John V. Faraci - Chairman and Chief Executive Officer
Anthony Pettinari - Citigroup
International Paper Company (IP) 2013 Citi Basic Materials Conference Call December 4, 2013 9:10 AM ET
John V. Faraci
Thanks Anthony. I'm very glad to be here today and I am because I believe that International Paper is repositioned and well-positioned to increase our cash flow generation from our current business portfolio and use that cash to build shareholder value. Today's conference is a good opportunity to frame up for all of you where International Paper is as we exit 2013, but more importantly, how we are thinking about International Paper as we move into 2014.
I'm pleased with the progress that we have made this year against our primary goals and I'm very confident about how we are positioned for next year's continued success, and those of you who were at our Investor Day in 2012 heard that we had laid out an EBITDA target of reaching $5 billion in the mid-cycle environment. I don't think we can yet say the U.S. economy is at a mid-cycle environment, but the portfolio that we have gives us a lot of upside as we continue to strengthen and improve our North American businesses and at the same time to ramp up the platforms that we've established around the globe.
We're continuing to generate a significant amount of cash and we have made some important decisions to share some of that cash with our shareholders which we'll update you on today. We remain on track to achieve our EBITDA targets and free cash flow goals and we are going to take another meaningful step next year to approach those targets again in an economic environment that we are assuming is not going to be mid-cycle. I hope we are wrong but even in a more of the same economy, I think International Paper is well-positioned to improve on this year's results.
IP is a cash flow story and it's just very simple, and we are at a very different place than we were performing at a higher, more sustainable level. Prior to 2008, free cash flow as shown in this slide was $700 million a year and included about $300 million a year of asset sales from timberland. We sold all that timberland, for those of you who have been following the Company for a number of years. And so if you look over the last five years, we have been generating about $1.8 billion a year without any asset sales because that timber is gone.
So we basically increased the free cash flow capability of the Company by 5x from the portfolio moves we made, which is why I say, as I said at the outset, International Paper is very much repositioned and well-positioned. And we are clearly a step change in our free cash flow and we still have the line of sight on approaching what we laid out at Investor Day, is close to $2 billion of free cash flow. But I think importantly, over the last five years that cash flow has been sustainable. You see the spike up in 2009, that's some of the sales shrink and because of that CapEx to $500 million, we are now still achieving in the $1.8 billion of free cash flow after about $1.5 billion of CapEx a year.
So, we have done what we said we would do. In September, with respect to returning cash to shareowners, on September we increased the dividends the second time since outlining our dividend policy last year. We also obtained an authorization from our Board to buy back $1.5 billion in stock. That program started in early September and as of yesterday we purchased roughly $400 million of stock back plus the 9 million shares at an average price of just under $45. So we are taking advantage of the opportunity to buy back at prices that we think are below the intrinsic value of the Company and we intend to continue to be opportunistic with respect to our share repurchase program.
This slide highlights, turning to dividend, the recent moves we've made with regard to the dividend and the potential for future dividend growth. We have increased the dividend by more than 33% since outlining our plan in mid-2012 from $1.05 at that point to $1.40 for the fourth quarter of this year. At around 30% to 40% of our free cash flow, which is what we said we want to get our dividend to, we have the potential to continue to grow our dividend to $1.60 to $2 given our free cash flow generation. And our approach to dividends has been very clear and we'll be consistent, annual reviews, incremental but meaningful moves and a sustainable dividend.
So how are we going to fuel the free cash flow growth? It's really with continued progress towards achieving that EBITDA goal of $5 billion. We started at $3.7 billion, our third quarter run rate annualized is $4.1 billion, and as I said we don't give guidance but I can tell you we're going to then make another meaningful step towards that $5 billion goal in 2014.
Let me take a minute and just share with you what enables us to do that in more of the same macroeconomic environment. International Paper has lots of levers to pull that are internal to the Company and I think that's what makes International Paper somewhat unique in our industry. We are not just dependent on the macro factors to improve our outlook. Share prices and demand have an impact, but even with demand and prices at levels they're at now, International Paper has got things going on that are going to improve our EBITDA and generate more cash in 2014. Let me just talk about a couple of them.
Repositioning in our North American papers business with the closure of the Courtland mill, this will result in a smaller but stronger business, well-positioned to compete with foreseeable future. We'll have two low-cost commodity mills and two specialty mills and we see, after we take the fixed cost out and get Courtland shutdown, we'll be incurring those costs in the third and fourth quarter of this year and the first and second quarter of next year but as we get to the second half of next year, that will all be behind us.
