A Paper Tiger With Real Teeth? Bullish Article Moves Shares In International Paper

Jul. 1.14 | About: International Paper (IP)

Summary

Barron's bullish article on International Paper seems to have ignited a rally in its shares.

International Paper has transformed itself over the last decade into an industrial packaging leader while shedding non-core assets. This transformation is now paying off with strong cash returns.

International Paper is undervalued by at least 20% and pays a growing and sustainable dividend.

Barron's has written a very bullish article on International Paper (NYSE:IP) speculating that International Paper is ramping up payouts and stock buybacks. Shares could rise 40% and the stock offers a 2.9% dividend. The story provides the following quotes,

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

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

Barron's opines that "International Paper is stronger-and far more profitable-than it was when Faraci took the top spot. Its best days could be yet to come. "

Cash Return

Since Free cash seems to be the basis of the story here let us take a look. My favorite cash yield-based metrics is Cash Return. This metric is capital structure agnostic. We can calculate cash return by adding free cash flow (cash from operations minus capital expenditures) to net interest expense (interest expense minus interest income), and then dividing the sum by enterprise value (market cap plus long-term debt, minus cash). We add back interest expense to free cash flow so that capital structure doesn't impact cash return. Therefore, Cash Return = (Free Cash Flow + Net Interest Expense) / (Enterprise Value).

Fiscal Period

Interest Expense

Free Cash Flow

Enterprise Value

cash return %

$ Million

%

Dec-99

-541

589

34846

3.24%

Dec-00

-816

1078

36371

5.21%

Dec-01

-929

665

32911

4.84%

Dec-02

-783

1085

30263

6.17%

Dec-03

-766

656

35687

3.98%

Dec-04

-743

1060

34027

5.30%

Dec-05

-593

355

27260

3.48%

Dec-06

-521

1223

21326

8.18%

Dec-07

-297

1887

19806

11.03%

Dec-08

-492

2669

16207

19.50%

Dec-09

-702

4121

18971

25.42%

Dec-10

-608

856

20877

7.01%

Dec-11

-541

1516

19189

10.72%

Dec-12

-672

1584

26695

8.45%

Dec-13

-589

1830

29616

8.17%

TTM/current

-506

1875

29508

8.07%

Click to enlarge

So Barron's article checks out. IP Cash Return at around 8% is much healthier than in the past.

Balance Sheet

However let us look at the total debt IP is carrying since it is in a notoriously cyclical and capital intensive business and debt can really kill a company like this in a downturn.

IP's long term debt at around $9 Billion seems to be in line with the past. However I think it would be wise for IP to reduce debt further rather than buy back shares using its free cash flow to prepare for the inevitable downturn.

The next chart lays out the income metrics - Net Income, Earnings Before Interest, Taxes and Depreciation and Amortization (EBTDA) and Earnings before Interest and Taxes (EBIT). As we can see given the capital intensive nature of IP's business its depreciation and amortization charges are quite high. The company's large debt load makes its susceptible to interest rates. An increase in interest rates will bring down its income rapidly.

The next chart shows that cash flow from operations are really healthy. Interest is covered over 5 times, so there is low risk of bankruptcy. It also shows that IP has been selling assets (reduction in Plants, Property and Equipment).

Dividends

IP's current dividend yield is 2.75%. In the Barron's article IP's CEO mentions that it plans to pay a sustainable dividend of $1.80 to $2 a share in future years. Based on current prices this works out to a yield of between 3.6% to 4%. Based on the chart below on free cash flow and earnings per share, this assertion seems to be reasonable.

Click to enlarge

(Source: Gurufocus).

Valuation

Wall Street analysts seem to be quite bullish on the company and are projecting EPS growth of 26% and 16% in 2014 and 2015, respectively.

Source: Morningstar.com

Assuming EPS of $4.55 in 2015 and cost of capital (discount rate) of 8% and a sustainable EPS growth rate of 8% for five years and 4% subsequently I'm arriving at a valuation of around $60 in 2015. This is assuming all goes well and the company continues to fire on all cylinders and the economy continues to improved.

Click to enlarge

(Source: Gurufocus.com DCF Calculator)

Based on historical median Price to Book and Price to Sales ratios IP does seem to be a little over-valued at this time. However median P/B and P/S ratios may not be applicable as the company has significantly changed over time due to divestitures and acquisitions.

Conclusion

My analysis supports the thesis that IP is undervalued by around 20% and supports a stock price of between $60 to $65. I don't think IP is undervalued by 40% as Barron's asserts. The generous dividend is a nice bonus. The company has transformed itself over the last decade, shedding under-performing assets (like timberlands) and building scale in container boards where it has become the largest manufacturer in the world. The management team headed by CEO John Faraci is seasoned and impressive. The company is highly leveraged to improvements in the economy and negatively leveraged to interest rates due to high debt and fixed costs. Overall I rate IP a sold buy and will be adding to my existing position.

Disclosure: The author is long IP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.