest share dilution, and mid-cycle FCF peak of $4 billion, a dividend of $2 per share is quite possible. This would provide a current yield-on-price over 4 percent. In such an environment, EPS could reach $6 a share. Since cyclical stocks tend to experience P/E compression as they reach their apex, just 11x those earnings still offers a $66 stock.
Please note an 11 P/E represents the normalized average of International Paper's lowest annual price/earnings ratios since 2006.
Before owning any security, I believe the investor must articulate an ownership thesis.
My thesis for continuing to own and accumulate International Paper common shares is as follows:
- The company has become the largest, global player in the industry.
- Management has focused upon cash generation and owner earnings.
- Experienced senior leaders have taken shareholder-friendly actions; the multi-year plan has improved revenues, maintained margins despite a tepid economic climate, and created significant shareholder value.
- Strong free-cash-flow and dividends are expected to increase.
- While not highly undervalued, the shares offer sound forward growth opportunities.
Furthermore, potential catalysts to ignite the stock to move higher include:
- The Temple-Inland acquisition: offering top and bottom line growth opportunities;
- IP becoming the largest and most dominant player in the paper and containerboard industry: when in a commodity business, it's often better to be the biggest and seek economy of scale;
- Any semblance of a global economic recovery: spurring the cyclical Materials sector stocks higher. Those with a strong presence in China, Latin America and North America should do best. International Paper business is concentrated in each of these regions.
Please do your own due diligence before making any investment decision. Good luck on all your 2013 investments.