We continue to see good momentum in 2014 in our Consumer Packaging business. But the real delta there is what's going on in one segment of it, which is our cup stock and cup business. We see some tremendous opportunities, the meaningful ones, as some of our big customers convert from foam to paper, and as we have seen McDonald's has announced they're going to convert from foam to paper in 14,000 locations, Dunkin' Donuts has said they have got under consideration. So, those two alone amount to 80,000 tons of incremental cup stock which happens to be the most profitable grade we make in our coated paperboard mills.
In Brazil, we expect a significant step-up in results in the corrugated packaging business that we own 75% of that we bought earlier this year with Grupo Orsa. And in paper, we are going to benefit from continued margin expansion. The strategy in Brazil is pretty simple. We had almost a 50% share of the Brazilian market, a 30% share of the Latin American market, but we export out of Brazil 50% of what we make. And as Latin America grows, and it's growing at 3% to 4% a year, we sell less volume in places like Europe that have lower margins and more in Latin America or Brazil that have margins that are at least $200 a ton higher. So the strategy has been and continues to be, as the region grows, we sell less product in the offshore markets, maintain our share in the region and there is significant leverage because if you think about $200 a ton and we're exporting 250,000 tons outside the region, that's significant.
In India, it's a small business but we have good improvement opportunities there. Basically as we bring IP's operating know-how and expertise, there's some pretty good assets, they just weren't operated at world-class levels because they didn't have the know-how, didn't have the experience.
And the biggest lever obviously in our portfolio is Industrial Packaging, and that's our corrugated packaging business, and as you see here, over the last several years we have tripled the size of the business in terms of revenues from the $4 billion to $12 billion, but much more important and significant is what's happened to EBITDA and the margins. EBITDA has grown by 6x, from $400 million to close to $2.5 billion. Margins have increased, EBITDA margins, from 9% to 22%. And return on invested capital which is not shown here is solidly in the double-digit level. So we have still got more opportunity in Industrial Packaging as we go from integrating businesses to optimizing.
If you think about this, for the last four years, five years, we have had two major acquisitions, $10 billion of buying Weyerhaeuser packaging business and then Temple. We have been focused on integrating those businesses. We haven't focused on optimizing them yet and now we can turn attention to that, and we think there is probably another $200 million over the next several years that's around optimization that has really nothing to do with demand and nothing to do with price.
And finally in our Russian joint venture, which is the largest joint venture I think in the industry in the world, it's not consolidated, so you don't see it in our cash flow. We are continuing to make progress, we completed the major capital projects that were part of the overall program when we formed the joint venture. In my perspective, that was the biggest risk in forming the joint venture, $1.5 billion of capital projects, close to $1 billion in one facility in Siberia, the biggest project in the industry in that part of Russia in 40 years. That's now behind us. The projects are starting to ramp up.
Next year we will be focused on debt repayment because those projects were financed on the joint venture's balance sheet, not International Paper's. And as we look forward to 2015, I think we can look forward to restoring and increasing the dividend. When we invested in Ilim seven years ago, we invested $650 million, we have taken out $250 million in dividends and there's significant dividend runway ahead of us as we start to pay down the debt associated with those capital projects.
When you think about the Bratsk facility which is in Siberia, it is the largest softwood pulp mill in the world, it's the lowest cost softwood pulp mill in the world delivered to Northern China and China accounts for 80% of the world's incremental pulp demand. So, we think we have got a strong position there.
Let me turn to another chart. I think it is pretty important. We have been talking about absolute performance for the last five or so minutes, I also think it is important to look at relative performance, how are we doing against our major competitors. And let me take a minute to orient this slide, and when we look at margins, we look at them with all the overhead allocated. So there are no corporate charges that are allocated back to the business, and we think we have got pretty good apples-to-apples comparison with our competitors.
Across the top, you have the Industrial Packaging competitors in North America and you are looking at several quarters of EBITDA margin. I think – and then on the bottom left you have Consumer Packaging. So we have got one public company competitor that reports on a segregated basis like we do. And on the right you have got our North American Papers business. And I think the point here is when you look at our EBITDA margins, it's pretty clear that we're outperforming the competition for a variety of reasons, really different in every business but we're outperforming.
So with that said, let's talk about 2014 for a bit. We see the macro environment as more of the same. I just got back from Europe earlier this week and I'm talking to people throughout Europe, I think most of Europe, most of the Eurozone has hit the bottom. Some places are starting to improve faster than others but again it's going to be a choppy slow recovery in Europe, but we think there's going to be a little bit of growth in Eurozone next year but not a lot. We see the U.S. economy improving a little bit but not a lot, so growing well below its potential. And in the rest of the world, the emerging markets are still growing but at a slower rate than they have been growing. So the bottom line, we kind of look at this and say, it feels like more of the same.
So, we all have to deal with the same economy but what makes International Paper different and what gives us the right, as we say, to win? Well, we have got strong leading positions in North America, we have the best margins, we have got a solid global footprint with profitable growth potential, we have got organic growth in the emerging markets, strong free cash flow generation, sustainable with still more runway to grow it further, and I think we have got great people. So that's really the story at International Paper for as we see 2013 and 2014, and I'd be glad to take your questions now.
I was just wondering, with the political pressure with shutting the Courtland mill and the fact that it's particularly new facility, what are the chances that those machines are going to restart?
John V. Faraci
Not high. There is, the Courtland is relatively new but I wouldn't call it a new mill. Courtland was a tough decision to make, 1,100 people in a small town is very difficult to make, but it was the right one for International Paper to make. We're actually going to redeploy a lot of the people of Courtland to other IP facilities. We are not selling the facility. That facility will be closed and eventually dismantled. So that capacity is just going to come out of the system. And it was not our lowest-cost facility. That was a new and large facility, it wasn't our lowest-cost facility.
John, could you comment on your capital structure, are you happy where you are, and I was also wondering about some of the high coupon bonds, what are your plans for those, just let them mature or is there something earlier?
John V. Faraci
We are shooting for a debt-to-EBITDA target of less than 3. We are just about there. So I think from a debt repayment standpoint, we look at – we don't have our debt coming due for the next two or three years, we have got a pretty big tower I think of 2017. At this point in time, we just look at refinancing that. We have looked at buying back some of the debt early. It is pretty expensive to do that given what the prices are. So we don't have to, we are not under any pressure to further deleverage. And so, I would say we're pretty happy from that perspective.
We have got the pension funding to do because even though higher interest rates reduce the accounting gap, the PBO gap, of assets versus liabilities, from a cash funding standpoint you think of our debt repayment over the next two or three years going to pension funding of $400 million plus or minus a year as opposed to debt repayment. We will repay the debt that is coming due or refinance it because we can really carry it to the debt level. With $1 billion plus the debt and with our EBITDA where it is, we can carry that kind of debt level.
Can you help us think of containerboard prices and relationship between virgin fiber based, recycled based and what the pricing is going forward, and I know there's been quite a few price hikes and at what point are you perhaps incentivizing competition here after many years of consolidation and rationalization?
John V. Faraci
So there are two pieces, I think there are two questions you are asking, how the recycled and virgin fiber prices compare and overall for the industry is it profitable to add capacity, and I'll comment on both of those. In today's market where wood costs are, mid-cycle fiber costs are much more advantaged with virgin linerboard, virgin linerboard is at the lower end of the cost curve than the recycle business, and recycle prices today aren't relatively high but virgin is much more advantaged. So that is good for International Paper since 55% of our capacity in North America is virgin based. So if you think about over time, the higher recycle prices go, the better off we are because we have got – because it makes the cost curve steeper. That's the point about recycle versus the virgin.
On today's market, if you just take today's OCC price and you take containerboard prices, that end margin lasts forever. We're seeing that some recycled mill investments look pretty good. But think about that for a minute. China is a huge importer of OCC, it's a 40 million ton box market in China, we're in it. So we know exactly how fast it is growing because we are selling a couple of hundred thousand tons of boxes in China. That market is growing at about 6%. That's 2.4 million tons of incremental OCC every single year. Where is that going to come from? Some is going to come from China as they do more collecting themselves but that's already been through the cycle a couple of times, most of the virgin recycled is going to come from Western Europe and North America. So it's inevitable that over time recycled prices are going to go up. And I think if you would pencil out any kind of investment and put in OCC prices $50 to $75 a ton higher than they are today, what you find is those OCC facilities become fourth quartile mills which again just makes the cost curve steeper in North America.
The other way to think about it too is, if we have 3% GDP growth in the U.S. economy which I think is probably what we should be shooting for, we are not there yet, so lots of reasons why we aren't, but I happen to believe that's what the U.S. economy is going to grow at over the next 10 to 15 years, and that is going to increase box consumption by about 1.5 point which is 300,000 to 500,000 tons a year. So you're going to need some additional capacity. If you pile up all that capacity into a flat box market, you got a different dynamic.
As far as the buyback is concerned, it's great to see you guys spending a lot of money and buying the stock back but at the current rate, if my math is right, you should be through the $1.5 billion authorization in about a year. So with that backdrop, how should we think about your plans to return capital once you are done with the $1.5 billion authorization?
John V. Faraci
We bought the shares with investors today where we were in share buyback program because there was – when we announced, we said it's a two to three year authorization. That didn't mean we are going to take two to three years to do it. It also doesn't mean we're going to finish it in a year. But I think looking at $400 million in the first 90 days would suggest that we've been both consistent and opportunistic and it's very possible we could complete the program within a year. We are going to see how things are going in 2014. We expect to generate a lot of cash. Not all of it is generated in the U.S. So we are paying our dividends out of the U.S., we are paying our interest out of the U.S., and we are buying back shares with U.S. cash flow but we have got a lot of strong cash flow generation in the U.S. with U.S. businesses.
John, maybe just a follow-up on OCC. OCC prices have been maybe a little bit weaker this year than many of us expected. I'm wondering I mean is that just emerging market economy is slower or is it collection rates rising?
John V. Faraci
If you look at the data, what you see is that there has been about close to 1 million tons of incremental OCC consumption in the U.S. and about 1 million tons of OCC export decline. Most of the exports out of the U.S. go to Asia. And it's hard to – we don't have really good data on what's going on with inventories in China but we have to assume that a bunch of that OCC are declines to China, but if the box market in China is growing at 2.5 million tons a year, you're not going to have reductions in OCC exports to China from the U.S. So for this year, that's where the – there is a plus and a minus when you look at the overall data. So that would say demand is basically flat and that's why prices have been basically flat, up and down but fundamentally flat.
And then kind of following up on China, you obviously have a business in China where profitability has been challenged in recent years, and when you think about your focus on earning your cost of capital, how do you think about that Chinese business in the next couple of years?
John V. Faraci
China is our toughest market in terms of making money. We have a big joint venture there in mix coated board and then we have the box business. The box business, we knew this when we bought it, when we bought it, it was operating at about 40% of capacity and [indiscernible] and the strategy is we bought it for less than replacement cost. It's going to take us – if the market is growing at 10% it will take us five years, if the market is growing at 6% it will take us six or seven years to sell off those box plants with profitable boxes and the returns will be okay.
In the much bigger business, the joint venture, we're producing 1.5 million tons of coated paperboard. That business was earning its cost of capital three years ago. But what you have in China is, and this is unique to papers, the same in steel and cement, you have excess capacity of a lot of basic materials, and so that excess capacity gets worked off returns are going to be low. So we are going to be pretty careful about incremental investments in China but we are in the business of long term.
If we conclude long-term that we can't make money, we'll look at other alternatives, but for the time being we have got a well running business, we have got a good partner and we will manage it through, and we have been through these situations before and they disappeared relatively quickly but I don't think we can conclude yet if that's just going to be a repeat going forward.
It looks like the folding box board market in China is growing at about 15%. I mean that's huge. It won't take much time for the excess capacity to get soaked up if that occurs for two or three years, but some of that has been substitution for low-end white line carton boards. So we are not going to make a long-term strategy decision based on 24 months of experience but ask that same question a couple of years from now and I think we'll have a more informed point of view.
In the meantime, we are going to be careful about incremental investments in that market because it is the most competitive one we see in the world. Everybody's there because it's a big market. But just because it's a big market doesn't mean it's profitable. IP doesn't have to be there.
And if you did have an incremental dollar capital to invest between Brazil, Russia, India, on Orsa I think there was an announcement potentially of some capacity additions there, how do you think about those three markets?
John V. Faraci
Let me just wrap up [indiscernible] because we don't have to be there. We are committed to being there at this point in time because we like the strategy, we like the businesses, the two businesses that we have, corrugated boxes and folding box board, we just need to be careful how we think about incremental investments and make sure we have got a line of sight and earning cost of capital returns.
In Brazil, we have got the corrugated packaging business and the paper business. The corrugated packaging business is Orsa which you have just referred to. The box market is growing at 3% to 4% a year. This is a great example. Without a lot of capital, this company is just full of opportunities because they didn't know what it could look like. They had three paper mills and six box plants and International Paper is all around the world. So there were whole trees full of low hanging fruit and it's not capital related. It's automation, it's debottlenecking. So we can grow with the market without making major investments in the business. It will be investments in box capacity, debottlenecking paper mills that are decent mills but can run much better. So we are excited about that.
I had a question on just your cash balances. So help me think through what the optimal levels are going forward, then also maybe just a sense for what's in the U.S. versus offshore and kind of how you think about that equation over time?
John V. Faraci
We need $500 million to $1 billion, kind of that range to operate. And then I can't tell you really off the top of my head how much cash we need U.S. versus offshore but we are not in a position where we are tight on cash in the U.S. or looking to repatriate cash because again our three big businesses in North America, corrugated packaging, printing papers and coated paperboard, they are all strongly cash positive. In fact we'd say we're generating more cash in the U.S. than we are outside the U.S., but we are generating a lot of cash in Brazil and a lot in Europe. So when you look at our overall cash balances which I think right now are plus $2 billion, it's not all sitting in the U.S. but we are in pretty good shape.
When you talk to your customers from time to time, green initiatives, reducing packaging, waste of packaging and stuff like that, is that a topic that is frequent, something you think about at all and how is that…?
John V. Faraci
Absolutely and it's not something that's new, it's something that's been around for a while. I'd say the tone, the word is not tone, the emphasis has gone over the last decade from recycling to sustainability. Now in all of that is, our customers are expecting us in packaging, whether it's the consumer packaging or corrugated packaging, to help them come up with innovations to use less packaging. I haven't met a customer in a while that says coming out I have to use more packaging. But they do want packaging that's going to protect the product because the risk of having a product barrier because the package is inadequate is high because the package cost isn't significant relative to the product that's in it.
So we see things like lightweight have been going on for a long time. Innovation in our business is how do we help our customers reducing these per packaging, how do we simplify SKUs, redesign packages. A great example, relatively small but second-largest seafood processing company [indiscernible] Seafoods in the country, we can't put away to substitute paper for styrofoam when they are shipping seafood to their customers. So there exactly we simplify the packaging by creating bigger use for board because we are substituting for styrofoam because of the way they don't want to use paper, pack it nice and it still works.
So we are at that innovation sustainability with our customers all the time and I think IP is not the only company that's got a good footprint on storage sustainability because I think the whole industry does. We haven't talked about that enough, we are probably the greenest of the industries out there since we have 70% of our energy comes from biomass, 100% of our raw material comes from renewable resources, but we are big users of water, fiber and energy and those are always at the intersection of better ways of thinking about around the world and how do we have more forests, how do we have clean water and how do we use less energy.
John, maybe just one last question. Could you update us on timeframe for xpedx and any thoughts there?
John V. Faraci
I really can't other than to say that we still believe that the transaction is possible. Bain approached us about a year ago. We knew it was going to take a lot of time to get this done given that we were basically taking, if we completed, two non-public companies and creating one public company out of them. First what we had to do is get audited financial statements which we have. I think that we have those. So we are having ongoing discussions with Bain about a whole myriad of issues and I think we are making some progress but we are not at the finish line, there is no guarantee that the transaction happens.
Bain approached us. So it's not a transaction IP has to do. We will do it if it's attractive to us and we think it's the right thing for the Company and our shareowners, and we think it could be, but we are not at a point yet where we can say that we have actually got a deal that we are going forward with. And once we make that announcement, if we get to that point, then there is a timeframe of registration statements filing with the SEC which is going to take several months.
Anthony Pettinari – Citigroup
Maybe one last question back there.
I think you just reported that Cyber Monday sales were up 18% year-over-year. Interested to get your thoughts on the online impact of your business?
John V. Faraci
The online impact, I think we're going to say they were down 18%. So the Black Friday was good and the Cyber Monday was weak but the online segment of the business is very strong. We have got our corrugated packaging business, we serve some of the big online shippers in a big way and their business is growing at 20%, 25% per year. It's still not a huge – it's a very visible consumption of corrugated because it arrives on your doorstep every single day. In and of itself, it's not a big user but if it continues to grow at 20% to 25% a year going forward, it's going to be a big segment and we are very well positioned in it and we see that strength of online sales in our shipments.
Anthony Pettinari – Citigroup
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